CHAPTER 3
The Nature of Supply Chain Costing
SUPPLY CHAIN MANAGEMENT REQUIRES a much broader view of profits, costs, and cost management than most firms currently possess. Senior executives across industries and at different levels in the supply chain have observed that their firms need to extend their “line of sight” to include their upstream and downstream trading partners’ costs of performing different activities within key processes. The firms need this information to effectively manage and reduce supply chain costs, make effective cost trade‐offs, and know where the greatest opportunities exist in their supply chain to reduce costs, increase profits, and improve performance.
Several formidable challenges confront managers attempting to expand cost visibility beyond their firms’ boundaries. Despite the focus most firms place on supply chain management, managers in many small suppliers and customers are not familiar with the concept or how their interactions with other trading partners drive costs and performance throughout the supply chain. The cost systems most firms use continue to focus internally, emphasize direct costs, and use traditional costing methods and tools to support supply chain decision making.
NATURE OF SUPPLY CHAIN MANAGEMENT
Considerable confusion continues to exist regarding the term supply chain management. Everyone has a somewhat different perspective or definition of this concept. Many logistics professionals and academics have suggested that logistics refers to those activities involved with material flows within the firm while supply chain management encompasses those material flows that span multiple firms. Others refer to supply chain management as the management of vendors or inbound supply.
The lack of a common definition inhibits communication and management across the supply chain. This situation limits managers’ ability to exchange profit margin and cost information and to align operational and financial performance measures across the supply chain. Managers must ensure that they and their trading partners share a common definition to permit effective communication of information across the functions within the firm and among the firms that make up the supply chain. Otherwise, situations can easily arise where firms focus on different parts of the supply chain and have conflicting objectives. For example, one trading partner may view the supply chain as the internal value chain, another may equate supply chain management with logistics, while a third trading partner may adopt a much broader view. Unless these differences are resolved, the ability to capture cost information and align performance with supply chain objectives will be extremely difficult.1
To ensure consistency and to support a broader perspective of supply chain costs, the following definition can be used for supply chain management:
Supply chain management is the management of relationships in the network of organizations, from end customers through original suppliers, using key cross‐functional business processes to create value for customers and other stakeholders.2
This definition represents an end‐to‐end process view of supply chain management. Supply chain costs can be most effectively managed when they are captured at the process level. There are eight commonly identified supply chain processes that span the supply chain from end user through the original sources of supply. Executives often speak in terms of these processes when describing their supply chains and interactions with their trading partners.
These processes exist in all supply chains and extend back from the end user across multiple firms to the ultimate supplier. As shown in Exhibit 3.1, each process bisects the functional silos found within the trading partners comprising a supply chain.3 The activities that comprise these processes transform material and information into value for the end user. Each of these activities drives cost and affects performance within the supply chain.
EXHIBIT 3.1 Supply Chain Framework and Processes
Source: Douglas M. Lambert, ed., Supply Chain Management: Processes, Partnerships, Performance, fourth edition (Ponte Vedra Beach, FL: Supply Chain Management Institute, 2014), p. 3. © Copyright Douglas M. Lambert. Used with permission. For more information about the SCM Framework, see drdouglaslambert.com.
These processes can and should be a focus of supply chain cost management. Depending on the supply chain, trading partners, and strategies employed, firms may have defined these processes differently. However, when a firm uses a standard set of processes, it obtains more effective communication and a shared understanding between managers from different firms in the supply chain. It also enables benchmarking with comparative “apples‐to‐apples” definitions.
Managing these eight processes to create the greatest value for the end user, at the lowest total cost, is an essential part of supply chain management. It requires integration of these processes internally and externally across multiple trading partners in the supply chain. These processes directly affect the value delivered to the end user and to key stakeholders throughout the supply chain. To improve the value proposition, managers need to understand how their decisions affect cost and performance both within their firm and in each of the trading partners comprising the supply chain. The timing and nature of these decisions affect costs differently and must be reflected in the costing approach to improve accuracy and support management decision making.
