Drive Quality, Cost, and Delivery for a Happier 2012

Happy New Year to all. May 2012 be a year of health and prosperity to you and yours. May it also be a year of health and prosperity for our businesses.

As has been the case in the past few years, we like to reflect on the past year and provide a business theme for the coming year.

As we end 2011 and begin 2012, we note a few observations and news items form the past month that have shaped how we are looking at the new year:

As we were doing our holiday shopping we noticed that every single store, except The Apple Store, advertised discounts across the board. We were seeing a few such signs in early December when we were reading about the retailers being optimistic about the holiday season. Also the stores were open all kinds of hours opening at 6 am and closing at midnight. Retailers were aggressively vying for consumer traffic and dollars. They also wanted to move as much of their inventory as possible before the holiday and thus not have to discount it even more.

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Supply Chain and Finance: Part 2 - Costing Methods

Let us continue with more financial based definitions for inventory.

There are five ways that Finance can value the inventory. Most companies choose a method and rarely change. The methods ar:

• First in, First Out (FIFO)
• Last in, First Out (LIFO)
• Average Costing (also called Moving Average)
• Standard Costing
• Order Specific Costing

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Finance and the Supply Chain

There is a relationship between Finance and the Supply Chain in almost any company. The Supply Chain has a majority of the assets of the company and is responsible for managing the lions share of the costs. The assets include factories, warehouses, and all the equipment and machines used in this facilities. The costs include the Cost of Goods Sold, labor, conversion costs, transportation, and distribution costs. When we add to all of this the value of the inventory being held, it is easy to see why Finance focuses on the Supply Chain.

It is the role of the Supply Chain to effectively and continuously manage the above mentioned assets and costs to help deliver the profit goals of the company. It is the role of Finance to ensure that exactly this happens. Finance accomplishes this by a mixture of partnering with and policing the Supply Chain. Finance prepares reports, briefs senior management, and oversees audits both internal and external to ensure that the company is being properly managed financially.

We have seen and experienced situations where Finance and the Supply Chain form a team and work together to achieve the company objectives. We have seen other companies where the relationship is more adversarial and Finance basically plays the role of a policeman. This often has to do with the culture of the organization and the personalities of the two executives leading the functions. It is in the power of the President or CEO of the business to nurture either partnership or adversity between Finance and the Supply Chain. There are CEOs that believe a little adversity, butting of heads, is good and the resulting course of action is more optimal for the vigorous debating.

Either way, it is imperative for the Supply Chain to understand exactly how finance views and calculates inventory. Let us look at few financial definitions regarding inventory management. While it might seem odd when first reading this, it is true. The Supply Chain does not have full control over the inventory as reported. When it comes to reporting, the Finance reports are what senior management and Wall Street tend to look at. Therefore, it is imperative for Supply Chain personnel to fully understand some basic Finance definitions.

There are two ways of recording and reporting inventory:  Perpetual and Periodic.

Perpetual:  This is the real time reporting, the day to day, hour to hour, reporting of what is on-hand in terms of Raw, Pack, WIP, Finished Goods, E&O, and what is in transit in each of these categories. Because of the sophistication of ERP systems, we can look at perpetual inventory levels in total, by part, and category any time we wish from any PC in the company. This inventory, these records and transactions, is what Supply Chain personnel deal with all the time. It is the inventory that is tangible and real. You can go out to the factory or warehouse floor and see this inventory.

Periodic:  As the name suggests, this is the periodic reporting of inventory. This is more the space Finance controls. The most common periods are months, quarters, and fiscal years. This is less about transaction records and much more about reporting. The periodic reports are the official reports of the company. They are based on the perpetual inventory at a set close point e.g. 11:59 pm of the last day of the month. If this was all Periodic inventory was about, there would be no difference between what the Supply Chain sees and manages and what Finance reports. This is rarely the case. Finance takes this base data and makes adjustments and accruals. They add and subtract dollars, not units, to inventory accounts  to fund or account for things such as scrapping obsolete goods, returns, warranty related transactions, in transits at the end of the period, and a variety of other bookkeeping details. This does impact the inventory levels positively or negatively depending on the nature of the adjustments.  Supply Chain personnel need to know exactly how since these final numbers are what the inventory objectives of the company are set on.

Many companies use the term Consolidated instead of Periodic.  Finance takes the Perpetual view at the end of a Period and “consolidates” all of the reserves, accruals, and other adjustments.  We prefer the term Consolidated to Periodic.

The Supply Chain lives in the Perpetual world.  Yet, the Supply Chain is measured against Consolidated objectives. Therefore, it is imperative that the Supply Chain be bilingual. We must know what we can control which is the Perpetual inventory. But, we must know what happens in month end Consolidations. The Supply Chain leaders need to know exactly what is consolidated at month end to better manage the Perpetual. They must also know how and why reserves, accruals, and adjustments are made and why. If a policy is flawed or will have a long term negative impact on operations, we can better advocate for a more balanced policy. Finance and General Management can and do use inventory as a cistern, sometimes, for costs that are in a gray zone from a Supply Chain perspective. The business decision may supersede Supply Chain logic, but at least we know what is being done and why. At least, we can make a good knowledgeable case for the Supply Chain point of view.

