The Hierarchy of Supply Chain Metrics
Measurement is the cornerstone of operational success. But for many managers, measuring supply chain performance is difficult because there are so many metrics available and so little guidance on how best to use them. New research points to a three-tiered hierarchy that enables managers to cut through this maze of metrics. Under this approach, managers quickly assess overall supply chain health at the top tier, diagnose problems at the mid tier, and identify corrective actions at the ground level.
By Debra Hofman -- Supply Chain Management Review, 9/1/2004
The shift to the demand-driven environment of the 21st century places new pressures—and increasing importance—on companies’ supply chain capabilities. The next generation of supply chain management is what AMR Research refers to as the demand-driven supply network—that is, a system of technologies and processes that senses and responds to real-time demand signals across a network of customers, suppliers, and employees.
The pressure to be demand-driven changes the rules of the game. Traditionally, supply chain decisions have been based primarily on capacity and constraints, but increasingly supply chains must give customers what they want when they want it. In short, the supply chain has to be not only lean and efficient but also responsive and dynamic. It’s not an easy combination to deliver, yet it’s more necessary than ever.
New benchmarking studies from AMR Research highlight the importance of excelling in the key capabilities of supply chain management. Our research shows that good demand forecasting yields tangible benefits in operational performance. Across industries, companies that forecast demand more accurately have 15 percent less inventory, 17 percent better “perfect order” ratings, and 35 percent shorter cash-to-cash cycle times than their peers. (The term perfect order refers to an order that is complete, accurate, on time, and in perfect condition.)
Even more interesting is the relationship between supply chain capabilities and key financial and market indicators. While there are clearly many factors that affect bottom-line financial performance, preliminary findings from our consumer products sector study reveal that companies that do a superior job of fulfilling customers’ needs—as evidenced by the perfect order—tend to have higher earnings per share (EPS), better return on assets (ROA), and heftier profit margins. Specifically, our data demonstrate that:
- An improvement of 10 percentage points in a perfect- order rating correlates with 50 cents better earnings per share. That may not sound like much, but on 1 million shares outstanding, it adds up to half a million dollars.
- Companies with better perfect-order ratings also tend to have better ROA. A gain of five percentage points in the perfect-order rating correlates with 2.5 percent better ROA. Again, it may sound minor, but on $1 billion in assets, it translates to $25 million.
- Better perfect-order performance also ties to higher profit margins. An increase of three percentage points in perfect-order performance adds 1 percent to profit margins. For a $1 billion company with a 10 percent profit margin, that increase would mean $10 million added to the bottom line.
The Challenge of Measuring Right
The first step toward achieving these kinds of superior performance levels is to know where your company stands today and why it is there. The only way to do that is to measure. Performance measurement is critical to achieving excellence and providing a solid platform on which to build superior supply chain capabilities. Of course, measuring supply chain performance is not a new practice. Most companies today measure at least some aspect of their supply chains, and they understand the need for a more comprehensive measurement program. So why is it so challenging? There are myriad causes, but AMR Research has identified the two most prominent.
First, there are simply too many possible measures. One of the major challenges is to figure out which metrics will yield the most benefit and information for the least investment of resources. The problem is not a lack of possible metrics but an overwhelming abundance of choices.
Second, what AMR Research calls “enablers” — the application technologies and best practices that enable performance — add to the complexity of the measurement task. Traditionally, companies have only measured operational performance indicators, such as cycle times and inventory levels, and not enablers. Benchmarking these enablers, however, is critical to having actionable information by going beyond the question of how are we doing to why do we do what we do. Why are we at our current performance levels? What impact are our technologies and best practices having on our performance? How is what the best-in-class companies do different from what we do?
The key is to focus on the few metrics that really matter—those that provide the most balanced view of end-to-end supply chain performance, which allow companies to see clearly how they’re doing and why, and where they’re making trade-offs. (For more on the secret of balance, see the sidebar below). Before identifying the few key metrics on which to focus, however, it’s important to understand how they all inter-relate. The metrics reflect the underlying realities of the supply chain they measure, and as such, none exist in a vacuum—although that’s often how they’re treated. Sample companies A and B in Exhibit 1 illustrate the following interdependencies that we often see in our benchmarking studies.
