Management Accounting in Supply Chains [1st ed.] 9783658285968, 9783658285975

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Andreas Taschner Michel Charifzadeh

Management Accounting in Supply Chains Inkl. SN Flashcards Lern-App

Management Accounting in Supply Chains

Andreas Taschner • Michel Charifzadeh

Management Accounting in Supply Chains

Andreas Taschner ESB Business School Hochschule Reutlingen Reutlingen, Baden-Württemberg Germany

Michel Charifzadeh ESB Business School Hochschule Reutlingen Reutlingen, Baden-Württemberg Germany

ISBN 978-3-658-28596-8 ISBN 978-3-658-28597-5 https://doi.org/10.1007/978-3-658-28597-5

(eBook)

# Springer Fachmedien Wiesbaden GmbH, part of Springer Nature 2020 This work is subject to copyright. All rights are reserved by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors, and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. This Springer Gabler imprint is published by the registered company Springer Fachmedien Wiesbaden GmbH, part of Springer Nature. The registered company address is: Abraham-Lincoln-Str. 46, 65189 Wiesbaden, Germany

Preface

Companies more and more compete as integrated supply chains rather than as individual firms. The success of the entire supply chain determines the economic well-being of the individual company. With management attention shifting to supply chains, the role of management accounting naturally must extend to the cross-company layer as well. Management accounting can make a significant contribution to supply chain success but is faced with a multitude of problems and challenges when trying to do so. Different corporate governance schemes, limited information exchange, goal system inconsistency, and process diversity among supply chain partners are just some examples in this respect. Students in supply chain management or management accounting are typically not familiarized with these issues. There is still a clear gap in higher education teaching when it comes to management accounting in a cross-company setting. Management accounting courses typically focus on a single entity’s performance only. Supply chain management courses, in turn, often touch on accounting and reporting aspects only marginally. It is no surprise, therefore, that there is not a single textbook available (neither in German nor in English language) that would cover supply chain management accounting in all its facets. This textbook tries to fill this gap. Our motivation for authoring this textbook comes from writing about a subject that we enjoy and find stimulating. As authors, we hope that we can pass on to the reader not only knowledge but also the excitement that we feel for the subject.

Intended Audience Since supply chains are most often international by nature and supply chain management accounting concepts do not differ between regions, the textbook is written in English language. It addresses readers both in Europe and overseas. This textbook covers the relevant topics in supply chain management accounting of a university course at a graduate level. The book has been written primarily for courses that

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are run in English language. It targets students who are already familiar with the fundamentals of management accounting and now want to extend their expertise in the field of cross-company (or network) management accounting—with supply chains being the typical case in point. Likewise, practitioners might draw valuable insights from the text. This book will be helpful for any of the following: – Intermediate and advanced courses or electives in supply chain management accounting for graduate students (MSc, MBA) – Intermediate and advanced courses in executive development programs – As a handbook for practitioners with a practical background in either accounting or supply chain management

Features of This Book – Textbook style The format of the book is textbook style, turning to theoretical concepts as far as these are necessary to understand the discussed topics. Each chapter provides learning objectives and gives practical examples that provide opportunities to learn and apply the content. – Scientific basis and practical application Both supply chain management and accounting in organizations are by nature practical tasks. However, with supply chain management accounting being a topic of a rather advanced nature, we consider it essential that readers have the necessary theoretical insights when making decisions in this field. Problems in a supply chain setting are often complex and require more insight than a simple “one-size-fits-all” approach. Therefore, this textbook equips readers with a thorough theoretical background that allows far-sighted decisions. Each chapter closes with an extensive list of references, which readers can use to work their way deeper into a specific topic. At the same time, the book provides examples of practical problems and solutions that prepare readers for application in real business situations. – International approach Since this book addresses readers in Europe and overseas, the contents and learning objectives do not target a particular region. Most supply chains are international nowadays and so is the focus of this book. – Assessment material Review questions and exercises at the end of each chapter facilitate the use of the text on the targeted range of courses: Review questions are short and help students to recapitulate and to review the most important aspects of a chapter, either individually or in a group. Exercises are usually embedded in a small case and feature a very practical approach. They help students to apply the learned competences.

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– Recommended chapter sequence The sequence of chapters has been deliberately chosen. From our long teaching experience as well as from industry insights, we believe that it makes sense to introduce students to the topic with a classification of supply chain management, management accounting, and the combination of both as a new discipline. Right after that, we lay the theoretical groundwork for supply chain management accounting and we outline its main challenges in practice. While the chapters are written mostly independent from each other, we would recommend following the chapter sequence in this book: Chaps. 4 and 5 deal with cost accounting and cost management. Chapters 6 and 7 cover concepts of supply chain finance and risk management. Chapter 8, ultimately, deals with performance measurement in supply chains, partly drawing from and referring to concepts discussed in previous chapters. Of course, readers with some background knowledge are free to choose from the covered topics in whatever sequence desired. – Supplementary materials This book provides additional study material, which will be available on the accompanying web site. This includes solutions to the end-of-chapter review questions and exercises. Additionally to these review materials, owners of the book have access to more online resources. Springer Nature Flashcards provide online quizzes for each chapter, containing numerous multiple-choice questions and assignments. To access Springer Nature Flashcards, enter your code provided with this book and follow the instructions.

Identical Chapter Structure All chapters in the book feature the same structure. Every chapter opens with a visualization of contents covered. Following that, each chapter outlines the learning objectives to be reached after having worked through the text. Learning objectives are clearly formulated knowledge, skills, or competencies that a reader should have after having worked through the chapter. At the end of each chapter, a glossary includes the most important concepts covered in the text. All chapters include review questions and exercises to deepen the knowledge and to control the learning progress. The review questions help the reader recapitulate selected issues and the exercises help students to apply the learned competences. Finally, every chapter ends with listing the literature that has been used. The text follows scientific standards by citing all relevant literature. These references provide readers with helpful links to scholarly works in the respective subject. Reutlingen, Germany

Andreas Taschner Michel Charifzadeh

Acknowledgments

The book reflects the efforts of many people. We gratefully acknowledge the continuous help and guidance of Catarina Gomes de Almeida from Springer Gabler from the initial idea of the book until its final publishing. We cannot list all the names here, but we are indebted to numerous students of our courses and colleagues for their feedback, ideas, and their inputs. A heartfelt thank you goes to our loved ones whose support and patience made this book possible in the first place. This book is dedicated to them.

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Contents

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Supply Chains, Supply Chain Management and Management Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.1 Management Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.2 Logistics and the Supply Chain Concept . . . . . . . . . . . . . . . . . . . . . . 1.3 Supply Chain Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.4 The Role of Management Accounting in Managing Supply Chains . . 1.5 Glossary and Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.6 Review Questions and Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Theoretical Concepts Relevant for Supply Chain Management Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.1 Why Theory Matters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2 The Neoclassical View and the Coase Theorem . . . . . . . . . . . . . . . . . 2.3 Transaction Cost Economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.4 Resource-Based Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.5 Agency Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.6 Summary: What We Learn from Economic Theory About Supply Chain Management and Supply Chain Management Accounting . . . . . . . . . . 2.7 Glossary and Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.8 Review Questions and Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Challenges in Supply Chain Management and Supply Chain Management Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.1 How Cross-organizational Collaboration Differs from Intra-company Collaboration: An Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2 New Governance Structures and Coordination Mechanisms . . . . . . . . 3.3 Interdependency Affecting Allocation Tasks and Surplus Appropriation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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3.4

The Impact of Uncertainty, Opportunism, and Trust on Information Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.5 A New Understanding of “Performance” . . . . . . . . . . . . . . . . . . . . . 3.6 Glossary and Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.7 Review Questions and Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Cost Accounting in Supply Chains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.1 A Brief Recap: Cost Accounting Tasks in an Enterprise . . . . . . . . . . 4.2 The Nature of Supply Chain Cost . . . . . . . . . . . . . . . . . . . . . . . . . . 4.3 Challenges and Approaches for Supply Chain Cost Accounting . . . . . 4.4 Open Book Accounting: A Way to Supply Chain Cost Accounting? . 4.5 Glossary and Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.6 Review Questions and Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Cost Management in Supply Chains . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.1 From Cost Accounting to Cost Management . . . . . . . . . . . . . . . . . . . 5.2 Inter-organizational Cost Management: An Overview . . . . . . . . . . . . 5.3 Chained Target Costing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.4 Kaizen Costing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.5 Life Cycle Costing in Supply Chains . . . . . . . . . . . . . . . . . . . . . . . . 5.6 Activity Based Costing in an Inter-organizational Setting . . . . . . . . . . 5.7 Glossary and Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.8 Review Questions and Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Supply Chain Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.1 The Need for Supply Chain Finance . . . . . . . . . . . . . . . . . . . . . . . . . 6.2 Working Capital Management Across the Supply Chain . . . . . . . . . . 6.3 Collaborative Cash-to-Cash Cycle Management . . . . . . . . . . . . . . . . 6.4 Supply Chain Finance Instruments: An Overview . . . . . . . . . . . . . . . 6.5 Selected Collaborative Supply Chain Finance Instruments . . . . . . . . . 6.6 Glossary and Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.7 Review Questions and Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Risk Management in Supply Chains . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.1 Defining Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.2 Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.3 Risk Identification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.4 Risk Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.5 Risk Response . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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7.6 Risk Response Planning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.7 Collaborative Risk Management in Supply Chains . . . . . . . . . . . . . . 7.8 Glossary and Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.9 Review Questions and Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Performance Measurement in Supply Chains . . . . . . . . . . . . . . . . . . . . . 8.1 Performance Measurement: An Overview . . . . . . . . . . . . . . . . . . . . . 8.2 Characteristics of Performance Measures in Supply Chains . . . . . . . . 8.3 Measuring the Performance in Supply Chains . . . . . . . . . . . . . . . . . . 8.4 Measuring Financial Performance of Single Entities in Supply Chains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.5 Measuring Operating Performance of Single Entities in Supply Chains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.6 Measuring Financial Performance of the Entire Supply Chain . . . . . . 8.7 Measuring Operational Performance of the Entire Supply Chain . . . . . 8.8 Measuring Relation-Oriented Performance Among Supply Chain Partners . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.9 Performance Measurement Systems in Supply Chains . . . . . . . . . . . . 8.10 Problems of Performance Measurement in Collaborative Networks . . 8.11 Glossary and Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.12 Review Questions and Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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About the Authors1

Andreas Taschner holds a diploma and a doctoral degree from Wirtschaftsuniversität Wien (Vienna University of Economics and Business). He has more than 10 years of industry experience. He was appointed Professor of Management Accounting at ESB Business School at Reutlingen University in 2011. His teaching and research interests include supply chain management accounting, comparative management accounting, management reporting, and investment appraisal techniques.

Michel Charifzadeh holds a diploma in business administration from Ludwig Maximilians University Munich and received his doctoral degree from EBS Universität für Wirtschaft und Recht, Oestrich-Winkel. He has worked several years as a project manager in mergers and acquisitions at Siemens AG. He was appointed Professor of Financial and Management Accounting in 2011 at ESB Business School at Reutlingen University. Michel Charifzadeh has been teaching and publishing in the fields of management accounting and control, performance measurement, financial accounting, corporate finance, company valuation, and mergers and acquisitions.

1 Both authors hold a chair and teach at ESB Business School, Reutlingen University. They have been researching, publishing, and teaching in the field of management accounting and management control for many years.

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Supply Chains, Supply Chain Management and Management Accounting

Supply Chain Concept

Supply Chain Management (SCM)

Management Accounting (MAC)

SCMAC

This textbook deals with management accounting in supply chains—two areas that many readers might not consider to be very close to each other. In fact, this assumption is wrong, as we will try to outline in the following. However, before diving deeper into the exciting world of supply chain management accounting, we need to develop an understanding of our two objects of investigation: On the one hand, what is a supply chain and what does “managing a supply chain” mean in practice? Is there a difference between logistics and supply chain management? On the other hand, what do management accountants do and how does their work relate to the management of supply chains? What tasks and problems might a cross-disciplinary function such as “supply chain management accounting (SCMAC)” possibly deal with? It is questions like these that need to be answered before we continue. This introductory chapter will do just that.

# Springer Fachmedien Wiesbaden GmbH, part of Springer Nature 2020 A. Taschner, M. Charifzadeh, Management Accounting in Supply Chains, https://doi.org/10.1007/978-3-658-28597-5_1

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Supply Chains, Supply Chain Management and Management Accounting

Learning Objectives After completing this chapter, you should be able to: 1. 2. 3. 4.

Define management accounting Explain the role of logistics and the “7 Rs” Understand the concept of a supply chain Define the concept of supply chain management and explain how it can create a supply chain surplus 5. Discuss and justify the need for a new discipline of supply chain management accounting

1.1

Management Accounting

As the name suggests, management accounting denotes that part of accounting that primarily deals with the information needs of managers. Generally, we distinguish the two siblings of the accounting family: financial accounting and management accounting. While financial accounting is oriented toward the information needs of external stakeholders (investors, creditors, customers, suppliers, the general public, etc.), the management accounting function focuses on internal stakeholders with management and decision making authority. Both financial accounting and management accounting share the common traits of all accounting systems. An accounting system: – – – – –

Records and stores The stocks and flows Of scarce goods and resources That have a value to the company in order to Ensure efficient and effective use of these goods and resources (Taschner and Charifzadeh 2016).

While financial accounting is subject to a tight regulatory regime, firms can develop and implement their respective management accounting systems as they see fit. The tasks and the scope of a management accounting system, therefore, is first and foremost defined by the management’s tasks and the information needs derived from them (Taschner and Charifzadeh 2016, Charifzadeh and Taschner 2017): 1. Planning: setting up plans and forecasts, anticipating potential future events and developments or future consequences of today’s decisions and actions. 2. Decision making: choosing between different alternatives and selecting the alternative that promises the greatest reward or the highest degree of goal achievement.

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Management Accounting

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3. Organizing: arranging the different elements of an organization into a purposeful and efficient order or structure. The main elements typically are assets, human resources, financial funds, and information. 4. Commanding and leading: influencing and motivating people (both inside and outside of the organization) to reach a desired goal. 5. Coordinating: harmonizing and aligning the structures, the processes, and the activities performed by the members of an organization towards common goals in order to avoid conflicts and dissynergies. 6. Monitoring: checking if an organization’s activities are consistent with its targets and goals, measuring the degree of goal achievement, initiating corrective actions and providing feedback to people involved. 7. Documenting: recording what has happened and what has been done in the past in order to provide a basis for future learning and assign responsibility and accountability for past actions and decisions. Management accounting is the internal accounting system that supports managers in carrying out management tasks (Charifzadeh and Taschner 2017). Readers must keep in mind that “management” is not synonymous with “top management” only. Management tasks can be found at different hierarchical levels. Project managers, key account managers, and product managers all have a need for accounting information in order to accomplish their tasks. Their main information source is management accounting—which, therefore, must be both comprehensive and flexible enough to satisfy different information needs of different management functions in the company. In fact, functional specialization in management also leads to a corresponding specialization in management accounting. In bigger companies, therefore, individual management accountants might be occupied with R&D issues only, while others focus on project control or logistics, for instance. The discipline that has above been labeled as “management accounting” is often also called “management accounting and control (MAC)”. In fact, control is an integral and indispensable element of any management accounting system. Control is possible only if and when devices, systems, processes, and activities are in place that ensure that a company’s plans and goals are achieved. Management, therefore, always encompasses control. Managing in the above sense is not possible without controlling outcomes and results of management actions. The same line of reasoning applies to management accounting as a support function. It is, therefore, a matter of personal taste rather than scientific rigor whether one prefers the label “management accounting” or “management accounting and control (MAC)”. We will consider both terms as synonymous in this book but will use “MAC” as an abbreviation only. In German-speaking countries, the term “Controlling” is typically used for MAC. Although the term might, at first sight, suggest otherwise, it is not limited to the control aspect only but comprises all tasks and activities that have been described as typical MAC functions. “Controlling” became popular in Germany in the early 1970s, when it was introduced mainly as a fashionable name for cost accounting, reporting, and budgeting

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(Schäffer and Binder 2008). In the meantime, though, the scope of controlling started to encompass all planning and management control processes at an operative as well as a strategic level. It is, therefore, safe to say that as of today, the German “Controlling” concept can be considered to be widely synonymous with management accounting and control (MAC).

1.2

Logistics and the Supply Chain Concept

From its early beginnings, human civilization depended on the ability to transport and store goods effectively and efficiently (Zijm et al. 2019). Erecting pyramids in Egypt or in Central America posed huge logistical challenges. Linking the Chinese empire with medieval Europe through what has become known as the “silk road” was first and foremost a logistical task. Trade nations such as the Netherlands or the British Empire established a network of trade outposts, harbors and fortified settlements across the globe in order to protect and manage transportation routes between their colonies and the home country. Not least, wars often have been won or lost on the basis of logistical strengths or weaknesses, respectively (Christopher 2016). The logistics discipline plays a huge role in global economy nowadays, and its importance continues to increase. In Germany, for instance, total revenue of the logistics industry has increased since the turn of the century by 81% to a volume of 279 billion € in 2019 (see Fig. 1.1). This represents more than 8% of Germany’s GDP. Factors that drive the growth of logistics are manifold. A main driver has been the globalization of trade; however, one can surely postulate a mutual interrelation of globalization and logistics. The expansion of global trade has increased the need for logistical solutions, such as standardized shipping containers (Murphy and Knemeyer 2018). Vice versa, the growth of logistics has been a catalyst for global trade. Without more and more sophisticated logistical solutions, global trade would not have been able to grow to the levels we observe today. Trade partners all over the world would not have been able to cross such large distances in an acceptable time and at bearable costs. Another factor boosting logistics in the past was widespread deregulation in many parts of the world in the 1970s and 1980s, which has led to relaxing governmental controls of carrier’s rates and fares since then. For instance, in the mid-1980s, lessened economic regulation of transportation in the EU resulted in lower road transport prices, thus boosting the trucking industry in Europe (Lafontaine, Malaguzzi Valeri 2009). In addition to this, we observe changes in consumer behavior, facilitated by changes in technology. Shopping online 24 h and convenient home delivery in various options such as next-day or even same-day delivery is in the meantime a part of our everyday life. It poses growth in logistics but also challenges at the same time. Here, technology works in two ways. It’s the technology that makes our consumer behavior possible (e.g. ordering goods and services on the internet) and at the same time, technology enables a vendor to satisfy

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TOTAL REVENUE IN BIL. EURO

Fig. 1.1 Total revenue of logistics industry in Germany (source: Bundesvereinigung Logistik; Fraunhofer SCS 2019)

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1.2 Logistics and the Supply Chain Concept 5

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the increased consumer demands. Without modern technology-based logistics management systems (such as automated order-picking systems), this would not be possible. The “7 Rs” (7 Rights) of Logistics Let’s have a look at how to define logistics. Of course, transportation and storage tasks are in the heart of the logistics discipline. While transport deals with the bridging of physical or geographical distances, storage bridges temporal distances, i.e. the time between supply or creation of an object and its subsequent use or consumption. However, logistics is more than “just moving and storing objects” as such. Expectations of modern logistics are high and can be summarized in the “7R objectives” or “7 rights” of modern logistics (Swamidass 2000, Zijm et al. 2019): – – – – – – –

The Right goods (i.e. as ordered) In the Right quantity With the Right quality At the Right time At the Right place At the Right cost At the Right sustainable impact/footprint”

Logistics is far from being an easy self-runner. Ensuring that these 7R objectives are met clearly requires management intervention. The logistics discipline, therefore, comprises operating tasks (handling shipments, labeling containers, loading trucks, etc.) as well as management tasks (scheduling transportation routes, negotiating contracts with freight forwarders, collecting and monitoring cost of resources employed in logistics, etc.). Logistics, therefore, can be defined as managing the procurement, movement, and storage of materials, parts or finished goods through the organization and its adjacent channels (Christopher 2016). Logistics in this sense encompasses both inbound and outbound flows as well as material flows that happen within company premises only (e.g. feeding a manufacturing line from buffer stock). Movement of physical objects is not possible without a related exchange of information, though. The point of origin and the point of consumption of assets and objects must communicate with each other. Modern logistics, therefore, must also manage the information flows that relate to physical flows (Zijm et al. 2019, Christopher 2016). Supply Chains While logistics has been around for many centuries already, the notions of “supply chains” and “supply chain management (SCM) are much more recent phenomena. The credit for having invented the SCM concept often goes to consultants Oliver and Webber at Booz Allen Hamilton in the early 1980s (Oliver and Webber 1982), who discussed the potential benefits of integrating the internal business functions of purchasing, manufacturing, sales and distribution (Alfalla-Luque and Medina-Lopez 2009). The idea of functional

1.3

Supply Chain Management

7

integration was soon extended beyond a firm’s organizational boundaries in order to include also those value-adding tasks and activities that are performed by external partners (suppliers, distributors, etc.). These value-adding activities are by no means limited to transportation and storing tasks. The sequence—or rather: network—of value-adding tasks and activities across various firms is at the heart of the supply chain concept. A supply chain can simply be defined as “. . . all functions involved in receiving and filling a customer request” (Chopra and Meindl 2016, p. 13). The ultimate goal of a supply chain is the maximization of supply chain surplus— defined as value to the end-customer minus total supply chain cost. Supply chain surplus can be shared among all partners in the supply chain—including the final customer. It is immediately apparent that a supply chain must comprise many tasks and activities that are not directly related to physical movements or storage, respectively. This has important implications when it comes to managing the supply chain.

1.3

Supply Chain Management

As has been outlined in the previous section, the term “supply chain” was first coined in the early 1980s. It took a few years, however, until supply chains were seriously considered as an object of management attention. In many of the leading academic journals, first references to supply chains and their management were made in the late 1980s and early 1990s (Alfalla-Luque and Medina-Lopez 2009)—almost a decade after the inception of the concept. Since a supply chain is a much broader notion than logistics, managing a supply chain also must have a broader focus than logistics management. Supply chain management (SCM) can be defined as . . .the management of upstream and downstream relationships with suppliers and customers in order to deliver superior customer value at less cost to the supply chain as a whole. (Christopher 2016, p. 3)

In the previous sub-section, we have defined the difference between value created and cost incurred as supply chain surplus. SCM encompasses all planning and management actions across supply chain partners upstream and downstream in order to maximize supply chain surplus. Since SCM encompasses logistics tasks, it also includes the management of physical flows. However, it is not restricted to physical flows management only (compare to Fig. 1.2). SCM also includes information flows as well as financial flows across supply chain partners, since proper management of these flows can also be a major source of value to the supply chain (Werner 2017). Effective supply chain management involves the management of supply chain assets and product, information, and fund flows to grow the total supply chain surplus (Chopra and Meindl 2016, p. 16).

Financial flows

Physical flows

Coordinating

Production stage 1 Retail

Commanding and Leading

Financial flows

Physical flows

Information flows

Production stage 2

Information flows

Fig. 1.2 Supply chain management (source: Knolmayer et al. 2009, p. 4, adapted)

Monitoring

Physical flows

Financial flows

Supplier

Information flows

Supply Chain

Financial flows

Physical flows

Information flows

Customer

Decision making

Organizing

1

Documenting

Planning

8 Supply Chains, Supply Chain Management and Management Accounting

1.3

Supply Chain Management

9

Since the various flows of material, information and money must be managed, this naturally involves the full bandwidth of business functions in an organization. Material flows would be managed by procurement, manufacturing or distribution, financial flows by finance and accounting and information flows, for instance, by marketing or legal, but this is surely not a complete list. Eventually, information flows will involve all corporate functions in a firm. An alternative definition of SCM, therefore, can also focus on its cross-functional nature. In this perspective, SCM comprises . . . the systemic, strategic coordination of the traditional business functions and the tactics across these business functions within a particular company and across businesses within the supply chain, for the purposes of improving the long-term performance of the individual companies and the supply chain as a whole. (Mentzer et al. 2001, p. 18)

Additionally, managing these diverse streams of resources across organizations requires customized tools. In performance measurement, for instance, monetary measures such as financial ratios would not be sufficient to capture all dimensions of managing a supply chain. We need to select performance measures that are capable of depicting the diverse flows of material and information, too. To conclude, the key characteristics of SCM can be summarized as follows: 1. SCM applies a cross-organizational perspective that ranges from the source of supply to the final end-customer. The single firm is no longer the key management object. Instead, SCM goals apply to individual supply chain partners as well as to the entire supply chain network. 2. SCM is not focused on management of physical flows only, but integrates information flows and financial flows into its perspective, since these are important sources of supply chain value. Maximization of supply chain surplus is not possible by managing the flow of goods and material only. 3. SCM is not only cross-organizational, but also cross-functional. Since the different flow types are under the responsibility of numerous different corporate functions, SCM must take a holistic view and integrate perspectives as diverse as operations, marketing, or finance and accounting. 4. SCM can no longer apply purely financial measures of success only. Instead, supply chain performance must be viewed as a multidimensional construct. 5. SCM’s ultimate goal is to maximize supply chain surplus—which is shared between the final supply chain customer and all firms contributing to creating value for the final customer. To some degree, managing a supply chain is not entirely different from managing a single firm or a specific corporate function within that firm: goals must be defined, activities must be organized, staff must be motivated and guided, etc. The characteristics of SCM outlined above, though, clearly show that managing a supply chain poses some significant

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additional challenges, which are mostly due to its cross-organizational and cross-functional nature. Not surprising, then, that support for supply chain management will have to take these issues into account. We will turn to this next when introducing the notion of supply chain management accounting (SCMAC).

