chap 3.pdf

CHAPTER 3 MEASURING LOGISTICS COSTS AND PERFORMANCE Dr.Faiza HAMDI 1. Logistics and the bottom line 2. Logistics and shareholder value 3. Logistics cost analysis 4. The concept of total cost analysis 5. Principles of logistics costing 6. Customer proftability analysis 7. Direct product proftability 8. Cost drivers and activity-based costing Dr. Faiza HAMDI 2 The costs of satisfying customer demand can be significant and yet, surprisingly, they are not always fully understood by organizations. One reason for this is that traditional accounting systems tend to be focused around understanding product costs rather than customer costs. Whilst logistics costs will vary by company and by industry, across the economy as a whole the total cost of logistics as a proportion of gross domestic product is estimated to be close to 10 per cent in the USA and in other countries costs of similar magnitudes will be encountered. However, logistics activity does not just generate cost, it also generates revenue through the provision of availability thus it is important to understand the profit impact of logistics and supply chain decisions. At the same time logistics activity requires resources in the form of fixed capital and working capital and so there are financial issues to be considered when supply chain strategies are devised. Dr. Faiza HAMDI 3 Logistics and the bottom line In turbulent business environment, ‘The bottom line’ has become the driving force which, perhaps erroneously, determines the direction of the company. In some cases this has led to a limiting, and potentially dangerous, focus on the short term. Hence we find that investment in brands, in R&D and in capacity may well be curtailed (reduced) if there is no prospect of an immediate payback. Just as powerful an influence on decision making and management horizons is cash flow. Strong positive cash flow has become as much a desired goal of management as profit. The third financial dimension to decision making is resource utilization and specifically the use of fixed and working capital. The pressure in most organizations is to improve the productivity of capital – ‘to make the assets sweat’. In this regard it is usual to utilize the concept of return on investment (ROI). Return on investment is the ratio between the net profit and the capital that was employed to produce that profit, thus: Dr. Faiza HAMDI 4 . It will be seen that ROI is the product of two ratios: the first, profit/sales, being commonly referred to as the margin and the second, sales/capital employed, termed capital turnover or asset turn. Thus to gain improvement on ROI one or other, or both, of these ratios must increase. The ways in which logistics management can impact on ROI are many and varied Figure 3.2 highlights the major elements determining ROI and the potential for improvement through more effective logistics management. Dr. Faiza HAMDI 5 Logistics impact on ROI Dr. Faiza HAMDI Capital employed, also known as funds employed, is the total amount of capital used for the acquisition of profts by a frm or project 6 Logistics and the balance sheet As well as its impact on operating income (revenue less costs) logistics can affect the balance sheet of the business in a number of ways. In today’s financially challenging business environment improving the shape of the balance sheet through better use of assets and resources has become a priority. Once again better logistics management has the power to transform performance in this crucial area. Figure 3.3 summarizes the major elements of the balance sheet and links to each of the relevant logistics management components. By examining each element of the balance sheet in turn it will be seen how logistics variables can influence its final shape. Dr. Faiza HAMDI 7 . - Dr. Faiza HAMDI 8 Cash and receivables This component of current assets is crucial to the liquidity of the business. In recent years its importance has been recognized as more companies become squeezed for cash. It is not always recognized, however, that logistics variables have a direct impact on this part of the balance sheet. For example, the shorter the order cycle time, from when the customer places the order to when the goods are delivered, the sooner the invoice can be issued. Likewise the order completion rate can afect the cash fow if the invoice is not issued until after all the goods are dispatched. One of Dr. Faiza HAMDI 9 Inventories Fifty per cent or more of a company’s current assets will often be tied up in inventory. Logistics is concerned with all inventory within the business from raw materials, sub-assembly or bought-in components, through work-in-progress to finished goods. The company’s policies on inventory levels and stock locations will clearly influence the size of total inventory. Also influential will be the extent to which inventory levels are monitored and managed, and beyond that the extent to which strategies are in operation that minimize the need for inventory. Dr. Faiza