- Trading off high inventories for good order quality: Compared to its peer companies, company A has high inventories, long cash-to-cash cycle time, good order quality (as evidenced by the perfect order metric), and low demand forecast accuracy (DFA), which is the difference between forecasted and actual demand. (The Key Metrics Defined sidebar below gives more information on key metric definitions.) What’s going on? Low DFA indicates that company A has poor visibility into demand. But the company still wants to be able to give its customers what they want when they want it. So it makes extra finished goods, keeping an inventory buffer to avoid stockouts. High inventories, in turn, drive a longer end-to-end cash cycle time but enable good perfect-order performance. Company A is willing to pay the price of high inventory-holding costs so it can always respond to customers quickly.
- Sacrificing customer responsiveness for low costs: Company B, on the other hand, has low inventories, short cash-to-cash cycle time, poor order quality, and low DFA. The company is clearly more focused on maintaining margins than on customer responsiveness. It, too, has low DFA, but it’s keeping inventories lean and cash cycle times short. The result: high stockouts, leading to poor perfect-order performance. The trade-off: Company B chooses to sacrifice customer responsiveness for a strong cost structure.
Note the pattern here: Demand visibility affects inventories, cash cycle times, and perfect-order fulfillment. While there are clearly more interdependencies and scenarios, this pattern of interaction holds in every company, albeit with different specifics.
Demand Visibility and Perfect Order
The problems at both company A and company B are driven by poor demand visibility. Analysis of our benchmark data supports the example; across industries, better demand visibility is directly correlated with better perfect-order fulfillment (see Exhibit 2). The better your demand visibility, the better your perfect-order rating. As Exhibit 2 shows, there’s a 2:1 relationship between the two; a one-point improvement in your demand forecast accuracy can get you a two-point improvement in your perfect-order score. Of course, companies can make up for poor demand visibility by throwing money at the problem—for example, keeping buffer inventory on hand. At best, poor demand visibility forces companies to make trade-offs between cost and customer responsiveness; at worst, it drives poor performance on both cost and responsiveness.
- Sharing forecasts and replenishment plans with customers.
- Sharing forecasts and replenishment plans with suppliers.
- Sharing forecasts and replenishment plans with logistics providers.
- Having a formal sales and operations planning (S&OP) process.
The top performers are increasing the flow of information through their network of trading partners—from their customers, through their own companies, and out to their suppliers and logistics providers. Through this flow, all parties have visibility into demand signals as early as possible.
Another critical metric is the perfect order, because it gauges how well a company delivers what its customers want when they want it. This measure is especially valuable because it’s the end result of a company’s operations; problems in any area of the business will eventually find their way into the perfect-order metric. Dissecting the components of an imperfect order—that is, each of the conditions that prevent a perfect order—allows a company to trace the trail of supply chain gaps and imperfections back to their source and then correct it. (The metric definitions sidebar lists some of these gaps and imperfections.)
Creating a Hierarchy of Metrics
There are clearly many important metrics, but it’s also clear that they’re not all equal, nor do they stand independently of each other. Which are the ones that matter? And what should you do with them once you have them?
AMR Research has developed what we call our Hierarchy of Supply Chain Metrics to bring order to the chaos. Designed to facilitate systematic and efficient performance management, the hierarchy is a three-tiered framework that gives managers a progressively more granular view of their performance.
Each of the three levels of the hierarchy, shown in Exhibit 3, serves a different purpose and is aimed at a different goal. The topmost “50,000-foot” level allows an executive to assess, with just three metrics, the overall health of the supply chain and the high-level trade-offs a company might be making. The next level of detail—call it the 25,000-foot view—uses a composite cash flow metric to provide an initial diagnostic tool. And the third level uses a variety of metrics that support effective root-cause analysis and allow highly efficient and precise corrective action. Let’s look at each in detail.
Top Tier: Assess. At the highest level are three key metrics: DFA, perfect-order fulfillment, and supply chain management (SCM) total cost. DFA sits at the top because it’s a driver, as noted earlier: When it’s good, the perfect-order score tends to be high, and when it’s bad, order fulfillment capability suffers. Together, DFA and the perfect order quickly reveal how responsive a supply chain is.
