Archive for July 6th, 2010

How Variance Analysis helps in understanding Cost Improvements in Supply Chain?

How many supply chain financial plans turn out to be exactly as planned? Very few or negligible percentage and this means difference between the budgeted level of cost and revenue and the actual level of costs and revenues. This is known as Variance. In short we are all aware of it. We plan a budget for a month and invariably end up with more than planned. We know that there is a variance. But we may not know how that variance did occur. This is an exercise to make that easily understandable for all.

Why should we understand the variance? We may know that material cost is over and above the plan. But we do not know whether it is due to consumption norm variance, price variance or volume variance. We often notice that the warehousing costs have gone. Every one is upset because it is an expenditure which would hurt the profitability. But do we spend time to understand what went wrong and are there opportunities to improve the cost spent on warehousing? Yes, that is possible through variance analysis.

Can any one right away implement Variance analysis? The answer is no, one should follow few steps in order to implement the Variance analysis. What are those steps?

1.Bench mark organizations performance against the best of breed performance and agree the performance norm or standard. For example a store man is expected to receive X number of pallets in a given environment per hour and that would be best of breed performance. After carefully understanding the limitations and opportunities within the organization, one should determine the number of pallets to be received in an hour, which is also known as productivity. And that becomes a norm for receiving activity. This would help us to determine how many store personnel are required to handle receiving activity based on given volume.

2.The next step would be to prepare budgets identifying three important factors, cost, volume, and norm. In other words every cost item in the budget should be derived using the above three drivers. This may not be applicable for fixed costs. This budget should be aligned with the organization’s overall activity plan for the year. This should be specific and customized for each product line.

3.Prepare periodical actual performance with regard to revenue and expenditure and compare with the budgets in order to understand the variance. The periodical actual performance data would be provided by your Finance Department.

4.Now, prepare the variance analysis in three forms, Cost Variance, Volume variance and Norm Variance and understand limitations and opportunities.
Isn’t it very simple? Now let us understand the variance analysis with an example.

Step 1: We have to create the standards:

Standard raw material consumption: 3KG per Unit;
Standard Cost: $11.00 per kg;
Standard labour norm 3 hours per Unit manufactured;
Standard Labour Cost: $4.00 per hour;
Fixed overhead was estimated to be $ 2,520

Step 2: Create the budget, in this case production budget:

The production budget can be drawn up as follows for 300 Units:
Budgeted Material Cost: (300 x 3 Kg. x $11) = $9,900
Labour Cost: (300 x 3 hours x $4) = $ 3,600.00
Fixed overhead: $ 2,520.00
Total Cost of producing 300 Units would be: $16,020.00
Unit Cost: $ 53.40 ($ 16,020/300).

Step 3: Prepare the actual performance (generally taken from Finance Department):

Let us now assume that the following actual information is now available:

Actual raw material consumption: 2.90 KG per Unit;
Actual raw material Cost: $10.77 per kg;
Actual labour norm achieved: 3.41 hours per Unit;
Actual Labour Cost: $4.23 per hour;
Fixed overhead: $ 2,520.00;
Total Units Produced was 325.

Total Cost of Production:

Material Cost – $ 10,150.73
Labour Cost – $ 4,687.90
Fixed Overhead – $ 2,520.00
Total cost – $ 17,358.62
Unit Cost – $ 53.41


There is no significant change in the Unit cost. However, one can notice few positive points and few opportunities for improvement. If we look at the material cost, the raw material usage was efficient by 3.33%; Procurement did a good job by procuring raw material at 2.09% cheaper than budgeted price. However, one can notice labour activity is an area of improvement. The labour productivity has gone down by 13.66% and the cost of labour also has gone by 5.75%. At the end of the day the improvements noticed in material usage saved the day by maintaining the same unit cost in spite of increase in the volume by 8.33%. The below table explains the variance in the form of Norm, Cost and Volume variance.

Action Points:

1.By using appropriate tools, one should evaluate the labour productivity and measure against the best of breed performance in order to understand the areas of opportunity and initiate necessary improvements.

2.At the same time, review the budgeting process and understand what went wrong with regard to labour costs. Implement the improvements to avoid lapses in future.
Before adjusting the budgets, it would be ideal to verify that the raw material consumption pattern is within the allowed limits and product quality is not at stake. And work closely with procurement team with regard to making sure that the material cost savings is sustainable.

It need not be the job of accountants to investigate variances directly, it is up to the supply chain manager and their analysts to monitor the costs closely and make sure that we add value to the business by improving cost efficiency.

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We all worry about Inventory Control and Inventory carrying costs. Let us ask one fundamental question, why we carry inventory at all? There could be many reasons for that but some very important are:

1. It enables the firm to achieve economy of scale.
2. It balances supply and demand.
3. It enables specialization in manufacturing.
4. It provides protection from uncertainties in demand and order cycle.
5. It acts as buffer between critical interfaces within the supply chain.