HAMDI 10 Property, plant and equipment The logistics system of any business will usually be a heavy user of fixed assets. The plant, depots and warehouses that form the logistics network, if valued realistically on a replacement basis, will represent a substantial part of total capacity employed (assuming that they are owned rather than rented or leased). Materials handling equipment, vehicles and other equipment involved in storage and transport can also add considerably to the total sum of fixed assets. Many companies have outsourced the physical distribution of their products partly to move assets off their balance sheet. Warehouses, for example, with their associated storage and handling equipment represent a sizeable investment and the question should be asked: ‘Is this the most effective way to deploy our assets?’ Dr. Faiza HAMDI 11 Current liabilities The current liabilities of the business are debts that must be paid in cash within a specifed period of time. From the logistics point of view the key elements are accounts payable for bought-in materials, components, etc. This is an area where a greater integration of purchasing with operations management can yield dividends. The traditional concepts of economic order quantities can often lead to excessive levels of raw materials inventory as those quantities may not refect actual manufacturing or distribution requirements. The phasing of supplies to match the total logistics requirements of the system can be achieved through the twin techniques of materials requirement planning (MRP) and distribution requirements planning Dr. Faiza HAMDI 12 Debt/equity Whilst the balance between debt and equity has many ramifcations for the fnancial management of the total business, it is worth refecting on the impact of alternative logistics strategies. More companies are leasing plant facilities and equipment and thus converting a fxed asset into a continuing expense. The growing use of ‘third-party’ suppliers for warehousing and transport instead of owning and managing these facilities in-house is a parallel development. These changes obviously afect the funding requirements of the business. They may also afect the means whereby that funding is achieved, Dr. Faiza HAMDIi.e. through debt rather than equity. 13 Logistics and shareholder value One of the key measures of corporate performance today is shareholder value. In other words, what is the company worth to its owners? Increasingly senior management within the business is being driven by the goal of enhancing shareholder value. There are a number of complex issues involved in actually calculating shareholder value but at its simplest it is determined by the net present value of future cash flows. These cash flows may themselves be defined as: Dr. Faiza HAMDI 14 economic value added (EVA) More recently there has been a further development in that the concept of economic value added (EVA) has become widely used and linked to the creation of shareholder value. The term EVA originated with the consulting frm Stern Stewart,2 although its origins go back to the economist Alfred Marshall who, over 100 years ago, developed the concept of ‘economic income’. Essentially EVA is the difference between operating income after taxes less the true cost of capital employed to generate those profits. Dr. Faiza HAMDI 15 . It will be apparent that it is possible for a company to generate a negative EVA. In other words, the cost of capital employed is greater than the profit after tax. The impact of a negative EVA, particularly if sustained over a period of time, is to erode shareholder value. Equally improvements in EVA will lead to an enhancement of shareholder value. If the net present value of expected future EVAs were to be calculated this would generate a measure of wealth known as market value added (MVA), which is a true measure of what the business is worth to its shareholders. A simple definition of MVA is: Dr. Faiza HAMDI 16 Market value added MVA = Net present value of expected . future EVA Clearly, it will be recognized that there are a number of signifcant connections between logistics performance and shareholder value. Not only the impact that logistics service can have upon net operating income (proft) but also the impact on capital efciency (asset turn). Many companies have come to realize the efect that lengthy pipelines and highly capital-intensive logistics facilities can have on EVA and hence shareholder value. As a result they have focused on fnding ways in which pipelines can Dr. Faiza HAMDI 17 The drivers of shareholder value The five basic drivers of enhanced shareholder value are shown in Figure 3.4. They are revenue growth, operating cost reduction, fixed capital efficiency, working capital efficiency and tax minimization. All five of these drivers are directly and indirectly affected by logistics management and supply chain strategy. Dr. Faiza HAMDI 18 Revenue growth The critical linkage here is the impact that logistics service can have on