1.4

The Role of Management Accounting in Managing Supply Chains

Management accountants support managers in their managerial tasks—be they general managers, project managers—or supply chain managers! At a conceptual level, supply chain management accounting (SCMAC) does not differ from “traditional” management accounting (MAC). The key management tasks (planning, decision making, motivating, monitoring, etc.) of course also apply when managing the entire supply chain. Based on such a line of reasoning, one might argue that SCMAC is well-advised to stick to the set of well-developed and extensively tested MAC tools and instruments that have been used in firms across the world for many years. There is no need for any new, SC-specific MAC tools and methods. If at all, existing MAC instruments might need some adaption to be suitable for supply chain management support (Jeschonowski et al. 2009). In fact, management accounting education still seems to follow this line of reasoning to a large extent. Supply chain-specific problems are not (yet) in the focus of MAC education. Let us substantiate this claim with a few selected examples: – In 2012, the Pathways Commission on Accounting Higher Education published its “National Strategy for the Next Generation of Accountants” (Pathways Commission 2012). The competency model developed by the Commission is multi-faceted and the report aims at establishing a foundational body of knowledge for future accountants but does not make reference to SCM or SC-related problems. – Apostolou et al. (2016), who review recent journal papers on accounting education, find continuing interest in establishing the core competencies of accounting but no article on SC-related aspects of accounting through the entire period studied. – In an extensive study, reviewing 114 higher-education textbooks, Taschner and Charifzadeh (2020) did not find substantial coverage of SCMAC tools and instruments, neither in SCM nor in MAC textbooks in German and English speaking countries. – In German-speaking countries, the International Controller Association (ICV) is the most widely recognized professional body for MAC. In its position paper on Controlling, the association outlines six broad competencies a modern controller should possess, but does not mention supply chains or inter-organizational issues (ICV 2013). – A notable, albeit somewhat rudimentary exception, is the body of knowledge as defined by the Institute of Certified Management Accountants in its content specifications for Certified Management Accountants (CMA) examinations (CMA 2014). The content specification dedicates a sub-section of the cost management section to supply chains—

1.4

The Role of Management Accounting in Managing Supply Chains

11

covering the following elements and concepts: Lean manufacturing, enterprise resource planning (ERP), theory of constraints and throughput costing, capacity management and analysis. Although this enumeration seems somewhat arbitrary, it is at least an explicit acknowledgment of the interface between MAC and SCM. Basing his judgment on some of the most prestigious and widely used frameworks of MAC education, a newcomer to the discipline would be tempted to assume that supply chains are not a relevant object for management accountants—at least none that would justify special treatment. There is indeed good reason to doubt whether today’s management accounting professionals already possess the skills and the cross-disciplinary business acumen that is needed to fulfill their support tasks in modern supply chains. Supply Chain Management Accounting as a New Discipline The time has come for a more serious look at SCMAC. First, companies more and more compete as integrated supply chains rather than as individual firms. The success of the entire supply chain determines the economic well-being of the individual company. Given the crucial role of supply chains for company success, it is increasingly important to understand how the coordination of the supply chain relationships can be achieved and how management control mechanisms can be used to support, plan, measure and assess supply chain results and performance (Ramos 2004). The demand for MAC support will continue to grow among supply chain managers to the same extent that their own function becomes critical for company success. Second, MAC as an academic discipline has seen the development of a number of concepts and tools during the past two decades that promise high potential for supply chain application. These tools and techniques show a strong process and activity (rather than hierarchy) focus, integrate non-financial aspects in their optimization approach and can be adapted for inter-organizational application (Axelsson et al. 2002). Third, SCM poses new problems and challenges that do not occur in a single-firm management setting. Supply chain management as a corporate function requires support for fundamental business decisions such as selecting the right partners, the right processes among partners and the right management tools in the company network (Beske et al. 2011)—tasks that are by definition not relevant within the single company. In addition, adapting management accounting and management control systems to a cross-company scenario can cause enormous difficulties in practice. In many cases, the legal independence of the business entities involved proves to be the major source of problems (Gebert 2011). This introductory chapter can only briefly sketch out the various challenges and opportunities that SCMAC is faced with. We will dive deeper into these topics in the following chapters. Academic debate has been focusing on many of them in the past

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20 years, but a common body of knowledge in supply chain management accounting has not yet emerged and essential elements of SCMAC still remain rudimentary in business practice or are missing altogether (Jeschonowski et al. 2009). We hope that this book can contribute to closing these gaps.

1.5

Glossary and Key Terms

Accounting

Controlling Logistics

Management accounting Supply chain Supply chain management Supply chain management accounting Supply chain surplus

1.6

The system that records and stores the stocks and flows of scarce goods and resources that have a value to the company in order to ensure efficient and effective use of these goods and resources. The German variant of management accounting and control, which is largely synonymous with MAC. The corporate function that deals with providing the right goods (i.e. as ordered) in the right quantity, with the right quality, at the right time, at the right place, at the right cost, and at the right sustainable impact/footprint. The internal accounting system that supports managers in carrying out management tasks. All functions of corporate partners upstream and downstream that are involved in receiving and filling a customer request. All planning and management actions across supply chain partners upstream and downstream in order to maximize supply chain surplus. The specific sub-discipline of management accounting that deals with providing management support to all functions in individual partner firms that are dealing with managing a specific supply chain. The positive difference between the value to the end-customer minus total supply chain cost. This is generally considered to be the ultimate goal of managing a supply chain.

Review Questions and Exercises

Review question 1.1: Describe the overall purpose of an accounting system and outline the differences between financial accounting and management accounting. Review question 1.2: Explain how the German concept of “Controlling” differs from Anglo-Saxon manage ment accounting. Review question 1.3: Explain the role of logistics in a modern economy.

References

13

Review question 1.4: Name and briefly explain the “7 Rs” that define a logistics goal system. Review question 1.5: Describe how the supply chain concept has extended the traditional view on logistics. Review question 1.6: Define the concept of supply chain management and explain how supply chain management can create a supply chain surplus. Review question 1.7: Discuss the need for a new discipline of supply chain management accounting.

Exercise 1.1: Logistics versus supply chain management The board of directors of “Fast & Furious Inc.”, a manufacturer of sports equipment, has decided to install a new management position “Supply Chain Management” that is planned to report directly to the Chief Operating Officer (COO). The current organization chart shows management positions for purchasing, logistics, and manufacturing, respectively. Discuss the interfaces and possible overlaps of the new SCM function with existing functions and prepare a suggestion on how Fast & Furious could possibly structure the new SCM function. Exercise 1.2: Supply chain management versus supply chain management accounting You are heading the small team of “Fast & Furious Inc.” management accountants that has supported top management and middle management in the past. Following the envisaged restructuring, you wonder, whether your team needs to be restructured as well. Discuss the new tasks and challenges that management accounting will be confronted with once “Fast & Furious Inc.” has fully adopted the SCM concept. How can your team prepare for these changes?

References Alfalla-Luque R, Medina-Lopez C (2009) Supply chain management: unheard of in the 1970s, core to today’s company. Bus Hist 51(2):202–221 Apostolou B, Dorminey JW, Hassell JM, Rebele JM (2016) Accounting education literature review 2015. J Account Educ 35:20–55 Axelsson B, Laage-Hellman J, Nilsson U (2002) Modern management accounting for modern purchasing. Eur J Purch Supply Manag 8:53–62 Beske P, Seuring S, Westhaus M (2011) Management accounting systems in supply chains—a concept and first empirical insights. In: Bogaschewsky R et al (eds) Supply management research. Springer Gabler, Wiesbaden, pp 337–350

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Bundesvereinigung Logistik; Fraunhofer SCS (2019) Quoted from de.statista.com. https://de.statista. com/statistik/daten/studie/166970/umfrage/umsatz-der-logistikbranche-in-deutschland/. Retrieved 13 Feb 2020 Charifzadeh M, Taschner A (2017) Management accounting and control—tools and concepts in a Central European Context. Wiley, Weinheim Chopra S, Meindl P (2016) Supply chain management—strategy, planning, and operation, 6th edn. Pearson, Harlow Christopher M (2016) Logistics and supply chain management, 5th edn. Pearson, Harlow Gebert K (2011) Performance control in buyer-supplier-relationships — the design and use of formal management control systems. In: Bogaschewsky R et al (eds) Supply management research. Springer Gabler, Wiesbaden, pp 29–53 Institute of Certified Management Accountants (2014) Content specification outlines—certified management accountant (CMA) examinations. https://www.imanet.org/-/media/ f2e090eb04954cfe8f0fbb1654281262.ashx. Retrieved 28 Jan 2020 International Controller Association—ICV (2013) The essence of controlling—the perspective of ICV and IGC. J Manag Contr 23(4):311–317 Jeschonowski D, Schmitz J, Wallenburg CM, Weber J (2009) Management control systems in logistics and supply chain management: a literature review. Logist Res 1:113–127 Knolmayer GF, Mertens P, Zeier A, Dickersbach JT (2009) Supply chain management based on SAP systems—architecture and planning processes. Springer, Berlin Lafontaine F, Malaguzzi Valeri L (2009) The deregulation of international trucking in the European Union: form and effect. J Regul Econ 35:19–44 Mentzer JT, DeWitt W, Keebler JS et al (2001) Defining supply chain management. J Bus Logist 22 (2):1–25 Murphy PR, Knemeyer MA (2018) Contemporary logistics. Pearson, Harlow Oliver R, Webber M (1982) Supply chain management: logistics catches up with strategy. Outlook 5:42–47 Pathways Commission (2012) Charting a national strategy for the next generation of Accountants. http://commons.aaahq.org/files/0b14318188/Pathways_Commission_Final_Report_Complete. pdf. Retrieved 13 Feb 2020 Ramos MM (2004) Interaction between management accounting and supply chain management. Supply Chain Manag Int J 9(2):134–138 Schäffer U, Binder C (2008) Controlling as an academic discipline: the development of management accounting and management control research in German-speaking countries between 1970 and 2003. Account Hist 13(1):33–74 Swamidass PM (2000) Encyclopedia of production and manufacturing management. Springer, Boston Taschner A, Charifzadeh M (2016) Management and cost accounting—tools and concepts in a Central European Context. Wiley, Weinheim Taschner A, Charifzadeh M (2020) Management accounting in supply chains—what we know and what we teach. Journal of Accounting and Organizational Change, forthcoming Werner H (2017) Supply chain management: Grundlagen, Strategien, Instrumente und Controlling, 6th edn. Springer Gabler, Wiesbaden Zijm H, Klumpp M, Heragu S, Regattieri A (2019) Operations, logistics and supply chain management: definitions and objectives. In: Zijm H et al (eds) Operations, logistics and supply chain management, Lecture notes in logistics. Springer, Berlin, pp 27–42

2

Theoretical Concepts Relevant for Supply Chain Management Accounting

Why Theory Matters

Neoclassical Theory

Transaction Cost

ResourceBased View

Agency Theory

SCMAC and Theory

Learning Objectives After completing this chapter, you should be able to: 1. Understand how theory can contribute to explaining different forms of collaboration in business 2. Be familiar with the fundamental traits of neoclassical theory, and why it cannot explain the existence of supply chains 3. Understand the concept of transaction costs 4. Discuss how the characteristics of bounded rationality, individual profit maximization, and opportunistic behavior lead to different forms of governance in transactions between two or more actors 5. Understand how supply chain management accounting helps to manage transaction costs in supply chain relationships 6. Be familiar with the contribution of resource-based theory to explaining the existence of supply chains (continued) # Springer Fachmedien Wiesbaden GmbH, part of Springer Nature 2020 A. Taschner, M. Charifzadeh, Management Accounting in Supply Chains, https://doi.org/10.1007/978-3-658-28597-5_2

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7. Discuss how collaboration as a form of managing supply chains can be a powerful relational resource 8. Gain an overview of agency theory and its behavioral assumptions of market participants 9. Identify problems that may arise between a principal and an agent, who collaborate in a supply chain setting 10. Discuss suggestions by agency theory, how to mitigate or avoid agency problems, and apply these to the supply chain context Supply chain management, as well as management accounting, have their origins in business practice. They are “applied sciences” in the sense that concepts and instruments developed by members of the scientific community ultimately have to meet the litmus test of practical relevance in order to be of value (a thought that is based on the philosophical tradition of pragmatism). Applied sciences are no “theory-free zones”, though—to the contrary! A practitioner is well-advised to become familiar with relevant theoretical concepts and ideas that have been developed, discussed and tested by smart minds in the past. This chapter will outline some theoretical concepts that have proven useful for tackling supply chain management accounting (SCMAC)-related questions. All theories originated in other disciplines, such as economics or political sciences. Their ideas proved powerful and generic enough, though, to be adopted in neighboring disciplines. Today, scholars with diverse backgrounds—not least supply chain management and management accounting— build on these conceptual cornerstones to develop “pragmatic solutions” in the above sense. We will introduce the theoretical concepts only as far as they are relevant for SCMAC. We do not intend to provide a comprehensive discussion but focus on key statements and their implications for SCMAC.

2.1

Why Theory Matters

In a simple market economy without collaboration, independent actors (firms and consumers) pursue their economic interests through two types of activities: economic transactions with other actors (purchasing resources, selling output, etc.) and activities inside organizational boundaries. Both types of activities are necessary for a company to thrive. But in any case, the distinction between “internal” and “external” activities and transactions is clear-cut and easy to make: internal activities employ their own resources only and are administered by internal rules and decisions, which are in turn governed by hierarchical relationships between individual members of the organization. External

2.1

Why Theory Matters

17

transactions require the mutual agreement of two independent actors (firms) and are typically based on some type of contractual agreement. In a more complex setting, these independent actors do not only trade with and compete against each other, but more and more engage in a third type of activity: collaboration. Collaboration across company borders is nothing else but a partial dilution of a firm’s boundaries: instead of pursuing its goals solely based on its own resources, a firm hands over certain tasks and responsibilities to other entities—and consequently ties its own economic success (at least to some extent) to the performance of its partners. Company managers—and management accountants supporting them—need convincing arguments for such a move: Why and under which circumstances is it beneficial for a firm to partly give up its independence and its freedom of decision making? This question has not only occupied many business men’s minds but has also spurred academic theory building. “There is nothing more practical than a good theory.” This quote attributed to social psychologist Kurt Lewin asks theorists to develop conceptualizations of empirical problems that eventually lead to new ideas and approaches about how these problems can be tackled. Practitioners, in turn, are asked to provide theorists with empirical data and evidence that can be used to improve the concepts further. Applied sciences depend and thrive on this constant interplay between theory and practice. In this particular case, theories should help explain – Why and how firms define their boundaries towards other entities, – Why different economic entities collaborate with each other, and – Which phenomena are relevant in inter-organizational collaboration. Theories of the firm typically focus on two questions (Heugens 2005): First, why do firms exist at all? And second, how do firms function? We extend this view by a third question that is in the focus of supply chain management and SCMAC, respectively: Why do different firms collaborate with each other and how can this collaboration be implemented? Theories that help answer these questions can be extremely important for business practitioners, be they managers or management accountants. Theories of the firm can, therefore, be considered the conceptual basis for SCMAC: 1. They help to find and to implement the most appropriate setup for a collaboration across supply chain partners and provide hints for business actors (instrumental perspective), 2. They provide the conceptual basis for explaining the different institutional arrangements (direct competition, alliances, joint ventures, vertical collaboration, etc.) that can be found between firms in modern economies (explanatory perspective). Once we understand the motives and the driving factors behind a particular institutional arrangement—such as collaboration along the supply chain—we are better equipped for managing this arrangement. Unfortunately (but not very surprisingly), no single theory has

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emerged yet that could capture and explain the phenomenon of “inter-firm collaboration” in its full complexity. In the following sub-chapters, we will briefly discuss the most important theoretical concepts that have been developed by theorists—and used by practitioners—when it comes to inter-company collaboration.

2.2

The Neoclassical View and the Coase Theorem

The Neoclassical Model In the course of the nineteenth century, economic thinking has developed a conceptual framework, which has come to be known as “neoclassical economics”. Neoclassical theorists consider the market as the most important—if not the only—mechanism for efficient resource allocation. Neoclassical thinking dominated (and to some extent still dominates) microeconomics, which deals with the behavior of individual actors (firms, consumers) in an economy. In neoclassical thinking, these actors are driven by their pursuit of maximizing individual benefit. It is the price mechanism that guarantees that resources are allocated to their most efficient use: a resource will be purchased by that party that can generate the highest individual benefit when employing it. As long as the price mechanism works, no other party will be prepared to match or outbid that offer (because the individual benefit to be gained would not justify such a high purchase price) and the resource, therefore, will always go to its most productive use. Of course, the most efficient outcome is achieved only, if and as long as a number of important conditions are met (Conner 1991): 1. The right input mix for each output is known. Economists refer to “production functions” to denote the combination of inputs needed to generate a certain output (e.g. a product that can subsequently be sold). Firms can bid for resources only if they know which types of resources and which quantities they need. 2. The marginal contribution (marginal benefit) of inputs is known. Neoclassical economics assumes diminishing marginal utility of inputs—a concept that is also well known in everyday life. In simple words, the concept merely states that having ever more of a particular resource adds less and less to total utility. The second unit provides smaller benefits than the first one, the third unit smaller benefit than the second one, etc. Eventually, marginal benefits become zero or even negative. Firms must be able to assess the marginal benefit of the next input unit in order to be able to quote the most appropriate price for it. 3. Information on inputs, prices and possible resource benefits is available to all market actors. Neoclassical markets are characterized by complete and perfect information. No actor has an information advantage that could be exploited, and arbitrage is not possible. 4. Resources are available on the market.

2.2

The Neoclassical View and the Coase Theorem

19

Markets bring actors together and allow trading between them. An actor that is looking for a particular resource (because it promises high benefits) will be able to locate and acquire this resource since other market actors are willing to sell it. In a neoclassical market, where there is demand, there is always supply. A market with the characteristics described above is considered to be “perfect”. Firms operating under perfect market conditions are the economic entities capable of transforming inputs (capital, materials, human labor, etc.) into outputs (goods and services). Neoclassical economists do not investigate the inside further: companies are considered identical, possessing similar processes and resources for generating outputs. The size and development of firms are limited by managerial and technical factors (Conner 1991), but are less important than market characteristics. We might say that neoclassical economics favors the external, transactional aspects of business over the internal valuecreating aspects. In a neoclassical world, firms remain black boxes that engage in individual market transactions but have no need for other governance schemes such as inter-firm collaboration. In neoclassical economics, there is no need and no justification for supply chains. Neoclassical theory cannot deny, though, that market transactions between independent actors are just one side of the coin. Firms also engage in a plethora of different activities inside their own organizational boundaries. The value creation process that turns resources into more valuable and beneficial outputs would not be possible without all those internal activities that are not governed by market forces. It was the British economist and Noble Price laureate Ronald Coase in his seminal article “The nature of the firm” (1937), who raised the question of why and how firms choose between fulfilling a certain task internally rather than relying on market transactions. Ronald Coase Coase’s arguments are still rooted in the neoclassical view of perfect markets: Intra-firm decision making and market transactions are two complementary resource allocation mechanisms and they both entail specific cost. He argued that within firms, the price mechanism does not work. Instead, allocation decisions are made by people using authority. Firms, therefore, have a choice between two alternative governance structures for their activities: markets and hierarchies. Coase argued that the choice between markets and hierarchies was determined mainly by differences in transaction costs (Geyskens et al. 2006). Resource allocation decisions will be internalized (i.e. be made subject to management decisions within the firm and not market transactions), whenever the firm proves to be the more efficient allocation mechanism. Firm boundaries are set, therefore, in such a way to ensure optimal resource allocation: whatever firms can do better than the market, will be internalized. Everything else remains subject to market transactions. Note that this view is still fully in line with neoclassical theory: If there is no transaction cost, every resource will be employed by that actor (firm) who values the resource most. Firms engage in market

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transactions selling and purchasing resources at contractually agreed market prices until all resources have reached the destination where they can be put to the most productive use, i.e. they generate the highest value possible (Holcombe 2018). In such a setting, market forces will eventually set firm boundaries, since each actor (firm) will grow or shrink in size until it has those resources (and only those!) under its control that cannot create higher value with any other actor in the market. Such a distribution of resources across firms constitutes the equilibrium state in a neoclassical world. Coase’s idea now opens the way to an explicit consideration of transaction costs and their effect on resource allocation among economic actors. If transaction costs are present (as is the case in real markets), optimal allocation of resources across all firms is no longer guaranteed. A resource exchange between firms is not realized, because the costs involved in the transaction exceed its marginal benefit. The lesson of the Coase theorem is not that resources are allocated to their highest-valued uses but rather that when they are not so allocated, the reason is that transaction costs stand in the way. (Holcombe 2018, p. 250).

Transaction costs are the main reason, why firms engage in activities themselves instead of entrusting other parties with their execution: initiating and monitoring these transactions involves costs that exceed the potential gains. The firm, therefore, is better off performing the activity internally. Transaction costs prevent value-increasing exchanges from happening, but they do not lower overall benefits: resources remain with their current owners. A market without any transaction costs will lead to the neoclassical equilibrium. The higher transaction costs in a market are (i.e. the less perfect that market is), the more potentially value-creating exchanges will be prevented and the more activities will be performed in-house by firms. Vice versa, the reduction or removal of transaction costs can enable fruitful exchanges of resources. It is Coase’s merit to have introduced a conceptual mechanism that can explain why and how companies choose between external market transactions and internal task fulfillment. As we will see in the next sub-chapter, transaction cost is a very powerful theoretical concept for supply chain management and SCMAC.

What SCMAC should know about neoclassical theory: – Firms can choose between different governance structures for their economic activities. Markets and hierarchies are the two main alternatives. (continued)

2.3

Transaction Cost Economics

21

– Markets generally work towards an efficient allocation of tasks and resources. The more perfect a market is, the easier it will be for a firm to commission a task to a third party that can perform it in a more efficient manner than the company itself. – It is transaction costs that put a limit to the market mechanism for efficient allocation of tasks and resources. If arrangements can be found and implemented that lower transaction costs, previously impossible transactions will be realized and resources will be put to a more efficient use overall. – Lowering transaction cost, therefore, can lead to win-win situations, leaving both parties better off than before, when the trade was uneconomical due to high transaction cost. – SCMAC should work towards eliminating such constraints to facilitate efficient resource exchange.

2.3

Transaction Cost Economics

The concept of transaction cost as introduced by Ronald Coase spurred an extensive discussion among scholars and eventually led to the development of what today is known as “transaction cost economics (TCE)”. Coase already noted that transaction costs occur both inside an organization as well as in external market transactions. In fact, the notion of “transaction” is very broad: A transaction occurs when a good or service is transferred across a technologically separable interface (Williamson 1996, p. 379).