Supply chain management requires a level of understanding of cost and what causes cost beyond that which currently exists in most firms. For example, a retailer's decision to implement vendor‐managed inventory (VMI) focuses on obtaining high product availability while simultaneously reducing the costs associated with holding inventory, forecasting, and order placement. The supplier assumes responsibility for these activities. If the supplier can perform these activities at a lower cost than the retailer, the supply chain can become more competitive by offering lower costs and higher availability to the end user. However, companies typically have limited control over the activities performed by supply chain partners and usually lack knowledge of what their activities cost. By analyzing these activities and how each firm contributes to overall performance and costs, managers can identify new opportunities to increase competitiveness and profitability.
A Need for a Broader View of a Supply Chain
Although most managers understand the supply chain concept defined here, in practice their focus remains narrow in scope. Managers generally define the supply chain as ranging from “dirt to dirt”; however, attention and action focus on managing the internal supply chain or limited segments of the supply chain such as inbound flows (supply management) or outbound flows (distribution or customer service). Functions or positions containing “supply chain” in the title rarely include the management of activities beyond transactions with immediate upstream or downstream trading partners.
A key premise of this book is that supply chain management (strategy, operations, and processes) drives the costing process. Executives need to understand the key features of their supply chain. These features include the operational processes and activities comprising the supply chain; how interactions occurring between firms drive differences in processes and activities (which drive costs); and how the role of the firm in the supply chain affects the interaction, processes performed, and supply chain cost.
SUPPLY CHAIN COSTING FRAMEWORK
Supply chain costing remains a work in process, and most firms have taken the first steps toward supply chain cost visibility. Cost management has long been a topic of significant discussion, first in physical distribution, then in logistics management, and now in supply chain management. Yet, most managers continue to rely on traditional general ledger accounting systems and simplistic (and flawed) cost allocation methods for the cost information needed to manage their operations. The purpose of that information is for external financial reporting and for compliance with government regulatory agencies. What is needed is internal managerial accounting that uses better and more valid assumptions to calculate costs.
Despite the tremendous effort expended in developing costing tools such as distribution costing, total cost management, direct product profitability, activity‐based costing, and cost to serve (customer profitability analyses), this narrow focus persists.
Faced with factors such as globalization, technology changes, intense competitiveness, and a well‐informed and price‐conscious end user, supply chain managers are putting a renewed focus on cost management. Cost increases, such as rising transportation costs, have forced managers to seek new opportunities to reduce costs in order to maintain prices without eroding profit margins.
Unfortunately, most managers focus their efforts on managing only those activities under their direct control. They view their responsibilities as beginning with the acquisition of inbound material and ending with delivery to the customer. In many instances, these managers work with their suppliers or customers to improve performance or reduce costs, but they generally do not attempt to examine or actively manage the processes and business practices of their trading partners. Instead, the focus is on obtaining the inputs or outputs necessary for achieving specific objectives for their internal value chain and leaving decisions on how these objectives are to be obtained to their trading partners.
Several leading‐edge firms have moved forward to advance their cost management systems and the cost and performance “intelligence” available to support the decisions managers make. These firms have made substantial gains in their ability to reduce costs, improve production, and increase profitability. They have applied technology to eliminate labor‐intensive and “non‐value‐adding” activities from their operations. Timely and more accurate information has enabled them to reduce forecasting error, inventory levels, and cycle times. The coupling of technology, information, and more accurate costs has allowed these firms to optimize their entire internal network and to incorporate several formerly disconnected processes into a systemic whole. These include order processing, order fulfillment, manufacturing flow, purchasing, returns management, and new product development and commercialization. Despite these tremendous advances, supply chain executives in these firms recognize that they have largely attacked only the “low‐hanging fruit” or those portions of the supply chain and related processes that lie under their direct control.
