This Week on SCDigest:
The “Probability” of Supply Chain ROI
Supply Chain Graphic of the Week and Supply Chain by the Numbers
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Expert Insight: Churchill Leadership Series
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Supply Chain Graphic of the Week: The Supply Chain ROI Probability Curve

   

This Week's Supply Chain by the Numbers for March 11, 2010: Britain's JCB seeks more Components made at Home; Maersk's Bottom Line Takes a Pounding; EPC Growth and Steel Company Investment Looking Up


   
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SUPPLY CHAIN TRIVIA
   

Q.

A fairly easy question this week, but what is the only directly-related supply chain/logistics company to make the most recent BusinessWeek list of the top 100 global brands?

   
A.
Click to find the answer below
   
The “Probability” of Supply Chain ROI

Ever so slowly, the economic winds seem to be changing for the better, though as we’ve noted before most CEOs are still looking for a better “all clear” signal before getting very aggressive with market development and investments in supply chain and elsewhere.

 

Still, many companies are sitting on giant piles of cash that are earning next to nothing, and indeed of late some investor groups have been demanding dividend increases as those piles of cash keep growing. That alone may trigger some companies to free up additional funding for supply chain projects. As I noted a few weeks ago, there is some evidence that companies are in fact looking at investments that can help them to get back on a growth trajectory without having to add much in the way of head count by achieving productivity gains.

 

My informal contacts in the supply chain software and automation worlds are telling me that prospect activity is picking up, at least in terms of potential projects and “pipeline” development, as it is often called. Though actual contract signings are still relatively slow, they too are picking up for sure, and after the rough 15 months, that’s good news for both companies and vendors.

 

With potential projects and investments naturally comes issues around return on investment (ROI). As we’ve recently reported, a number of companies have raised their internal financial “hurdle rates” substantially, thereby winnowing the field of potential projects, conserving cash, and (in theory) ensuring only the most outstanding projects receive funding.


Gilmore Says:
 

"This is the real world. Investments do have a probability curve, as both logic and real world outcomes makes clear."

What do you say?

 
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your Feedback here
 

So here may be a bit of a shocker – the way most of us have thought about ROI calculation is simply all wrong.

 

I touched briefly on this subject many years ago, but it’s time to take another look. The way most of us in both business and at solution providers have been taught to calculate ROI is to add up the costs of the project and line them up against the financial benefits over some period of time. That leads to any one of a number of methods to determine ROI, whether it is a simple payback period calculation, internal rate of return, discounted cash flow, etc.

 

There is much to discuss even with these approaches (for example, what should be included in both cost and benefit categories?). But for today’s purposes, I will note all these usual methods have something in common: the end result is usually a single number, such as an internal rate of return expected to be 22.5% or something like that. That number must pass a company’s given ROI threshold in any particular budget cycle to be funded.

 

But, as I heave learned from my friend Doug Hubbard of Hubbard Decision Research, it is actually somewhat silly to think about ROI as a single number, for all kinds of reasons.

 

It is instead much better to think about ROI for a project as a probability curve. The absolute reality is that there are a range of potential financial outcomes that are possible for a given initiative.

 

Understanding those probabilities for potential success or less than success is critical to considering ROI. Some investments, for a variety of reasons, are more risky in terms of achieving the expected return; others are less so.

 

As just one example of this concept, Hubbard’s long years of doing work in IT-related projects have shown that internally developed software has a greater probability of failing to meet expectations than projects using commercial packages. You can agree with that assessment or not, but assuming for a minute this is true, what it says is that for a given project that involves a make or buy decision, you could have options that both have nearly identical “one number” ROIs (say both with internal rates of return of 24%), but which would have very different probabilities of achieving that number. The internally developed systems have more risk.

 

As shown in the chart nearby that is our Supply Chain Graphic of the Week, what seems to me the real power of this type of analysis is that you can understand the investment and its range of potential outcomes at a much more accurate and interesting level.

 

For example, there is the obvious analysis of estimating the likelihood that a given investment will achieve its expected return, which we can also think of as “the most likely” result.

 

Further, by using this approach a company can also estimate the probability that the project will exceed the company’s hurdle rate, or the likelihood that it will at least have a positive return. A company may be more likely to approve a project where the likelihood of at least achieving a positive return is high, as another example of how this can work.

 

These kinds of analyses can help better understand the risk-reward trade-off of potential investments, and even lead to rethinking some aspects of a potential project to reduce risk and shift the curve to the right, if you will.