Such “technologically separable interfaces” can be firms’ organizational boundaries (leading to a market transaction), but can be found within organizations as well. Transaction costs, therefore, occur both in intra-company as well as in inter-company activities. TCE became widely known through the work of US American economist Oliver E. Williamson, who was a student of Ronald Coase. Williamson received the Nobel Memorial Prize in Economic Sciences for his contributions to economic theory in 2009. Based on the definition of transactions given above, transaction costs occur whenever goods or services are transferred between institutional or organizational units. These units might be part of the same, bigger organizational entity (e.g. different departments within the same company) or might belong to separate organizations (e.g. two companies trading with each other at market terms). In this sense, transaction costs are . . .costs of resources utilized for the creation, maintenance, use, and change of institutions and organizations. They include the costs of defining and measuring resources or claims, the costs of utilizing and enforcing the rights specified, and the costs of information, negotiation, and enforcement. (Furobotn and Richter 1997, p. 40)

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It is important to note from this definition that transaction costs occur both in the initiation as well as in the execution of an activity or transaction. The central question of transaction cost theory is whether a transaction is more efficiently performed within a firm (vertical integration) or outside it, by autonomous market contractors. The a priori TCE assumption is that market governance is more efficient than vertical integration owing to the benefits of competition. Activities inside an organization are prone to bureaucracy and other sources of inefficiency since there is no competitive pressure (Geyskens et al. 2006). In this thinking, TCE is still closely linked to the neoclassical line of reasoning: Transaction costs inhibit economically beneficial activities and transactions—as we described earlier in this chapter, an idea that has already been brought forward by Coase. Transaction costs, therefore, can be viewed as an efficiency indicator of transactions: the lower the transaction costs, the more efficient a specific transaction is (and the closer one moves towards the ideal of a perfect market). According to TCE, transaction cost cannot be entirely avoided, because economic actors are always faced with two fundamental constraints: bounded rationality and opportunism. Although still seeking for individual profit maximization, actors possess “bounded rationality” only (as opposed to complete rationality), because they cannot foresee all potentially influencing factors and contingencies in a given situation. Actors are not fully informed about what might happen in the future and what (potentially opportunistic) behavior their transaction partners will show. In order to limit the negative consequences of this uncertainty, parties typically engage in contractual relationships. But contracts cannot be “complete” either in the sense that all possible contingencies are covered and explicitly regulated. Contractual parties try to protect themselves through contracts, but the risk of unforeseen events or opportunistic behavior can never be ruled out completely. The more effort is put into preparing and enforcing contracts, the higher transaction costs will be (Williamson 1985). The central tenet of TCE is that actors should always try to identify the most efficient governance mode for a particular activity or transaction, i.e. the one option that entails minimum transaction cost. TCE scholars have extensively investigated the factors that influence transaction cost and therefore guide the choice between market transaction or internal task completion (governed by hierarchical relationships). The more pronounced these factors are, the closer a given situation is to “market failure”, which in turn suggests that internal task completion is more efficient than a market transaction. TCE has identified the following key factors for possible market failure (Williamson 1975, 1985): Asset Specificity Some resources are easily obtainable in the market. You can find numerous suppliers that offer the same product or service and its features are quite homogeneous: tires for a car manufacturer, memory chips for a computer firm or batteries a toy manufacturer uses for its radio-controlled toy cars. In contrast, other assets may be tailored to a specific transaction or business relationship: a special machine that is required for a certain manufacturing step, staff with very specific expertise that is required for a particular task, a warehouse at a very

2.3

Transaction Cost Economics

23

specific location that is used for trade with a particular customer only—examples are not difficult to find. Such transaction-specific assets cannot be easily redeployed in other activities or transactions. They provide benefits only in the particular transaction or business relationship that they have been designed for. In a market environment, such a situation opens the way for opportunistic behavior: knowing that the partner’s asset is (almost) worthless outside of the current business relationship, one might be tempted to ask for better terms and conditions than originally agreed upon. Granting additional favors (such as price reductions) would still be less costly for the partner than ending the relationship as such (which would lead to a complete loss of the specific asset). In addition, replacing the asset will not be easily possible, since the specific resource is not offered by other market participants—it’s not available in the market. Transaction-specific assets increase a firm’s vulnerability to blackmailing by transaction partners. TCE, therefore, suggests that in such a situation, the firm will revert to vertical integration and perform the activity in-house. The hierarchical authority structures inside the company provide much better safeguarding against opportunistic behavior than market contracts (Geyskens et al. 2006). Uncertainty Uncertainty mostly stems from a lack of information. Incomplete information makes it hard to foresee all contingencies surrounding an activity or exchange and its possible outcomes. Since contingencies are not (fully) known, they cannot be specified in contracts either— you cannot regulate what you don’t know. Uncertainty (lack of information) can refer to environmental conditions as well as to partners’ performance. In the first case, the firm cannot assess and foresee the influencing factors that might affect the business relationship in the future (e.g. because the market environment is too dynamic and complex, demand fluctuates, technology changes, etc.). In the latter case, the firm cannot easily measure and verify the contractual partner’s performance (e.g. because a task is jointly completed by several parties and individual contributions cannot be easily separated). The resulting ambiguity will increase transaction costs (specifying very detailed contracts, setting up and running complex monitoring systems, engaging in frequent information exchange meetings, etc.). Similar to a situation with high asset specificity, a firm will tend to perform tasks and activities in-house, if they are linked to high environmental or behavioral uncertainty, respectively. TCE posits that hierarchical governance schemes are more appropriate in such situations than market exchange. Transaction Frequency Apart from asset specificity and uncertainty, transaction frequency is often cited as the third influencing factor. It refers to the extent to which transactions recur (Geyskens et al. 2006). Williamson (1985) argued that transaction frequency provides an incentive for firms to employ hierarchical governance because the overhead cost of hierarchical governance will be easier to recover for recurring transactions. The more often a particular task or activity is performed, the more sense it makes to take care of it oneself.

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TCE can explain why firms choose different institutional arrangements for their economic activities, i.e. why they perform certain activities in-house, while they rely on outside partners in other cases. TCE identifies key factors that lead to situations of “market failure” and subsequently trigger in-house execution of certain activities. Market contracting is more probable to occur when assets are not specific to a particular transaction, when several partners and the necessary information exist (Mentzer et al. 2004). TCE explains why firms must own some assets and why it is better to have market-type relations when sufficient suppliers are available (Heugens 2005). Note that doing everything in-house would certainly not be optimal either. Excessive vertical integration requires a complex internal organization, a very high degree of task specialization and subsequently high coordination efforts. This would drive up internal transaction cost. In addition, the danger of “bureaucratic slack” is always present in an in-house solution. It is, therefore, more efficient to rely on third parties for some activities—all the more so if the costs of identifying and monitoring these partners can be kept low. This logic is very familiar to management accounting. In fact, outsourcing analyses and make-or-buy decisions constitute key tasks of management accounting. Although they might not be labeled as such (but rather be called “process cost” or “overhead”), transaction cost constitutes a major factor in such analyses. Management accountants, therefore, must develop an adequate toolset to identify and measure these cost items as well as integrate them into the decision making in their organization. At a supply chain level, this task does not change as such, but is merely transferred to a higher complexity level: Supply chains can be viewed as examples of yet another type of institutional arrangement—one that is called “relational governance” by TCE scholars. Relational governance structures form a compromise between pure market transactions and hierarchical integration. They . . . incorporate a large informal component and are therefore not easily legally enforceable. Instead, nonjuridical mechanisms such as mutual dependence, trust, parallel expectations, joint action, and procedural fairness sustain them. (Geyskens et al. 2006, p. 522).

No matter what the institutional arrangement for a particular transaction looks like— TCE posits that reducing transaction costs will help spur business activities: When transaction costs are reduced, people regularly execute transactions that were practically impossible in the past, such as transactions in the middle of the night, transactions with unknown transactors living on the opposite side of the globe, and transactions of extremely rare products. (Suematsu 2014, p. 3).

2.4

Resource-Based Theory

25

What SCMAC should know about transaction cost theory: – Transaction costs cannot be fully avoided since markets are not perfect and market actors are always subject to bounded rationality and opportunistic behavior. – High asset specificity, high uncertainty, and high transaction frequency are the main causes of market failure, suggesting that hierarchical governance schemes are more appropriate. Whenever these conditions apply, in-house solutions become an attractive alternative to market transactions. – SCMAC must work towards minimizing transaction costs both for intra-firm and inter-firm transactions, thus increasing efficiency of the firm’s activities and opening the way for entirely new business models. – SCMAC should be able to identify the factors driving transaction costs in specific circumstances and transaction types since this is a prerequisite to increasing efficiency. – SCMAC should develop adequate routines, instruments, and measures to assess and allocate transaction costs to their causal factors and economic agents, respectively.

2.4

Resource-Based Theory

Similar to TCE, what is today called the “resource-based view” (or resource-based theory—RBT) originated in economics and found its way to adjacent disciplines—first strategic management, later also operations management and entrepreneurship theory (Hitt et al. 2016). The original idea of RBT is attributed to economist Edith Penrose (1959), who asked how firms create advantages over industry rivals with their respective strategies. Wernerfelt (1984) linked competition to firms’ respective resource positions. Barney (1991), finally, added the central thought that . . .firms need valuable and rare resources to gain a competitive advantage, but in order to sustain that advantage over time, the resources must also be difficult to imitate and non-substitutable by other firms’ resources. (Hitt et al. 2016, p. 78).

This describes the central tenet of RBT: it is a firm’s access to unique, non-imitable resources that defines its competitive position. RBT’s definition of what constitutes a “resource” is fairly broad and certainly not limited to natural (or even physical) resources only. In this view, resources are . . .the tangible and intangible entities available to the firm that enable it to produce efficiently and/or effectively a market offering that has value for some market segment(s). (Hunt 2000, p. 128)

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A resource as such does not yet constitute a competitive advantage. Resources simply contribute to producing a market offering that has value. Many resources might be easy to imitate or substitute (such as commodities, for instance) and do not lead to competitive advantage. Flour is certainly an indispensable resource for bakeries, but hardly ever constitutes a true competitive advantage for a single bakery. RBT distinguishes seven major types of resources (Hunt and Davis 2012): financial, physical, legal, human, organizational, informational and relational resources. As a matter of fact, this broad conception of resources opens the way to its integration in supply chain management, as we will see in the following. Similar to TCE, resource-based theorists posit that markets are not perfect. Market imperfections (such as missing information or high transaction costs) allow firms to develop and keep (or acquire) resources that are not ubiquitous, but rather scarce and hard to imitate or duplicate, respectively. A firm might have access to human (e.g. staff with unique know-how and experience), legal (e.g. patents) or relational resources (e.g. exceptional customer intimacy) that are superior to those of its competitors and thus put that particular firm into a competitive advantage. As long as the firm can maintain its “resource advantage” (because markets are not perfect), it will also defend its competitive advantage against rivals. Once competent staff quits, patents expire, or customers defect to competitors, the competitive advantage is lost. Two aspects of RBT are of particular interest for supply chains: 1. It is non-physical (informational and relational) resources rather than physical resources that possess the characteristics of inimitability and non-substitutability that are necessary to constitute a competitive advantage. Their value is more difficult to imitate and their function is more difficult to substitute. 2. Possession of valuable resources is a necessary, but not a sufficient condition for competitive advantage (Sirmon et al. 2007). Firms must also manage these resources effectively: a firm’s resource portfolio needs to be optimized (acquiring, accumulating, developing, and divesting resources), and the potential of a valuable resource base must be leveraged through effective strategies. In short: it takes good management to leverage a competitive resource position. Collaboration as a Relational Resource Collaboration in a supply chain can be viewed as a joint attempt to leverage resource advantages. If each partner contributes its own unique and inimitable resources, the entire supply chain will profit and improve its competitive position—a win-win situation for all partners. In that view, teaming up in supply chains is a natural step for firms, if they could not acquire missing resources through other means or imitate the resources of their competitors. In addition, collaboration itself can be a source of new competitive advantage by creating “relational resources” that are unique and (almost by definition) inimitable by competitors—since they are excluded from that cooperative network. Trade partners who deal with each other “at arm’s length” only, forego potential benefits that collaborative supply chain partners can profit from (e.g. by mutually exchanging information that is

2.4

Resource-Based Theory

27

important for the partner’s planning tasks or by replacing lengthy contracts with trust, therefore lowering transaction costs). However, such potential benefits are not a guarantee for competitive advantage (see argument 2 above). In order to truly leverage these relational resource benefits, supply chain partners need to manage their activities and resources properly. It takes professional supply chain management to profit from potential resource advantages (Hitt et al. 2016). Effective and efficient supply chain management will integrate supply chain partners’ resource contributions into a true competitive advantage that is beneficial for each supply chain member. This logic has not remained undisputed. One might argue, for instance, that many activities along a supply chain do not depend on inimitable and non-substitutable resources. Indeed, operations management (OM) scholars generally want to identify practices that many firms can implement . . . Even a casual glance at large-sample OM studies shows that many OM scholars want to study how broadly available practices that are in no way inimitable or rare influence performance: just-in-time principles, kanban, lot size reduction, employee involvement, statistical process control, supply chain collaboration, et cetera. These practices have proven valuable in numerous empirical studies, but are incompatible with the RBT. The RBT would predict that these practices do not lead to sustained competitive advantage since every firm can implement them. (Bromiley and Rau 2016, p. 101).

In this view, good supply chain management first and foremost is good management rather than the creation or exploitation of unique resource advantages. These two views are not as far apart as it might seem at first glance. In fact, daily supply chain activities might mostly require “good old management skills”. But through collaboration, firms can learn from their supply chain partners (Halldorsson et al. 2007). Supply chain collaboration can do more than just improve the efficiency and effectiveness of operational tasks. Collaboration is not only “output-oriented” but also “learning-oriented”. Being part of a supply chain opens the opportunity to access another firm’s core competencies through cooperation as an alternative to building such competencies in-house (Haakansson et al., 1999). Even if it might not be evident in daily operations, a supply chain can be a powerful relational resource.

What SCMAC should know about resource-based theory: – A firm’s competitive advantage (at least partly) stems from its ability to create and maintain inimitable and non-substitutable resources. – The pure possession of valuable resources is not sufficient to generate a competitive advantage. Firms must also manage these resources effectively. (continued)

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– Non-physical resources often provide bigger competitive advantages than physical resources, since they are more difficult to imitate or substitute. – Collaboration as a form of managing supply chains can be a powerful relational resource—first because they give access to partners’ critical resources and second because they provide learning opportunities that would not arise outside a cooperative relationship. – SCMAC must develop and implement methods to properly evaluate and manage critical resources both within the own company and across supply chain partners.

2.5

Agency Theory

The diligent reader of this chapter will not be surprised to learn that also the next theoretical concept originated from economics: agency theory. In-depth modelling of the problem started in the 1970s, with economists Stephen Ross (1973) and Barry Mitnick (1973) commonly being considered as its “conceptual fathers”. Agency theory is a close relative of transaction cost theory. However, while transaction cost theory deals with transactions in general, agency theory focusses on specific performance relationships between principals and agents. Such agency relationships can be found in many disciplines outside economics and agency theory’s ideas were soon adopted in sociology, management (Eisenhardt 1989) or in work involving the theory of the firm (Jensen and Meckling 1976; Pratt and Zeckhauser 1985). As its name suggests, agency theory investigates principal-agent relationships. In an agency relationship, one party (the principal) delegates work or decisions to another party (the agent). A constituent characteristic of such a relationship is that actions of the agent do not only affect his own economic welfare but influence the payoff of the principal, too. The agent works on the principal’s behalf, but at the same time, wants to maximize own benefits while keeping the principal’s control power as low as possible (Fayezi et al. 2012). Examples of principal-agent relationships are manifold in today’s business world. A well-researched agency relationship exists between shareholders and managers. Other examples of typical principal-agent interactions are owners (shareholders) and creditors, employers and employees, insurance firms and insured parties, landowner and tenant, and—of particular interest in this book—the relationships between customers and suppliers in a supply chain. In many cases, the roles are flexible—a party can be a principal in one relationship but at the same time an agent in another relationship (Picot et al. 1997). Agency theorists have conceptually gone a long way from the neoclassical idea of perfect markets, as can be seen in a number of assumptions, which agency theory builds upon (Arrow 1985, Fayezi et al. 2012, Zu and Kaynak 2012; Ekanayake 2004; Rungtusanatham et al. 2007, Fleisher 1991):

2.5

Agency Theory

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– Potential goal conflicts exist between the principal and the agent. Both parties do not necessarily aim at the same outcome, and their preferences do not match. – Both the principal and the agent act in their own self-interest. Parties are not altruistic. Agents, although being engaged in order to act in the interests of the principal, will use their operational scope for their own benefit and potentially to the detriment of the principal. – Agency relationships are characterized by information asymmetry. The principal typically lacks information that is available to the agent, which opens leeway for selfish behavior. In business practice, these characteristics of agency relationships result in three different types of problematic situations according to agency theory: (1) hidden characteristics, (2) hidden action or hidden information, and (3) hidden intention (Arrow 1985). Hidden Characteristics This describes a situation in which a principal doesn’t know some important characteristics of the engaged agent. The agent conceals traits, capacities or qualities. The principal may find out—but this happens at a time when a contract has been made already. Thus, it is too late to decide for another agent. This problem is also called ‘adverse selection’, a problem that insurance companies know more than well. People who buy insurance will typically consider themselves to be exposed to a more-than-average risk. Thus, an insurance company may find itself in a situation where most of its life-insurance customers show above-average risk-behavior. Hidden Action and Hidden Information In these types of situations, a principal is not able to observe all the actions of the agent. The principal cannot monitor or control all activities of agents due to lack of time or physical distance between the two parties. A variant of hidden action is hidden information. This is a situation in which the principal might be able to observe the actions of an agent, but is incapable of understanding or evaluating them. A familiar example is an invoice of your local car garage, listing several repairs and replacements of parts of the engine of your car. You might not be able to verify whether all these repairs and replacements have been necessary or even whether they have actually been made at all. In a supply chain context, a customer may have to blindly rely on the quality promises of a supplier. The risk that agents abuse information asymmetry opportunistically is called the ‘moral hazard’ problem in agency theory. Hidden Intention The third type is a situation in which principals—in contrast to the other two—can even observe and judge the detrimental actions of the agent. However, the principal is not able to prevent them. The true intentions of the agent weren’t visible to the principal ex ante. Now, he is not in a position to sanction the adverse actions and force the agent to loyal behavior.

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This is called a ‘hold up’ in agency theory and typically occurs in business practice when one party is dependent on another. Examples are manifold in supply chain practice. A supplier who is dependent on a large customer might be exposed to ever-increasing price pressure. At the same time, a customer may be dependent on a single supplier who is the only one in the market who can deliver the required quantities and quality. Note that in conceptual terms hidden intention is closely related to what we called ‘asset specificity’ in transaction cost economics, earlier in this chapter. Agency Costs In order to avoid the situations described above, and to prevent the problems of adverse selection, moral hazard and hold up, the principal may want to take countermeasures. At the same time, an agent seeking an engagement might try to convince a principal of his positive attributes or intentions. Such measures to overcome the information asymmetry, however, require effort, time and resources and therefore cause costs, so called agency costs. Agency costs incur in three forms (Jensen and Meckling 1976): 1. Monitoring costs of the principal The principal must acquire information that is necessary to monitor and control the agent. Examples are costs of operating performance measurement systems as a means of managers’ accountability. In a supply chain, a manufacturer may monitor the creditworthiness of a supplier that is his single source for a very specific intermediate product. 2. Signaling costs of the agent The agent incurs costs to reduce the information asymmetry between him and the principal. For the agent, this is typically necessary prior to being awarded a contract. Examples are proofs of quality, such as quality certificates, or guarantees committed by a supplier to win a contract. 3. Residual loss Despite the monitoring and control efforts of the principal and the signaling efforts of the agent, there remains a welfare loss. The welfare loss is defined as the first-best solution—a perfect collaboration of principal and agent, which would only be achievable under the fiction of complete information—and the second-best solution, which is found under the given state of information asymmetry and opportunistic behavior. Solving the Agency Problem Agency problems cannot be solved completely but they can be mitigated by certain arrangements. Agency relationships will typically be governed by some type of (formal or informal) contract, trying to limit the occurrence of adverse selection, moral hazard, and hold-ups. The overarching aim of agency theory is to design contracts or to install institutions that can alleviate these agency problems (Halldorsson et al. 2007). Measures to mitigate agency problems can be distinguished into (1) actions prior to the contractual engagement of an agent and (2) actions after making the contract, i.e. during the collaboration with an agent.

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Agency Theory

31

Prior to making a contract with an agent, a principal can invest in mechanisms to select the right agent for his purposes: 1. Screening Principals can try to collect as much information as possible about a potential contract partner prior to entering into a contract. Examples are recruitment tests such as assessment centers before hiring managers, checking the creditworthiness of a debtor before granting a loan, or obtaining references before contracting a supplier. 2. Self-selection Sometimes, simply asking (screening) wouldn’t help, since agents wouldn’t reveal their negative characteristics and intentions. In this case, principals can try to detect hidden characteristics of agents by offering differentiated contract proposals. For example, insurance companies offer policies with and without a deductible. This incentivizes clients to choose a policy according to their self-perceived risk. High-risk clients will reveal their hidden characteristics by choosing the contract option without a deductible. In a supply chain context, a car manufacturer could offer two contract options: one with higher purchase prices but involving high penalties in case of a suspension of deliveries and one with less favorable purchase conditions but at the same time low penalties. A supplier who would consider himself of higher risk would probably reveal his true characteristics by choosing the second option. Mitigating the agency problem after a contract has been made, i.e. during the collaboration with an agent, deals mainly with the question of how to align the interests of the agent with the interests of the principal. Agency theorists distinguish two general types of mechanisms that can be used to manage agency relationships and their inherent problems (Rungtusanatham et al. 2007): 1. When using outcome-based management mechanisms, both the principal and the agent can observe outcomes, and the principal rewards the agent based on measured performance outcomes (Ekanayake 2004). This would incentivize the agent to strive for the desired results as defined by the principal. Outcome-based management compensation emphasizes results regardless of how the agents achieve them. 2. When using behavior-based management mechanisms, the principal introduces behavioral controls to monitor the agent’s behavior and efforts to complete the task. Behavior-based mechanisms emphasize the task and the processes performed by the agent, which (when followed) lead to the outcome desired by the principal (Eisenhardt 1989; Ekanayake 2004). The critical issue in managing an agency relationship, therefore, is to clearly identify the specific characteristics of the particular relationship (i.e. degree of information asymmetry, goal conflicts, opportunities for opportunism, etc.) and then choose the most efficient combination of outcome-based and behavior-based management mechanisms for this

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specific relationship (Halldorsson et al. 2007; Eisenhardt 1989; Logan 2000). Different management mechanisms not only show varying degrees of effectiveness under specific conditions but also cause different amounts of agency costs. Principal-agent relationships are frequent phenomena in modern business. They can be found between suppliers and their customers or between company owners and managers, respectively. As mentioned above, principal-agent relationships frequently occur between firms partnering in a supply chain. An interesting aspect of supply chain relationships is the fact, that often the seemingly “weaker” (i.e. smaller) supply chain partner might be able to exert considerable power and influence because it possesses informational advantages to the bigger (focal) supply chain partner.

What SCMAC should know about agency theory: – Agency theory investigates principal-agency relationships. Such relationships can be found in many different business situations—not least between supply chain partners. – Agency relationships are typically characterized by goal conflicts, information asymmetry, and opportunistic behavior. This may result in agency problems such as adverse selection, moral hazard, and hold-ups. – Knowing that opportunistically behaving agents may abuse their freedom and informational advantage, principals will take measures to limit such behavior. However, effective management of principal-agent relationships is difficult and may entail high costs (agency costs). – Agency theory provides suggestions for possible instruments to mitigate or avoid the problems that are typical for agency relationships. These instruments deal with selecting good agents in the first place. Managing an existing agency relationship can be done with outcome-focused or relationship-focused incentive schemes. – Since these instruments are applicable to supply chains as well, SCMAC must be able to assess their appropriateness in particular supply chain settings.

2.6

Summary: What We Learn from Economic Theory About Supply Chain Management and Supply Chain Management Accounting

The theoretical concepts presented in this chapter do not explicitly focus on supply chains and no one of them even mentions “supply chain management accounting” as a task or corporate function. Still, they provide valuable insights and important hints to managers and management accountants for answering the central question that we have outlined at the beginning of this chapter: Why and under which circumstances is it beneficial for a firm

2.6

Summary: What We Learn from Economic Theory About Supply Chain Ma . . .

33

Table 2.1 Overview of theories relevant for SCMAC Neoclassical economics – Perfect market – Individual profit maximization

Transaction cost theory – Bounded rationality – Individual profit maximization – Opportunism

Resource-based theory – Bounded rationality – Joint learning

Key research question

– Efficiency of resource allocation between firms to reach equilibrium

– Optimal governance mode for specific transactions

Object of analysis Lessons for SCMAC

– Firm

– Transaction

– Inimitable and nun-substitutable resources as sources of sustained competitive advantage – Resource

– Lowering transaction costs will improve market efficiency

– Supply chains can help minimize transaction costs, SCMAC must identify and manage the factors driving them (asset specificity, uncertainty, transaction frequency)

Main assumptions

– Supply chains can leverage resource advantages if they can properly evaluate and manage them

Agency theory – Bounded rationality – Individual profit maximization – Opportunism – Goal conflicts – Design of contracts that mitigate agency problems and minimize agency costs – Relationship – Supply chains are typical examples of agency relationships – Selecting the right supply chain partners can mitigate agency problems and save agency costs – Outcomefocused and relationshipfocused instruments help manage a supply chain

Source: Adapted from Halldorsson et al. (2007)

to partly give up its independence in order to engage instead in collaborative relationships with other firms? The theories described in this chapter are partly overlapping, but also conflicting with each other. They reflect the continuous academic quest to find valid and lasting conceptual answers to the empirical problems businesses observe and deal with every single day. Such answers cannot relate to the individual case, though. They are no recipes for success. They necessarily stay at a higher conceptual level, and their findings and suggestions need to be

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related to a specific firm and the business situation it is faced with. Table 2.1 provides a very high-level overview of the theories’ main attributes. Just like a competent medical doctor is able to relate specific symptoms with the generic medical knowhow to come up with an effective medical treatment, management accountants can do the same in a specific supply chain setting: identify the key characteristics and framework conditions of a particular supply chain relationship in order to come up with instruments and processes to adequately manage it. Being familiar with the key theoretical concepts can serve as a “mental map” for SCMAC in this continuous quest for effective and efficient supply chain management.