The Next Frontier in Supply Chain Cost Management
Supply chain managers recognize that the next frontier in supply chain cost management lies in the portions of the supply chain beyond their direct control. These executives have long recognized that many of their costs and business processes are driven by the behavior and practices of their trading partners. To address these factors, these executives are attempting to implement practices that focus on management throughout and across the supply chain. In a sense, they are attempting to influence the performance of activities and achieve outcomes from processes in which they exert little direct control or ownership. They also realize that their firms lack the cost and performance intelligence necessary for making informed business decisions that affect the supply chain. To date, supply chain managers have combated this situation largely by exchanging operational performance data. Cost information is rarely exchanged due to the sensitivity associated with financial data and concerns regarding the release of competitive information. In most instances, managers perceive the exchange of operational data as having significantly less risk than exchanging cost and financial information. Compounding this situation, existing cost management systems frequently preclude the exchange of the needed cost information. Traditional general ledger cost systems do not possess the capability to provide the accurate cost information needed for managing products, services, and information flows through complex supply chains.
Conventional cost systems fail to support supply chain decision making. To demonstrate why, divide the value chain into two segments—internal and external. The internal value chain represents the firm. Conventional approaches view the firm as a group of functions that perform tasks, produce costs, and create value. The profit margin represents the difference between what the firm's customers are willing to pay for the product or service minus the firm's costs. Multiple processes link the internal value chain to the external value chain, which is made up of a network of trading partners. As goods or services move through the supply chain, they pass through other firms in the supply chain where value and costs are created. However, conventional cost systems fail to capture how these interactions drive costs within the firm or the trading partners in the external supply chain. The portrayal of the supply chain as a network of internal value chains is useful for understanding why a broader view of costs is required so that managers can better manage the linkages and interrelationships to affect the costs and profits of each trading partner.
Many of the costs incurred with a firm's internal value chain are driven by business practices occurring in the external supply chain (see Exhibit 3.2). The figure illustrates that a company must think beyond its four walls. For example, the manufacturer's purchasing, receiving, inventory, and manufacturing process costs are driven by how well external suppliers make and deliver components. A decision by a supplier to employ a low‐cost motor carrier to reduce transportation costs may increase the manufacturer's costs through increased variability in order cycle time. The result may be higher inventory levels or work stoppages on the manufacturing line. A supplier's business practices also have a direct effect on the cost of raw materials or components acquired by the manufacturer.
EXHIBIT 3.2 Intrafirm Costs Largely Driven by Trading Partners' Business Practices
Source: Adapted from Gary Cokins, Activity‐Based Cost Management: An Executive's Guide (New York: John Wiley & Sons, 2001), p. 164. Copyright Gary Cokins. Used with permission of the author.
Downstream customers can also have a major effect on upstream suppliers' internal costs. A key retailer may unilaterally decide to reduce inventory levels and order more frequently. This decision may result in higher costs for the manufacturer, who now needs to hold more inventory and has a higher frequency of deliveries. The tailoring of supply chains to meet end‐user needs drives many different costs within the upstream trading partners. Suppliers increasingly go to market through several distribution channels and have shifted functions across trading partners to best meet these needs. Supply chain managers have begun to employ tools such as customer profitability and total landed cost analyses to understand the implications of going to market through multiple channels.
Likewise, external costs incurred by trading partners can be driven by the firm's internal business practices. If a retailer chooses not to exchange demand data, upstream suppliers will consequently experience the “bullwhip” effect. In the bullwhip effect, wide swings in demand result in higher costs for suppliers due to increased forecast error and inventory levels, greater use of expedited transportation, and changing production levels and schedules. The retailer experiences higher costs as well because fewer products are available and suppliers pass along their costs in the form of higher prices.
Supply Chain Management Is Complex
By its very nature, supply chain management is very complex. Supply chains are frequently described as an interlinked set of trading partners that convert raw materials or data into products or services in response to end‐user needs. These descriptions fail to capture the many different products and services flowing through the firm, the variety of trading partners and relationships that interact with the firm, and the multiple processes in which the firm participates. Firms frequently operate in numerous supply chains, each with different strategies, trading partners, and end users. This complexity makes supply chain cost management challenging and difficult. In addition, managers often are reluctant to exchange information, especially about costs, when their trading partners conduct business with competitors. Exhibit 3.3 illustrates supply chain complexity and the relationship between trading partners and competing firms.
Supply chain professionals must recognize that they cannot apply a one‐size‐fits‐all strategy when managing their business relationships or the processes that support these relationships. As business practices are tailored to meet the needs of these relationships, so must the performance measures and cost information be tailored so managers can determine how the relationship is performing and affecting the firms.
