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 does this mean to achieving competitive advantage in the supply chain? Lets start with an example.
This company is in the clothing business. Although proud of its 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 the companys inventory revealed that $19 million in inventory half the overall value of inventory the company carried was obsolete. Storage had to be provided for $19 million worth of clothes that the company knew no one was ever going to 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 the company keep this inventory around?
The answer is that company executives were paid to do the wrong thing. Upper management compensation (also known as a bonus) was partially based upon the end result of the income statement i.e., earnings. Thus, this part of compensation should have motivated 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 Administrative 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 increases 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 the company would receive only $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 lets 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 million, 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, but we are also artificially inflating the balance sheet.
Key Performance Metrics
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 have 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).
Parcel delivery companies, in particular, should emphasize these statements to their clients. By more efficiently delivering client packages, we can decrease the operating cost lines of the Income Statement. By providing better delivery quality, we can increase the top line (sales) of the Income Statement. Both increase profitability for the client. By taking over and operating logistics assets for clients, we improve the capital structure of the client company, which improves the Balance Sheet and capital leverage. Finally, by more rapidly delivering client packages, we decrease the cash-to-cash cycle (the time between paying vendors and receiving payment from customers) and thus, improve the Cash Flow Statement.
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 parcel delivery as a part 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 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.
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, Ph.D. is a Distinguished Professor of Business in the Department of Marketing and Logistics at the University of Tennessee. He can be reached at 865-974-1652 or jmentzer@utk.edu.