2.7

Glossary and Key Terms

Adverse selection

Agency cost Agency relationship Agency problem

Asset specificity

Bounded rationality Coase theorem

Governance structure

Hold up

Information asymmetry

A situation (and in agency theory defined as an ‘agency problem’) in which a principal contracts an agent who subsequently turns out to have the wrong characteristics. Cost that is incurred by a party (mostly the principal) in an agency relationship for specifying the task and rewarding or monitoring the agent, respectively. A relationship where one party (the principal) delegates work or decisions to another party (the agent). Hidden characteristics, hidden information or hidden intentions by an agent lead to agency problems. These may appear as an adverse selection of agents, moral hazard of agents, or a hold-up, once a contract is signed. The fact that an asset is tailored to a specific transaction or business relationship, which makes it very difficult to be redeployed in other activities or transactions. The fact that actors do neither possess complete information nor can fully process all information that is available. The neoclassical view that bargaining between independent market actors will lead to the most efficient resource allocation as long as transaction costs are sufficiently low. The presence of transaction cost leads to certain tasks being realized within the firm instead of being outsourced to third parties. The set of explicit and implicit rules and contracts in an organization or business relationship that define (1) the distribution of responsibilities, rights, and rewards, (2) procedures for reconciling the conflicting interests of stakeholders and (3) procedures for proper supervision, control, and information flows. A situation (and in agency theory defined as an ‘agency problem’) in which an agent acts opportunistically and abuses a one-sided dependency of the principal. The fact that the actors in a business relationship do not have the same amount and the same type of information. In agency relationships, agents typically have an information advantage over their principals. (continued)

2.8

Review Questions and Exercises

Inimitability

Moral hazard

Nonsubstitutability

Opportunism

Perfect market

Resource Transaction Transaction cost

2.8

35

A resource’s characteristic that makes it hard or even impossible for other parties than the resource owner to imitate that resource. Resource inimitability is one source of competitive advantage for a firm. A situation (and in agency theory defined as an ‘agency problem’) in which an agent acts opportunistically and abuses the information asymmetry to the detriment of the principal. A resource’s characteristic that makes it hard or even impossible for other parties than the resource owner to identify and employ a substitute for that resource. Non-substitutability is one source of competitive advantage for a firm. An actor’s practice to take advantage of or exploit opportunities in his/her own favor regardless of other principles and rules or potential adverse consequences for other parties. A market that is characterized by complete transparency on available inputs, prices, and production functions as well as by low or non-existent transaction costs. In a perfect market, all market actors possess the same, complete information. In a perfect market, individual utility maximization will lead to Pareto-optimal resource allocation. A tangible or intangible entity available to the firm that enables it to produce efficiently and/or effectively a market offering that has value for others. A transaction occurs when a good or service is transferred across a technologically separable interface (e.g. different organizational entities). Costs incurred for the initiation, execution, and monitoring of a transaction. They include the costs of defining and measuring resources or claims, the costs of utilizing and enforcing the rights specified, and the costs of information, negotiation, and enforcement.

Review Questions and Exercises

Review question 2.1: Explain how theory can contribute to explaining collaboration between firms in general and how theory can support supply chain practitioners in performing their job. Review question 2.2: Discuss the fundamental traits of neoclassical theory and briefly explain why it cannot explain the existence of supply chains. Review question 2.3: Explain the concept of transaction costs and show how they influence the distribution of resources among economic actors (firms). Review question 2.4: Discuss how the characteristics of bounded rationality, individual profit maximization, and opportunistic behavior lead to different forms of governance in transactions between two or more actors.

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Theoretical Concepts Relevant for Supply Chain Management Accounting

Review question 2.5: Describe how SCMAC helps identify and manage transaction costs in supply chain relationships. Review question 2.6: Outline how resource-based theory can explain the existence of supply chains. Review question 2.7: Discuss how collaboration as a form of managing supply chains can be a powerful relational resource that improves competitive advantage. Review question 2.8: List and explain the key problems that may arise between a principal and an agent when collaborating in a supply chain setting. Review question 2.9: Discuss the options suggested by agency theory on how to mitigate or avoid agency problems in a supply chain context. Exercise 2.1: Theory hints in supply chain management accounting Your company has been doing business with one of your major suppliers for several years. The business relationship is good but has never gone beyond formal purchasing frame contracts. The supplier’s management has now changed and the new management team has approached your company with a business proposal to jointly develop a new product, which would be based on an innovative technology patented by the supplier. The supplier hopes to tap a new business area, while your own company could solidify its competitive position in the market. Analyze this situation using the theoretical concepts outlined in this chapter. Which opportunities and challenges will this new cooperative relationship entail and how can your company best cope with them?

References Arrow KJ (1985) The economics of agency. In: Pratt JW, Zeckhauser RJ (eds) Principals and agents: the structure of business. Harvard Business School Press, Boston, MA, pp 37–51 Barney JB (1991) Firm resources and sustained competitive advantage. J Manag 17:99–120 Bromiley P, Rau D (2016) Operations management and the resource based view: another view. J Oper Manag 41:95–106 Coase RH (1937) The nature of the firm. Economica 4:386–405 Conner KR (1991) A historical comparison of resource-based theory and five schools of thought within industrial organization economics: do we have a new theory of the firm? J Manag 17:121–154 Eisenhardt KM (1989) Agency theory: an assessment and review. Acad Manag Rev 14:57–74 Ekanayake S (2004) Agency theory, national culture and management control systems. J Am Acad Bus Camb 4(1/2):49–54 Fayezi S, O’Loughlin A, Zutshi A (2012) Agency theory and supply chain management: a structured literature review. Supply Chain Manag Int J 17(5):556–570

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Fleisher CS (1991) Using an agency-based approach to analyze collaborative federated interorganizational relationships. J Appl Behav Sci 27(1):116–130 Furobotn EG, Richter R (1997) Institutions and economic theory: the contribution of the new institutional economics. The University of Michigan Press, Michigan Geyskens I, Steenkamp J-B, Kumar N (2006) Make, buy, or ally: a transaction cost theory metaanalysis. Acad Manag J 49(3):519–543 Haakansson H, Havila V, Pedersen AC (1999) Learning in networks. Ind Market Manag 28:443–452 Halldorsson A, Kotzab H, Mikkola J-H, Skjøtt-Larsen T (2007) Complementary theories to supply chain management. Supply Chain Manag Int J 12(4):284–296 Heugens P (2005) A neo-Weberian theory of the firm. Organ Stud 26:547–567 Hitt M, Xu K, Matz Carnes C (2016) Resource based theory in operations management research. J Oper Manag 41:77–94 Holcombe RG (2018) The Coase theorem, applied to markets and government. Indepen Rev 23 (2):249–266 Hunt S (2000) A general theory of competition: resources, competences, productivity, economic growth. Sage, Thousand Oaks Hunt S, Davis D (2012) Grounding supply chain management in resource-advantage theory: in defense of a resource-based view of the firm. J Supply Chain Manag 48(2):14–20 Jensen MC, Meckling WH (1976) Theory of the firm: managerial behavior, agency costs and ownership structure. J Financ Econ 3(4):305–360 Logan MS (2000) Using agency theory to design successful outsourcing relationships. Int J Logist Manag 11(2):21–32 Mentzer JT, Min S, Bobbitt LM (2004) Toward a unified theory of logistics. Int J Phys Distrib Logist Manag 34:606–627 Mitnick B (1973) Fiduciary rationality and public policy: the theory of agency and some consequences. Paper presented at the annual meeting of the American Political Science Association, New Orleans, LA Penrose ET (1959) The theory of the growth of the firm. Wiley, New York Picot A, Dietl H, Franck E (1997) Organisation: Eine ökonomische Perspektive. Schaeffer-Poeschel, Stuttgart Pratt JW, Zeckhauser RJ (1985) Principals and agents: the structure of business. Harvard Business School Press, Boston, MA Ross SA (1973) The economic theory of agency: the principal’s problem. Am Econ Rev 63 (2):134–139 Rungtusanatham M, Rabinovich E, Ashenbaum B, Wallin C (2007) Vendor-owned inventory management arrangements in retail: an agency theory perspective. J Bus Logist 28(1):111–135 Sirmon DG, Hitt MA, Ireland RD (2007) Managing firm resources in dynamic environments to create value: looking inside the black box. Acad Manag Rev 32:273–292 Suematsu C (2014) Transaction cost management—strategies and practices for a global open economy. Springer, Cham Wernerfelt BA (1984) Resource-based view of the firm. Strat Manag J 5:171–180 Williamson OE (1975) Markets and hierarchies: analysis and antitrust implications. Free Press, New York Williamson OE (1985) The economic institutions of capitalism: firm markets, relational contracting. Free Press, New York Williamson OE (1996) The mechanisms of governance. Oxford University Press, Oxford Zu X, Kaynak H (2012) An agency theory perspective on supply chain quality management. Int J Oper Prod Manag 32(4):423–446

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Challenges in Supply Chain Management and Supply Chain Management Accounting

MAC Tasks

SC Theory Relevant for MAC

SC Challenges for MAC

Changed Governance

Allocation Difficulties

Uncertainty + Opportunism

Measuring Performance

Learning Objectives After completing this chapter, you should be able to: 1. Understand the similarities and the differences between management accounting in an intracompany surrounding and in a cross-organizational supply chain setting 2. Identify governance structures in supply chains and the role management accounting can play in these structures 3. Define the term “relational rent” 4. Identify the conditions that lead to prosperous collaboration by a fair allocation of tasks and a fair sharing of surpluses 5. Explain the phenomenon of “value chain envy” 6. Understand the importance of information flows in a supply chain and explain the “bullwhip effect” 7. Identify two perspectives of “performance” in a supply chain context

# Springer Fachmedien Wiesbaden GmbH, part of Springer Nature 2020 A. Taschner, M. Charifzadeh, Management Accounting in Supply Chains, https://doi.org/10.1007/978-3-658-28597-5_3

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Challenges in Supply Chain Management and Supply. . .

Chapter 1 has outlined the main tasks that management accounting is typically charged with in a business entity. For most of these tasks, management accountants can draw on a rich set of tools and methods that have been developed both in business practice and academia over the past decades. These management accounting tools, though, have been devised for intra-company application. They build upon and further refine governance mechanisms, processes, and routines that are typical for companies that are organized as single legal entities or as a group of interrelated entities (corporations). Supply chains do not possess these characteristics. Their governance structures and coordination mechanisms differ significantly from those that can be found within a single firm. Chapter 2 has outlined the main theoretical underpinnings for cross-company collaboration per se. Both theory and business practice argue that under certain conditions it makes perfect sense for independent business entities to collaborate and move closer together by forming supply chains. But as Chap. 2 has also well shown, such collaborative setups give rise to numerous potential problems and challenges, which are not relevant or at least much less pronounced when acting within a single firm. In the present chapter, we further elaborate on these issues and outline the key challenges that management accounting is faced with when pursuing typical management accounting tasks in a supply chain environment.

3.1

How Cross-organizational Collaboration Differs from Intra-company Collaboration: An Overview

We have outlined the key tasks of management accounting in Chap. 1. Management accounting (MAC) is typically responsible for a diverse set of activities including, but not limited to, planning and budgeting, performance measurement (with direct links to employee evaluation and compensation), management reporting and information management, and—last but not least—coordination of management activities across different corporate functions and management layers. These MAC functions generally do not change when moving from the internal perspective within a single firm to the cross-company collaboration level. Individual supply chain members will still pursue their own operational and strategic management activities, which need MAC support. In addition, however, a new, supra-organizational, management layer is introduced, which needs to be planned, controlled, and coordinated: The supply chain itself appears as an object of management attention that is closely intertwined with, but not entirely identical to, the individual partner firms making up the supply chain. Management accounting, therefore, has to fulfill tasks both at the individual company level and at the supply chain level. While the set of MAC tasks and functions does not fundamentally differ between these two management layers, the framework management accounting operates in, all the more does. Drawing on some key theoretical concepts, Chap. 2 has outlined the main lines of reasoning why firms engage in collaborative setups

3.1

How Cross-organizational Collaboration Differs from Intra-company . . .

41

and what typical problems such cooperation brings along. Let us briefly summarize the key tenets here: 1. Transaction costs limit the efficiency of pure market transactions. Transaction costs, therefore, are a key motive behind firm collaboration. At the same time, they are also a key object of management attention. Transaction costs need to be measured, controlled, and managed both at the individual firm layer as well as at the supply chain layer. At the same time, all these management and control activities cause new transaction costs themselves. 2. Transaction costs depend on the specific circumstances and the governance model of a transaction or collaboration. 3. Partner firms in a supply chain pursue different goals. Being individual players in the market, they strive for individual profit maximization. Thus, goal conflicts are likely and opportunism cannot be fully avoided. 4. Individuals possess bounded rationality only. They are limited in their ability to collect, interpret, and adequately process information. They are prone to errors and biases and will usually not be able to identify the “best possible” alternative. Instead, individuals typically look for “good enough solutions”. This is true for all members of an organization, including managers and management accountants. 5. Cross-company cooperation is marked by information asymmetry. Individual supply chain members possess incomplete information only about their partners’ goals and activities. This lack of transparency gives rise to potential agency problems. 6. Many of these challenges are further aggravated, if and when firms engage in multiple supply chains and are therefore part of more than one cross-company collaborative network. What does this mean for management accounting in supply chains? In a nutshell, management accounting cannot simply copy tools and processes from the single firm layer to the cooperation layer. The framework is too different. What tends to work for management accounting in a single firm, might miserably fail when being applied in the supply chain. The problems are manifold for management accounting (see also Table 3.1): – Governance and coordination systems differ considerably between an individual firm and a network of multiple firms. The rules and procedures that define accountability, responsibility, and authority between partners form a general framework, which MAC must adapt to. – Resource and task allocation, as well as surplus appropriation among partners, cannot be planned and controlled using the same tools that are applied at the single firm layer. – Asymmetrical or even missing information seriously affects management accounting’s role as a central information hub for decision makers. Uncertainty and potential opportunism play a bigger role than in a single firm; trust might replace other coordination mechanisms that management accounting typically applies within the firm.

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Table 3.1 Key characteristics of firm cooperation and their implications for management accounting

Effect of transaction cost

Bounded rationality

Information asymmetry, incomplete information Goal conflicts, opportunism

Immersion in multiple supply chains

Governance and coordination Which governance mode to be used for minimal transaction cost? Choice between market, hierarchy, and collaboration Choice between market, hierarchy, and collaboration How to align goal systems? Contracts to avoid opportunism Conflicting governance structures

Appropriation and allocation Cost-optimal task configuration and allocation across supply chain partners

Information, trust, and uncertainty Collecting information and avoiding uncertainty cause new transaction cost

Performance measurement How to identify and measure transaction cost?

Information overload, routines & programs

Planning and info exchange, reporting

Hidden / unclear cost

Alignment of task allocation with partners’ goal systems

Recognition of hidden actions and hidden intentions

No unambiguous allocation of cost and revenues possible

Synergies and antagonisms influencing performance Supply chains with different end-customers need different performance measures How to define “competitive advantage” across multiple supply chains?

Source: authors

– Performance measurement is still a key MAC task, but it is much less clear what needs to be measured and how such a measurement can be implemented in an effective and efficient manner across supply chain partners. We discuss these issues in more depth in the following sections.

3.2

3.2

New Governance Structures and Coordination Mechanisms

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New Governance Structures and Coordination Mechanisms

Management accounting does not take place in a vacuum. Management accountants are part of a bigger organizational setup, they have to follow rules and processes, which have been defined and agreed upon by other parties (e.g. company management) and which apply to all members of a particular organizational entity. Management accounting itself, in turn, influences other actors and organizational units. As outlined in Chap. 1, management accounting performs important planning and coordination tasks for the organization and typically acts as a central information hub, relating various actors and decision makers with each other. A company’s management control system typically comprises the allocation of decision rights, the information structure, and performance measures and incentives within the company (Veen-Dirks and Verdaasdonk 2009). Management accounting and management control activities have an important influence on the behavior of people working in the organization. Management accounting, therefore, is an integral part of what we call the “governance system” of an organization. The governance system sets the framework for acting and decision making in an organization (Crisan 2016). It can be defined as the framework of rules and practices that ensures accountability, fairness, and transparency in a company’s relationship with all its stakeholders (financiers, customers, management, employees, government, and the community). The governance framework consists of 1. Explicit and implicit contracts between the company and the stakeholders for the distribution of responsibilities, rights, and rewards, 2. Procedures for reconciling the sometimes conflicting interests of stakeholders in accordance with their duties, privileges, and roles, and 3. Procedures for proper supervision, control, and information flows to serve as a system of checks-and-balances. A company’s internal governance structure acknowledges the fact that “. . . there are multiple interests and that the challenge is to achieve a viable and fruitful balance of interests and power” within an organization (Nooteboom 1999, p.1). This makes sure that all actors within the organization have a reliable basis for their activities. You know what to expect from others and you know what others expect from you. Provided that the governance structure is clear, authority relationships (“Who is the boss?”) and processes to deal with conflicts (“How can this issue be escalated?”) are defined and known to all parties. Firms define much of their internal governance structure through their organizational setup. The decisions taken along a number of key organizational dimensions define the balance of responsibilities, accountability, and information flows between different internal stakeholders (top and middle managers, employees):

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– Specialization (the degree to which the overall task of the organization is broken down and divided into smaller component parts) – Departmentalization (distribution of work, grouping of jobs according to some logical arrangement) – Reporting relationships (span of control, i.e. number of subordinates per supervisory function) – Authority delegation along the centralization/decentralization continuum (assigning power/responsibilities of management to other organization members) – Coordination mechanisms (such as meetings, reports, work orders, process descriptions, escalation procedures, etc.) Example The Swedish retail bank Svenska Handelsbanken AB is often cited as an exemplary model of radical decentralization and delegation of power to lower hierarchical levels. From the early 1970s onwards, and initiated by its then CEO, Jan Wallander, Handelsbanken followed a management philosophy that was based on (Lindsay and Libby 2007): – Customer focus, meaning that bank employees with direct customer contact had more authority and responsibility than product managers – Radical decentralization, leading to branch offices and their managers having a high degree of freedom and responsibility, whereas bank headquarters was not involved in operations – Employees’ accountability for individual performance Implementing these principles across the entire organization, Handelsbanken had established a clear and consistent governance system that significantly differed from many other banks at that time. It is easy to see that management accounting can successfully perform its tasks only if a clear governance system is in place. Vice versa, it will also contribute itself to defining and implementing a company’s governance structure. The common body of knowledge in management accounting that students learn in their accounting classes and practitioners apply in their daily routine work is based on this governance assumption. To a certain extent, management accounting can also contribute to implementing the governance mechanisms that define the relationship between the firm and its environment (such as firm owners, the general public, or public authorities). This part of a firm’s governance system, however, is often subject to regulation and rules set by legislation. Example Coming back to the example of the banking industry, banks are subject to a complex set of rules and regulations both at a country and at a supra-national level. Given their special nature and their pivotal role in the economic system, banks’ relation with other stakeholder

3.2

New Governance Structures and Coordination Mechanisms

45

groups (owners, debtors, public authorities, the general public, etc.) are marked by several traits that distinguish their governance structure from those typically found in manufacturing firms: – Balancing out the conflict between profit-seeking interests of owners (and bank managers hired by owners) on the one hand and security-seeking bank customers/ debtors on the other hand. Since banks typically operate with higher leverage (debtequity ratio) than manufacturing firms, the moral hazard problem is potentially more aggravated: bank owners and managers pursue activities that are potentially in conflict with the interest of bank customers such as savers. – Setting rules that prevent banks from pursuing overly risky ventures, because a bank’s failure would have much more severe negative effects on the economy (negative externalities) than, for instance, the failure of a manufacturing firm. The interest of the general public or the economy as a whole needs to be taken into account more explicitly than would be the case in the manufacturing industry. – More comprehensive reporting and monitoring rules that allow regulating bodies a deeper insight into a bank’s activities than would be typical for a manufacturing firm. Banks, consequently, need to provide a higher degree of transparency to regulators than firms operating in other industries. Governance mechanisms work not only within organizations but also across different organizational entities—such as supply chains. There as well, the need arises to coordinate the authority and power relationships that determine how financial, material, and human resources are allocated and flow within a chain. (Gereffi and Korzeniewicz 1994, p. 97)

Cross-organizational governance mechanisms, however, differ significantly from intraorganizational governance—with severe consequences for management accounting. Different Governance Models First, we have to recognize that cross-company relationships can take many different forms. In fact, cross-company cooperative relationships can be viewed as intermediary solutions on a governance spectrum that reaches from pure market transactions to complete hierarchy (Gereffi et al. 2005). Gereffi et al. (2005) distinguish five different governance structures for global value chains: 1. Markets: spot transactions with low or even no switching costs for the parties 2. Modular value chains: suppliers make products or components following the customer’s specifications 3. Relational value chains: interactions are more complex than in modular value chains, mutual dependencies increase

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Table 3.2 Factors characterizing the five governance models

Market Modular Relational Captive Hierarchy

Complexity of transactions Low Medium High High High

Ability to codify transactions High High Low High Low

Capabilities in the supply base High High Medium Low Low

Degree of explicit coordination and power asymmetry Low Low Medium High High

Source: Gereffi et al. (2005); Ashenbaum et al. (2009)

4. Captive value chains: small suppliers are completely dependent on their customer, the switching cost for suppliers is very high 5. Hierarchy: vertical integration (by acquisition or merger) leads to a high degree of managerial control as a primary governance instrument These five archetypical governance models are characterized by four factors: (1) the complexity of the inter-firm transactions (i.e. the amount and complexity of information required to sustain the transactions), (2) the degree to which these transactions can be codified (e.g. through standardization or automated IT systems), (3) the extent to which suppliers have the necessary capabilities to meet the buyers’ requirements (without interference or direction from the buyer), and (4) the degree of explicit coordination and power asymmetry between partner firms. The combination of these factors leads to the classification of value chain governance models as outlined in Table 3.2. As can be seen from these brief descriptions, the level of explicit coordination and power asymmetry increases when going from markets to hierarchies. One is safe to say that traditional management accounting tools are tailored to hierarchical governance structures. Cross-company relationships that are marked by other types of governance mechanisms typically pose problems to management accounting, since they do not provide the same structural and procedural framework that MAC tools build upon. Management accounting, in turn, also has an influence on governance mechanisms at the network layer. Accounting contributes to network governance and coordination through at least two different mechanisms (Mouritsen and Thrane 2006): – Self-regulating mechanisms that allow financial and distributional effects of network relations to flow automatically without intervention from a center (e.g. transfer prices, fees, rules for cost and profit distribution). They allow interaction with a minimal amount of friction in day-to-day activities. – Orchestration mechanisms that help develop the network as an entity with a common objective (e.g. partner screening, technology mapping, competency management).

3.2

New Governance Structures and Coordination Mechanisms

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Management Accounting vs. Governance It should be noted that management accounting and control is not synonymous with governance. Some typical supply chain governance and coordination mechanisms—such as information sharing—will clearly be on management accountants’ agenda. Other potential mechanisms are closer to operations management (e.g. coordinated inventory management techniques) or legal departments (e.g. contracts). Governance, therefore, includes the notion of control but is a wider concept (Veen-Dirks and Verdaasdonk 2009). Management accounting and control, therefore, relates typical elements such as allocation of decision rights, information exchange and performance measures and incentives to the internal functioning of a company, while the notion of supply chain governance relates these concepts to the whole supply chain (Veen-Dirks and Verdaasdonk 2009). In fact, supply chain governance mechanisms typically comprise, but are not limited to the following elements (see also Arshinder et al. 2011; Hernández-Espallardo et al. 2010; Varoutsa and Scapens 2015): – – – – – –

Contractual arrangements Information technology / IT systems Information sharing agreements and processes Joint decision-making processes Trust Cooperative norms

Management accounting is actively involved in some of these elements, but cannot provide the full set of potential governance mechanisms. The effectiveness and efficiency of supply chain management accounting systems, therefore, to a large extent depend on supply chain governance elements that are beyond its direct influence. But as has been outlined in Table 3.2, there is no single supply chain governance model, since the nature of the supply chain collaboration—and the typical challenges and tasks emerging from it— will differ. Different supply chain topologies and governance models, therefore, lead to different task sets for management accounting (see also Lind and Thrane 2010): – Single bilateral relationship In some cases, a single bilateral relationship between one buyer and one supplier might form the core of the entire supply chain. The success of this relationship dominates the entire supply chain’s competitiveness. Choosing the right supplier and taking an appropriate make-or-buy decision is key. Sharing relevant cost information between the two parties and agreeing on adequate control systems are central accounting tasks in such an organizational set-up. – Serial relationships Other supply chains are characterized by serial relationships, leading to a chain of individual supply chain partners, each one performing a dedicated step in the value

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creation process. In addition to the bilateral activities outlined in case one, the allocation of tasks and responsibilities among partners along the supply chain becomes imperative. Deciding on the most effective degree of vertical integration for each partner can become a complex, challenging accounting task that requires a high degree of information sharing and plan alignment. – Multiple supply chain partners in one direction Different from serial relationships, some supply chains are marked by one focal company dealing with a multitude of supply chain counterparts in one direction—either several suppliers or several distributors. Here again, allocation problems arise, but this time the focal company has to properly allocate tasks among several partners that are at the same stage of the value chain, i.e. these partners are potential substitutes for each other. Proper segmentation becomes important as does the determination of an optimal degree of centralization or decentralization, respectively. – Multiple supply chain partners in both directions Focal companies might also be confronted with a multitude of partners both upstream and downstream in their supply chain. Management accounting will have to provide adequate information to allow prioritization and alignment of heterogeneous preferences among the multitude of supply chain actors. The availability of reliable and comparable inter-organizational cost information becomes crucial in such a setting. – Web of cross-organizational relationships Last but not least, a company might find itself in a complex web of crossorganizational relationships that belong to different supply chains. In such a networktype setting, indirect effects (positive and negative “externalities”, synergies and dissynergies) are decisive for success, and management accounting would typically be expected to identify and quantify such effects as far as possible. Supply chains can evolve over time and therefore change their character and governance structure (Varoutsa and Scapens 2015). Newly established business relationships require different governance mechanisms—and accounting instruments supporting them!—than long-running partnerships. As a supply chain moves through different phases in its life cycle, management accounting will have to adapt and further evolve its tools and instruments in order to provide support for supply chain management. We can conclude that supply chains pose multiple governance challenges to management accounting: First, supply chains possess characteristics that make an unreflected application of MAC tools ineffective. Management accounting tools must be adapted to be useful in supply chains. Second, supply chains can take many different governance forms depending on their topology and complexity. There is no uniform set of supply chain management accounting tools that could be applied in any supply chain. Third, supply chains evolve and mature over time, necessitating a subsequent adaptation of MAC tools in order to stay effective. Finally, management accounting for its part has an effect on the governance structure itself, which might require further adaptation of MAC instruments.