Even though there are five reasons given, I see only two reasons and they are, to meet uncertain demand and to save costs. The very important reason why we carry inventory at different levels in supply Chain is due to uncertain demand. We carry inventory in anticipation of customer order. That is a fair assumption, but the issue that bothers me is lack of efficiency in demand forecasting. I agree no one is good at creating forecasts accurately. But you can always improve your inaccuracy as you go forward and my question is why we are unable to correct it, is it impossible? No it is not, but it needs some level efficiency to achieve it.

Cartoon Source:http://www.scdigest.com, contributed by Kari McEwen.

The other reason is to achieve economy of scale. Fully justified in case of seasonal demand products such as fire crackers, winter clothing, rain jackets etc. but not sure why should go for mass production for an every day consumed product and suffer from inventory carrying costs?

If some one is able to find answers these two questions, we have cracked the DNA of Inventory Control. In my opinion inventory control is about discipline. Discipline in planning discipline in buying, discipline in selling and discipline in warehousing and managing inventory. If we are able to develop checks and balances to control forecast inaccuracy, we should be infusing discipline into planning activity. If we are able to balance our buying process and do not allow EOQ factor to influence our buying pattern, we would be in a position to control what we buy and buy what we sell. In the name of cost savings, I have witnessed large corporations buying huge quantities and ending up with inventory that bites. As long as one is able to liquidate inventory quickly, it works out well for any organization. Procurement experts should look at establishing collaborative approach with the suppliers and develop solutions to could liquidate non moving inventory and at the same time meet the unplanned demand.

Being a supply chain professional I have worked closely with many sales teams. Surprisingly, I have seen one similarity across all industries and that is, demand is generated for a product for which the organization is running low on inventory. Is it something to do with customer mindset? Not sure. If we agree with a production plan and create inventory for product “A” and invariably the demand is more for product “B” which was not part of our planning. I am unable to understand the reason behind this pattern. We end up creating back orders, low clear to build ratio and order processing is on allocation instead automated.

I have worked with a great and successful CEO who used to send a very simple message to sales, “sell what is available”. It needs great ability to do that. I strongly believe that Sales teams all over the world have the ability to do that. It is only matter of honing that skill aggressively. The best example is the second hand car sales person. Often we end up buying what he wants to sell.

We do hear about inventory shrinkage, it is an unpardonable blunder. One of the objectives of warehousing is to assure protection of assets. If we are unable to achieve it with the help of world class WMS (warehouse management systems) and with best of breed surveillance techniques, it is shame. If you are unable to handle operational excellence, outsource and drive excellence through KPI monitoring and improving.

Explore the possibility of establishing pull process with regard to buying and by using Vendor Management Inventory (VMI) model and differ the inventory ownership. Collaborating with vendors and sharing consumption pattern in order to prepare the suppliers for the demand onslaught or slump. Explore the possibility of using Cross Dock or JIT models (again a pull process). In order to implement all these concepts, the supply should be abundant, delivery cycle time should be very short and competitive market conditions. All industries may not enjoy the luxury of meeting all the above mentioned criteria. In those circumstances, we should explore conventional inventory control techniques and keep the inventory carrying costs down.

Inventory carrying cost us in $$ and it may not appear in P&L as a direct cost, but it is a fact that it costs us up to 25% per annum as explained in the below given graphic.

Hence, it is essential to control the inventory and add value to the business process by minimizing inventory carrying costs. In order to control inventory we need inventory status update on online basis (inventory visibility). The first step towards inventory optimization is to know your total inventory in supply chain. The second step would be to understand poor inventory management symptoms. They are:

1. Increasing number of back orders;
2. Low Inventory Turns;
3. High Customer Turnover rate;
4. Lost Sales;
5. Periodic lack of sufficient storage space;
6. Inventory Variance;
7. Obsolete inventory.

Some of the suggestions for improving inventory control:

1. Create Inventory Visibility;
2. Introduce aging (FSN) analysis of Inventory if not already in practice;
3. Create accountability and introduce incentives for meeting inventory targets;
4. Implement Cycle Counts every week and ensure stock take once a month;
5. Classify the inventory (A,B, and C) and increase focus on big ticket items;
6. Improve surveillance efficiency to eliminate pilferage;
7. Optimize Ordering Process;
8. Share POS information and consumption patterns with Vendors;
9. Make Vendors jointly responsible for avoiding stock outs and excess inventory;
10. Align supply with Demand;
11. Invest time in reducing supply lead time;
12. Partner with suppliers with great flexibility to adopt to the changing demands;
13. Introduce checks and balances in Forecasting methodology;
14. Develop six month rolling forecast plan and freeze some portion of the plan depending upon supply lead time;
15. Opt for modular production techniques;
16. Deploy excess buffer manufacturing capacity/encourage like minded third party manufacturers;
17. Introduce postponement to address product differentiation;
18. Explore possibility of inventory differing concepts for dependent demand related products;
19. Consider Inventory balancing in a decentralized inventory carrying situation;
20. Consider consignment sales for independent demand products to maximize sales.

