4

Measuring logistics costs and performance

Logistics and the bottom line

Today’s turbulent business environment has produced an ever greater awareness amongst managers of the financial dimension of decision making. ‘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 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 utilisation, and specifically the use of fixed and working capital. The pressure in most organisations is to improve the productivity of capital – ‘to make the assets sweat’. In this regard it is usual to utilise 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:

This ratio can be further expanded:

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 in order to gain improvement on ROI, one or other, or both, of these ratios must increase. Typically, many companies will focus their main attention on the margin in their attempt to drive up ROI, yet it can often be more effective to use the leverage of improved capital turnover to boost ROI. For example, many successful retailers have long since recognised that very small net margins can lead to excellent ROI if the productivity of capital is high, e.g. limited inventory, high sales per square foot, premises that are leased rather than owned, and so on.

Figure 4.1 illustrates the opportunities that exist for boosting ROI through either achieving better margins or higher assets turns or both. Each ‘iso-curve’ reflects the different ways the same ROI can be achieved through specific margin/asset turn combination. The challenge to logistics management is to find ways of moving the iso-curve to the right.

The ways in which logistics management can impact on ROI are many and varied. Figure 4.2 highlights the major elements determining ROI and the potential for improvement through more effective logistics management.

Figure 4.1 The impact of margin and asset turn on ROI

Figure 4.2 Logistics impact on ROI

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 4.3 summarises 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, we can see how logistics variables can influence its final shape.

Figure. 4.3 Logistics management and the balance sheet

Cash and receivables

This component of current assets is crucial to the liquidity of the business. In recent years its importance has been recognised as more companies become squeezed for cash. It is not always recognised, 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 affect the cash flow if the invoice is not issued until after all the goods are despatched. One of the less obvious logistics variables affecting cash and receivables is invoice accuracy. If the customer finds that his invoice is inaccurate he is unlikely to pay and the payment lead-time will be extended until the problem is rectified.

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 minimise the need for inventory.

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 of ‘Is this the most effective way to deploy our assets?’ should be asked.

Current liabilities

The current liabilities of the business are debts that must be paid in cash within a specified period of time. From the logistics point of view the key elements are accounts payable for bought-in materials, components, and so on. 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 reflect 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 MRP and distribution requirements planning. If premature commitment of materials can be minimised, this should lead to an improved position on current liabilities.

Debt/equity

Whilst the balance between debt and equity has many ramifications for the financial management of the total business, it is worth reflecting on the impact of alternative logistics strategies. More companies are leasing plant facilities and equipment and thus converting a fixed 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 affect the funding requirements of the business. They may also affect the means whereby that funding is achieved, i.e. through debt rather than equity. The ratio of debt to equity, usually referred to as ‘gearing’ or ‘leverage’, will influence the return on equity and will also have implications for cash flow in terms of interest payments and debt repayment.

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 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:

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 firm 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. Thus:

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:

And, as we have already noted:

Clearly, it will be recognised that there are a number of significant connections between logistics performance and shareholder value: not only the impact that logistics service can have upon net operating income (profit) but also the impact on capital efficiency (asset turn). Many companies have come to realise the effect that lengthy pipelines and highly capital-intensive logistics facilities can have on EVA and hence shareholder value. As a result they have focused on finding ways in which pipelines can be shortened and, consequently, working capital requirements reduced. At the same time they have looked again at their fixed capital deployment of distribution facilities and vehicle fleets and in many cases have moved these assets off the balance sheet through the use of third-party logistics service providers.

The drivers of shareholder value

The five basic drivers of enhanced shareholder value are shown in Figure 4.4: revenue growth, operating cost reduction, fixed capital efficiency, working capital efficiency and tax minimisation. All five of these drivers are directly and indirectly affected by logistics management and supply chain strategy.

Figure 4.4 The drivers of shareholder value

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. In Chapter 2 it was suggested that higher levels of customer retention lead to greater sales. Typically this occurs because satisfied customers are more likely to place a greater proportion of their purchases with that supplier.

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 significant proportion of total supply chain costs embedded in the final product.

There is also a growing recognition that time compression in the supply chain not only enhances customer service but can also reduce costs through the reduction of non-value-adding activities. This is an issue that we shall return to in Chapter 7.