3.3

Interdependency Affecting Allocation Tasks and Surplus Appropriation

3.3

49

Interdependency Affecting Allocation Tasks and Surplus Appropriation

As has been outlined several times before, supply chains constitute a governance type that is distinctly different from pure market relationships (at arm’s length transactions) on the one hand and hierarchical structures within an organization (vertical integration) on the other. Partners in a supply chain will be motivated to engage in such a “third way” of doing business only if they can realistically hope to reap sufficient benefits from the cooperation—benefits that should be larger than those that could be realized by other governance types. Economists and management scholars have coined the term “relational rent” for surpluses that are created through cooperation. Relational rent has been defined by Dyer and Singh as a supernormal profit jointly generated in an exchange relationship that cannot be generated by either firm in isolation and can only be created through the joint idiosyncratic contributions of the specific partners. (Dyer and Singh 1998, p. 662)

Put more bluntly, firms cooperate because they believe that 1 + 1 > 2 (Zhang et al. 2017). This belief in possible synergies constitutes the main motive behind cooperation. Each firm contributes own resources and competencies, which are subsequently combined in the collaborative relationship to generate value that exceeds what each partner would have been able to achieve on his own. Relational rent (or synergies from collaboration) can be generated, for instance, through an exchange of knowledge (creating new insights that would not have been possible before), combining complementary resources, lowering transaction costs, or joint investments in special assets (Zhang et al. 2017). Example The automotive industry is marked by an extensive distribution of tasks across supply chain partners. Car manufacturers (original equipment manufacturers, or OEMs) have delegated many tasks in developing and manufacturing new car models to their suppliers. Suppliers build expertise in specific components, profit from higher volumes (economies of scale) and solidify their bargaining position towards OEMs. OEMs, in turn, need not build costly capacities for specialized tasks, can pass over part of the market risks (capacity utilization) to suppliers and profit from expert know-how that is available with suppliers only. In today’s world, a fully integrated car manufacturer, i.e. an OEM completing all valueadding steps with own resources, would certainly not be competitive—unless it manages to occupy a very small and specific niche that is not interesting to other competitors. For the vast majority of OEMs, however, cooperation with supply chain partners has become the

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Challenges in Supply Chain Management and Supply. . .

norm and is the only way to achieve the profitability levels that are expected by their shareholders. The quest for relational rent ties supply chain partners together and creates interdependencies both at the input (resources) and at the output (surpluses) level: 1. At the input level, tasks and responsibilities must be allocated among supply chain partners in a way that leads to relational rent. 2. At the output level, generated surpluses must be allocated among partners in order to compensate them for invested inputs and incentivize further collaboration. The input and the output layer are closely interconnected. The supply chain collaboration will be sustainable only if all partners perceive a benefit in their contribution, i.e. if they receive what they consider to be at least a “fair share” of the total relational rent generated. Supply chain managers and management accountants supporting them, therefore, are faced with multiple challenges, which are discussed further in the following. Efficient Task Allocation Among Supply Chain Partners Management accounting needs to ensure that task allocation among supply chain partners is effective and leads to the highest possible relational rent. Inappropriate allocation of tasks and responsibilities among partners will not create synergies, but might even lead to a situation where 1 + 1 < 2 (i.e. partners impeding each other). Example Imagine a situation where a manufacturer and its supplier must decide whether raw material inventories should be kept at the supplier’s or at the manufacturer’s premises. What are respective warehousing costs, at which location will inventory management be easier, how does the location of raw material supplies affect replenishment times (and subsequently agility of the supply chain), etc.? Management accounting of both partner firms will have to provide the necessary information and will have to do an analysis that can be used as a basis for the final decision. Task allocation among supply chain partners, therefore, will require the availability of extensive cost information in order to identify the most efficient split of tasks and responsibilities. Collecting this cost information from partner firms will be challenging because it is proprietary and confidential. Even if the information is shared, management accounting might find it hard to compare cost information coming from different cost accounting systems, because definitions and cost structures will differ. While cost consolidation can already be challenging within a single organization, it is even more difficult across multiple organizations. More will be said about inter-organizational cost accounting and cost management in Chaps. 4 and 5.

3.3

Interdependency Affecting Allocation Tasks and Surplus Appropriation

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Surplus Appropriation Among Supply Chain Partners Management accounting needs to devise appropriate mechanisms to allocate surpluses among partners. Allocating surpluses in proportion to the number of resources invested might seem to be a fair and pragmatic solution approach, but proves to be unrealistic: 1. First, supply chain partners will expect compensation not only for resources invested but also for risks and responsibilities assumed—which are not necessarily in line with resource commitments. 2. Second, an exact measurement of partners’ resource commitments for a specific collaborative activity or task is very difficult and error-prone. In business practice, for instance, firms also contribute intangible resources (such as know-how) that are very difficult to measure in monetary terms. In addition, companies also deploy resources to protect themselves against competitive imitation (Foss 2003) or replication of valuecreating activities by third parties (Lepak et al. 2007). If supply chain partners engage in such activities, they inevitably consume resources that cause cost. It can be very difficult to decide whether the cost incurred for such “defensive” activities contributes to the supply chain’s overall success and therefore should be taken into account at all. 3. Third, and maybe most importantly, supply chain partners have no interest in ensuring a “fair” distribution of surpluses. On the contrary, each supply chain partner will typically try to maximize its own share in the relational rent generated, no matter how close the cooperation might be. As has been discussed in Chap. 2, agency problems and opportunistic behavior are common in supply chain relationships. Consequently, an allocation of the surplus based on the amount of invested resources will most probably be biased by hidden action or hidden information in a supply chain relationship. Resource commitment, therefore, is not a suitable allocation basis for surplus appropriation, because it provides wrong incentives for supply chain partners and is prone to agency problems. Instead, surpluses should rather be distributed in proportion to value created. It is important to note that “value” in this context is not measured by value of inputs, but denotes the value perceived by final customers (i.e. benefits). If and as long as final customers perceive an increase in value, they will be prepared to pay a higher compensation (price) for the more valuable (beneficial) market offer. If a supply chain partner’s activity increases value, it deserves being compensated through a higher share in surpluses generated. Example Let us assume a very simple supply chain consisting of two firms only: a supplier delivers goods to a manufacturer who, in turn, sells the final product to end customers. Partners collaborate because they expect to reap higher profits than would be possible if they were to deal at arm’s length only.

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= = +/= =

SUPPLIER Revenues Cost of Goods Sold (COGS) Gross profit Funconal expenses (R&D, SG&A) Other operang expenses EBIT Interest expense / income EBT Income tax Net income / net loss

Challenges in Supply Chain Management and Supply. . .

100.00 € 65.00 € 35.00 € 15.00 € 7.00 € 13.00 € 4.00 € 9.00 € 2.70 € 6.30 €

= = +/= =

MANUFACTURER Revenues Cost of Goods Sold (COGS) Gross profit Funconal expenses (R&D, SG&A) Other operang expenses EBIT Interest expense / income EBT Income tax Net income / net loss

180.00 € 100.00 € 80.00 € 25.00 € 14.00 € 41.00 € 6.00 € 35.00 € 10.50 € 24.50 €

Total supply chain surplus can be determined by adding up both partners’ net income and currently amounts to 6.30 + 24.50 ¼ 30.80 €. The manufacturer’s profit is not only higher in absolute terms, but also in relative terms: profit margin is 6.3% for the supplier, but 13.6% for the manufacturer. Let us now suppose that both partners agree to change the design of the component supplied by the upstream partner. The supplier incurs higher COGS (higher cost of raw material) as well as additional R&D expenses. The supplier will implement the improvement only if it receives adequate compensation. In an input-oriented compensation scheme, the supplier would receive a higher price in proportion to the higher cost incurred. This would leave the supplier with higher sales revenues, which compensate for the higher cost, but net income would not change. The incentive to engage in the improvement action would be minimal for the supplier. The manufacturer, in turn, would try to pass on its increased COGS (higher purchase price from supplier) to the end-customer. Depending on end-customers’ demand elasticity, the manufacturer would be left with a higher or a lower profit than before. In any case, the commercial risk would remain with the manufacturer. A more robust scheme would try to work backward from end-customers’ willingness to pay. Let’s assume that the improved component design leads to new product characteristics that are perceived as genuine improvements by end-customers. The manufacturer, therefore, can charge higher prices and revenues go up to 200 €. The supplier, in turn, is confronted with a 10 € increase in COGS and a 3 € increase in R&D cost. Overall supply chain profit will still increase by 20 – 13 ¼ 7 €. The initiative is certainly adding value and should be implemented. This will happen only, however, if both partners receive a share in the additional profit. If, for instance, the supplier can charge 115 € instead of the previous 100 €, net income will increase to 7.70 € and the profit margin will improve to 6.7%. The manufacturer will still be left with a net income of 28 €, which is higher than before and translates into a profit margin of 14.0 %—both partners profit from the initiative.

3.3

Interdependency Affecting Allocation Tasks and Surplus Appropriation

= = +/= =

SUPPLIER Revenues Cost of Goods Sold (COGS) Gross profit Functional expenses (R&D, SG&A) Other operating expenses EBIT Interest expense / income EBT Income tax Net income / net loss

115.00 € 75.00 € 40.00 € 18.00 € 7.00 € 15.00 € 4.00 € 11.00 € 3.30 € 7.70 €

= = +/= =

MANUFACTURER Revenues Cost of Goods Sold (COGS) Gross profit Functional expenses (R&D, SG&A) Other operating expenses EBIT Interest expense / income EBT Income tax Net income / net loss

53

200.00 € 115.00 € 85.00 € 25.00 € 14.00 € 46.00 € 6.00 € 40.00 € 12.00 € 28.00 €

Total input, therefore, is not an appropriate yardstick for surplus sharing, since it will set wrong incentives. The output-oriented scheme, however, is not easy to implement either, since both partners need to share cost and revenue information and must refrain from exerting disproportionate negotiating power. It must be noted, however, that a firm’s ability to capture a share of the surplus created is not necessarily proportional to its contribution to value created. Supply chain partners with high bargaining power will be able to capture a larger share of the surplus. In addition, firms also employ “isolating mechanisms” (Lepak et al. 2007) that prevent replications of value-creating activities by other supply chain partners. Such isolating mechanisms could by physical or legal barriers, for instance. Example Imagine a simple supply chain where supplier A provides a component that is crucial for the final product that is assembled and sold by manufacturer B. The manufacturer B might try to negotiate a right of exclusivity, preventing the supplier A from selling the component to any other party. Having such a contractually agreed right of exclusivity, manufacturer B has isolated himself from potential competitors using the same component and at the same time has put himself into a stronger bargaining position, since supplier A has no other market for its product. Supplier A, in turn, might design the component as a “black box” that cannot be opened or disassembled by the manufacturer. By employing such a physical isolating mechanism, the supplier reduces the risk that manufacturer B might re-engineer the component himself or invites other suppliers to copy the functional design. This increases manufacturer B’s dependency on supplier A and thus builds a counterweight to the manufacturer’s exclusivity rights. Value Chain Envy The mutual dependencies between supply chain partners might make it very difficult to stop the cooperation altogether, but partners will try to maximize their own benefits from

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the cooperation—without risking a break-up of the cooperation as such. Firms will keep an eye on their supply chain partners’ ability to reap a share in relational rent. If value captured disproportionally exceeds the contribution to value creation for a particular firm, other firms in the supply chain will experience “value chain envy” (Mol et al. 2005). They will try to increase their own share, for instance through vertical integration (expanding own tasks and activities at the expense of the supply chain partner). Example If a manufacturer observes that profit margins of its distribution partners significantly exceed its own margin, the firm might be tempted to open a new, direct, distribution channel (e.g. an online store) to bypass the distribution partner and subsequently cash in the high margins that apparently can be generated in distributing the product. Value chain envy, in fact, is an indicator for the competitive relationship that exists between supply chain partners. Supply chain partners do not compete for end-customers (in fact, they share the same end-customers!), but they do compete for a share in relational rent generated. Profits are ultimately made vertically and not horizontally, as the product passes through the sequence of supplier-buyer relationships that make up the value system. (Mol et al. 2005, p. 255)

A ratio to measure the proportion of relational rent (supply chain surplus) obtained by supply chain partners is the value share ratio. It is computed by calculating the surplus captured by one party divided by the value created by the same party: Value share ratio ¼

share of relational rent captured by partner share of value created by partner

ð3:1Þ

A supply chain would be in equilibrium (i.e. without any value chain envy potential) when at all stages the ratio equals 1. Thus, a value chain ratio of 1 would be considered “fair”. Such a situation is very unlikely to happen, though, since every partner engages in isolating mechanisms and uses bargaining power to increase its own ratio to a value > 1. Still, supply chains are not “shark pools” where all partners fight each other in a quest for an ever higher share in relational rent. Remember that it is supply chain cooperation that makes relational rent possible in the first place. The size of the pie is bigger than without cooperation and thus supply chain partners can generate surpluses that are bigger in absolute size than without cooperation—even if their ratio is < 1. Second, cooperation in a supply chain can open the way to so-called “private benefits” for partners (Dyer et al. 2008). Private benefits are not apparent to the other supply chain partners and therefore are not subject to value chain envy. Private benefits cannot be captured by other supply chain partners, because they lack the specific resource combination or know-how base that would be necessary for doing so.

3.4

The Impact of Uncertainty, Opportunism, and Trust on Information Flows

55

Example A supplier with extensive experience in the automotive industry enters into its first supply contract with a global aircraft manufacturer. Given its high bargaining power, the aircraft manufacturer can reap the biggest share of relational rent generated. The supplier, however, is still satisfied with the cooperation, since he gains invaluable experience in the new industry and learns more about how to transfer technologies and processes to the automotive industry. This ability to transfer know how from the aircraft to the automotive industry is a private benefit that cannot be captured by any other partner in the supply chain. As these explanations show, allocating inputs and outputs within a supply chain proves to be a challenging task. Nevertheless, management accounting can contribute in several ways to mastering this challenge: 1. Management accounting can provide a quantitative basis for task allocation by collecting and analyzing cost information across the supply chain partners involved. 2. Management accounting can establish a measurement system that is able to quantify the value contributions of all supply chain partners. Such a system should be able to capture both total value created by a supply chain partner and incremental value created (i.e. the increase in total value created in between two periods, see also Garcia-Castro and Aguilera 2015). 3. Finally, management accounting can help establish a “fair” link between inputs consumed (cost) and value created (surplus) by developing appropriate incentive systems, such as profit and revenue sharing contracts, transfer pricing agreements or compensation payments between supply chain partners.

3.4

The Impact of Uncertainty, Opportunism, and Trust on Information Flows

Information has become a key resource in modern business. A company’s ability to organize and manage information flows, therefore, has a direct effect on its competitiveness. As has been outlined in Chap. 1, collecting, processing and disseminating information within the organization is a key management accounting task. Within an organization, management accounting often takes the role of a central information hub, in particular for financial information such as costs and revenues. To do so, management accounting taps a variety of data sources and IT systems within the organization, most notably the financial accounting system. In order to ensure seamless and efficient information flows, companies often implement ERP (enterprise resource planning) systems that provide a comprehensive, standardized platform for planning and managing a company’s financial and non-financial resources. In addition, procedural rules and routines define the responsibilities and tasks of different stakeholders. A hierarchical company structure not only defines escalation routines in case of problems and disputes in information management but also provides a

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general framework for management reporting (standardized dissemination of information to company decision makers). Availability of comprehensive, yet focused, information, seamless information flows between all organization members and entities and the ability to quickly analyze and act upon new information are crucial for an effective and efficient information system. These factors have a direct effect on overall company performance. The pivotal role of information for overall performance and business success holds true for cooperative settings as well. Information management is also a central trait of cooperative behavior and has a strong influence on cooperative performance. Numerous studies have investigated the various facets of the information—performance link in cooperative relationships (Panahifar et al. 2018, Ralston et al. 2017): – Secure sharing of information between supply chain partners prevents leaking of proprietary information to competitors outside the collaboration – Information exchanged between supply chain partners must be accurate and free of errors to enable joint planning and decision making. – Higher information readiness and timeliness allow faster response times across different supply chain levels. – In general, a higher willingness to share information (increasing information availability across all supply chain levels) has proven to be a driver of supply chain performance. The information – performance link, of course, applies to individual companies as well. Information management already proves to be a challenging task within a single organization. In a supply chain setting, however, it is even more difficult, because: 1. Numerous technical and structural information barriers exist between supply chain partners. IT systems are not compatible, sources of information are unclear or not revealed between partners, and reporting routines do not match across companies. 2. Information is asymmetrically distributed between partners. Although cooperating with each other, supply chain partners are reluctant to share proprietary information. Information, therefore, does not readily flow between partners. Asymmetries build up and information is hidden from other partners. 3. No uniform rules for analyzing and interpreting information are available. supply chain partners apply different definitions for similar phenomena, which leads to misunderstandings and erroneous decisions across supply chain levels. As has been outlined in Chap. 2, human decision makers are characterized by bounded rationality. Nevertheless, they tend to look for information for their decision making. Missing, ambiguous or unclear information will lead to uncertainty: decision makers are not sure about the causes of observed situations or events, about possible consequences of decision alternatives, or about the conditions influencing the decision. Uncertainty has been

3.4

The Impact of Uncertainty, Opportunism, and Trust on Information Flows

57

Order volume

50

40

20 15 10

Customer

Retailer

Distributor

Manufacturer

Supplier

Supply chain

Fig. 3.1 Exaggerating fluctuations from the bullwhip effect (source: authors)

found to be one of the most important moderating effects in supply chain performance and comprises market, technological, and environmental uncertainty (Tarifa-Fernandez and De Burgos-Jiménez 2017). The “Bullwhip” Effect One of the most well-known examples of the negative effects of uncertainty in supply chains is the so-called bullwhip effect. It describes the effect by which slow moving consumer demand at the downstream end of the supply chain creates large swings in production for the suppliers at the other (upstream) end of the supply chain (Wang and Disney 2016). Small changes in end-customer demand lead to much larger changes in demand (and production) at upstream layers in the supply chain. As a consequence, inventory levels are increased, forecasts are unjustifiably changed, and production schedules vary largely (see Fig. 3.1). The existence of the bullwhip effect is a direct consequence of uncertainty (lack of information) in the supply chain. Decision makers react to this uncertainty and the perceived variability in demand in a number of ways, which all help create the bullwhip effect (Lee et al. 1997, Simchi-Levi et al. 2009): 1. Forecasting based on actual demand If retailers and distributors do not share demand information with their suppliers, these will typically base their own order and manufacturing patterns on actual demand observed, adding a safety stock level to account for potential demand variability. An (isolated) increase in demand by end-customers would be interpreted by the subsequent entities upstream as a general increase in demand in the future. In order not to run out of

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stock, the distributor orders a higher volume from the manufacturer. The manufacturer, in turn, follows in the same mind and orders a yet higher volume at its suppliers. Consequently, every consecutive level of the supply chain will overestimate the initial product demand resulting in exaggerated fluctuations. The simple pattern “actual demand + safety stock” therefore leads to ever higher demand fluctuations at upstream layers of the supply chain. 2. Batch ordering Firms may not immediately place an order with their supplier. Instead, they often accumulate demand first. Ordering larger batches from their suppliers helps them save on transportation cost, profit from quantity discounts, or keep fixed order cost low. Surplus items will be stocked until they are consumed or re-sold. Although the firm might be faced with more or less constant demand, its own batch ordering leads to high demand fluctuations with its supplier: periods of high order volumes are followed by periods with no orders (since stock levels are still sufficiently high to satisfy demand). Demand variability, therefore, will be higher for the supplier than for the firm itself. 3. Price fluctuation In many markets (e.g. for commodities), prices vary and the timing of placing an order is essential to profit from lower spot market prices. Firms, therefore, tend to place higher orders than needed when prices are comparatively low and delay orders during times of higher market prices. This can cause distorted demand information. Again, demand fluctuations are aggravated. 4. Shortage gaming This is a phenomenon known in markets that are affected by occasional periods of short supply (e.g. because of seasonal or climatic influences). When firms expect periods of short supply, they tend to place larger orders than necessary, anticipating that the quantity effectively supplied might be rationed. Such a surge in demand can sum up to large demand booms over the entire supply chain. Consequently, even though a firm itself might experience relatively stable demand, its own shortage gaming behavior will increase demand variability with its suppliers. Example Referring one more time to Fig. 3.1, in our example, the customer orders initially 10 units of a product. The retailer then orders 15 units from the distributor to be prepared for any additional orders. The distributor, in turn, orders 20 units of the product from the manufacturer as ordering a batch of 20 allows for a quantity discount. When receiving the order, the manufacturer then orders 40 units, which allows him to operate production at scale. Finally, the supplier may order material for 50 or more units to benefit from a special order of other suppliers upstream. Eventually, at least 40 units will be produced for an actual demand of 10 units. The example shows how the actual demand may get distorted going down the supply chain. The bullwhip effect and its main causes are typical examples of the negative consequences of restricted or biased information flows. Inventory levels could be reduced,

3.4

The Impact of Uncertainty, Opportunism, and Trust on Information Flows

59

production patterns could be smoothed and risk management actions could be avoided if the information would be exchanged more freely between supply chain partners. Improved information flows would, therefore, improve overall supply chain effectiveness and efficiency. It must be noted, however, that the simple rule “more information is better” is not universally true. As every management accountant will readily confirm, there is a natural limit to the amount of information that can be processed by individual decision makers. If the amount of information becomes too large, human decision making is deteriorating again. This phenomenon is known as “information overload”. Information overload denotes the simple fact that individuals can actually receive too much information, leading to a deterioration of their performance. The information – performance relationship is therefore often visualized as an inverted U-curve (Eppler and Mengis 2004; Taschner 2012). This effect has been researched in different disciplines—not least in accounting. Effective and Efficient Information Supply Until the apex of the inverted U-curve has been reached, providing more information will improve decision-making performance. The apex is the point of maximum information effectiveness. Having this amount of information will lead to the best possible decision. This does not mean, however, that this also is the point of highest information efficiency. While effectiveness roughly describes “contribution to goal achievement”, efficiency denotes an input-output relationship. Collecting, processing and communicating more information causes additional costs. The additional cost incurred might outweigh the (small) benefits derived from adding more information. Put differently: if marginal costs of adding more information exceed marginal benefits, the resulting information level is inefficient. In business practice, of course, management accountants cannot exactly determine the optimal amount of information that should be collected and shared among supply chain partners in order to reach maximum effectiveness and efficiency. As has been outlined above, supply chain partners will be reluctant to share and disseminate information among each other. It is, therefore, safe to say that, in practice, the danger of information overload is smaller across supply chain partners than it is within a single organization. Management accountants in supply chains might, therefore, be less worried about “flooding” their decision makers with too much information from supply chain partners. They will, however, be faced with comparatively high costs of information exchange. Supply chain partners need to agree on and implement shared data formats, operating routines, common technical interfaces, etc., driving up the cost of information exchange. Information efficiency, therefore, is a major concern for management accountants in supply chains: how to organize information exchange without letting cost explode? Trust Firms develop a variety of different governance structures to preserve their interests against opportunistic behavior from other parties. Among them are mechanisms such as incentive structures, monitoring mechanisms, contracts, norms, or interpersonal trust (Jap and

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Challenges in Supply Chain Management and Supply. . .

