Management Accounting

A Case for Fatter Supply Chains

Adding a bit more inventory and time into lean supply chains could bolster shareholder value and profitability during hard times.
Marie LeoneFebruary 9, 2006

Ice-cream loving dieters across the globe laughed with delight, and yogurt-eating weight watchers slathered bagels with butter, on Wednesday morning after hearing that a new $415 million federally funded study concluded that low-fat diets do not cut health risks.

The study, conducted by Rockefeller University, shed new light on dieting strategies in much the same way that two recent (but less generously funded) business studies provide fresh insights into “lean” supply chains. By relying on just-in-time (JIT) initiatives, lean supply chains squeeze inefficiencies out of the system by cutting extra inventory as well as time.

One concern about JIT initiatives, especially in the wake of major supply disruptions caused by hurricanes Katrina and Rita, is whether supply chains can become too lean, thereby leaving no margin for error when the unexpected occurs. Another worry is the short-term and long-term effects of the supply disruptions themselves. The studies attempt to provide some answers.

Drive Business Strategy and Growth

Drive Business Strategy and Growth

Learn how NetSuite Financial Management allows you to quickly and easily model what-if scenarios and generate reports.

In one study, “The Effect of Supply Chain Disruptions on Long-term Shareholder Value, Profitability, and Share Price Volatility,” the authors draw a direct correlation between supply disruptions and shareholder value. It found, for example, that companies that suffered supply-chain disruptions experienced share-price returns 33 percent to 40 percent lower than industry and general-market benchmarks. Further, share price volatility was 13.5 percent higher in these companies in the year following a disruption than in the prior year.

Disruptions have a greater effect on profitability, say authors Kevin Hendricks, a professor at the University of Western Ontario’s Ivey School of Business, and Vinod Singhal, a professor of operational management at Georgia Institute of Technology. The study found that in the year leading up to a disruption announcement, companies averaged a stunning 107 percent decline in operating income, a 114 percent drop in return on sales, and an 11 percent rise in costs. In aggregate, says Singhal, these leading indicators warned of major supply problems that were brewing even before the disruptions were made public.

To be sure, “there is a limit to how much efficiency can be wrung out from supply chains,” notes the study, which counsels managers to focus on preserving gains by ensuring “disruption free performance of supply chains.”

The authors, who analyzed more than 800 disruptions announced by publicly traded companies between 1989 and 2000, found that up to 68 percent of these companies underperformed their respective benchmarks — a percentage the professors called “significant.”

Some disruptions were caused by production problems; others, by shipping delays. For example, Sony Corp.’s shortage of PlayStation 2 video games in 2000 was caused by a dearth of critical components; Motorola Inc.’s parts shortage in 1999 was fueled by an unexpected surge in mobile-phone demand.

The study also highlighted underperformance in several other profitability categories. For instance, in the year prior to the disruption announcement, return on assets fell by an average of 93 percent, inventory levels grew by 14 percent, and sales declined by 7 percent. Usually, an increase to the asset base would be good news, but Singhal points out that when the inventory builds up while sales fall, lower asset turnover is the diagnosis.

The findings are pertinent to today’s market, adds Singhal, because the pattern of negative effects did not waver during the 11-year study period. What’s more, supply-chain disruptions are not expected to diminish in the foreseeable future, according to “The Supply Risk Management Benchmark Report,” a study by the Aberdeen Group.

Aberdeen found that 80 percent of the 180 companies surveyed experienced supply disruptions within the past 24 months, and more than 75 percent of the participants expect supply risk to increase over the next three years due to “supply market instability, new regulatory requirements, natural disasters, and terrorism attacks.”

In addition, companies reported an average 12.9 supply disruptions or outages during the past year, with poor quality or damaged goods being the most often cited problem (50 percent), followed by missed or late deliveries (49 percent), unexpected increases in supply costs (47 percent), longer lead times (33 percent), and supply capacity constraints (32 percent.)

More telling, Aberdeen reported that “best practices,” including low-cost country sourcing, outsourcing, integrated supply systems, and JIT initiatives, have made companies “more vulnerable” to supply disruptions than any time in the past. For instance, while JIT efforts reduce inventory costs and streamline operations, the initiatives also leave little or no buffer of extra stock or time to deal with supply or delivery glitches, says the report.

As with any effort to slim down, the trick is to apply lean tactics in moderation. “Companies need to decide how best to balance just-in-time practices with just-in-case possibilities,” contends Randy Strang, vice president of consulting services for UPS Supply Chain Solutions. That includes contingency planning to help managers determine safety stock levels, to prioritize customer orders in the event of a disruption, and to identify substitute suppliers located close to the customer who can step in if needed.

“Making a supply chain lean increases the velocity of your goods/working capital. Yet, it also increases your vulnerability to uncertainty,” notes Strang.

The Risks of Supply-Chain Best Practices

Supply Strategy Opportunities Risks
Low-cost Country Sourcing • Access 20% to 30% lower material and labor costs.

• Move supply closer to manufacturing and customer sites in emerging markets. • Longer lead times.

• Increased risk of supply disruptions and transportation capacity and performance issues.

• Exposure to new political, security, regulatory, tariff, and currency risks. Outsourcing • Improve operating performance and service levels.

• Lower operating costs. • Limited visibility or control of service levels or selection and performance of sub-tier suppliers. Lean and Just-in-time (JIT) • Reduce inventory costs.

• Streamline operations. • Little, if any, buffer stock or time increases risk of stock outages and manufacturing disruptions due to supply or delivery glitches. Vendor-managed Inventory (VMI) and Integrated Supply • Improve spend leverage.

• Improve service and fill levels.

• Reduce management burdens.

• Access “one-stop shop.” • Increased reliance on single supplier for broader range of materials and services.

• Limited ability to directly manage spend visibility, quality, and performance. Supply Base Rationalization • Improve spend leverage.

• Reduce management burdens.

• Improve strategic supply relationships. • Increased reliance on fewer or even sole-source suppliers links performance to financial and operation health of supplier.

• Increased likelihood of dual-or sole-sourced suppliers relying on single sub-tier supplier. Source: Aberdeen Group, September 2005