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 ROI. 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 rationalise distribution networks and production facilities are increasingly being driven by the realisation that the true cost of financing that capital investment is sometimes greater than the return it generates.

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.

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 finished product) can be six months or longer in many manufacturing industries. By focusing on reducing cash-to-cash cycle time in the supply chain, dramatic reductions in working capital can be achieved. Cash-to-cash cycle time is calculated as shown in the box below.

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 a higher priority because an unrealistically low cost of capital is often used in decision making.

Tax minimisation

In today’s increasingly global economy, organisations have choices as to where they can locate their assets and activities. Because tax regimes are different country by country, location decisions can have an important impact on after-tax free cash flow. It is not just corporate taxes on profits that are affected, but also property tax and excise duty on fuel. Customs regulations, tariffs and quotas become further considerations, as do rules and regulation on transfer pricing. For large global companies with production facilities in many different countries and with dispersed distribution centres and multiple markets, supply chain decisions can significantly affect the total tax bill and hence shareholder value.

The role of cash flow in creating shareholder value

There is general agreement with the view of Warren Buffet³ that ultimately the value of a business to its owners is determined by the net present value of the free cash flow occurring from its operations over its lifetime. Thus the challenge to managers seeking to enhance shareholder value is to identify strategies that can directly or indirectly affect free cash flow. Srivastava et al.⁴ have suggested that the value of any strategy is inherently driven by:

1. an acceleration of cash flows because risk and time adjustments reduce the value of later cash flows;
2. an increase in the level of cash flows (e.g. higher revenues and/or lower costs, working capital and fixed investment);
3. a reduction in risk associated with cash flows (e.g. through reduction in both volatility and vulnerability of future cash flows) and hence, indirectly, the firm’s cost of capital; and
4. the residual value of the business (long-term value can be enhanced, for example, by increasing the size of the customer base).

In effect, what Srivastava et al. are suggesting is that strategies should be evaluated in terms of how they either enhance or accelerate cash flow. Those strategic objectives can be graphically expressed as a cumulative distribution of free cash flow over time (see Figure 4.5) with the objective of building a greater cumulative cash flow, sooner. Obviously the sooner cash is received and the greater the amount then the greater will be the net present value of those cash flows.

Figure 4.5 Changing the cash flow profile

Source: Srivastava, R. et al., ‘Market-Based Assets and Shareholder Value: A Framework for Analysis’, Journal of Marketing, Vol. 62, No. 1, January 1998, pp. 2–18

In recent years a number of studies have been conducted which highlight the connection between supply chain excellence and financial performance. A study by Accenture⁵ in collaboration with INSEAD Business School in France and Stanford University in the USA analysed the financial performance of 636 companies in 24 industries and found that those companies classed as supply chain leaders also tended to be above average in terms of sustained profitability. More recently, the research company Gartners has conducted an annual survey⁶ of the top 25 supply chains, drawing on a combination of published financial data and peer group evaluation. It is probably no coincidence that most of those companies ranked in the top 25 are also above average in terms of MVA. For example at the time of writing Apple, Procter & Gamble, and Wal-Mart were amongst the highest ranked companies.

Logistics cost analysis

After a century or more of reliance upon traditional cost accounting procedures to provide an often unreliable insight into profitability, managers are now starting to question the relevance of these methods⁷. The accounting frameworks still in use by the majority of companies today rely upon arbitrary methods for the allocation of shared and indirect costs and hence frequently distort the true profitability of both products and customers. Indeed, as we shall see, these traditional accounting methods are often quite unsuited for analysing the profitability of customers and markets since they were originally devised to measure product costs.

Because logistics management is a flow-oriented concept with the objective of integrating resources across a pipeline that extends from suppliers to final customers, it is desirable to have a means whereby the 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 organisation. Typically, conventional accounting systems group costs into broad, aggregated categories which do not then allow the more detailed analysis necessary to identify the true costs of servicing customers buying particular product mixes. Without this facility to analyse aggregated cost data, it becomes impossible to reveal the potential for cost trade-offs that may exist within the logistics system.