Anderson 2003). Such opportunistic behavior can take many different forms in a collaborative relationship: “(i) Distortion of information, including overt behaviors such as lying, cheating, and stealing, as well as more subtle behaviors such as misrepresenting information by not fully disclosing it. (ii) Reneging on explicit or implicit commitments such as shirking, or failing to fulfill promises and obligations.” (Jap and Anderson 2003). As it turns out, one of the most effective and efficient mechanisms of information exchange in supply chains is trust. Trust can be defined as the confidence of one party in a two-way relationship that the other party will not exploit its vulnerabilities (Ghosh and Fedorowicz 2008). Once a trusted relationship has developed, one party to that relationship will be willing to be vulnerable to the actions of the other party, even if that other party cannot be readily monitored or controlled (Jap and Anderson 2003). The expectation of honesty and mutual benevolence can help reduce transaction costs and the costs of sharing information. It can be an effective substitute for much costlier alternative governance structures such as complex formal contracts or institutionalized control mechanisms. Some studies even find that trust as a “relational governance” mechanism and contracts as a more formal governance instrument complement and mutually reinforce each other (Poppo and Zenger 2002). In supply chains, trust develops in a variety of different formats (Ghosh and Fedorowicz 2008): 1. Calculative trust: the belief that a partner will cooperate given the likely costs and benefits that can be derived from the relationship, 2. Competence trust: the belief that a partner can perform a certain task, 3. Integrity trust: the belief that a partner tells the truth and fulfills promises, 4. Predictability trust: the belief that a partner’s actions are consistent enough to be forecasted in a given situation. Information exchange and collaboration performance can be significantly improved if supply chain partners have reached a sufficient level of trust. Supply chain management accountants, therefore, must support trust building between partners and implement appropriate mechanisms of “trust monitoring”. Developing a functioning information management system across the supply chain will not be possible without management accounting also engaging as a facilitator for the emergence of trust between supply chain partners (Anderson and Sedatole 2003). We will deal with measuring and evaluating the level of trust and how this supports the strategic objectives in a supply chain in more detail in Chap. 8.

3.5

A New Understanding of “Performance”

The term “performance” is a key concept in business and management. In its most general sense, the term can denote the act itself of doing something (for instance a “dance performance”) as well as the assessment of the skills level or the quality of this act (i.e. a judgment whether it was a “good” or a “bad performance”). In a business context, the term

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A New Understanding of “Performance”

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is most often used in this latter meaning: “performing” in business means accomplishing a task, meeting certain expectations, reaching a goal, or fulfilling an obligation. In this sense, performance cannot be observed or assessed without applying a yardstick or benchmark for comparison purposes. This might be a budget, a project plan, a customer’s expectation, or a contractual obligation. In a business context, these yardsticks and expectations are mostly of an economic and financial nature. A firm wants to reach certain financial and non-financial goals. These goals typically serve as the central yardsticks for assessing performance. Performance measurement, consequently, is the act of creating transparency about the economic success of an organization, a unit within an organization, or even an individual member of an organization (Charifzadeh and Taschner 2017). It can be defined as the process of evaluating quantitatively and/or qualitatively the effectiveness and the efficiency of an activity or a business process (Neely et al. 1995). Businesses, therefore, could not thrive without measuring their performance. In fact, performance measurement serves a number of important purposes in a company (Lima-Junior and Carpinetti 2017; Akyuz and Erkan 2010): 1. Performance measurement allows an assessment and continuous control of progress that has been made towards reaching defined goals. 2. Performance measurement is needed to highlight accomplishments and successes that have been realized so far. 3. Performance measurement improves a firm’s understanding of key processes and what is needed to perform them in the best possible manner. 4. Performance measurement helps identify bottlenecks and potential problems in company operations. 5. Performance measurement provides insights about possible future improvement actions. The importance of performance measurement for business success can hardly be overestimated. More will be said about performance measurement and performance management in Chap. 8. In this section, we focus on a few key problems that are relevant when applying the concept of performance measurement to entire supply chains instead of individual firms only. In fact, broadening the performance measurement concept to collaborative setups leads to numerous challenges, which decision makers and management accountants must be aware of. Two Perspectives of Performance in a Supply Chain Context As already stated above, performance in a business context is ultimately seen as synonymous with “financial success”. Businesses want to generate financial surpluses—at least, if they are profit-oriented (which is true for most business entities). Supply chain management, in turn, is a discipline and a corporate function that is concerned both with operational aspects (such as inventory levels, quality of service, replenishment times, etc.) and

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with financial aspects (such as capital tied up in inventories, or transaction cost). Much of what supply chain management is concerned about is not directly measurable in monetary units but is expected to have indirect (positive) effects on a company’s financial performance. These indirect links are difficult to quantify, though. It is not surprising, therefore, that performance measurement in a supply chain context is often focusing on operational performance (Shi and Yu 2013). How a specific improvement in operational performance (e.g. a 10% reduction in replenishment times) translates into financial performance is difficult to say. As Ketchen and Giunipero put it: Scholars often argue that SCM has “bottom line” impact via such metrics [speed, dependability, quality, cost, and flexibility], but the case for such relationships is based largely on assertion rather than demonstration. (Ketchen and Giunipero 2004, p. 54)

Supply chain performance measurement not only has to struggle with the question of operational versus financial performance. A second aspect is complicating the matter even further. In a supply chain context, we can take two perspectives when measuring performance. We can assess supply chain performance by focusing on individual firm performance (micro perspective). In contrast to this, we can try to measure performance at the supply chain level (macro perspective). This distinction is not only a matter of finding appropriate indicators but touches the very heart of supply chain management: How is the performance of the entire supply chain linked to performance levels reached by its individual members? Can individual firm performance levels be taken as valid proxies for the entire supply chain performance or is the firm—supply chain performance link more complicated? Can, for instance, increased performance of one member maybe even lead to a decrease in supply chain performance? And could the supply chain’s performance improve, although individual firm performance levels do not? Supply chain performance measurement must acknowledge that there might be significant “performance spillover effects” between supply chain partners. These spillover effects can be positive (i.e. amplifying each other) or negative (i.e. attenuating each other). Spillover effects can work both from the individual firm to the entire supply chain as well as from the supply chain level to the individual firm level—opening the way, for instance, for “performance free-riding”, i.e. profiting as an individual firm from improved supply chain performance without contributing to it. Example Imagine a relatively simple supply chain consisting of three partners to exemplify the above two points a bit further: a European consumer goods manufacturer sells its products to private households via different sales channels. A key component of its product is supplied by a trusted partner firm located in South-East Asia. Shipping of the component is under the responsibility of a global freight forwarding company, which both partners have been doing business with for a long time. Ultimately, the success of the supply chain is determined by end-customers’ satisfaction with the product and the services surrounding

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A New Understanding of “Performance”

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it (e.g. shipping options and payment terms offered, warranty periods, maintenance services, etc.). Each supply chain member contributes to overall success by performing certain tasks and activities. If the manufacturer starts a new marketing campaign that drives up demand, this will translate into higher sales for the manufacturer—but eventually also for the supplier (higher demand for the component) and the freight forwarder (more shipments). Has overall supply chain performance improved as well? Whether total financial supply chain surplus increases is not clear. Partners might be able to cope with the higher demand only by implementing costly extra measures that actually decrease profits. This additional resource consumption might not be evenly distributed across partners, thus having very different effects on each partner’s profitability. In any case, marketing costs will be shown in the manufacturer’s income statement only. If and to what extent the improved top line (sales revenues) also improves the bottom line (net income) is not clear. Surplus distribution among partners might also change. Since one-time marketing costs are borne by the manufacturer only, the other partners profit from a spillover effect: they record increased sales, which are likely to translate into higher profits if the business as such is profitable. One might argue that both the supplier as well as the freight forwarder have to increase their operating performance. After all, they need to cope with higher demand and still have to maintain previous service levels (e.g. delivery times, product quality). Partners might have to introduce new processes or IT systems, for instance, in order to make an improvement of the manufacturer’s financial performance possible. In any case, there are multiple links between partners’ operating and financial performance that need to be considered when establishing a performance measurement system across the entire supply chain! Research shows that supply chain performance is often tackled at the individual firm level only (Kache and Seuring 2014). This is justified, if and as long as one considers spillover effects to be small and mostly positive. Since the joint performance of multiple entities in a supply chain is difficult to measure, focusing on individual firm performance and inferring supply chain performance from there is the easier approach. However, as mentioned above, the performance of the network of multiple partners as such is hardly the sum of every single entity’s performance (Kache and Seuring 2014). What Is An Appropriate Performance Measure for Supply Chains? Since profit-oriented business entities ultimately apply a financial yardstick for measuring performance, management accounting takes recourse to a variety of indicators that either measure effectiveness (degree of goal achievement) or efficiency (ratio of inputs consumed to outputs achieved). Since (1) financial goals and outputs are ultimately considered to be the most important ones and (2) inputs are often expressed in financial values, it is comparatively easy for management accounting to treat effectiveness and efficiency as financial in nature.

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It must be noted, though, that neither effectiveness nor efficiency is a purely financial indicator. In fact, even if a firm’s ultimate goal is “making profits”, it is immediately clear that financial performance will be influenced by many other performance aspects that are not financial, but rather operational in nature. This is all the more true for entire supply chains, as has been noted above. In any case, management scholars and practitioners mostly agree that the performance of a business entity—be it an individual firm or an entire supply chain—is a multi-dimensional construct, comprising both operational and financial dimensions. This multi-dimensionality of supply chain performance and the importance of operational performance aspects for financial performance is widely recognized by management scholars and practitioners. It is the very imperative of supply chain management to assume a significant positive relationship between improved operational performance and improved financial performance. A disruption in the supply chain, in turn, will eventually generate significant financial losses for the firms involved (Shi and Yu 2013). No agreement has been reached, though, on which and how many performance dimensions should be distinguished. We mention just a few conceptualizations here in order to show their diversity: – A very generic performance framework has been suggested by Beamon (1999), who distinguishes three performance dimensions “resources”, “output” and “flexibility”. Operationalization of Beamon’s concept in a supply chain context often focuses on “total cost” and “inventory” for resources, “(supplier) lead time” and “profitability” for output, and “volume flexibility” and “delivery flexibility”, respectively (Kache and Seuring 2014). – Webster (2002) develops a concept comprising cost, agility, responsiveness, flexibility, and sustainability as supply chain performance dimensions. – Shepherd and Günter (2006) suggest that supply chain performance is measured along 5 dimensions: cost, time, quality, flexibility, and innovativeness. – Gunasekaran and Kobu (2007) offer a comprehensive review and classification for supply chain measurement and metrics. They treat a number of metrics in five classes: order planning, supplier evaluation, production level, delivery, and customer. This list could be continued, without a clear consensus emerging on what actually constitutes “supply chain performance”. Even financial performance can be viewed as comprising more than one dimension itself. Financial performance could be assessed using accounting-based indicators such as net income or EBIT, for instance. But it could just as well be expressed by a firm’s ability to increase its market capitalization or its share price (market-based financial performance). To conclude, it is far from obvious how supply chain performance should eventually be defined. Measuring and expressing performance by a single indicator is of course still possible, as long as the influence of other performance dimensions is sufficiently clear. Management accounting typically tackles this multi-dimensional nature with performance measurement systems (PMS). A PMS is a set of interrelated performance indicators, with interrelations

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being either of a mathematical or a logical nature (Charifzadeh and Taschner 2017). In any case, the performance indicators in a PMS must be specific enough to be measurable, they should be universally applicable (i.e. not specific to a few individual supply chains only), and their measurement must be repeatable, quantifiable, as well as traceable in order to produce valid and reliable results for subsequent performance management (Min 2015). How to Overcome Supply Chain-Specific Barriers in Performance Measurement? Evaluating supply chain performance is a complex and difficult undertaking—not only because of the conceptual problems that have been outlined in the previous two sub-sections above, but also, because management accounting is often confronted with a number of additional, interrelated, operational problems when it comes to measuring performance across a multitude of independent partners in a reliable and valid manner (Lohmann et al. 2004; Lima-Junior and Carpinetti 2017): 1. Limited data availability and inconsistent reporting Data is not centrally available, indicators that are relevant for supply chain performance are tracked at a department or functional level only, no uniform PMS is available across functions within the company—let alone across companies in the supply chain. Consequently, performance indicators are reported in various incompatible formats to different stakeholder groups only. 2. Weak or no performance measurement system In many cases, the available performance indicators do not form a genuine PMS, but rather constitute a “list of potentially relevant indicators”. Potential causal relationships between indicators are not made explicit. Since firms might not even know about the full list of indicators that are used by their supply chain partners, there is no possibility to consolidate the available indicators into one coherent system. Performance measurement remains dispersed and uncoordinated. 3. Lack of agreement among partners The above problems are also partly due to a missing agreement on what to measure in the first place. Supply chain partners tend to focus on their own operational and financial performance, leading to a general lack of cross-organizational indicators, which might be even more relevant for expressing the overall performance of the supply chain. 4. Reluctance to exchange data Concerns about data confidentiality and a general reluctance to share competitively sensitive information hamper communication between supply chain partners. Their willingness to build a shared PMS and continuously exchange measured performance data between partners is often limited for competitive reasons. Technical difficulties such as incompatible IT systems further aggravate these communication and reporting problems.

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It is not surprising, then, to note that many companies do not yet engage in supply chain performance measurement in the true sense of the word. A survey conducted by Keebler and Plank in 2009 showed that companies measure a wide variety of both effectiveness and efficiency indicators, some of them with a purely internal focus, others oriented towards their supply chain partners (Keebler and Plank 2009). Supply chain performance measurement remains a challenging task both for academics and for business practitioners. We will come back to this issue in more detail in Chap. 8.

3.6

Glossary and Key Terms

Bullwhip effect

Cross-organizational governance Information overload

Isolating mechanism Orchestration mechanisms Performance

Performance measurement system Performance spillover effects Private supply chain benefits Relational rent Self-regulating mechanisms Trust Value Value chain envy

The effect by which slow-moving consumer demand at the downstream end of the supply chain can create large swings in production for the suppliers at the upstream end of the supply chain. The rules and procedures that determine how financial, material, and human resources are allocated and flow within a supply chain. The effect that individuals have a limited information processing capacity and their performance, therefore, deteriorates once they receive more information than they can handle. A mechanism that prevents replications of value-creating activities by other supply chain partners. Mechanisms that help develop the network as an entity with a common objective. The act of doing something as well as the assessment of the skills level or the quality of this act. In a business context, performance refers to accomplishing a task and reaching a goal. A set of interrelated performance indicators, with interrelations being either of a mathematical or a logical nature. The fact that individual firm performance is (positively or negatively) affected by a change in supply chain performance—and vice versa. Benefits for a firm that cannot be captured by other supply chain partners, because they lack the specific resource combination or knowhow base that would be necessary for doing so. Surpluses that are created through cooperation only and could not be reaped by individual firms in isolation. Mechanisms that allow financial and distributional effects of network relations to flow automatically without intervention from a center. The confidence of one party in a two-way relationship that the other party will not exploit its vulnerabilities. In a supply chain context, value denotes the benefit of a market offer as perceived by the final customer. A firm’s attempt to reap part of the supply chain partner’s surplus because that partner’s share in relational rent is perceived as disproportionately high.

3.7

3.7

Review Questions and Exercises

67

Review Questions and Exercises

Review question 3.1: Explain the key problems that management accounting is faced with in a crossorganizational supply chain setting. Review question 3.2: Distinguish and briefly describe different governance structures in supply chains and explain the implications for management accounting. Review question 3.3: Define and explain the term “relational rent” in a supply chain. Review question 3.4: Explain why input-oriented profit sharing is not effective in supply chains and outline a more appropriate profit-sharing arrangement. Review question 3.5: Explain the phenomenon of “value chain envy”. Review question 3.6: Outline the role of trust as a governance mechanism in supply chains. Review question 3.7: Describe the importance of information flows in a supply chain and explain the “bullwhip effect”. Review question 3.8: Explain how financial performance and operating performance differ in a supply chain. Review question 3.9: Name and describe the key problems when measuring performance across multiple supply chain partners. Exercise 3.1: Moving from single sourcing to dual sourcing Your company has long relied on a single supplier when procuring a key component for your best-selling product. With product sales still increasing, your top management is increasingly worried about the dependence on this single partner. Your company has, therefore, decided to move to dual sourcing. In the future, the key component will be procured from two sources: the existing supplier and a new, still to be identified, second supplier. The management accounting team has been asked to support this initiative with appropriate information and analyses. In particular, the team is asked to prepare an answer to the following questions: – Which coordination mechanisms between the company and its two suppliers will be appropriate in the future setting? – Which factors should be taken into account when allocating purchase quantities between the two suppliers?

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– Which information should be exchanged between the three partners and how can the necessary conditions be created? – Which aspects of supplier performance need to be monitored and measured in the future?

References Akyuz G, Erkan T (2010) Supply chain performance measurement: a literature review. Int J Prod Res 48(17):5137–5155 Ashenbaum B, Maltz A, Ellram L, Barratt MA (2009) Organizational alignment and supply chain governance structure: introduction and construct validation. Int J Logist Manag 20(2):169–186 Anderson SW, Sedatole KL (2003) Management accounting for the extended enterprise: performance management for strategic alliances and networked partners. In: Bhimani A (ed) Management accounting in the digital economy. Oxford University Press, Oxford, pp 36–73 Arshinder K, Kanda A, Deshmukh G (2011) A review on supply chain coordination: coordination mechanisms, managing uncertainty and research directions. In: Choi TM, Cheng TC (eds) Supply chain coordination under uncertainty, International handbooks on information systems. Springer, Berlin, pp 39–82 Beamon BM (1999) Measuring supply chain performance. Int J Oper Prod Manag 19(3):275–292 Charifzadeh M, Taschner A (2017) Management accounting and control—tools and concepts in a Central European Context. Wiley, Weinheim Crisan E (2016) A separation between supply chain management and supply chain governance. Rev Int Comp Manag 17(3):240–249 Dyer JH, Singh H (1998) The relational view: cooperative strategies and sources of interorganizational competitive advantage. Acad Manag Rev 23/4:660–679 Dyer JH, Singh H, Kale P (2008) Splitting the pie: rent distribution in alliances and networks. Manag Decis Econ 29:137–148 Eppler M, Mengis J (2004) The concept of information overload: a review of literature from organization science, accounting, marketing, MIS, and related disciplines. Inform Soc 20:325–344 Foss NJ (2003) The strategic management and transaction cost nexus: past debates, central questions, and future research possibilities. Strat Organ 1(2):139–169 Garcia-Castro R, Aguilera R (2015) Incremental value creation and appropriation in a world with multiple stakeholders. Strat Manag J 36:137–147 Gereffi G, Korzeniewicz M (1994) Commodity chains and global capitalism. Praeger, Westport Gereffi G, Humphrey J, Sturgeon J (2005) The governance of global value chains. Rev Int Polit Econ 12(1):78–104 Ghosh A, Fedorowicz J (2008) The role of trust in supply chain governance. Bus Process Manag J 14 (4):453–470 Gunasekaran A, Kobu B (2007) Performance measures and metrics in logistics and supply chain management: a review of recent literature (1995–2004) for research and applications. Int J Prod Res 45(12):2819–2840 Hernández-Espallardo M, Rodríguez-Orejuela A, Sánchez-Pérez M (2010) Inter-organizational governance, learning and performance in supply chains. Supply Chain Manag Int J 15(2):101–114 Jap S, Anderson E (2003) Safeguarding interorganizational performance and continuity under ex post opportunism. Manag Sci 49(12):1684–1701

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Kache F, Seuring S (2014) Linking collaboration and integration to risk and performance in supply chains via a review of literature reviews. Supply Chain Manag Int J 19(5-6):664–682 Keebler JS, Plank RE (2009) Logistics performance measurement in the supply chain: a benchmark. Benchmark Int J 16(6):785–798 Ketchen D, Giunipero L (2004) The intersection of strategic management and supply chain management. Ind Market Manag 33(1):51–56 Lee H, Padmanabhan V, Whang S (1997) Information distortion in a supply chain: the bullwhip effect. Manag Sci 43(4):546–558 Lepak D, Smith K, Taylor MS (2007) Value creation and value capture: a multilevel perspective. Acad Manag Rev 32(1):180–194 Lima-Junior F, Carpinetti L (2017) Quantitative models for supply chain performance evaluation: a literature review. Comput Ind Eng 113:333–346 Lind J, Thrane S (2010) Towards accounting in network settings. In: Hakansson H, Kraus K, Lind J (eds) Accounting in networks. Routledge, New York, pp 60–79 Lindsay RM, Libby T (2007) Svenska Handelsbanken: controlling a radically decentralized organization without budgets. Issues Account Educ 22(4):625–640 Lohmann C, Fortuin L, Wouters M (2004) Designing a performance measurement system: a case study. Eur J Oper Res 156:267–286 Min H (2015) The essentials of supply chain management—new business concepts and applications. Pearson, New York Mol JM, Wijnberg NM, Carroll C (2005) Value chain envy: explaining new entry and vertical integration in popular music. J Manag Stud 42(2):251–276 Mouritsen J, Thrane S (2006) Accounting, network complementarities and the development of interorganisational relations. Accounting. Organ Soc 31(3):241–275 Neely A, Gregory M, Platts K (1995) Performance measurement system design: a literature review and research agenda. Int J Oper Prod Manag 15:80–166 Nooteboom B (1999) Interfirm alliances: analysis and design. Routledge, London Panahifar F, Byrne P, Asif Salam M, Heavey C (2018) Supply chain collaboration and firm’s performance: the critical role of information sharing and trust. J Enterprise Inform Manag 31 (3):358–379 Poppo L, Zenger T (2002) Do formal contracts and relational governance function as substitutes or complements? Strat Manag J 23:707–725 Ralston P, Richey R, Grawe S (2017) The past and future of supply chain collaboration: a literature synthesis and call for research. Int J Logist Manag 28(2):508–530 Shepherd C, Günter H (2006) Measuring supply chain performance: current research and future directions. Int J Prod Perform Manag 55(3):242–258 Shi M, Yu W (2013) Supply chain management and financial performance: literature review and future directions. Int J Oper Prod Manage 33(10):1283–1317 Simchi-Levi D, Kaminsky P, Simchi-Levi E (2009) Designing and managing the supply chain: concepts, strategies and case studies, 3rd edn. McGraw-Hill, New York Tarifa-Fernandez J, De Burgos-Jiménez J (2017) Supply chain integration and performance relationship: a moderating effects review. Int J Logist Manag 28(4):1243–1271 Taschner A (2012) Management Reporting—Erfolgsfaktor internes Berichtswesen. Springer Gabler, Heidelberg Varoutsa E, Scapens RW (2015) The governance of inter-organisational relationships during different supply chain maturity phases. Ind Mark Manag 46:68–82 Veen-Dirks P, Verdaasdonk P (2009) The dynamic relation between management control and governance structure in a supply chain context. Supply Chain Manag 14:466–478

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Wang X, Disney S (2016) The bullwhip effect: progress, trends and directions. Eur J Oper Res 250:691–701 Webster M (2002) Supply system structure, management and performance: a conceptual model. Int J Manag Rev 4:353–369 Zhang S, Li N, Li J (2017) Redefining relational rent. Technol Forecast Soc Change 117:315–326

4

Cost Accounting in Supply Chains

Cost Accounting Recap

Supply Chain Cost

SC Cost Accounting

Open Book Accounting

Learning Objectives After completing this chapter, you should be able to: 1. Explain the main differences between financial accounting and cost accounting 2. Understand and describe the main tasks of cost accounting in an enterprise and the key conceptual components of a cost accounting system resulting from these tasks 3. Define and explain the nature of supply chain cost 4. Understand how supply chain cost is treated in standard cost accounting systems 5. Name and explain the key challenges that cost accounting is faced with when extending the view from the single firm to the entire supply chain 6. Discuss the different options of aligning and harmonizing cost accounting systems across supply chain partners 7. Explain the basic logic of consolidating cost information across supply chain partners 8. Name and describe different options of exchanging cost-relevant information between supply chain partners (continued) # Springer Fachmedien Wiesbaden GmbH, part of Springer Nature 2020 A. Taschner, M. Charifzadeh, Management Accounting in Supply Chains, https://doi.org/10.1007/978-3-658-28597-5_4

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9. Describe the basic idea of open book accounting (OBA) and discuss the various factors and conditions influencing OBA’s benefits to a supply chain This chapter focuses on cost accounting, which is often considered to be the “multipurpose tool” of any management accountant. In Chap. 1, we have defined management accounting as the internal accounting system that supports managers in carrying out management tasks. Although closely related to each other, management accounting and cost accounting are not synonymous: cost accounting is the system that gathers, analyzes, and reports cost information in the company. As such, it is a central element of management accounting. But management accounting comprises more than just cost information since managers also need more than only cost information for their decision making (Taschner and Charifzadeh 2016). Unlike its companion financial accounting, cost accounting is not subject to extensive regulation and firms are more or less free to structure their cost accounting system as they see fit. Over the course of time, informal standards and best practices have emerged, though, and cost accounting systems tend to show similarities across firms—at least at a higher, conceptual, level. Financial accounting data is subject to extensive disclosure requirements and standardized information (mostly coming from a company’s annual accounts) is available to stakeholders outside of the organization (e.g. creditors, tax authorities, suppliers, customers, etc.). However, the information that is processed and stored in a company’s cost accounting system is hardly ever shared with third parties. First, there are no disclosure requirements for cost accounting data (except for cases in regulated industries), and second, cost accounting data is typically considered to be relevant for a company’s competitive position, which is why firms usually do not share it with their business partners. This poses a dilemma for supply chain management accounting: cost information is not only of utmost importance within the own organization but also plays a pivotal role in managing the entire supply chain. The advent of SCM has led—and is still leading—to serious challenges for firms’ cost accounting systems: What developed more than 100 years ago and has been further improved since then for application within a single business organization, now must be extended to a cross-organizational system—an application area that is still in a fledgling status. In the following sub-chapters, we will discuss the challenges that are posed to cost accounting by the SCM philosophy as well as possible tools and concepts to overcome these challenges.