EXHIBIT 3.3 Complexity Driven by Participation in Multiple Supply Chains
Source: Douglas M. Lambert, ed., Supply Chain Management: Processes, Partnerships, Performance, fourth edition (Ponte Vedra Beach, FL: Supply Chain Management Institute, 2014), p. 7. © Copyright Douglas M. Lambert. Used with permission. For more information about the SCM Framework, see drdouglaslambert.com.
The nature of supply chain decision making requires a different approach for capturing and analyzing cost data across multiple firms. Decisions made within a single firm can have a ripple effect across the supply chain, driving costs in a manner totally unanticipated by the decision maker. In some instances, a decision made with the intent to improve a firm's profitability may have severe consequences elsewhere in the supply chain and decrease the marketplace competitiveness of the end product or service. This situation results from the lack of cost visibility and knowledge within the supply chain.
Arraying Costs Along Three Dimensions
Supply chain costing extends the focus of cost management across the firm's boundaries. Traditional systems are constrained by design to capturing cost information within the four walls of the firm and to satisfy the requirements for external financial reporting. Supply chain costing broadens managers' perspectives by providing cost visibility at the activity level from the ultimate source of supply to the end user. Activity‐level information further expands managers' views by identifying the cost drivers for these activities and by providing the capability to portray costs along the supply chain resources, supply chain cost objects, and supply chain process dimensions (see Exhibit 3.4).4
EXHIBIT 3.4 Dimensions of Supply Chain Cost Information
- The supply chain resources dimension addresses not only the direct and indirect costs within the firm but expands these categories to include the resource costs of trading partners spanning the entire supply chain. This dimension portrays costs based on the behavior of these costs and the decisions that create them. These cost categories include the direct and indirect costs for the firm and its upstream and downstream trading partners. Direct costs can be directly traced to an activity and are caused by the performance of the activity. Direct costs would include the direct labor and materials consumed in production in a traditional cost management system. Indirect costs include those costs not directly incurred in production. However, many indirect costs can be assigned to activities performed by other functions in the firm such as marketing, logistics, or research and development. Since indirect costs are not directly consumed by production activities, traditional cost systems arbitrarily allocate indirect costs to production activities such as direct labor hours.
- The supply chain processes dimension captures costs driven by activities performed within each supply chain process5 by trading partners spanning the supply chain. Process costs encompass the cost of the activities comprising the process across all firms in the supply chain (Exhibit 3.5). This view enables supply managers to determine how each firm's performance contributes to the overall cost of performing each process, or how the behavior of upstream suppliers or downstream customers drives activity performance costs. Supply chain managers can use this information to more effectively determine how to improve the overall performance or total cost of performing the process. Process improvement efforts can focus on high‐cost activities, functions, or activities that can be shifted to other trading partners who can perform them more efficiently, or cost trade‐offs can be performed between activities and other processes to lower the overall total cost achieved by the supply chain.
EXHIBIT 3.5 Process View of Cost Information in a Supply Chain
Source: Adapted from Gary Cokins, Activity‐Based Cost Management: An Executive's Guide (New York: John Wiley & Sons, 2001), p. 169. Copyright Gary Cokins. Used with permission of the author.
- The supply chain cost object dimension classifies costs by customer, supplier, product, or service, and by distribution or marketing channel to support a cost or profitability analysis by any of these cost objects. This dimension breaks out costs by customer or supplier relationships and distribution channels within the supply chain. Costs are traced to specific trading partners or channels based on how their behavior, business practices, or transactions incur costs within the supply chain. Transaction costs include the costs of conducting activities between the firm and its upstream suppliers or downstream customers. The supply chain view includes the portion of each trading partner's costs associated with participating in a specific supply chain. The supply chain cost differs from the sum of the trading partners' costs since any trading partner may simultaneously participate in multiple supply chains. This dimension captures the costs incurred by employing a specific strategy across the supply chain. Product costs include those costs, direct and indirect, associated with the product. Product characteristics are used to classify or categorize costs. Product design captures all the supply chain costs associated with the research and development of a product, or product category, across the supply chain. Production costs incorporate all the production costs, including raw materials, components, and subassemblies. The life‐cycle category encompasses all the costs incurred by the supply chain during the lifespan of the product, from initial concept and design through to disposal and recycling.