Of course, responsiveness by itself does not guarantee a healthy supply chain. Companies have gone out of business while being responsive because they lost sight of costs. Therefore, to get a comprehensive and balanced view of the overall health of a supply chain, it is essential to include a look at cost. Most companies make a trade-off between customer responsiveness (as captured in their perfect-order fulfillment rating) and costs.
Mid Tier: Diagnose. The next level looks at cash-to-cash cycle time. This critical metric not only allows a company to see how well it’s managing cash flow but also facilitates analysis of the components that tell what’s happening deeper in the supply chain. The cash-to-cash metric is a composite that includes customer and supplier payment times and total inventories. It lets managers see whether there’s balance between the time it takes to pay suppliers and the time it takes customers to pay.This metric also indicates whether the inventory metric, which can contribute to high cost and/or a low perfect order, deserves further analysis. High inventories might be a result of excess in raw materials (RM), work-in-process (WIP), or finished goods (FG). Each of these components is a symptom of a different underlying problem.
Only after looking at the four metrics in the hierarchy’s top two tiers does it make sense to dive into more detailed metrics to look for ways to correct any problems uncovered at the top. Instead of attempting to wade through the chaos of 50 or 100 metrics at the start, the hierarchy allows you to begin with just four and use what is uncovered there to guide your path through the remaining metrics.
Ground Level: Correct. Analyzing the detailed metrics at the ground level reveals the root causes of high inventories, high costs, or poor customer responsiveness. Once the cause is identified, managers can design and implement the interventions that will correct it with the most efficient use of resources.
In our benchmarking studies, AMR Research has a portfolio of approximately 45 operational metrics, some of which are listed in Exhibit 3. Metrics at the ground level include supplier effectiveness indicators. These indicators include the percentage of supplier receipts that passed quality and on-time standards as well as the raw material inventory, purchasing operating costs, and direct material costs that interact with and are often affected by supplier performance. Other ground-level metrics include those that indicate a company’s level of operational effectiveness. Among these are order cycle time, production schedule variance, plant utilization, work-in-process and finished goods inventories, supply chain management (SCM) cost details, and details about the perfect-order fulfillment total.
The Hierarchy in Practice
Consider the example of ConsumerCo, a $1-billion manufacturer of household products. ConsumerCo’s business strategy is to be a lower-cost provider than its competitors while keeping product quality on par with the market. An examination of its supply chain metrics reveals that its performance accurately reflects this business strategy (see Exhibit 4). However, the company has some specific opportunities to shore up its external relationships—with suppliers, logistics providers, and customers—in very targeted ways. By doing so, ConsumerCo can continue to keep costs down while improving its customer responsiveness. To accomplish this, it is helpful to look at each of the tiers in greater detail.
Assess: Trading customer responsiveness for costLooking at ConsumerCo’s top tier, you can see its DFA and Perfect Order rating are both low and its SCM total costs are good. Consistent with its strategy, this company is focused on reining in costs but is doing so at the expense of customer responsiveness.
Diagnose: A cash management opportunity
At the mid tier, ConsumerCo’s overall cash cycle time is slightly longer than the average but not worrisome. However, the component metrics are interesting.
- High inventories—Total inventories are on the high side, which is something to investigate further at the ground level of the hierarchy. This information also tells us that the problem with the perfect order may not be a lack of inventory. Rather, ConsumerCo might have the wrong inventory or lack visibility into its inventory.
- Cash management opportunities—ConsumerCo pays its suppliers in 25 days on average (days payable outstanding or DPO), but its customers take an average of 43 days to pay— an immediate opportunity to improve cash flow. In addition, the long days sales outstanding (DSO) might be related to poor perfect-order performance, reflecting customer dissatisfaction with order quality.
Correct: Trading partner opportunities
At the ground level, deeper root-cause analysis uncovers specific supplier, logistics provider, and customer areas that need corrective action.