4.1

4.1

A Brief Recap: Cost Accounting Tasks in an Enterprise

73

A Brief Recap: Cost Accounting Tasks in an Enterprise

Cost information is crucial for running a business. Planning and decision making would not be possible without it and cost accounting is the corporate function that managers turn to when they need cost information. In order to generate information that is relevant to company management, a cost accounting system must (1) collect cost data from various internal sources, (2) put the cost data into a suitable structure (categorization and grouping of cost data), (3) allocate cost to the different objects that are relevant to management (e.g. departments or other organizational sub-units, products, specific customer orders, etc.), and finally (4) present and report the cost data in a format that is understood and accepted by managers. A cost accounting system typically provides answers to the following three questions (Taschner and Charifzadeh 2016): 1. Which amounts of different resource types have been consumed in the period? 2. Which organizational entities have been involved in that resource consumption process and which amounts have been consumed by which entity? 3. Which marketable goods and services have been produced with these consumed resources? The general layout and structure of most cost accounting systems reflect these three basic questions (Taschner and Charifzadeh 2016): – Cost type accounting This first subsystem collects data on amounts and values of consumed resources (i.e. costs), mainly drawing on the basic accounting data that is used by financial accounting as well. Cost type accounting not only collects but also categorizes cost items by type of resource consumed (e.g. labor cost, material cost, energy cost, etc.). Where applicable, the categorization in fixed and variable cost items is implemented here as well. – Cost center accounting The second subsystem allocates cost amounts to different organizational sub-units (cost centers). Cost center accounting sheds light on the question where in the organization particular resources have been consumed. Since the source of resource consumption is not always clear and organizational units often also share resources, cost center accounting has to take recourse to different cost allocation methods. – Cost unit accounting The third subsystem relates consumed resources (i.e. cost) to goods and services produced. In this step, cost per unit of output is determined and important information for subsequent product pricing is derived. Cost unit accounting also relates cost to revenues, therefore allowing profit determination for individual products or customer orders, for instance.

4

Cost Accounting in Supply Chains

Cost types

Cost centers

Cost units

Direct cost Indirect cost

Basic cost

Revenues

Imputed cost

Required expenses

Neutral expenses

74

(short-cut: single-stage cost allocation)

Financial accounting

Cost type accounting

Cost center accounting

Cost unit accounting

Fig. 4.1 Conceptual structure of a cost accounting system (source: authors)

The basic logic of a cost accounting system is depicted in Fig. 4.1. Although cost accounting is not subject to regulation, cost accounting systems—in particular in big companies—are typically highly structured and standardized. Firms define their own valuation rules and cost allocation methods, they set up their own cost classification schemes and cost center structures. Often clear guidelines have been developed on how products and orders are priced and which cost information has to be communicated to company management. In short, cost accounting systems can be very complex but are typically confined to the organizational boundaries of the firm.

4.2

The Nature of Supply Chain Cost

It comes as no surprise that the notion of “cost” constitutes the cornerstone of cost accounting. At a very general level, cost can be defined as a sacrifice made to achieve a particular purpose (Taschner and Charifzadeh 2016). The sacrifice typically materializes as a consumption act of valuable resources (labor, raw materials, energy, capital, etc.). Cost accounting focuses on those consumption acts that happen purposefully, with the typical purpose in a business environment being the “achievement of company goals”. Wasting resources without any purpose or incurring an extra-ordinary loss, therefore, do not constitute “cost” in the above sense and such occurrences are disregarded in cost accounting systems. As outlined above, a firm’s cost accounting system should not only identify and measure costs incurred but should also assign and allocate cost items to the objects that are

4.2

The Nature of Supply Chain Cost

75

ultimately responsible for the resource consumption. This so-called cause-effect principle is considered to be the most preferred way of cost allocation since it charges objects (e.g. individual departments in a company or individual customer orders) with exactly those costs that they are responsible for. The cause-effect principle, therefore, ensures a high degree of transparency and clear responsibilities for costs incurred. It is the standard approach for assigning direct costs to products and customer orders, respectively. In many cases, though, costs incurred cannot be allocated following the cause-effect principle, since it is either not clear which objects have actually consumed the resource amounts or it is simply not worth the effort of determining this. This is the typical problem of overhead (or indirect) cost allocation. Resources are shared (e.g. several departments using the same office building), or consumed resource quantities are not measured for each individual object, but for entire periods only (e.g. consumption of auxiliary materials in manufacturing). In such cases, the cause-effect principle cannot be applied and cost accounting takes recourse to other, less accurate, principles of cost allocation (e.g. the proportionality principle). As long as overhead cost amounts are not too big and their relevance for management and decision making is limited, such less accurate allocation approaches are acceptable and widely used in cost accounting practice. Supply Chain Cost as Overhead Cost The distinction of direct and indirect (overhead) cost has serious implications for the recording and management of supply chain cost. As a first approximation, we can define supply chain cost as the value of all resources that are consumed when establishing and managing relations with other supply chain partners. By their very nature, SCM tasks and activities involve third parties, i.e. business entities outside of the firm’s own perimeter. Unfortunately, traditional cost accounting typically treats costs of dealing with third parties as overhead cost, i.e. they are not assigned to individual products, customers, or orders, but are distributed across a multitude of objects (Weber 2012). The focus of most cost accounting systems clearly is on internal resource consumption. This approach assumes that the firm is acting in spot markets, where transactions and relations with external parties are unspecific, undifferentiated and not key to business success. The cost accounting focus is on the products, their characteristics and the costs incurred when producing them. Many cost accounting systems, therefore, place much less emphasis on a detailed and specific measurement and allocation of transactional and relational cost items and focus on product cost instead. It is clear that this (general ledger-based) cost information is not sufficient to make appropriate decisions about supply chain configurations or processes (Lalonde and Pohlen 1996): How could a company’s managers make appropriate decisions about their supply chain relationship if they have no reliable information on the costs coming with it? This blind spot of traditional cost accounting is all the more critical since even many of the firm’s internal cost items are driven by external trading partners’ behavior and business practice. Improved cost visibility—both within and across firms—would enable executives to better understand how their relationships with key customers or suppliers drive costs throughout the supply chain (Pohlen et al. 2009).

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Supply Chain Cost Accounting Supply chain cost accounting, therefore, must go beyond traditional cost accounting in a number of aspects: – Different from traditional cost accounting, supply chain cost accounting must develop a clear definition of what constitutes supply chain-related costs (supply chain cost definition). – Following point 1, rules must be set up for allocating supply chain-related cost to the objects that are responsible for these cost items (supply chain cost allocation). – Third, supply chain cost accounting must establish structural and procedural solutions to exchanging and sharing cost-related information between supply chain partners (supply chain cost information sharing). If a supply chain cost accounting system does not meet these requirements, it cannot fulfill its purpose—which is similar to cost accounting in the single firm, namely assessing the current cost situation of supply chain partners, determining the causal factors driving cost in the supply chain and providing cost information to all decision makers across the different supply chain layers (Stölzle et al. 2005). Cost, revenues, and profits, therefore, are the central management objects in cross-organizational cost accounting (Schoppmann 2005)—as they are in single firm cost accounting systems. Definition of Supply Chain Cost The starting point of all supply chain-related considerations clearly is a definition of what supply chain cost should denote in the first place. Cost accounting literature and business practice have discussed this question under different headers such as co-ordination cost, supply chain cost, or transaction cost, respectively. The basic tenet is unchanged, however: We need to identify and properly measure all costs that are caused by cooperation activities within and along a supply chain. Such costs can be of an operative nature (implementing and monitoring the cooperation) or of a more strategic nature (designing and establishing the cooperation, Drews 2001). Another way of looking at these costs is to define supply chain cost as all costs that are incurred when initiating, negotiating, monitoring and adapting mutual performance relationships with supply chain partners (Seuring 2001). Supply chain costs occur because collaborative task fulfillment must be aligned and coordinated across supply chain partners (Veil 2001). As outlined above, such costs are typically handled as (undifferentiated) overhead costs in traditional cost accounting. Supply chain cost accounting must deliberately identify and separate these cost items in order to make them manageable. It is important to note here that supply chain costs will occur both at the company level as well as at the relationship (cross-company) level. For a better understanding of their nature, it, therefore, makes sense to differentiate cost into three broad categories (Seuring 2001, 2002):

4.2

The Nature of Supply Chain Cost

77

– Direct cost: These are defined as in traditional cost accounting and can be assigned to individual products. – Process cost: These are overhead costs that relate to administrative activities within a company. These costs arise from the organizational framework of the single company and can be managed within a single supply chain partner’s organization. – Transaction cost: These are overhead costs that are caused by all activities dealing with the information of and the communication with SC partners. They can be managed across SC partners only. Capturing these cost items might be possible for a single company—managing them is certainly not. The third cost category of transaction cost is typically treated as indirect (here: “process”) cost in traditional cost accounting systems. Its explicit separation from other cost items is specific to supply chain cost accounting. These cost categories are still too generic to be implemented in a firm’s cost accounting system. In order to properly capture supply chain-related costs, cost items must be clearly specified and delimited from other costs. Meuser has developed a very specific suggestion for supply chain-related co-ordination cost that can be implemented in a firm’s chart of accounts (Meuser 1997): 1. Transaction cost (a) Search cost (cost of searching for and identifying suitable supply chain partners) (b) Initiation cost (c) Negotiation cost (d) Decision cost (e) Arrangement cost (f) Monitoring cost (g) Adaptation cost (h) Termination cost 2. Information cost (a) Cost of information procurement (b) Cost of information storage (c) Cost of information processing (d) Cost of information transfer/communication 3. Logistics cost (relates both to physical and monetary flows!) (a) Transportation cost + cost of funds transfer (b) Storage cost + cost of funds deposit (c) Transshipping and picking cost + cost of centralizing funds The above exemplary listing clearly shows that supply chain costs occur as a by-product of physical flows as well as of information and financial flows. At the same time, it also exemplifies the need for a multi-dimensional cost categorization: A firm will not abandon its currently used system of categorizing and structuring cost items. Labeling certain cost

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items as “supply chain-related”, therefore, will not replace, but simply complement, already existing cost categorization schemes. Preparing a firm’s cost accounting system (or specifically: its cost type accounting system) for supply chain applications simply leads to multi-dimensionality: one and the same cost item can be categorized in different ways— depending on which categorization dimension is applied. This adds complexity but is inevitable in a supply chain environment (Pohlen et al. 2009). Example Imagine that a firm asks for legal advice coming from a specialized law firm when negotiating a complex frame contract with a new supplier. In traditional cost type accounting, the law firm’s invoice will typically be treated as “third party cost” (cost categorization 1). Since these costs do not relate to a specific product but affect all future dealings with that supplier, cost accountants will further categorize the cost item as “indirect (administrative) overhead cost” (cost categorization 2). When introducing the SCM concept, the company now needs to clearly separate costs relating to a specific supply chain from other, unrelated, cost items. The law firm’s invoice amount will, therefore, be categorized (i.e. labeled) as “supply chain cost for supply chain [XYZ]”—a third, additional, categorization. Depending on the purpose of future analyses or cost allocation tasks, cost accountants will take recourse to one or several of these cost categorizations to properly treat the specific cost item. Supply Chain Cost Information We have outlined above that supply chain cost (no matter what their specific labeling looks like) needs to be managed across all supply chain partners. To put it differently: the individual firm not only cares about its own supply chain cost but also about its partners’ supply chain cost. In order to optimize costs across the entire supply chain, cost information needs to be exchanged between partners. Cost knowledge is important to negotiate fair deals between supply chain partners, the distribution of functions and tasks between supply chain partners cannot be efficient without proper cost knowledge (Norek and Pohlen 2001). Even if the exchange of cost data itself is limited, cost information is necessary to determine appropriate transfer prices between supply chain partners—which in turn allow a fair distribution of supply chain surpluses (Weber 2012). Such an exchange of supply chain cost data between partners is confronted with two major obstacles, though: 1. First, supply chain partners are often used to exchanging operational data (e.g. order forecasts, expected delivery dates, etc.), but cost data is rarely shared (Pohlen et al. 2009). This is mostly due to data confidentiality considerations and concerns about weakening one’s own negotiation position if business partners have access to the own firm’s cost data. 2. Second, an alignment of cost categorization schemes is difficult, since firms have implemented their own systems independently from each other. However, a meaningful and unbiased interpretation and consolidation of these costs necessitate agreement on a

4.3

Challenges and Approaches for Supply Chain Cost Accounting

79

shared cost categorization scheme between supply chain partners. If partners use entirely different cost categorization approaches, their respective cost data is not comparable and joint decision making will be systematically flawed. We will come back to these points later in this chapter when discussing the concept of open book accounting.

4.3

Challenges and Approaches for Supply Chain Cost Accounting

Supply chain cost accounting extends the inward-looking view of traditional cost accounting systems and integrates a firm’s trading partners in a number of ways: Effects of partners’ actions on the firm’s own cost structure need to be made transparent and possible effects of own actions on partners’ cost structure must be considered. The basic cost accounting tasks, as well as the typical cost accounting info needed to fulfill these tasks, do not differ significantly from a single-firm scenario. The cost objects, however, do not only encompass well-known objects such as individual (customer) orders or tasks but now extend beyond the single firm (see Table 4.1). This extended scope of supply chain cost accounting poses a number of challenges to a firm’s cost accounting system (Hess 2002): 1. Standardization and harmonization Cost accounting information coming from a partner’s system can only be properly integrated into a firm’s own decision making if it is clear how to interpret and “read” the data. Supply chain partners, therefore, must standardize and harmonize their systems as much as possible in order to avoid misinterpretations. 2. Aggregation and consolidation In the SCM perspective, management focus shifts from the single firm to the cooperative network. Performance measures as well as cost and revenue figures, therefore, need to be determined at the network level rather than the firm level. This requires aggregation and consolidation of individual firms’ data into a consistent set of supply chain-related data. Structural and procedural alignments between partners’ cost accounting systems are necessary in order to make comparisons and consolidation possible (Drews 2001). 3. Communication Since cost data originates in each partner firm’s proprietary cost accounting system, rules and processes need to be established that determine how and which information is exchanged between partners. We will handle these points in the following and have a more detailed look at point 3 in the next sub-chapter.

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Table 4.1 Cost accounting information needs in supply chains Task Determine performance of single order or task

Allocate tasks to individual SC partners Conclude agreements between SC partners

Determine prices Monitor agreements between SC partners

Allocate surplus between SC partners Determine overall SC success

Structure pool of SC partners

Determine attractiveness and performance of individual fields of cooperation

Define and improve allocation rules between partners

Info type Profit/loss Contribution margin Prices Cost Prices Cost Quantities, time and quality Prices Prices Cost Quantities, time and quality Profit/loss Cost Revenues Profit/loss Cost Revenues Profit/loss Revenues Profit/loss Contribution margin Cost

Object Individual order

Sub-orders/tasks Orders and sub-orders/tasks

Orders Orders and sub-orders/tasks

Orders SC partner network SC partners

Cooperation field

Orders

Source: Veil (2001), p. 108f, adapted and translated

Standardization and Harmonization of Cost Accounting Systems Across Partners It should be clear by now that a minimum degree of harmonization and conceptual alignment between supply chain partners’ cost accounting systems is indispensable if cross-organization cost accounting tasks are to be pursued. The degree of harmonization, however, will vary (see also Schoppmann 2005): 1. In some cases, no cross-organizational cost accounting is necessary at all. In a competitive and transparent market, arm’s length transactions are sufficiently efficient and the key information exchanged between trading partners is the market price for the good or service exchanged. 2. In the typical supply chain setting, some degree of collaborative optimization based on aggregated/consolidated figures is possible and beneficial to partners. Quality and speed of decision making can be improved and business risk can be reduced if more information than just prices is exchanged between partners.

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Challenges and Approaches for Supply Chain Cost Accounting

81

3. In some cases, the benefits of a detailed and closely aligned cross-organizational cost accounting system are so big that firms align their approaches even further, leading to an integrated cost accounting system across supply chain partners. The degree of harmonization can range from selective coordination (of cost item definitions and valuation principles, for example) to partial or full integration, merging cost account sub-systems across partner firms and establishing a single, cross-company system with the supply chain being the key entity in focus (see Fig. 4.2). Going for closer integration and harmonization of cost accounting systems clearly involves more effort and higher costs, while at the same time limiting individual firms’ independence and discretionary decision making when it comes to product costing and pricing. A fully integrated cost accounting system, therefore, will be a rare exception. Partial integration, however, can be beneficial in many more situations. Supply chain partners will have to decide whether their integrated supply chain cost accounting system is (Schoppmann 2005): 1. Run in parallel to each firm’s own cost accounting system. In this case, each supply chain partner actually works with two different cost accounting systems: a proprietary one for own purposes and a shared one for supply chain decision making (parallel cost accounting systems), 2. Replacing individual cost accounting systems. Supply chain partners abandon their proprietary systems and use the shared, integrated system only (substituting cost accounting system), 3. Used for specific occasions and decisions only, while each partner continues to use its proprietary system for recurring costing and pricing decisions (complementing cost accounting system). If supply chain partners decide to go for at least a minimum degree of harmonization and integration, they must decide on the elements of their cost accounting systems to be aligned. Starting points are manifold and cover all elements of a standard cost accounting system (see Table 4.2). Aggregation and Consolidation of Cost Accounting Information We have outlined in the previous sub-section that total harmonization of cost accounting systems is unrealistic—and often unnecessary. Supply chain partners will retain a certain degree of flexibility and discretion not only in setting up their own cost accounting system but also in performing their tasks and contributions to the final supply chain output. After all, the very idea of collaborating with supply chain partners rests on the assumption that this governance structure provides more benefits than spot market transactions (no integration) on the one hand and full hierarchical integration on the other hand. The value-adding processes and exchange relationships between supply chain partners, therefore, are faced with aggregation and consolidation challenges and problems similar to

Manufacturer

Customer

Cost type accounting

Cost type accounting

Cost type accounting

Fig. 4.2 Options to combine cost accounting systems across supply chain partners (source: Stölzle et al. 2005, p. 64, adapted)

Cost type accounting

Cost center accounting

Cost unit accounting

Income for the period

Manufacturer

Cost type accounting

Cost center accounting

Cost unit accounting

Income for the period

Customer

4

Cost type accounting

Cost center accounting

Cost center accounting

Cost center accounting

Cost center accounting

Income for the period

Cost unit accounting

Income for the period

Supplier

Cost unit accounting

Income for the period

Income for the period

Customer

Coordinated

Cost unit accounting

Manufacturer

Supplier

Partly integrated

Cost unit accounting

Income for the period

Supplier

Fully integrated

82 Cost Accounting in Supply Chains

4.3

Challenges and Approaches for Supply Chain Cost Accounting

83

Table 4.2 Harmonization options of cost accounting systems across supply chain partners Sub-system Cost type accounting

Cost center accounting

Cost unit accounting

Cross-system

Requirement – Ensure structural match of cost hierarchies and cost categorizations across SC partners, align definitions of the key cost types – Align valuation principles for inventory and work in process items – Capture cost and value of individual contributions (activities, partial deliveries), not only the final product – Introduce a jointly defined cost category “cooperation cost” and identify its most relevant cost drivers across partners – Define cost centers and organizational sub-units in a way that encompasses cross-organization relations (e.g. cross-organizational support departments) – Align cost center definitions and delimitations for supply chain-related functions with each partner in order to facilitate cost information exchange and consolidation – Include cost and revenue information of cooperation partners in own cost allocation sheets – Allocate cost and revenues not only to final products but also to partial contributions from individual partners in order to allow determination and consolidation of inter-partner profits and losses – Agree on joint rules for overhead cost allocation – Separate fixed from variable cost – Separate cooperation cost from execution-related cost – Align or merge cost accounting systems across SC partners – Ensure measurability of cooperation cost by defining and implementing appropriate indicators and measurement instruments

Source: Drews (2001), p. 92, adapted, extended and translated

the ones that appear in consolidated group accounting (Veil 2001). Partners retain responsibility for all cost accounting tasks at the task/sub-order level but establish an additional layer where cost information is consolidated at the order/network level (which spans several supply chain partners’ contributions). At this network or supply chain layer, product costing needs to follow a consolidation approach similar to consolidation in a group of related companies, because a simple addition of sub-orders will distort results. Consolidation is necessary only if supply chain partners retain their own cost accounting systems and only exchange partial cost and revenue information. A fully integrated cost accounting system across all supply chain partners and layers (which is a rather hypothetical case, as we have outlined in the previous sub-section) would provide full transparency and would eliminate the need for any subsequent consolidation (Schoppmann 2005)—at least for cost accounting purposes (we do not consider financial accounting regulations here). On the other hand, consolidation will not be possible without at least some harmonization of cost accounting systems. Without harmonization, cost elements and revenues cannot be reasonably consolidated and compared. The basic idea of consolidation

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is the elimination of double-counting of cost and revenues. Let us further explain this idea using a fictitious example. Example A supply chain consists of three partner firms: a supplier, a manufacturer, and a retailer. Integration between supply chain partners is relatively high: partners have agreed to exchange information on their respective full absorption cost and have agreed on fixed transfer prices. Given partners’ cost structure and agreed transfer prices, profit margins for all partners are fixed as well and known to each partner. The initial, unconsolidated, picture looks as follows: Unconsolidated data Full cost

Supplier 10.00 €

of which: purchased inputs from SC partners of which: other conversion cost

Agreed profit Transfer price (= revenues)

10.00 €

Manufacturer

Final customer

Retailer

21.50 €

SC Sum

15.00 €

20.00 €

11.00 €

17.00 €

45.00 € 28.00 €

4.00 €

3.00 €

17.00 €

1.00 €

2.00 €

1.50 €

4.50 €

11.00 €

17.00 €

21.50 €

49.50 €

Supply chain partners charge transfer prices that are based on their respective cost structure and agreed profit margins. Simply adding up cost and revenue figures across all partners results in the total cost and revenue figures as shown in the last column. These figures, however, are not reflecting the true cost and revenue performance of the supply chain as such. The supplier’s revenue of 11 €, for instance, is shown as purchase cost with the manufacturer, who will add this cost item to its own total cost (11 + 4 ¼ 15 €). Following this simple additive logic leads to considerable double counting of both cost and revenue items and no reasonable supply chain decision can actually be based on such additive figures. Instead, supply chain partners must eliminate redundancies through consolidation, leading to the adapted picture below: Consolidated data Supply chain cost

Supplier 10.00 €

of which: purchased inputs from SC partners of which: other conversion cost

Agreed profit Supply chain revenues

Manufacturer 4.00 € -

10.00 €

€

4.00 €

Final customer

Retailer 3.00 € -

€

3.00 €

21.50 €

SC consolidaon 17.00 € -

€

17.00 €

1.00 €

2.00 €

1.50 €

4.50 €

11.00 €

6.00 €

4.50 €

21.50 €

Note that nothing changes for the final customer. The price charged (21.50 €) remains unchanged. Through consolidation, however, supply chain partners now have an unbiased view of total cost and total revenues for this particular transaction or customer order. They can identify the main sources of cost and can initiate targeted cost reduction initiatives.