These three dimensions act as a kaleidoscope, allowing managers to view costs in different ways simultaneously. Cost information can be portrayed as needed by product, process, or trading partner/channel to support decisions managers make. Within the supply chain, all costs need to be identified to be effectively analyzed and controlled. These dimensions encompass a wider array of costs than incorporated in traditional cost systems.
How Firms Are Responding to the Need—Four Approaches
We can categorize how managers have responded to the need for a more sophisticated and expanded view of cost management into four different approaches:
- The first approach includes those firms that have developed sophisticated and detailed cost management systems. These firms have begun to expand their line of sight regarding performance and cost information in the supply chain. They do this by requiring their suppliers to provide cost information, estimating their trading partners' costs, or engaging in limited exchanges of cost information with select trading partners.
- The second approach consists of those firms that have held back from attempting to exchange cost information. They hold back because their cost systems cannot provide the needed information; development of a more sophisticated system appears impractical; managers believe the investment to obtain better cost information may not be worth the effort; they anticipate that impending ERP implementations will produce the needed capability; or they have major operational issues to address before being able to commit resources to obtain better cost information.
- The third approach includes many small suppliers and customers that lack an understanding of supply chain management or costing techniques. Despite their size, these firms represent a large proportion of many supply chains and have a significant effect on process performance (time, quality, functionality, and flexibility) and costs.
- The fourth approach encompasses managers who understand how interactions between and across the supply chain drive cost and performance both within their firms and in their trading partners. These managers and their firms have embarked on a journey toward having end‐to‐end visibility across the entire supply chain, or what we refer to as supply chain costing. Some firms are much further along this journey than others; however, no firm has yet completed the journey. Due to the complexity of the process, participation in multiple supply chains, the varying capabilities of other trading partners, and ongoing changes occurring in the supply chain, few firms will ever fully complete this journey. Managers recognize that the journey may never be fully completed, but the knowledge and insight available to managers and the potential to achieve sustainable cost reductions and performance improvements makes the journey a worthwhile pursuit.
Integrating Supply Chain Activities
Integration of supply chain activities offers significant opportunities for cost reduction. Although the costs, complexities, and risks of managing a highly integrated supply chain can be as substantial, they are not significantly different from the costs of integrating and operating a corporation of comparable size.6 In many instances, how costs will change due to integration is not well understood or recognized. As a result, most supply chain integration efforts have, to date, been limited in scope.
Supply chain costing is fundamental to the concept of supply chain management. Cost reduction is one of the most frequently stated objectives of executives employing supply chain management. Few supply chain executives currently have the cost visibility necessary to understand how each trading partner drives cost and performance. Having this understanding coupled with the ability to effectively make cost trade‐offs across the entire supply chain can lead to the identification of opportunities to achieve a sustainable competitive advantage.
Executives across all tiers in a supply chain require a framework for costing and analyzing key business processes. They need to share cost information in a consistent and understandable format to promote trust across multiple trading partners. It is essential to measure and sell the benefits of collaborative action in the supply chain. This means identifying opportunities to lower costs and improve performance, demonstrating the value created for key stakeholders, and translating process improvements into financial performance in the firms' financial statements. It requires determining how each trading partner is contributing to value creation, measuring the progress of the supply chain toward achieving performance targets, and ensuring that the benefits and burdens resulting from supply chain initiatives are equitably allocated among the participating trading partners.
Later sections of this book expand on these ideas by developing the conceptual foundation required for cost management and developing cost information. Supply chain costing tools are summarized and, when appropriate, discussed. There is an emphasis on the importance of aligning performance measures with supply chain management practices and articulating the challenges to reaching the supply chain cost management goals firms are seeking.
SUPPLY CHAIN COSTING DEFINITION
The adoption of supply chain management and a process view results in a different perspective regarding cost management than exists in most firms. The focus shifts from determining and analyzing only the costs incurred within a single firm when producing goods or services to one of determining the costs incurred by the entire supply chain in providing the final product or service to the end user. To improve the value proposition presented to the end user, supply chain managers must look across the entire supply chain for new ways to enhance product or service quality while reducing costs. The need and concept for supply chain costing has been discussed; however, the literature has not previously defined supply chain costing.