- Supplier relationships—ConsumerCo has raw-material inventories that are 20 percent higher than average. At the same time, the supplier on-time rating (the rate at which suppliers meet on-time commitments of raw material) is 5 percent lower than the average, a likely contributor to having higher raw-material inventory to serve as a buffer. An examination of supplier-related costs reveals high procurement operating costs and on-par direct material costs. In a nutshell, ConsumerCo is paying its suppliers well and, as exposed in the cash-to-cash metric, is paying them relatively quickly. However, it is not receiving the service levels it requires from its suppliers.
- Logistics provider relationships—Looking at the components of the perfect order uncover one potential source of the low perfect-order rating. ConsumerCo’s delivery delays and damage in transit are each 5 percent higher than average. As both of these metrics relate to a transportation theme, we can look at the related cost details. Consistent with its low total SCM costs, ConsumerCo’s transportation costs are very good, at 4 percent below the average. One possibility is that it might be paying its logistics providers so far below industry standards that service levels suffer. ConsumerCo should reconsider pricing and service-level agreements with its logistics providers.
- Customer relationships—Corrective action that improves the perfect order might also help improve customer payment times, thus improving overall cash cycle time. In addition to revealing logistics-related issues,ConsumerCo’s perfect-order detail also shows higher-than-average stockouts. In other words, although the company has a lot of inventory, it’s the wrong inventory. That fact ties directly back to its poor demand visibility. ConsumerCo has an opportunity to segment its customers and collaborate more closely with key customers to improve demand visibility, thus reducing costs and improving service at the same time. Using the hierarchy provides a focused means to assess, diagnose, and correct a company’s supply chain health. It enables efficient root-cause analysis by clearly highlighting the problem areas and their interdependencies, providing a way to trace any issue to its source through an increasingly granular focus.
Seven Steps to Success
While it’s widely understood that measurement is key to excellence, companies face significant challenges when designing and implementing an effective measurement program. Here are seven recommendations for how to start tackling these challenges:
1. Follow four, universal principles to design an effective metrics portfolio. Many companies struggle when designing their own metrics portfolio. The specific characteristics of your business will determine to some extent the particular metrics that make sense for your organization. At the same time, however, there are some universal guidelines:
- Keep it balanced. Make sure the portfolio is well-balanced among the dimensions of cost/efficiency, service/quality, time, and effectiveness. At a minimum, a metrics portfolio must include demand forecast accuracy, the perfect order, supply chain costs, and cash-to-cash cycle time.
- Work from the outside in. Add ground-level or more detailed metrics from the outside in. In other words, identify what you’re trying to accomplish, and then add metrics that mesh with your goals, business model, and strategy.
- Focus on the outcome. Don’t try to measure every aspect of a process; focus on and measure the outcome of a process.
- Beware of the “mushroom effect.” It’s a fine line between too many metrics and too few metrics, and the portfolio has a tendency to grow. Use the 80/20 rule to aim for the least number of metrics that will give you the most information for the least investment of resources.
2. Proactively address organizational resistance. In many companies, there is plenty of resistance to measurement. It is particularly acute for an internal performance-management group that is embarking on a cross-divisional measurement project. As with other types of change management, it’s important to expect resistance and attempt to avert it in advance. Pay attention to the culture of your organization. Is it measurement-friendly? Is there a history of measuring and using the measures for improvement? If not, you will need to have a change-management component to your program that actively seeks senior-management support. It’s important to communicate clearly what will be done with the metrics and to emphasize their use for continuous improvement rather than solely for evaluation of individual or departmental performance.
3. Beware of tunnel vision. While everyone agrees that no metric exists in a vacuum, there is still a tendency to focus on individual metrics such as inventory. It’s essential to understand how the metrics interplay in your organization and to step back and use the numbers to tell the whole supply chain story by taking into account all the interactions and interdependencies.
4. Analyze the root causes. It’s impossible to overstate the importance of analyzing the root cause of whatever gaps you find in your supply chain performance. That may sound obvious, but it’s surprising how many companies skip this step and try to go straight to a solution, often borrowing from generalized advice about “what best-in-class companies do.” Understanding the unique reasons behind your gaps is critical to your ability to design the right solution.
