Somewhere in each of the last five books I have written is the phrase, "What gets measured gets rewarded and what gets rewarded gets done." What this means to achieving competitive advantage in the supply chain is the topic of this column, so let's start with an example.
Company C is in the clothing business. Although proud of their new product development efforts and how well this function is coordinated with marketing to develop and market products that are customer driven, an analysis of Company C's inventory revealed that $19 million in inventory -- half the overall value of inventory Company C carried -- was obsolete. Storage had to be provided for $19 million worth of clothes that the company knew no one was going to ever buy.
When you consider the cost of money tied up in this obsolete inventory, the cost of storage (i.e., providing a warehouse to hold the inventory), and the cost of risk (after all, there is an annual premium to be paid on the insurance policy that protects this inventory from damage or theft), you have to ask yourself, "Why would Company C keep this inventory around?"
The answer is Company C executives were paid to do the wrong thing. Upper management compensation (bonus) was partially based upon the end result of the income statement -- i.e., earnings. Thus, this part of compensation should have motivated Company C management to get rid of the inactive inventory -- selling the same amount of products (the sales, or top line, of the income statement) without the cost of carrying the inactive inventory (which would substantially reduce the general selling and ddministrative lines on the income statement) would significantly increase earnings.
However, the other part of the compensation plan for upper management was the impact of their decisions on the retained earnings line on the balance sheet -- generally a good idea since increasing retained earnings is increasing shareholder value, which is one of the primary jobs of upper management.
Since inventory shows up on the balance sheet as an asset, a $19 million decrease in inventory has to balance somewhere on the balance sheet. Since this was obsolete inventory, management estimated Company C would only receive $1 million in proceeds from "selling off" the obsolete inventory -- proceeds that would be placed in cash. The impact of this decision is an $18 million decrease in assets, which has to be balanced by an $18 million decrease in retained earnings -- a drop from $21 million to $3 million, or a drop of 86%!
Clearly, management will not want to take any action that reduces shareholder value so substantially. But let's look at this from another point of view. Shareholder value is already that low. The original balance sheet looks better, but is actually inaccurate because we are showing inventory worth $38,000,000, when in fact half the inventory is composed of obsolete product that is only really worth its market value of $1 million. By keeping the obsolete inventory in stock, we are not only negatively impacting the income statement, we are also artificially inflating the balance sheet.
At its most simple, performance metrics should address the three key business statements -- the Income Statement, the Balance Sheet, and the Cash Flow statement. The first tells us how much money we are making and how much we are keeping after all the bills are paid. The second tells us where the money we got to keep is being invested. And the third tells us the rate at which money flows in and out (and if we are going to run out.)
More importantly, though, we need Key Performance Indicators (KPIs) that tell us if we are making ourselves easy to do business with and whether we are letting tactics overshadow strategies. Companies that are able to create value for their customers by satisfying their needs and wants generally increase their market share and their profitability. Thus, an important part of any business, and certainly of any supply chain, is making it easy for customers to do business with us. Therefore, KPIs that measure delivery performance, customer satisfaction and what our customers truly value are critical to competitive advantage.
Finally, letting attention to short-term tactics overshadow the accomplishment of long-term strategies (the Company C example) can hurt the profitability and competitive viability of a company or a supply chain as a whole. Setting and meeting quarterly KPIs is no more important than setting and meeting the long-term KPIs of the supply chain. These long-term KPIs include the types of relationships to have with various supply chain partners to achieve long term profitability and competitive advantage.
In closing, if you pay your people to do the wrong things, do not be surprised if that is exactly what they do. Develop KPIs that measure sales and costs (with the resultant measure of earnings); assets and liabilities; cash flow; critical operations; and customer service, but do not forget that these measures tend to be short term (quarterly or yearly) metrics. Also develop metrics that assess your progress toward long term supply chain goals that drive competitive advantage. Finally, compensate your people for achieving these balanced KPIs.
John T. Mentzer holds the Bruce Excellence Chair of Business and is the Executive Director of Integrated Value Chain Forums. He can be reached at [email protected] For over 50 years, University of Tennessee (UT) faculty have played amajor role in the supply chain/logistics arena -- conducting innovative research, publishing leading-edge findings, writing industry-standard textbooks, and creating benchmarks for successful corporate supply chain management. Programming is top-ranked in Supply Chain Management Review, U.S. News & World Report, and Journal of Business Logistics. Certification is available. http://SupplyChain.utk.edu