Based on the research performed for this book, the following definition of supply chain costing was developed:
Supply chain costing is the collection, expense assignment, and analysis of cost information across all of the work activities comprising a supply chain for the purpose of identifying opportunities to obtain a competitive advantage through a combination of reduced costs or improved performance.
Supply chain managers require an extended view of costs. Companies do not operate in isolation, and many of the costs incurred by a firm are driven by activities and processes performed by external trading partners. As products or services move forward in the supply chain, more and more costs are accumulated. The marketplace cost experienced by the end user is the sum of the activity costs performed by all the trading partners.
Supply chain managers require visibility of costs, and what causes costs, from dirt to dirt to have the ability to control the final cost experienced by the end user (Exhibit 3.6). The exhibit represents at a high level an activity‐based costing (ABC) cost assignment and tracing flow. The “resource” expenses are consumed by the work activities of people and assets. The work activities are in turn consumed by the products and customers. Then, like circus elephants in a line with each one's trunk holding onto the tail of the elephant in front of it, the upstream tier customer's purchase price and volume becomes a “resource” expense to its next tier as a buyer. Without this visibility, managers will miss opportunities to reduce costs or the ability to optimize costs at a more strategic level through interfirm cost trade‐offs.
The process view incorporated in this definition of supply chain costing enhances strategic management by breaking out direct and indirect product costs as well as the transaction and process costs occurring across the supply chain. It involves tracing all types of costs to the products, customers, or channels and measuring their contribution to the firm's profitability. Managers can target the supply chain relationships that yield or show the potential to yield the greatest contributions and act to minimize high cost/low value‐added relationships.
EXHIBIT 3.6 Visibility of Cost Information Provided by Supply Chain Costing
Source: Adapted from Gary Cokins, Activity‐Based Cost Management: An Executive's Guide (New York: John Wiley & Sons, 2001), p. 169. Copyright Gary Cokins. Used with permission of the author.
The combination of activity‐level information and the cost, product, and relationship dimensions enables supply chain costing to categorize costs as needed to support the decisions managers make at the operational, tactical, and strategic levels. Operational decisions will require detailed information involving directly assignable costs and transaction costs by product and trading partner. For example, a purchasing supervisor may be deciding whether to source a product from two competing vendors based on the landed cost or total cost of ownership. In contrast, a tactical decision may involve a different view of costs at a higher level. Supply chain managers may be determining whether to outsource functions and will need to determine how supply chain, interface, trading partner, product, production, and process costs will vary. Strategic decisions would require cost information at a different level. Senior executives would require information regarding how different network designs would drive process costs with each trading partner across an entire supply chain over the entire life cycle of the products being distributed. Supply chain costing can support these different decision‐making levels by having visibility of activity costs and cost drivers.
NOTES
- 1. Douglas M. Lambert and Terrance L. Pohlen, “Supply Chain Metrics,” International Journal of Logistics Management 12, no. 1 (2001): 1–19.
- 2. Douglas M. Lambert, ed., Supply Chain Management: Processes, Partnerships, Performance, Fourth Edition, Ponte Vedra Beach, FL: Supply Chain Management Institute, 2014, p. 2.
- 3. A complete and thorough discussion of this framework, the eight supply chain processes, and the application of these processes to integrate and manage the supply chain can be obtained at drdouglaslambert.com.
- 4. The following section expands on Seuring's framework of cost, product, and relationship dimensions based on the results of the research and review of the literature related to supply chain costing. See Stefan Seuring, “Supply Chain Costing,” in Cost Management in Supply Chains, ed. Stefan Seuring and Maria Goldbach (Heidelberg, Germany: Physica‐Verlag), p. 24.
- 5. Refer to Figure 3.1 for the eight major supply chain management processes.
- 6. National Research Council, Surviving Supply Chain Integration: Strategies for Small Manufacturers (Washington, DC: National Academy of Sciences, 2000), p. 31.