 

As an easy example, high levels of supply chain software customization unquestionably add risk. In the past, that risk often involve outright failure; today, it is more often related to problems that lead to delays in getting the software to work right and therefore to start achieving positive cash flow. So, even if the theoretic return is higher with the customizations, the trade-off may look much less favorable when the risk is considered. While we may all understand that intuitively, this approach offers a better way to quantify that.      

 

This really is a better way. Investments do have a probability curve, as both logic and real world outcomes makes clear (meaning the actual ROIs for any type of supply chain investment vary all over the place across companies). The likelihood of well exceeding the most likely ROI is usually small, so the curve usually starts to drop off pretty rapidly to the right of that number. How the curve looks to the left is often the key.

 

Of course, it takes some skill to develop this approach, but it is not as hard as you may think. Hubbard has a specific method he uses to determine the likelihood of various outcomes, and then uses a Monte Carlo simulation to develop the curve (Monte Carlo simulation is very brief summary is a method that uses a sort of random number generation to simulate hundreds or thousands of occurances).

It would require more space than I have hear to do real justice to this, but for example, let’s say in a transportation management system (TMS) project, your confidence in reducing total logistics headcount through efficiency gains may be higher than it is over how much you will save from load optimization, or whatever. This insight is used to measure and build the probability model.One has a confidence factor of 80%; the other, maybe 50%. This kind of info can be used to generate an overall probability curve.

 

It’s unquestionably a more complicated approach than the traditional methods for ROI calculation. Some managers and/or their companies will find a “one number” approach is just more suited to their temperament and liking. This approach requires nuance; the other more “certainty.” Clearly, the ROI models and methodologies for ROI calculation used by supply chain technology vendors are almost universally “one number” oriented, and those often provide a basis for the company’s own calculations.

 

Companies sometimes utilize a mini-version of this approach in a sense, such as presenting three scenarios for ROI and/or cost savings; often, this involves presenting “most likely,” “best case” and “worst case” scenarios. This is better than just one number, I suppose, but it begs the question: What is the likelihood of each possibility?

 

I was told five years or so ago by a senior manager at Dell that his company at the time used a methodology much like this. Not sure if that is still the case at Dell. I would be very curious to know if any of our readers out there and/or their companies use anything similar in estimating potential ROI.

 

I am out of space. Hope I was clear, and more on this soon. At least, I hope you will agree it is fundamentally a better approach, even if it may be too much for many companies. But even then, just thinking this way can improve even traditional approaches to ROI calculation, in my opinion.

As an aside, as we reported this week, the supply chain community lost one of its leading thinkers with the death of the University of Tennessee's Dr. Tom Mentzer. We summarize his great career and ask our readers for any memories they may have about Tom: Supply Chain Thought Leader Tom Mentzer of the University of Tennessee Loses Cancer Battle

What is your reaction to the idea of probability-based ROI analysis? Like it or not? Like the idea, but it seems too hard? Has your company ever used anything similar? Are there other approaches? Let us know your thoughts at the Feedback button below.

 

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YOUR FEEDBACK

We received many good letters on our First Thoughts piece on Why Bad Supply Chain Processes? That includes our Feedback of the Week from R.T. Galvin, a supply chain leader at a company he didn't want mentioned, who says in part there just aren't enough truly great supply chain executives to go around.

You his letter plus more on this topic below.


Feedback of the Week: On Why Bad Supply Chain Processes?

An ex-boss once told me there were 70 uber Supply Chain Leaders in the US, and they move from company to company every 2 years.

I have been fortunate enough to have reported to 2 of the 70. That was almost 10 years ago, and I truly believe she was right. There isn't enough good managers to go around. Now, this is obviously an overstatement, but I have found the last 3 companies I have been associated with say they want to change, but in actuality they resist change. The Fortune 100 do it right, because typically you find they have the deep pockets enough to invest in tools, ERP's and new concepts.

Everyone wants LEAN principles, but how many are willing to invest in it. Companies want Six Sigma, but will they pay for and stick with it? It's easy to advertise for a new Supply Chain Director, or Continuous Improvement Guru with a pedigree, but often their attempts at change although clearly necessary, get blocked by the Leadership Team that often desires the change.