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. For example, it may be possible to trade-off costs in such a way that total costs increase, yet because of the better service now being offered, sales revenue also increases. If the difference between revenue and costs is greater than before, the trade-off may be regarded as leading to an improvement in cost effectiveness. However, without an adequate logistics-oriented cost accounting system it is extremely difficult to identify the extent to which a particular trade-off is cost-beneficial.

The concept of total cost analysis

Many problems at the operational level in logistics management arise because all the impacts of specific decisions, both direct and indirect, are not taken into account throughout the corporate system. Too often decisions taken in one area can lead to unforeseen results in other areas. Changes in policy on minimum order value, for example, may influence customer ordering patterns and lead to additional costs. Similarly, changes in production schedules that aim to improve production efficiency may lead to fluctuations in finished stock availability and thus affect customer service.

The problems associated with identifying the total system impact of distribution policies are immense. By its very nature, logistics cuts across traditional company organisation functions with cost impacts on most of those functions. Conventional accounting systems do not usually assist in the identification of these company-wide impacts, frequently absorbing logistics-related costs in other cost elements. The cost of processing orders, for example, is an amalgam of specific costs incurred in different functional areas of the business which generally prove extremely difficult to bring together. Figure 4.6 outlines the various cost elements involved in the complete order processing cycle, each of these elements having a fixed and variable cost component which will lead to a different total cost for any one particular order.

Figure 4.6 Stages in the order-to-collection cycle

Accounting practice for budgeting and standard-setting has tended to result in a compartmentalisation of company accounts; thus budgets tend to be set on a functional basis. The trouble is that policy costs do not usually confine themselves within the same watertight boundaries. It is the nature of logistics that, like a stone thrown into a pond, the effects of specific policies spread beyond their immediate area of impact.

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 difference between the two options that is the relevant accounting information for decision making in this case. Figure 4.7 shows how total logistics costs can be influenced by the addition, or removal, of a depot from the system.

Figure 4.7 The total costs of a distribution network

Understanding the cost-to-serve

We have already observed that whilst most companies have very good insight into product-related costs, they often know little about the costs of serving customers. This is paradoxical given that the difference between profit and loss is often determined by what happens after the product leaves the factory. Of equal concern in this era of omni-channel distribution is that the costs associated with serving customers through different channels may not be immediately visible.

The problem is that conventional cost accounting systems, as we have observed, tend to be focused around ‘vertical’ functions rather than ‘horizontal’ flows. These flows can relate to the processes that are involved in servicing of customers. Figure 4.8 illustrates the difference between a vertical and a horizontal orientation to cost accounting.

The successful achievement of defined service goals involves inputs from a large number of functional areas and activity centres within the firm. Thus an effective costing system must seek to determine the total systems cost of meeting desired service objectives (the ‘output’ of the system) and the costs of the various inputs involved in meeting these outputs.

Figure 4.9 illustrates how serving three different channels may make a differential impact upon functional costs and, in so doing, provide a logical basis for costing within the company. As a cost or budgeting method, channel costing is the reverse of traditional techniques: under this scheme a functional budget is determined now by the demands of the channels it serves. Thus in Figure 4.9 the cost per channel is identified horizontally and from this the functional budgets may be determined by summing vertically.

Figure 4.8 Horizontal flows that cut across functional boundaries

Figure 4.9 The programme budget (£’000)

Given that the logic of channel costing is sound, how might it be made to work in practice? This approach requires firstly that the activity centres associated with a particular distribution channel be identified, e.g. transport, warehousing, inventory, etc., and secondly that the incremental costs for each activity centre incurred as a result of serving that channel must be isolated. Incremental costs are used because it is important not to take into account ‘sunk’ costs or costs that would still be incurred even if the channel were abandoned. We can make use of the idea of ‘attributable costs’⁸ to operationalise the concept:

Attributable cost is a cost per unit that could be avoided if a product or function were discontinued entirely without changing the supporting organisation structure.

In determining the costs of an activity centre, e.g. transport, attributable to a specific channel, the question ‘What costs would we avoid if this channel were no longer serviced?’ should be asked. These avoidable costs are the true incremental costs of servicing the channel. As well as using this approach to understand the cost-to-serve by channel the same principles can be applied to analysing customer profitability.