sales volume and customer retention. Whilst it is not generally possible to calculate the exact correlation between service and sales there have been many studies that have indicated a positive causality. It can also be argued that superior logistics service (in terms of reliability and responsiveness) can strengthen the likelihood that customers will remain loyal to a supplier. Dr. Faiza HAMDI 19 Operating cost reduction The potential for operating cost reduction through logistics and supply chain management is considerable. Because a large proportion of costs in a typical business are driven by logistics decisions and the quality of supply chain relationships, it is not surprising that in the search for enhanced margins many companies are taking a new look at the way they manage the supply chain. It is not just the transportation, storage, handling and order processing costs within the business that need to be considered. Rather a total pipeline view of costs on a true ‘end-to-end’ basis should be taken. Often the upstream logistics costs can represent a signifcant Dr. Faiza HAMDI 20 proportion of total supply chain costs embedded in the fnal product. Fixed capital efficiency Logistics by its very nature tends to be fixed asset ‘intensive’. Trucks, distribution centres and automated handling systems involve considerable investment and, consequently, will often depress return on investment. In conventional multi-echelon distribution systems, it is not unusual to find factory warehouses, regional distribution centres and local depots, all of which represent significant fixed investment. One of the main drivers behind the growth of the third-party logistics service sector has been the desire to reduce fixed asset investment. At the same time the trend to lease rather than buy has accelerated. Decisions to rationalize distribution networks and production facilities are increasingly being driven by the realization that the true cost of financing that capital investment is sometimes greater than the return it generates. Dr. Faiza HAMDI 21 Working capital efficiency Supply chain strategy and logistics management are fundamentally linked to the working capital requirement within the business. Long pipelines by definition generate more inventory; order fill and invoice accuracy directly impact accounts receivable and procurement policies also affect cash flow. Working capital requirements can be dramatically reduced through time compression in the pipeline and subsequently reduced order-to-cash cycle times. Dr. Faiza HAMDI 22 Working capital efficiency Surprisingly few companies know the true length of the pipeline for the products they sell. The ‘cash-to-cash’ cycle time (i.e. the elapsed time from procurement of materials/components through to sale of the fnished product) can be six months or longer in many manufacturing industries. By focusing on eliminating non-value-adding time in the supply chain, dramatic reduction in working capital can be achieved. So many companies have lived with low inventory turns for so long that they assume that it is a feature of their industry and that nothing can be done. They are also possibly not motivated to give working capital reduction Dr. Faiza HAMDI 23 Tax minimization increasingly global economy, organizations have choices as to where they can locate their assets and activities. Because tax regimes are diferent country by country, location decisions can have an important impact on after-tax free cash fow. It is not just corporate taxes on profts that are afected, but also property tax and excise duty on fuel. Customs regulations, tarifs and quotas become further considerations, as do rules and regulation on transfer pricing. For large global companies with production facilities in many diferent countries and with dispersed distribution centres and multiple markets, supply chain decisions can signifcantly afect the total tax bill Dr. Faiza HAMDI and hence shareholder value. 24 The role of cash flow in creating shareholder value There is general agreement with the view of Warren Bufet that ultimately the value of a business to its owners is determined by the net present value of the free cash fow occurring from its operations over its lifetime. Thus the challenge 1 time to an acceleration of cash fows because risk and managers adjustments reduce seeking to enhance shareholder value is to identify strategies that the can value directlyof later cash fows; or indirectly afect free cash fow. Srivastava et al. have suggested that 2 cash fows (e.g. higher revenues thean increase in the level of value of and/or lower any strategy is inherently driven by: costs, working capital and fxed investment); 3 a reduction in risk associated with cash fows (e.g. through reduction in both volatility and vulnerability of future cash fows) and hence, indirectly, the frm’s cost of capital; and 4 the residual value of the business (long-term value can be enhanced, for Dr. Faiza HAMDI 25 example, by increasing the size of the customer