Enron - Ten Years Later

Has it really been ten years?

Apparently yes.

Ten years ago on December 2, 2001, Enron shocked the world and filed for bankruptcy.

It was an incredible story on many levels.  The company came into being in 1985 with the merger of Internorth and Houston Natural Gas.  It was renamed and rebranded as Enron.  CEO Ken Lay, COO Jeff Skilling, and CFO Jeff Fastow became the darlings of Wall Street and the business press as they took the company to astronomical heights.  At one point, the company was ranked #7 on the Fortune 500, employed over 20,000 employees, and had revenues over $110 billion.

In the end, this trio of Lay, Skilling, and Fastow, became infamous as their gross mis-management and criminal acts came to light. It became clear that Enron was a house of cards and a sham.  It all toppled down in very short order. Thousands of their employees were left with nothing. Just a few years earlier, these same employees thought they had it made simply because of the success of the company and the growing strength of the stock price. It is a very sad story in the history of American business.

We never really understood what Enron did. Sure, we read about their leasing and brokering model in natural gas and electricity. It did not seem that magical and that compelling to us. We did not understand the basis for this business model to create the amount of buzz and revenues the company was generating. Maybe it made sense in natural gas and then electricity to some degree. But, when they began to move into broadband and talked about doing the same with water they truly lost us. It made no sense. We did not understand what they did and how they made so much money doing it.

Were we just that smart? In retrospect, possibly. But at the time it was a resounding NO! We actually felt stupid. Why stupid? Clearly, Enron was a raging success. Everyone believed that Enron had created a new business and business model. There are stories of Skilling basically calling analysts and others that questioned the Enron model as morons. While we were never at such meetings, we just assumed there was something we were missing. Thus, we were among the moronic and stupid that Skilling talked about and berated.

We were smart in one regard.  Because we did not understand, we did not invest in the company. We would have certainly felt really dumb had we invested and lost capital.

We are management consultants. We operate in the Supply Chain parts of the business. Critical to our ability to help clients cost effectively improve their planning, inventory management, and customer service is to first and foremost have as deep an understanding as to what they do and how they operate. We need to do this as quickly and effectively as we possibly can. If we do not understand our clients’ businesses, there is very little chance we can help them. If we do not understand their business, provide valuable assistance, and act with integrity, we would not have any clients.

In reflecting on Enron ten years later, there are two age old and related lessons to keep top of our minds.

1. If your first reaction to any business deal or investment opportunity is that it sounds too good to be true, it probably is. Therefore, be very cautious about getting involved.


2. The following is attributed to Albert Einstein, though it is not confirmed, and we paraphrase anyway:  If you cannot explain what you are doing to a five year old, you yourself do not have a good grasp of what you are doing… or might be hiding the real nature of your business.  The parts after the ellipsis is ours.

The Value of an SKU?

Very recently we got a phone call from an old colleague who works for a home decor company. He was about to go into a meeting with the executive committee where he was going to propose an SKU management process. He was trying to justify the need and wanted to pick our brains specifically on determining the total cost of carrying an SKU. He said that he had done an internet search on the subject and came up with nothing.

We were glad he called us. We live for questions just like this.

We offered him the following. Most people that look at SKU management look at the contribution to sales. They evaluate eliminating the lowest contributors. The decision is easier if there are other offerings of the same product to absorb the revenue that is being cut. Not moving on SKU management because of not having the exact costs is just an excuse not to manage, i.e. reduce, SKUs. 

It is not an easy question.  

This problem is the same as trying to find the profit by SKU. This is something that consumer products companies have struggled with for years. It is easy to track revenues by SKU. That comes right off of the invoices.  The hard part is to apportion the cost properly. This can be done but it is not an exact science. The best we can do is approximate the costs. The easiest way is to use the percentage of sales to whatever cost base one chooses to use. This will provide as good as an estimate as one could get in short order. Getting an exact measure would require a very sophisticated accounting system and probably not worth the cost of tracking and maintaining the data to that level of granularity.

If we are to use Percent of Sales by SKU to evaluate SKU costs, why not just use Percent of Sales?

We had another colleague that ran the supply chain of a $1B Latin American subsidiary of a consumer products company. He had a very simple rule for which SKUs ought to be deep sixed. He simply said, “If we sell less than a pallet of an SKU per month, it is not worth keeping. It should be cut.” It was a brilliant and visual rule. It resonated with Sales, General Management, and certainly in the Supply Chain. Even marketing folks, who are always the most reluctant to cut SKUs, could not really argue with this very simple logic. On a sales volume of $1B, everyone understood that an SKU that sold such a paltry amount had to be absorbing more cost per unit than other products. Simply changing over in the factory, several months of supply run, and the inventory carrying costs probably made the costs of such an SKU disproportionate.

SKU management need not be complicated. It can and should follow some pretty simple and clear guidelines. It can be accomodated via spreadsheets or a tool such as DemandCaster which incudes an SKU rationilization component. We have found that this either is something that resonates with the executive team or not. If it does not resonate, they will ask for numbers and justifications they know cannot be obtained.

What are your experiences in this area?

Can you determine the cost of maintaining a single SKU?

What are your rules of thumb for putting an SKUs on the consider to cut list?