Customer profitability analysis

One of the basic questions that conventional accounting procedures have difficulty answering is: ‘How profitable is this customer compared to another?’ Usually customer profitability is only calculated at the level of gross profit – in other words the net sales revenue generated by the customer in a period, less the cost of goods sold for the actual product mix purchased. However, there are still many other costs to take into account before the real profitability of an individual customer can be exposed. The same is true if we seek to identify the relative profitability of different market segments or distribution channels.

The significance of these costs that occur as a result of servicing customers can be profound in terms of how logistics strategies should be developed. Firstly, customer profitability analysis will often reveal a proportion of customers who make a negative contribution, as in Figure 4.10. The reason for this is very simply that the costs of servicing a customer can vary considerably – even between two customers who may make equivalent purchases from us.

If we think of all the costs that a company incurs from when it captures an order from a customer to when it collects the payment, is will be apparent that the total figure could be quite high. It will also very likely be the case that there will be significant differences in these costs customer by customer. At the same time, different customers will order a different mix of products so the gross margin that they generate will differ.

As Table 4.1 highlights, there are many costs that need to be identified if customer profitability is to be accurately measured.

The best measure of customer profitability 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 referred to earlier and incremental revenue. Using this principle helps circumvent the problems that arise when fixed costs are allocated against individual customers.

Figure 4.10 Customer profitability analysis

Source: Hill, G.V., Logistics – The Battleground of the 1990s, A.T. Kearney., Inc.

What sort of costs should be taken into account in this type of analysis? Figure 4.11 presents a basic model that seeks to identify only those customer-related costs that are avoidable (i.e. if the customer did not exist, these costs would not be incurred).

The starting point is the gross sales value of the order from which is then subtracted the discounts that are given on that order to the customer. This leaves the net sales value from which must be taken the direct production costs or cost of goods sold. Indirect costs are not allocated unless they are fully attributable to that customer. The same principle applies to sales and marketing costs as attempts to allocate indirect costs, such as national advertising, can only be done on an arbitrary and usually misleading basis. The attributable distribution costs can then be assigned to give customer gross contribution. Finally, any other customer-related costs, such as trade credit, returns, etc., are subtracted to give a net contribution to overheads and profit. Often the figure that emerges as the ‘bottom line’ can be revealing as shown, in Table 4.2.

Figure 4.11 Customer profitability analysis: a basic model

Source: Gattorna, J.L. and Walters, D.W., Managing the Supply Chain: A Strategic Perspective (Palgrave Macmillan, 1996), reproduced with permission of Palgrave Macmillan

Table 4.2 Analysis of revenue and cost for a specific customer

In this case a gross contribution of £70,000 becomes a net contribution of £56,400 as soon as the costs unique to this customer are taken into account. If the analysis were to be extended by attempting to allocate overheads (a step not to be advised because of the problems usually associated with such allocation), what might at first seem to be a profitable customer could be deemed to be the reverse. However, as long as the net contribution is positive and there is no ‘opportunity cost’ in servicing that customer the company would be better off with the business than without it.

The value of this type of exercise can be substantial. The information could be used, firstly, when the next sales contract is negotiated and, secondly, as the basis for sales and marketing strategy in directing effort away from less profitable types of account towards more profitable business. More importantly it can point the way to alternative strategies for managing customers with high servicing costs. Ideally we require all our customers to be profitable in the medium-to-long-term and where customers currently are profitable we should seek to build and extend that profitability further.

Figure 4.12 represents a simple categorisation of customers along two dimensions: their total net sales value during the period and their cost-to-serve. The suggestion is that there could be a benefit in developing customer specific solutions depending upon which box of the matrix they fall into. Possible strategies for each of the quadrants are suggested below.

Figure 4.12 Customer profitability matrix

Direct product profitability

An application of logistics cost analysis that has gained widespread acceptance, particularly in the retail industry, is a technique known as direct product profitability (DPP). In essence it is somewhat analogous to customer profitability 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 profit on a particular item.

For the supplier it is important to understand DPP in as much as his ability to be a low-cost supplier is clearly influenced by the costs that are incurred as that product moves through his 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 influence it favourably.

Table 4.3 describes the steps to be followed in moving from a crude gross margin measure to a more precise DPP.