base). Logistics cost analysis - Because logistics management is a flow-oriented concept with the objective of integrating resources across a pipeline which extends from suppliers to final customers, it is desirable to have a means whereby costs and performance of that pipeline flow can be assessed. - Probably one of the main reasons why the adoption of an integrated approach to logistics and distribution management has proved so difficult for many companies is the lack of appropriate cost information. - The need to manage the total distribution activity as a complete system, having regard for the effects of decisions taken in one cost area upon other cost areas, has implications for the cost accounting systems of the organization. - Generally the effects of trade-offs are assessed in two ways: from the point of view of their impact on total costs and their impact on sales revenue. Dr. Faiza HAMDI 26 The concept of total cost analysis - Figure 3.6 outlines the various cost elements involved in the complete order processing cycle, each of these elements having a fxed and variable cost component which will lead to a diferent total cost for any one particular order. Dr. Faiza HAMDI 27 A further feature of logistics decisions that contributes to the complexity . of generating appropriate cost information is that they are usually taken against a background of an existing system. The purpose of total cost analysis in this context is to identify the change in costs brought about by these decisions. Cost must therefore be viewed in incremental terms – the change in total costs caused by the change to the system. Thus the addition of an extra warehouse to the distribution network will bring about cost changes in transport, inventory investment and communications. It is the incremental cost diference between the two options that is the relevant accounting information for decision making in this case. Figure 3.7 shows how total logistics costs can be infuenced by the addition, or removal, of a depot from the system. Dr. Faiza HAMDI 28 The cost of holding inventory There are a number of costs to be included. The largest cost element will normally be the cost of capital. The cost of capital comprises the cost to the company of debt and the cost of equity. It is usual to use the weighted cost of capital to refect this. Hence, even though the cost of borrowed money might be low, the expectation of shareholders as to the return they are looking for from the equity investment could be high. Dr. Faiza HAMDI 29 Principles of logistics costing -One of the basic principles of logistics costing, it has been argued, is that the system should mirror the materials flow, i.e. it should be capable of identifying the costs that result from providing customer service in the marketplace. A second principle is that it should be capable of enabling separate cost and revenue analyses to be made by customer type and by market segment or distribution channel. This latter requirement emerges because of the dangers inherent in dealing solely with averages, e.g. the average cost per delivery, since they can often conceal substantial variations either side of the mean. we must first define the desired outputs of the logistics system and then seek to identify the costs associated with providing those outputs. Dr. Faiza HAMDI 30 A useful concept here is the idea of ‘mission’. In the context of logistics and supply chain management, a mission is a set of customer service goals to be achieved by the system within a specifc product/market context. Missions can be defned in terms of the type of market served, by which products and within what constraints of service and cost. A mission by its very nature cuts across traditional company lines. Figure 3.8 illustrates the concept and demonstrates the diference between an ‘output’ orientation based upon missions and the ‘input’ orientation based upon functions. Dr. Faiza HAMDI 31 The successful achievement of defined mission goals involves inputs from a large number of functional areas and activity centers within the firm. Thus an effective costing system must seek to determine the total systems cost of meeting desired mission objectives (the ‘output’ of the system) and the costs of the various inputs involved in meeting these outputs. Dr. Faiza HAMDI 32 Figure 3.9 illustrates how three supply chain missions may make a diferential impact upon activity center/functional area costs and, in so doing, provide a logical basis for costing within the company. As a cost or budgeting method, mission costing is the reverse of traditional techniques: under this scheme a functional budget is determined now by the demands of the missions it serves. Thus in Figure 3.9 the cost per mission is identifed horizontally and from this the functional budgets may be determined by summing vertically. Dr. :Faiza HAMDI 33 Customer proftability analysis There are many costs that need to be identifed if customer proftability is to be accurately measured. The best measure of customer proftability is to ask the question: ‘What costs would I avoid and what revenues would I lose if I lost this customer?’ This is the concept of ‘avoidable’ costs and incremental revenue. Using this principle helps circumvent the problems that arise when fxed costs are allocated against individual customers. Dr. Faiza HAMDI 34 Dr. Faiza HAMDI 35 Dr. Faiza HAMDI 36 Customer proftability analysis: a basic model Dr. Faiza HAMDI 37 Customer proftability matrix Figure 3.12 represents a simple categorisation of customers along two dimensions: their total net sales value during the period and their cost-to-serve. Dr. Faiza HAMDI 38 Build These customers are relatively cheap to service but their net sales value is low. Can volume be increased without a proportionate increase in the costs of service? Can our sales team be directed to seek to infuence these customers’ purchases towards a more proftable sales mix? Danger zone These customers should be looked at very carefully. Is there any medium- to long-term prospect either of improving net sales value or of reducing the costs of Dr. Faiza HAMDI 39 Cost engineer These customers could be more proftable if the costs of servicing them could be reduced. Is there any scope for increasing drop sizes? Can deliveries be consolidated? If new accounts in the same geographic area were developed would it make delivery more economic? Is there a cheaper way of gathering orders from these customers, e.g. the Internet? Protect The high net sales value customers who are relatively cheap to service are worth their weight in gold. The strategy for these customers should be to seek relationships which make the customer less likely to want to look for alternative suppliers. At the same time we should constantly seek opportunities to develop the volume of business that we do with them whilst strict control of costs. 40 Dr. keeping Faiza HAMDI Direct product proftability An application of logistics cost analysis that has gained widespread acceptance, particularly in the retail industry, is a technique known as direct product proftability – or more simply ‘DPP’. In essence it is somewhat analogous to customer proftability analysis in that it attempts to identify all the costs that attach to a product or an order as it moves through the distribution channel. The idea behind DPP is that in many transactions the customer will incur costs other than the immediate purchase price of the product. Often this is termed the total cost of ownership. Sometimes these costs will be hidden and often they can be substantial – certainly big enough to reduce or even eliminate net proft on a particular item. Dr. Faiza HAMDI 41 Direct product proftability For the supplier it is important to understand DPP in as much as his/her ability to be a low-cost supplier is clearly infuenced by the costs that are incurred as that product moves through their logistics system. Similarly, as distributors and retailers are now very much more conscious of an item’s DPP, it is to the advantage of the supplier equally to understand the cost drivers that impact upon DPP so as to seek to infuence it favorably. Table 3.3 describes the steps to be followed in moving from a crude gross margin measure to a more precise DPP. Dr. Faiza HAMDI 42 Dr. Faiza HAMDI 43 Cost drivers and activity-based costing There are four stages in the implementation of an efective mission costing process: 1 Define the cnustonmer ser vicne setmeint The basic principle all customers share the characteristics should be treated diferently. is same that service because requirements not and they 2 Ideintify the facntonr s that pr onducne var iationins iin the cnonst onf ser vicne This step involves the determination of the service elements that will directly or indirectly impact upon the costs of service, e.g. the product mix, the delivery characteristics such as drop size and frequency or incidence Dr.of Faiza HAMDI 44 3 Ideintify the specnifcn r esonur cnes used ton supponr t cnustonmer setmeints This is the point at which the principles of activity-based costing and mission costing coincide. The basic tenet of ABC is that the activities that generate cost should be defned and the specifc cost drivers involved identifed. These may be the number of lines on an order, the people involved, the inventory support or the delivery frequency. 4 Attr ibute acntivity cnonsts by cnustonmer type onr setmeint Using the principle of ‘avoidability’ the incremental costs incurred Dr. Faiza HAMDI through 45 The basic purpose of logistics cost analysis is to provide managers with reliable information that will enable a better allocation of resources to be achieved. Given that the purpose of logistics and supply chain management, as we have observed, ultimately is concerned to meet customer service requirements in the most cost efective way, then it is essential that those responsible have the most accurate and meaningful data possible. Dr. Faiza HAMDI 46

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