We all know these techniques but still end up with huge inventory. The reason behind the debacle is lack of discipline in implementing the best practices and silo approach adopted by majority of organizations. In order to achieve overall success, we need an integrated and collective approach internally and collaborative approach externally.

Cartoon Source:http://www.scdigest.com, contributed by David Armstrong.

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Do we have Retail supply chain, FMCG supply Chain, automotive supply chain, IT supply chain etc? In my opinion, no and what we have is “PULL” Supply Chain and “Push” Supply Chain”. Supply chain processes fall into one of two categories depending on the timing of their execution relative to customer demand. All the above industries fall under Pull or Push supply chain. We have also seen hybrid new model called “Pull and Push” supply chain. What ever is the industry, as long as you make supply chain efficient using either pull techniques or push techniques or both, that is what matters to the business.

What is Pull Supply Chain?

Under pull supply chain, products are manufactured or procured based on specific customer requests. We also know it as “Built to Order” or “Configured to Order” model. We often see this model operating in IT/High Tech Industries, where customization is the competitive advantage. Briefly, we have seen this model in automotive industry and it is being used in high end luxury market segment. The objective of this model is to minimize the Inventory carrying and optimize supply. Pull model are is as a response to growing uncertainty in demand and short product cycle. Some of the characteristics of this model include:

1. Volatile demand situation;
2. High rate of Customization;
3. Minimal Inventory Carrying;
4. Not a off the shelf product;
5. Highly dynamic and effective distribution network.

Even though there are many challenges in implementing a pull supply chain in a globalized environment, converting a push supply chain into a pull supply chain is considered as next frontier of innovation and lean thinking. Particularly if we are able to implement pull process for procurement activity and take advantage of Point of Sale information to provide the demand visibility to suppliers, it would be a great innovation. Again supply chain visibility is a very challenging aspect and costly proposition as well. However, if we are able to achieve overcoming all hurdles, the business would be saving costs (warehousing, inventory carrying; capital costs etc.) and also could introduce JIT or Cross Dock Operation which are again cost efficient models. As the pull of material is linked to POS data and store inventory data, the buffer inventory if any in the supply chain will get corrected automatically from time to time eliminating excess inventory. This process would eliminate waste and save costs and also known as agile supply chain model. Internet becomes the backbone of this model. This model could work very well in FMCG industry if the business model is well understood and a solution is developed and implemented efficiently.

What is Push Supply Chain?

Under Push model, products are manufactured or procured based on anticipated customer orders (speculative). This model is also known as Built to Inventory or Built to Sock. The name itself reveals its functionality. Products are manufactured in anticipation of customer needs. There are no prizes for identifying industries that use push model, it is obvious that retail heavily uses push model. Even though direct to store or cross docks are implemented, overall retail supply chain is based on push model. Some of the big names in the retail industry are trying to adopt the hybrid model which is a combination of pull and push. Some of the key challenges and characteristics could include:

1. High inventory costs,
2. Challenging working capital requirements due to low inventory turns;
3. Huge warehousing and distribution costs;
4. Inability to meet dynamic market conditions and
5. Seasonal demand and off the shelf product.

Push programs represent a top down approach. The core assumption of push programs is that demand can be anticipated and that it is more efficient and reliable to mobilize resources in pre-specified ways to serve this demand. However, in reality globalization posed several challenges and one of them is hyper-competition. Hyper-competition is a state, in which the rate of change in the competitive rules of the game are evolving rapidly and business survival is becoming a challenge. As the customers are becoming demanding, if the product is not available in the store, they are willing to look at other options in the market place. This is forcing retailers carry huge inventories and opt for low cost sourcing models which in turn increase the procurement cycle time. In case of demand slump due to financial recession or change buying habits or seasonal weather conditions, businesses are forced to create artificial demand by unleashing promotions in a scale never seek in market place. To objective is to draw the customer to the store and try to sell the product. Product proliferation and Scrambled Merchandising is further making push model more complex and challenging for the retail industry and for push model.

The world is becoming a complex place to do business. It is up to the Supply Chain managers to come forward and take the responsibility of aligning supply chain to business needs and objectives. There is an urgent need for Supply Chain experts who can customize supply chains to need of the hour. Do away with recycling supply chain professionals within the industry. Embrace change in order to innovate and improve supply chain health. A true supply chain professional should be comfortable working in a pull or push environment as long as S/he is functionally and professionally trained using both models. Having said that, supply chain is a not a rocket science, it is all about commonsense and thinking outside the box.

Cartoon Source: http://www.scdigest.com, contributed by Gerry Anderson

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