The importance to the supplier of DPP is based on the proposition that a key objective of customer service strategy is ‘to reduce the customer’s costs of ownership’. In other words the supplier should be looking at his products and asking the question: ‘How can I favourably influence the DPP of my customers by changing either the characteristics of the products I sell, or the way I distribute them?’

From pack design onwards there are a number of elements that the manufacturer or supplier may be able to vary in order to influence DPP/square metre in a positive way, for example, shelf-ready packaging, increasing the delivery frequency, direct store deliveries, etc.

Cost drivers and activity-based costing

As we indicated earlier in this chapter, there is a growing dissatisfaction with conventional cost accounting, particularly as it relates to logistics management. Essentially these problems can be summarised as follows:

• There is a general ignorance of the true costs of servicing different customer types/channels/market segments.
• Costs are captured at too high a level of aggregation.
• Full cost allocation still reigns supreme.
• Conventional accounting systems are functional in their orientation rather than output oriented.
• Companies understand product costs but not customer costs.

The common theme that links these points is that we seem to suffer in business from a lack of visibility of costs as they are incurred through the logistics pipeline. Ideally what logistics management requires is a means of capturing costs as products and orders flow towards the customer.

To overcome this problem it is necessary to change radically the basis of cost accounting away from the notion that all expenses must be allocated (often on an arbitrary basis) to individual units (such as products) and, instead, to separate the expenses and match them to the activities that consume the resources. One approach that can help overcome this problem is ‘activity-based costing’ (ABC).⁹ The logic of ABC is sound. Essentially, in the context of logistics and supply chain management the argument goes as follows: serving customers generates activity, activity consumes resources and resources cost money. The key to ABC is to seek out the ‘cost drivers’ along the logistics pipeline that cause costs because they consume resources. Thus, for example, if we are concerned to assign the costs of order picking to orders then in the past this may have been achieved by calculating an average cost per order. In fact an activity-based approach might suggest that it is the number of lines on an order that consume the order picking resource and hence should be seen as the cost driver.

The advantage of using ABC is that it enables each customer’s unique characteristics in terms of ordering behaviour and distribution requirements to be separately accounted for. Once the cost attached to each level of activity is identified (e.g. cost per line item picked, cost per delivery, etc.) then a clearer picture of the true cost-to-serve will emerge. Whilst ABC is still strictly a cost allocation method, it uses a more logical basis for that allocation than traditional methods.

The reason for advocating an ABC approach to logistics and supply chain cost analysis is that enables the adoption of activity-based management.

Activity-based management aims to utilise the insights provided by ABC to steer the business towards better long-term profitability. It does this by recognising the real costs of serving customers and channels. Once those costs are known decisions can be taken to either change the way that customers are serviced, or the terms on which sales are made or to rationalise the customer base or to encourage customers to change the product mix they order and so on. Without the detailed understanding of individual customer profitability and relative channel costs, the likelihood is that a significant proportion of total profitability in the business is being eroded.

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-effective way, then it is essential that those responsible have the most accurate and meaningful data possible.

References

1. State of Logistics Report, Council for Supply Chain Management Professionals. (Annually)

2. Stewart, G.B., The Quest for Value, Harper Business, 1991 (EVA is a registered trademark of Stern Stewart & Co).

3. Buffet, W., Annual Report, Berkshire Hathaway Corporation, 1994.

4. Srivastava, R. et al., ‘Market-Based Assets and Shareholder Value: A Framework for Analysis’, Journal of Marketing, Vol. 62, No. 1, January 1998, pp. 2–18.

5. Creating and Sustaining the High-Performance Business, Accenture, 2003.

6. O’Marah, K., and Hofman, D., “Top 25 Supply Chains”, Supply Chain Management Review, October 2009.

7. Johnson, H.T. and Kaplan, R.S., Relevance Lost: The Rise and Fall of Management Accounting, Harvard Business School Press, 1987.

8. Shillinglow, G., ‘The Concept of Attributable Cost’, Journal of Accounting Research, Vol. 1, No. 1, Spring 1963.

9. Cooper, R. and Kaplan, R.S., ‘Profit Priorities from Activity-Based Costing’, Harvard Business Review, May–June 1991.