I recently encountered a COO who challenged a process that I had helped implement at a world's leading technology company, saying it couldn't be done at our $350million OEM. It was difficult biting my tongue and not telling him big titles at small companies do not always equal success. Ultimately, he relinquished and we were able avoid a $5million obsolescence putting the process in place. The 70 uber leaders do it right, and if they stick around long enough, process improvements will prevail.

If you have one and then lose them, try to replace them with one who is not of the uber class. At least you stand a chance at retaining the improvements obtained before the churn.

R. T. Galvin
Supply Chain Leader


More on Why Bad Supply Chain Processes?:

 

I essentially agree with your statements and your lists.  Now, what can practitioners do about it?

Suggest you may want to steer them toward the CSCMP Supply Chain Standards, and the self-assessment methodology contained in the book.  The Coca-Cola Company adopted Standards as the basis for their audit and assessment practice worldwide, and several other companies have made major improvements through the application of the practices contained therein.  The Second Edition was just published in Sept 2009, and contains 40% more content than the previous edition published in 2004, supporting your statements about how fast things change.  In addition, we point out that:

  • Research into today’s current supply chain practices accounted for 66% of the new content
  • The SME review and input accounted for 34% of the new content
  • 38% of the original statements were updated to make them more current and accurate through both input from SMEs and through research 
  • 4% of the original best practice statements are now minimum standards and 2% were no longer valid (as minimum) 
  • The deliver product section (4.0), which contains the majority of the supply chain process, has over 45% new information 

Before you ask, yes, we (Supply Chain Visions) headed up the project to write and rewrite the Standards.  But, no, we do not receive any royalties from the sales.  Our only interest in achieving wider distribution is to support CSCMP in their mission to educate the membership.

For more information, I suggest you ping http://cscmp.org/resources/standards.asp

 

Mike Ledyard
Partner
Supply Chain Visions

 


Bang on, Dan! You implied it in your bullet "Managers Just Don't Know", but let me add a paraphrase: "Disconnect Between Management's Perception of Processes & Reality", typically the result of not engaging the workforce in process improvement initiatives".

By the way, when did Bill Gates say "“Automating bad processes just allows you to do the wrong things faster” ? Our industry has heard "THE BEST TECHNOLOGY AND SYSTEMS INSTALLED IN OPERATIONS WITH ILL-CONCEIVED MATERIAL FLOWS & PROCESSES WILL ONLY ENABLE USERS TO DO THINGS BADLY - - - FASTER!" for over twenty years.

John M. Hill
Vice President
Senior Consultant

TranSystems


You once again have hit the nail on the head!  More surprising is that when you approach executives with the prospect that their supply chain processes might be faulty, they look at you as if you had 3 head.  I can’t tell you how many times I’ve heard “…but we just spent a fortune on a new software package, our processes are great!”

“Fixing processes” can be challenging, but it isn’t rocket science.  Your message is absolutely correct.

 

Rick Feltenberger ¦ Principal

The Supply Chain Center

 


I agree wholeheartedly with your column!!!   

My take on "why bad supply chain processes" exist is that some don't know any better, some don't have the time or resources to fix it, and others simply suffer from a too heavy reliance on systems, software, and technology as the solution to all supply chain ills.   A lot of improving supply chain processes depends on becoming more observant as you view your supply chain processes and logistics functions.  I recommend the following to help:   

  • Become hyper-vigilant about the more discrete elements of your everyday supply chain environment
  • Look for patterns amidst your everyday routines (pattern recognition)
  • Regard anything out of ordinary patterns as possibly a risk or intentional distraction
  • Focus on incongruent people, equipment, processes, methods, material flow, etc.
  • Look beyond what you are shown or told and,
  • Do not tune out familiar surroundings---look deeper for things that you may have missed

As the saying goes, "God gave you two eyes and two ears; use them when visiting sites, facilities, and partners in the supply chain."  You can also "learn to listen" to what others who work the process have to say about it.   Professionally yours,   Tom

Thomas L. Tanel, C.P.M., CTL, CCA, CISCM
President and CEO
CATTAN Services Group, In
c.

 

SUPPLY CHAIN TRIVIA
Q.

A fairly easy question this week, but what is the only directly-related supply chain/logistics company to make the most recent BusinessWeek list of the top 100 global brands?

A.

UPS, at number 31. Software provider SAP, which arguably should be considered as a supply chain-related company, was just a bit ahead of UPS, at number 27. We were surprised actually that FedEx did not make the list, as when your name has become a verb that is some sign of brand power. The BW methodology for ranking the brands is not really clear, we must say.