FLOW Before Cost

I attended a SAPICS webinar with Carol Ptak yesterday and this prompted me to burst into print on this topic of Flow vs. Cost.

The conclusion I have come to is that the conflict is a result of misaligned focus that has become a deep truth over the past 80 odd years since the inception of GAAP (Generally Accepted Accounting Practices). GAAP helps govern the world of accounting according to general rules and guidelines. It attempts to standardize and regulate the definitions, assumptions, and methods used in accounting across all industries.

Over the years, we have become fixated on Net profit and 2 of it’s components, variable and fixed costs.

Net Profit calculation

Organizational performance measures focus on these 2 areas and are then broken down to departmental level to the extent that staff have developed an inward focus on cost control in order to meet KPI’s. Unfortunately, this inward focus results in wasted effort focusing on areas that negatively impact on flow through the business. An example is pushing product into production to achieve recoveries when these products aren’t required by the market. The focus to drive unit cost down forces each individual department to optimise without consultation with others in the value chain. The unintended consequences are that false constraints pop up everywhere and everyone becomes a firefighter. Huge effort is expended in non-value adding activities building frustration and resentment between the departments in the value chain, cementing the Silo effect.

Inventory reduction programs become a procurement target and as such, the focus remains on incoming materials. This exacerbates the overall problem in that we end up with stock imbalances because of the global nature of supply chains. Supplier lead times mostly exceed 3 months, whereas Customer tolerance times are measure in days. Replenishment orders are placed against a forecast, whereas the production scheduler is trying to replenish stock based on actual demand. The mis-alignment between the lead times leads to materials being consumed in production activities they weren’t forecast for. Warehouses end up with too little stock of some SKUs, too much stock of other SKUs and over all too much stock.

Industry and Operations Management has forgotten that there is another step in the financial equation that looks at return on investment.

ROI Equation

Bringing Inventory into the equation at the correct level will direct your focus from cost reduction to FLOW. Remember, we aren’t ignoring cost, we are changing our focus in away that optimises cost by focusing on FLOW. In other words, FLOW protects cost, but cost doesn’t protect flow.

To evaluate your current position, using the production example above, we will see that pushing manufacturing orders into production increases the level of work in progress (WIP) which will directly affect your customer service levels. Little’s law clearly shows how the amount of inventory within a system directly impacts on the delivery lead time of that system.     (Lead time = Throughput x WIP)

Little's Law

You can use this equation to do some quick analysis of your operation at a global or local level, the results will surprise you. Run scenarios to see if your WIP levels support your Customer Service target (lead time commitment to customer), or what inventory level is required to achieve the desired service level.

Why should we change? Changes in the market over the last 40 years have resulted in an increase in complexity to supply chains. Globalization has resulted in competition exploding at all levels in every industry. The result as mentioned earlier is that Asia has become the source of supply for most industries, hence the long lead times. At the same time, Customer demand has increased because of consumer access to information via the internet. These days, if the consumer doesn’t get what they are looking for in shop a, they go directly to shop b. This need for instant gratification flows upstream through the Supply Chain to the manufacturers and all the links in between. So, no matter what industry you are in, as long as you have a supply chain you need to protect flow to keep your customers happy.

What do we change to? Before you make any changes, you need to know where you want to be. In other words, your strategy needs to be clear in order to guide you to your goal. Most companies have clear goals and targets. By knowing where you want to be, you will be able to plot your path towards the goal and create a strategy and action plan to get there.

How to implement the change? The change starts with clear communication to all the members of your value chain so that everyone is has the same understanding of the changes and what is required of them. Secondly, make your metrics relevant to the new strategy so that you can measure your progress from the start. The equations above provide an organizational measure, and this needs to be broken down to the individual departments, always checking backwards for relevance. A good test is to ask members at different levels of the organizational structure to explain how their measures tie in to the overall measure. If they can articulate this, they understand it. If not, retrain.

How to optimise Return on Investment(ROI). FLOW protects cost and in order to stimulate flow we need to change from a push methodology to one of pull. Focusing on Customer demand as the trigger, you pull production through the process to satisfy the customer order in the case of make to order (MTO), or to replenish your stock buffer in the case of make to stock (MTS). This trigger moves upstream from buffer to buffer, until an order is placed on the Supplier to replenish the first buffer. The buffer positions exist in every organization, they just aren’t used as buffers. The buffers act as shock absorbers between the decoupled lead times, making them independent of each other and reducing the overall lead time to customer. The lead time now becomes the delivery time from the last buffer to the customer, instead of the full manufacturing lead time, or even worse, the cumulative lead time. These decoupled lead times make variability much easier to manage, so the flow of information upstream and product downstream is protected, ensuring the shortest possible lead time. This automatically optimises unit cost from both fixed and variable perspectives and at the same time optimises customer service.

Another major advantage of the demand driven methodology is that because replenishment orders are dependent on customer demand, the inventory ordered becomes more relevant to the market which in turn allows us to reduce inventory significantly and still meet stringent customer requirements. The result is a significant increase in your return on investment.

In conclusion, you can continue to focus inward at cost, but this isn’t going to make you agile and responsive to the increased demand and could ultimately cost you your business. Covid-19 has created a major shift in global supply chains and consumer patterns, and to remain competitive we need to change our business models.

Should you have any questions or comments, please raise them in the comments section or email to dave@sacoaching.co.za. You can also call me on +27 82 777 0922.

About the author

Dave Hudson is a supply chain and operations specialist and executive coach with over 30 years’ experience, and currently 1 of 5 endorsed Demand Driven instructors on the African continent.

 

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