Take the case of high inventories. First, you need to know whether it’s raw-materials, work-in-process, or finished-goods inventories that are high. Then you need to know why. High finished-goods inventories, for example, could be the result of poor demand visibility (you’re not making the right products or the right amounts) or poor inventory visibility (you’re making the right products, but you can’t see what you have during the commitment process). Each requires a different solution. If the problem is poor demand visibility, the solution includes practices and technologies that help with the demand side of the equation, such as demand-forecasting software and increased collaboration with key customers. If the problem is poor inventory visibility, the solution might include order- promising software and available-to-promise capabilities.
There are many other possible causes and solutions for poor supply chain performance. The point is, understanding the root cause of your particular performance gaps at a particular point in time—and the root cause will be different at different times—is critical to designing and implementing effective solutions.
5. Use a top-down approach to analysis. Order matters. That point is too easily overlooked. Using the top-down approach as outlined in the Hierarchy of Supply Chain Metrics allows you to focus your efforts and be more efficient in how you analyze your results. This approach makes the process less painful and allows you to do it more often.
6. Measure enablers. Operational metrics should be supplemented by measures of how much a company uses enablers such as best practices and application technologies. It’s critical to have a solid understanding of where you stand compared to your peers with regard to those enablers as they are important levers to help adjust performance.
7. Measure in the context of a performance-management program. Implement a comprehensive, ongoing performance-management program—not just a one-time measurement exercise. A comprehensive program includes portfolio design, data collection, data analysis, solution design, and solution implementation. Many companies measure key performance indicators, but the results sit on a shelf collecting dust. It’s vital to measure at regular intervals (for example, annually) so you can continually track the impact of any adjustments you’ve made or any changes in your environment and better manage them. It’s particularly useful to baseline your performance prior to a major market or organizational change to get a clear picture of the change’s effect on performance.
In an increasingly competitive, complex, and demand-driven environment, superior supply chain capabilities are critical to success. Continual diagnosis of your supply chain health is key to achieving and sustaining supply chain superiority. By using a structured approach, such as the Hierarchy of Supply Chain Metrics, managers can quickly apply continuous and effective performance measurement, analyze root causes of problems, and navigate the path to excellence.
The Secret of Balance While superior perfect-order performance is good, excelling at both cost and service is even better. The companies in AMR Research’s benchmarking studies that maintain a balance between excellence in both supply chain management costs and perfect-order performance have, on average, 60 percent better profit margins, 65 percent better earnings per share, and two to three times the return on assets compared to their industry peers. How do they do it? How can you excel at both cost and service? It turns out that the companies that are best in overall cost or service are not best in every component of cost or service. In each component, they’re close to, or slightly above, their industry median. But it adds up to best overall because most companies are uneven in their performance; they might be best in one component but worst in another. What the best companies do is relentlessly measure their performance against the industry at the component level and figure out exactly how much less than perfect at each component they can afford to be and still be best overall. They’re constantly working the levers of their performance, aiming to be consistently good in all the details, so they can excel at the total. For each component, they’re not the best and they’re not the worst; they’re consistently good.
Perfect Order
An order that is complete, accurate, on time, and in perfect condition.The conditions that prevent a perfect order include:
Stockout/manufacturing delay.
Late shipment.
In-transit/delivery delays.
Order not meeting customer requirements due to:
Inaccurate shipment.
Poor quality of finished goods.
Damage to finished goods in transit. Demand Forecast Accuracy
The difference between forecasted and actual demand. Specifically, this is the inverse of the mean absolute percent error (sometimes referred to as MAPE). Cash-to-Cash Cycle Time
A composite of the following metrics.
Ship to customer delivery: Time taken from shipment of finished goods to delivery at cutomer’s address.
Raw material receipt to payment: Time from receipt of raw materials to payment, also called days payables outstanding (DPO).
Inventory days: Average days of inventory on hand.
Days sales outstanding (DSO): Measurement of the average collection period from invoicing to cash receipt. SCM Costs
Total supply chain management operating costs, made up of the following components: * Direct purchasing operating cost.
* Manufacturing operating cost.
* Transportation cost.
* Warehouse/DC operating cost.
* Inventory holding cost.
* Customer service operating cost. Source: AMR Benchmark Analytix
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