Finance and Supply Chains compatibility
Over the years, there have been articles written that promote the ‘leading role of Finance in the Sales & Operations Planning (S&OP) process and more generally, the integration of Supply Chains and Finance data in real-time, to provide ‘instant’ visibility for a business. This is supposed to “accelerate the decision-making process and enhance the organisation’s resilience”. While it sounds good, should it happen?
Prior to being enthused about implementing the idea, consider that the S&OP process was designed to be a collaborative process between people based in organisation silos. And from its earliest days, Finance was a part of the process. So, does Finance feel neglected due to the design of an organisation’s S&OP process, including the ‘why’?
An additional thought is whether the Aim and Objectives of Finance and Supply Chains are compatible. While an element of the Finance function is forward looking concerning the availability of internal cash and external finance, the majority is financial accounting and cost accounting of products, plus managing Treasury. However, the planning and scheduling of supply chains is forward looking and recognises that a major risk to the business is not understanding an organisation’s network of supply chains.
Procurement provides an example concerning objectives not being compatible. A role of Procurement within a Supply Chains group is to provide the lead in gaining a better understanding of the organisation’s supply markets and to build a collaborative relationship with critical Tier 1 suppliers. But when Procurement reports through Finance, the objectives are more likely driven by purchase price and purchase price variance measurements.
Finance applications and supply chains
Commercial organisations are assessed on financial parameters by investors and banks and at the corporate level by the board of directors and senior management. The main parameters are profit, return on capital invested, and return on equity, based on statements structured to report historical financial information.
These statements and reports are not designed to provide an understanding of operational activities or measure performance within an organisation’s Supply Chains. The main link between financial reports and operations is the product cost, provided within cost accounting. This is based on the assumption that if product costs are lower than standard, then at the end of an accounting period, the company is profitable.
But traditional cost accounting contains assumptions. The most popular is that overheads can be arbitrarily allocated to a product line based on its supposed use of a resource – the more use of a company’s resources equals more revenue. But this approach can lead to higher absorption variances and misleading variance analysis. It also encourages behaviours such as:
- products produced in large batches to minimize the number of changeovers (set-ups)
- using quantity discounts to gain favourable purchase price variances against the standard
- purchasing unnecessary raw materials in bulk if a supplier may increase the price
Finance can help to improve supply chains
Although traditional financial accounts and cost accounting will not disappear, Finance can assist with implementing process for use to improve supply chain processes. This commences with a cost accounting system that recognises flows through processes, measures it and encourages behaviour that improves it.
Throughput Accounting is such an approach. It addresses the limitations of absorption cost accounting by changing the focus from reducing costs to increasing throughput for the total system. It pursues effectiveness through recognising constraints, with improved planning and scheduling. However, the concept is not accepted by accounting standards. But that should not stop finance and accounting professionals working with operations to implement a suitable flow accounting system that utilises current data and provides results using minimum resources.
This system should also include the measurement of Contribution Margins. The contribution of a product line (SKU) is available to help pay the fixed costs of the business and is the amount remaining after direct costs have been subtracted from revenue. The Contribution Margin is the residual amount divided by the revenue as a percentage.
Contribution Margin should be used for product rationalisation. If a product has a positive Contribution Margin, although a negative profit when conventionally calculated, it contributes to fixed costs and profit and so should be kept. This process avoids a situation where the board meeting of a public company considered discontinuing the biggest selling product because it was making a ‘loss’ under conventional costing. However, if a product’s contribution margin is negative, then action is required to delist the product, redesign it or increase prices.
The next level that Finance can assist the Supply Chains group is with implementing the financial metrics required for ‘Level 2’ Supply Chains – Operations. These are discussed in the eBook ‘Supply Chains Operating Performance – a Financial Approach to Measurement’. The metrics are required to support the management of an organisation’s ‘core’ Supply Chains (from Tier 1 customers back through the business to Tier 1 suppliers) and contains five statements:
- Supply Chains Working Capital
- Cash to Cash cycle time
- Supply Chains Value Added (VA)
- Supply Chains Return on Invested Capital (SC-ROIC)
- Inventory (FG) value, based on a Coefficient of Variance Management (CoVM) analysis
An additional measure that is valuable for segmenting customers when allocating resource is the Cost to Serve. This process identifies actual profitability by customer across geographies and product segments. It enables a business to use a more logically based approach to differentiating service levels, rather than be a business that is inherently ‘flexible’ (putting out fires).
Assistance from Finance with the Spend Analysis will improve Procurement’s understanding of supply markets. Spend Analysis evaluates the criticality of a buy, by category/sub-category and therefore the business relationship required with selected suppliers. It relies on Accounts Payables that are cleaned and classified (which is not required for accounting purposes), as an input to the ‘Risk-Spend Positioning’ matrix.
Sales & Operations Planning (S&OP) has always required Finance to evaluate the proposed plan on the basis of cash flow, financing and profitability. The misunderstanding by Finance departments appears to be that S&OP is not a finance department budget review routine, but a tactical level, cross function business planning process.
With the increase in unexpected events that can cascade through a company’s interconnected supply chains network, there is an urgent need for Finance and the Supply Chains group to develop a fast analysis of the total cost of ownership (TCO) for alternative actions.
From this discussion, a need can be identified in your business for a closer working relationship between Finance and the Supply Chains group to develop and implement practical financial solutions. However this does not need to extend to ‘integration’ between the two groups, given their different Aims and Objectives.
