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Supply Chain complexity and profit & loss (P&L): An attempt to understand the true cost of complexity

Supply Chain

publication date 4 / 07 / 2017

In June, KEDGE BS launched a cycle of breakfast debates : KEDGE Insights breakfasts.
The first one was dedicated to Supply Chain and was presented by Mozart Menezes, Senior KEDGE Professor in Supply Chain Management, Director of the Supply Chain & Complexity Management Lab, together with an ISLI graduate who is Group Sourcing & Supply Chain Director for Recommerce Solution and who was previously Care Supply Chain Director at Orange.

Measuring and Managing Supply Chain Complexity

Using the words of Mariotti , former CEO of Rubbermaid, “Companies all over the world are struggling with a crisis... They are starting to realize that this crisis \--- the Complexity crisis \--- is crippling them, destroying their profits, and draining their resources… In the quest for high growth in low/no-growth markets, companies have proliferated nearly every-thing: products, customers, markets, suppliers, facilities, locations, etc. Some of the time, the proliferation actually does lead to top-line revenue growth, but as the top line goes up, the bottom line actually goes down dramatically…”.
Current accounting practices allocate support-functions (fix-) costs in ways that do not satisfy executives. A recent report by McKinsey  shows that only 28% of them believe current accounting practices provide transparency on the true cost of services and only 21% consider that current practices facilitate meaningful dialogue on cost control. Moreover, only 15% hold that cost allocation drives correct behavior towards using centralized services.

A major problem with the current practices is that they do not allocate costs according to the complexity brought up by products and services; on the contrary, they allocate costs based on revenues, which implies that products with low sales will bear very little of the S&GA and other indirect costs while those same products may be the ones contributing the most to increase complexity.
The resulting dynamics induces practices that increase product proliferation and gives no incentives for retiring old non-profitable products and services that add very little to the bottom line. On the other hand, there are high incentives for generating new products because the link between the top line (revenue) and diversity of products is easy to establish.

Out of control complexity is constantly blamed for negatively affecting the performance of supply chains, increasing the amount of inventory write-offs, decreasing the amount of net profits per employee, increasing the cost of sales, and decreasing return on assets.
The Supply Chain & Complexity Management Lab (sc2m lab), at Kedge Business School-Bordeaux, is involved in a wide crusade for taming complexity. The sc2m lab focuses its efforts to addressing this pressing issue on how to measure and subsequently explore, in the best way, the inherent complexity of firms’ supply chains.
The study proposed is lightly invasive requiring easily disguised data, which is beneficial for protecting sensitive information.  Moreover, data collection is relatively easy. Indeed, this investigator could collect the whole set of data in a single afternoon from a firm in the fashion industry. The idea is to map supply chains’ processes (at higher level without operational details) and quantify the complexity in each step of the process. Following, we will link the complexity to operational performance metrics to understand the effects of changes on drivers of complexity and their impact on the bottom line, to eventually develop mechanisms for controlling complexity, then calibrate understanding and systems’ reactions. First results show a strong link between complexity and financial performance.

The picture above does not tell everything though. The reason for the incomplete conclusion is that fixed-cost allocations are done using some variation of an ABC cost accounting scheme. Of course, those costs need to be allocated, but it does not mean that the allocation scheme chosen is adequate. Thus, we revisit the issue but with the following old trick: we sort all business units by gross margins (or total sales) and then compute the cumulative pre-tax profit as more units are added – see the figure below as an illustrative example. In the figure, the 10th unit’s profit adds to the previous 9 units’ profits.
The yellow points are drawn using the ABC cost accounting scheme and it resembles very much the allocation by sales (or volume) in this case. The blue points, on the other hand, allocate costs using the complexity index (size of points is proportional to complexity of each business unit). It is easy to see that some of the ‘stars’ business units do not look as ‘stars’ anymore when another fix-cost allocation scheme is used. Moreover, the results suggest that pre-tax profits could improve by nearly 50% with a better choice of business units to keep open. Of course, we are not suggesting that some business units should be closed; the conclusion is that there is a lot to understand when evaluating business units’ performances

The study with the manufacturer is now diving deep into replicating the analysis at SKU level. A similar curve is obtained when analyzing the profitability of each SKU. We find curves such as the one below: one can look beyond the projections of pre-tax profit based on gross profit, to observe the real impact of complexity on firms’ results. Have you ever wonder where al the profits projected went?

Why all those analyses at the beginning of the year never match the end of the year results? If you are asking yourself these questions, you are not alone. The lab is working with a selected group of firms exploring how complexity eats profits through inefficiencies; and in particular those that are difficult to allocate to any particular product. They appear because there are too many SKUs, markets, and channels. We must better understand the complexity issue so we can make smarter and more informed choices.

Are you ready to jump onboard?

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