4.3

Challenges and Approaches for Supply Chain Cost Accounting

85

Simple as this consolidation seems to be, it requires considerable trust between partners, because they need to exchange sensitive cost and profit information. In order to allow for easy and efficient consolidation, supply chain partners should also agree on uniform or shared information systems—a requirement that might lead to additional investment needs at the partner level. Communication and Cost Information Exchange We have already outlined several times that cross-company cost accounting is possible only if and to the extent that supply chain partners exchange cost information. Lacking this mutual cost information, supply chain partnerships are prone to typical agency problems (see Chap. 2): information asymmetry can be exploited by the more informed partner to the detriment of the less informed partner. Since cost, revenues and profits are the central management objects in most cross-organizational settings, cost information plays an especially important role in this respect. Several alternative approaches are available to supply chain partners to help solve the problem of cost information asymmetry (see also Schoppmann 2005): 1. Partners can rely solely on market prices of goods and services exchanged. If one firm charges too high prices for its contribution and other supply chain partners pass on these prices, demand for the final product will eventually decrease. Ultimately, customers will provide feedback to the supply chain through decreasing demand. It is evident, though, that this mechanism does not solve the issue as such: Customers react to final product prices only. The demand mechanism, therefore, does not identify the supply chain layer or partner that is ultimately responsible for the weakening competitive position of the entire supply chain. 2. It is more likely that selfish behavior of one supply chain partner will evoke explicit reactions and retaliation from other supply chain partners. If the supply chain wants to avoid a deteriorating market position, other supply chain layers need to sacrifice part of their profits in order to make up for the higher prices of their business partners. It is very likely that firms that can no longer realize their expected minimum surplus will eventually initiate countermeasures—either by withdrawing from the supply chain or by searching new, alternative partners that can replace the selfish partner. It is important to note that this effect works both downstream (suppliers or manufacturers retaliating against distributors, for instance) as well as upstream (manufacturers replacing existing suppliers). 3. Even if supply chain partners do not exchange cost information directly, firms always have the option to compare prices of their own partners with alternative offers in the markets. This cost and price benchmarking is standard practice not only within supply chains but in virtually all markets. After all, surveying current market conditions is an integral part of company management. It might be difficult, however, to find valid and useful price comparisons for products and services that are very specific and not

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commonly traded outside of the own supply chain (e.g. a component that is exclusively manufactured by one supplier for its only manufacturing customer). 4. Supply chain partners that belong to the same group of companies are often governed by a more or less complex scheme of transfer prices. Different from pure market-based prices, transfer prices are not the result of a free interplay of demand and supply. Instead, a third, governing, entity (typically group headquarters or any other group unit with hierarchical authority) influences or even dictates the price to be charged between the two trading partners (typically subsidiaries of the same group). The set prices are mainly used as an instrument for profit allocation between subsidiaries, but also have motivational effects for individual units and their management teams. The use of transfer pricing is limited to group-internal supply chains only. In addition, the resulting profit allocation effect will be the object of intense scrutiny by national tax authorities. 5. Even if they do not engage in a direct exchange of cost information as such, firms might find it useful and more realistic to provide operational data to their supply chain partners, which can be used to make inferences about cost structures. When partners have been engaging for a long time in a mutual business relationship, they typically have acquired deep knowledge about the industry as such, typical business models and the most important factors driving cost and value in it. Having such background knowledge, partners can simply exchange information on the most important cost drivers and make cost inferences from them. If raw material prices, for instance, are known to be the key cost driver, close observation of their market prices might be a sufficiently accurate proxy for a supplier’s true cost situation. The same line of reasoning can apply to other potential cost drivers such as labor productivity or cost of capital (for very capitalintensive industries), respectively. 6. Last but not least, supply chain partners might engage in a direct exchange of detailed cost data, providing transparent information of their own cost structure to other supply chain layers further up- or downstream. This approach, which is generally known as “open book accounting” will be discussed in more detail in the following sub-chapter.

4.4

Open Book Accounting: A Way to Supply Chain Cost Accounting?

Cooperation between legally independent economic actors forces supply chain partners to engage in at least a minimum of information exchange. Whenever organizational functions and activities are outsourced and/or entrusted to other economic actors, information exchange is the only way to “get back in touch” with these functions (Mouritsen et al. 2001). The need for information exchange between business partners has been recognized both in academic discussions as well as in business practice early on (Otley et al. 1995; Hopwood 1995)—even before the term “supply chain management” as such has been coined and widely used.

4.4

Open Book Accounting: A Way to Supply Chain Cost Accounting?

87

Today, the systematic, mutual exchange of financial and accounting data between legally independent supply chain partners is generally known as “open book accounting” or OBA in short (Romano and Formentini 2012). Open book accounting is an essential pre-requisite for a multitude of different cost accounting and cost management tasks (Hoffjan and Kruse 2006; Agndal and Nilsson 2010): – Identification of cost drivers along the supply chain (“What’s influencing our total supply chain cost most?”) – Comparison of cost structures between supply chain partners (“Are our partners subject to the same cost constraints and cost impacts as we are?”) – Verification of margins of individual supply chain actors (“Do we reap a fair share of total supply chain surpluses or do we lose out compared to our partners?”) – Price controls between partners (“Is the latest price increase of our partner actually justified and substantiated by a corresponding cost increase?”) Open book accounting can denote a variety of different cost information exchange systems. The specific set-up not least depends on the following factors (Hoffjan and Kruse 2006): – Power distribution between partners Supply chain partners with strong bargaining power will be more inclined to ask for cost information than to provide their own cost information themselves. Weaker partners, in turn, will have a higher motivation to share such sensitive information, since they might be excluded from the supply chain if they don’t conform to their stronger partners’ requests. In a unidirectional setting (one partner providing cost information to the other partner), OBA is basically not more than a simple monitoring tool applied by the stronger supply chain partner. Bi- or multi-directional OBA, which is practiced between supply chain partners of similar negotiation power, can be used as a joint optimization tool, provided that partners possess the necessary degree of trust in each other. – Duration of cooperation Short-term, occasional business relationships will often not justify the effort needed to establish a reliable and mutually agreed system of cost information exchange. Potential benefits are simply not big enough to engage in such a venture and often the level of trust between partners is not yet sufficiently high to make them accept the risks that come along with increased cost transparency. If used at all in short-term relationships, OBA might be regarded as a support instrument for pricing and price control between partners. Genuine OBA, however, is typical for long-term partnerships, where the potential benefits outweigh the high initial effort. – Number of partners involved In principle, OBA can be practiced between any number of supply chain partners, but coordination effort and the risk of potential agency problems increase in line with the

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number of partners involved. In business practice, therefore, OBA is mostly used as a bilateral tool only. Of course, a focal partner in the supply chain can have a multitude of individual, bilateral OBA agreements with other partners (as is often the case, for instance, for the OEM and its suppliers in the automotive industry). This focal partner will retain the cost information collected from various partners for its own purposes only and will not share it widely among partners. Success Factors of Open Book Accounting Successful implementation of open book accounting depends on a number of factors that significantly influence its overall efficiency and effectiveness (Kajüter and Kulmala 2005; Hoffjan and Kruse 2006; Agndal and Nilsson 2010; Möller et al. 2011; Romano and Formentini 2012): – The level of commitment and mutual trust between partners is a major influencing factor for successful implementation of OBA. Commitment in this respect can be defined as partners’ willingness to dedicate resources and to make concessions towards each other. Commitment also expresses itself in the willingness to maintain the partnership as such. Trust, in turn, shows in the perceived sense of the partner’s integrity and a general expectation that the partner will keep agreements. It is obvious that OBA arrangements stand a better chance to be effective if partners show a high level of both commitment and trust. – General economic trends and industry characteristics might also influence OBA implementation. If partners face intense competition, for instance, the perceived need to continuously engage in cost cutting exercises might increase partners’ willingness to start open book accounting. A similar effect might be produced by a deteriorating business cycle that forces companies to focus more on cost across the entire supply chain. – Firm-specific characteristics, such as the availability of accounting staff, similarities (or deficiencies) in partners’ accounting systems, or the general cooperative atmosphere between partners can constitute serious impediments or facilitators, respectively, for a successful implementation of OBA. – Last but not least, the availability of incentives influences OBA acceptance and effectiveness. Apart from the general benefit of belonging to an efficient supply chain, partners might be motivated for participation through specific incentives such as sharing profit from joint improvement projects or guaranteed profit margins based on the cost data provided. They might also be entitled to compensation for documented cost increases (e.g. if market prices for an important commodity increase), or can qualify as a preferred partner when engaging in OBA. It is important that the nature of the OBA arrangement fits its purpose and companies’ expectations. Finding and agreeing on the most suitable setting will considerably influence

4.4

Open Book Accounting: A Way to Supply Chain Cost Accounting?

89

partners’ acceptance of the OBA agreement and subsequently also its chances of success. This comprises a number of different dimensions: – The nature of the data exchanged must fit companies’ cost accounting systems and their management needs. Cost data can be collected and exchanged for various cost objects, such as individual products, cross-company processes (e.g. R&D), or contracts for specific services rendered by a supply chain partner. The cost data can be purely period-focused or can span the entire life cycle of the object. – OBA data exchange can happen on a continuous (i.e. in regular, pre-defined intervals such as regular supplier audits) or on a discontinuous basis (e.g. only during the development phase of a new product, for specific improvement projects only, during initial supplier evaluation and selection, etc.). – OBA can be formalized (e.g. using standardized forms and templates, providing detailed instructions for collecting data and filling in forms) or not formalized (based on ad-hoc agreements between partners). Example Suomala et al. (2010) present an example of a manufacturer of mining equipment and one of its strategic systems suppliers. In a joint OBA initiative, the partners developed cost models for the components exchanged that followed an activity-based costing (ABC) format. The manufacturer was actively seeking ways to pass on more responsibility to its suppliers and the management teams of both companies supported the OBA initiative. The supplier expected considerable benefits in sharing own cost data with the manufacturer since this was expected to facilitate future R&D projects. The supplier had a sufficiently strong negotiation position towards the manufacturer and did not expect any short-term negative effects (e.g. when re-negotiating supply contracts). In short: both companies had the necessary level of commitment and trust to engage in an OBA project that also promised sufficient benefits to both parties. Based on ABC cost data for all components delivered by the supplier to the manufacturer, both parties agreed on target profit margins for the supplier. Both parties agreed that these target margins should be used as a long-term guideline and would not have any shortterm effects on prices. The joint exercise not only provided surprising insights for both partners but also strengthened the mutual commitment towards the long-term profitability of both partners. In this sense, it is an example of a unidirectional, one-time OBA project that is based on mutual trust with a clear long-term commitment and sufficient incentives for both partners. Weaknesses of Open Book Accounting It should be noted that open book accounting is not free of problems. The general idea of a mutually created transparency between two trustworthy partners willing and able to cooperate may turn out to be not more than a romantic illusion in many cases:

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– Cost transparency alone does not save costs: The idea of OBA is striking. Cost transparency can help to identify potentials for cost savings throughout the supply chain and create “win-win” situations. But these benefits do not come automatically. If the disclosed cost information is not used for analyzing such potentials, there will be no benefits from OBA. – Breach of confidentiality: By disclosing sensitive cost data to other suppliers, manufacturers may reveal strategically relevant information that the supplier’s competitors may use. Competitors could, for instance, derive information about innovative production processes from the cost data. – Threat of opportunistic behavior: By making cost information transparent, a supplier automatically reveals its profit margins. This can make a supplier vulnerable. A manufacturer, for instance, may use the data of one supplier in negotiations with other competing suppliers. Manufacturers sometimes even use cost data of various suppliers to compose a hypothetical price offer by picking the lowest cost positions from different suppliers. The sum of these cost positions represents a fictitious “best-in-class supplier”, that defines the cost standard for negotiations. – Abuse of market power: Resulting from the above, business practice often uses OBA arrangements as a price management tool rather than for cost management (Lührs 2010). In such a setting, the stronger supply chain partner uses its negotiation power to force weaker partners to make their cost structure transparent—less so to initiate joint cost management actions, but rather to dictate price reductions on products and services rendered. Common as such an approach might be in practice, it does not reflect a truly cooperative approach and therefore should not be considered as supply chain management in its true meaning. Because of such practices, OBA has sometimes been criticized of being a tool that is mainly used by large and powerful manufacturers to squeeze out suppliers. Despite this, however, OBA can be a value creating instrument. If applied in a balanced, fair and trustful setting, OBA can lead to efficiency gains, resulting in cost reductions and ultimately profit increases that when shared among the partners benefit both sides.

4.5

Glossary and Key Terms

Cause-effect principle of cost allocation Consolidation of cost information

Cost

The rule to assign and allocate cost items to the objects that are ultimately responsible for the resource consumption. The process of eliminating cost and revenue effects of transactions that take place between supply chain partners in order to determine the net cost effect of a product or customer order to the supply chain in its entirety. A sacrifice made to achieve a particular company purpose. (continued)

4.6

Review Questions and Exercises

Cost accounting Cost center accounting Cost type accounting Cost unit accounting Open book accounting Supply chain cost Transfer price

4.6

91

The system that gathers, analyzes, and reports cost information in the company. The subsystem that allocates a cost amount to different organizational sub-units (cost centers). The subsystem that collects data on amounts and values of consumed resources. The subsystem that relates consumed resources (i.e. cost) to goods and services produced. The systematic and mutual exchange of financial and accounting data between legally independent supply chain partners. The value of all resources that are consumed when establishing, operating and managing relations with other supply chain partners. A price that is to be charged for goods and services between two inter-related actors (e.g. subsidiaries of the same group of companies) and that is usually set by a third, governing, body (e.g. group headquarters).

Review Questions and Exercises

Review question 4.1: Explain the main differences between financial accounting and cost accounting. Review question 4.2: What are the main tasks of cost accounting in an enterprise and how are these implemented in a typical cost accounting system? Review question 4.3: Explain the nature of supply chain cost. How can supply chain cost be distinguished from other cost concepts used in cost accounting? Review question 4.4: How are supply chain cost treated in standard cost accounting systems? Why is this approach insufficient for managing cost across firms? Review question 4.5: Name and explain the key challenges that cost accounting is faced when handling supply chain cost in a standard cost accounting system. Review question 4.6: Explain the different options of aligning and harmonizing cost accounting systems across supply chain partners. Under which conditions will each option be an appropriate choice for the firms involved? Review question 4.7: Explain why cost information must be consolidated across partner firms in order to provide valid cost information for the supply chain. What is the basic conceptual logic followed in cost consolidation?

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Review question 4.8: Name and describe different options of exchanging cost-relevant information between supply chain partners. Review question 4.9: What is the basic idea of open book accounting (OBA)? Which factors and conditions need to be considered in order to assess OBA’s benefits to a supply chain? Review question 4.10: Outline the problems of open book accounting in practice.

Exercise 4.1: Identifying supply chain-related cost “Take It Easy” is a manufacturer of light-weight, high-comfort, mattresses. It realizes more than half of its total sales through two specialized mattress retail store chains. Recognizing the pivotal role of its retail partners, Take It Easy wants to establish joint management processes with both chains. Both retailers have several other mattress labels in their portfolio, but Take It Easy is certainly an important supplier for them as well. The manufacturer, therefore, is optimistic that this initiative will be well received. As a first step, Take It Easy wants to improve cost transparency. Its cost accounting system is fairly well established and manufacturing cost per model is known and closely tracked. The initiative now focuses on supply chain cost—here to be understood as all cost items related to dealing with the two retail partners. Take It Easy is convinced that joint cost reduction efforts promise significant gains if implemented properly. The manufacturer, therefore, wants to propose a collaborative supply chain cost improvement initiative to its retailers. Which cost items should be in scope of this initiative both at Take It Easy and at its retail partners? How can “supply chain cost” be defined and properly recorded in this situation? Exercise 4.2: Open book accounting Hay Minion Inc. is an agricultural machinery manufacturer. With agriculture becom ing more and more industrialized in many markets, Hay Minion’s customer base is increasingly marked by big cooperatives and large landowners, who are all very pricesensitive. Hay Minion, therefore, wants to start an efficiency improvement initiative together with two of its key suppliers. One of them, Shafts United, is a family-owned and family-run manufacturer that has a long-standing business relationship with Hay Minion. Shafts United clearly depends on its business with Hay Minion. The second target supplier, Global Screws Inc., is a large multi-national group that serves a large customer base in various industries. Hay Minion is an important, but not business-critical, customer for Global Screws. Hay Minion wants to propose open book accounting to both suppliers but recognizes that the initial situation differs between the companies. How could a workable OBA

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solution look like that helps Hay Minion identify efficiency gaps, but takes into account the particular characteristics of the two different supplier relationships? Should Hay Minion aim for a unified scheme or rather go for two separate agreements?

References Agndal H, Nilsson U (2010) Different open book accounting practices for different purchasing strategies. Manag Account Res 21(3):147–166 Drews H (2001) Instrumente des Kooperationscontrolling. Gabler, Wiesbaden Hess T (2002) Netzwerkcontrolling—Instrumente und ihre Werkzeugunterstützung. Gabler, Wiesbaden Hoffjan A, Kruse H (2006) Open book accounting als Instrument im Rahmen von Supply Chains— Begriff und praktische Relevanz. Control Manag Rev 50(2):94–99 Hopwood AG (1995) Looking across rather than up and down: on the need to explore the lateral processing of information. Account Organ Soc 21(6):589–590 Kajüter P, Kulmala HI (2005) Open-book accounting in networks: potential achievements and reasons for failures. Manag Account Res 16(2):180–204 Lalonde BJ, Pohlen TL (1996) Issues in supply chain costing. Int J Logist Manag 7:1–12 Lührs S (2010) Kostentransparenz in der Supply Chain—Der Einsatz von Open Book Accounting in Zulieferer-Abnehmer-Beziehungen. Gabler, Wiesbaden Meuser S (1997) Koordinationskostenrechnung: Ein auf dem Lean-Management-Gedanken basierendes Controlling-Instrument im Anlagengeschäft. Peter Lang, Frankfurt/Main Möller K, Wildolph M, Isbruch F (2011) The effect of relational factors on open-book accounting and inter-organizational cost management in buyer-supplier partnerships. J Purch Supply Manag 17:121–131 Mouritsen J, Hansen A, Hansen CO (2001) Inter-organizational controls and organizational competencies. Manag Account Res 12(2):221–244 Norek CD, Pohlen TL (2001) Cost Knowledge. A Foundation for Improving Supply Chain Relationships. Int J Logist Manag 12(1):37–51 Otley D, Broadbent J, Berry A (1995) Research in management control: an overview of its development. Br J Manag 6:31–44 Pohlen T, Klammer T, Cokins G (2009) Supply chain costing. CSCMP Explores 6(Special Issue):1–15 Romano P, Formentini M (2012) Designing and implementing open book accounting in buyersupplier dyads: a framework for supplier selection and motivation. Int J Prod Econ 137(1):68–83 Schoppmann R (2005) Interorganisationales Kostencontrolling: Kostenmanagement, Kostenrechung und Open-Book-Accounting für Kooperationen und Netzwerke. Vahlen, München Seuring S (2001) Supply Chain Costing—Kostenmanagement in der Wertschöpfungskette mit Target Costing und Prozesskostenrechnung. Vahlen, München Seuring S (2002) Supply chain costing—a conceptual framework. In: Seuring S, Goldbach M (eds) Cost management in supply chains. Physica, Heidelberg, pp 15–30 Stölzle W, Hofmann E, Hofer F (2005) Supply Chain Costing: Konzeptionelle Grundlagen und ausgewählte Instrumente. In: Brecht U (ed) Neue Entwicklungen im Rechnungswesen—Prozess optimieren, Berichtswesen anpassen, Kosten senken. Gabler, Wiesbaden, pp 52–85 Suomala P, Lahikainen T, Yrjänäinen L, Paranko L (2010) Open book accounting in practice— exploring the faces of openness. Qual Res Account Manag 7(1):71–96

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Taschner A, Charifzadeh M (2016) Management and cost accounting—tools and concepts in a central european context. Wiley, Weinheim Veil T (2001) Internes Rechnungswesen zur Unterstützung der Führung in Unternehmensnetzwerken. Cuvillier, Göttingen Weber J (2012) Logistikkostenrechnung—Kosten-, Leistungs- und Erlösinformationen zur erfolgsorientierten Steuerung der Logistik, 3rd edn. Springer, Heidelberg

5

Cost Management in Supply Chains

Cost Management Intro IOCM

Chained Target Costing

Kaizen Costing

Life Cycle Costing

Activity Based Costing

Learning Objectives After completing this chapter, you should be able to: 1. Understand and explain the conceptual differences between cost accounting and cost management 2. Describe the three key focus areas of cost management 3. Discuss the benefit of cost management in a supply chain environment and outline typical application scenarios in supply chains 4. Name the most important prerequisites for successful IOCM implementation 5. Explain the target costing process and assess the applicability of target costing in various supply chain scenarios 6. Understand the overall logic of Kaizen costing and outline possible usage scenarios of Kaizen costing in a supply chain environment (continued)

# Springer Fachmedien Wiesbaden GmbH, part of Springer Nature 2020 A. Taschner, M. Charifzadeh, Management Accounting in Supply Chains, https://doi.org/10.1007/978-3-658-28597-5_5

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7. Explain the conceptual differences as well as the similarities between life cycle costing, life cycle assessment, and supply chain management 8. Describe how SCM can help improve life cycle cost for a product 9. Distinguish the different activity levels that are relevant for activity-based costing and explain how ABC can relate to SCM Cost accounting and cost management are not synonymous terms. In this chapter, we outline how cost accounting forms the basis for a pro-active management of cost and how cost management can be implemented in a supply chain environment. Similar to cost accounting, cost management concepts need to be adapted when being transferred from the single firm to a cross-company setting. While most companies do make use of cost accounting one way or the other, many smaller firms might not have adopted any cost management techniques so far. In fact, it might well be through a request coming from one of their supply chain partners that they are for the first time confronted with cost management tools at all. We will discuss some of the most widely used cost management approaches in this chapter. We do not claim to provide an exhaustive treatment of the techniques as such, but rather focus on their applicability in supply chains.

5.1

From Cost Accounting to Cost Management

Fulfillment of management tasks would not be possible without proper cost information. As outlined in Chap. 4, cost accounting systems play a pivotal role when it comes to providing task-relevant information to managers—both at the firm level as well as at the supply chain level. Cost accounting systems collect cost data, categorize and group this cost data, allocate cost to different management objects and finally present and report the cost data to managers. We have, therefore, described cost accounting as the system that gathers, analyzes, and reports cost information in the company and the supply chain, respectively. Important as these tasks might be, they are not sufficient to ensure a company’s or supply chain’s success. Continuous tracking and analysis of cost is a necessary but not sufficient pre-requisite to manage a business venture. It merely forms the basis for all subsequent actions that aim at pro-actively managing cost. If cost accounting represents the short-term, continuous tracking and analysis of cost, then cost management denotes the pro-active, long-term oriented influencing of costs (Charifzadeh and Taschner 2017). Cost management is the combination of all activities and tools used to influence cost in order to achieve company goals. Cost management builds on cost accounting but is not synonymous with it (see Fig. 5.1). Goal-oriented cost management focuses on three interrelated and complementary aspects (Charifzadeh and Taschner 2017):

5.2

Inter-organizational Cost Management: An Overview

Cost accounting

97

Cost management

Collect cost

Actively influencing cost

Document activities Assign cost to various objects

Relate cost to business drivers other than output level

Short-term optimization

Early initiated

Long-term oriented

Fig. 5.1 Cost management versus cost accounting (source: Charifzadeh and Taschner 2017, p. 63)

– Managing cost level: How high are costs and how can overall costs be reduced? – Managing cost behavior: How do costs change if the activity level changes and how can costs be made adaptive to these activity changes? – Managing cost structure: What is the mix between direct and indirect cost elements and what can be done to reduce indirect (i.e. overhead) costs? Possible answers to these questions are manifold and they form the bridge between cost accounting on the one hand and management tasks on the other (see Fig. 5.2). Management accountants need to develop a set of tools and methods that help both themselves and firm managers bridge the gap between cost information and pro-active management action. This set of tools and instruments is commonly referred to as cost management. Given its pro-active and future-oriented nature, cost management has a much more strategic focus than cost accounting. Cost accounting info can be readily used to initiate short-term corrective actions and incremental improvements. A sustainable and significant improvement of cost structure and cost level, however, will not be possible without additional, strategic, actions. In this sense, cost management can also be viewed as simultaneously improving the strategic position of a firm and reduce its costs (Cooper and Slagmulder 1998).

5.2

Inter-organizational Cost Management: An Overview

Pro-active, future-oriented, cost management in the above sense is not only an issue for single firms, but also for entire supply chains. In fact, scholars have even argued that supply chains are one of the last remaining opportunities for significant cost reduction (Christopher and Gattorna 2005). In this view, cost reduction opportunities at the firm level have been mostly exploited and the remaining possibilities are not big enough to yield significant competitive advantages. Given the ever intensifying interdependence of firms in networks and supply chains, the share of transaction cost and coordination cost in total cost

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Focus areas of cost management Reduce overall cost level

Increase efficiency (faster, simpler, less often, etc.)

Outsource activities Change suppliers Increase level of automation Make use of economies of scale

Make cost more adaptive to activity changes

Increase flexibility of staff (e.g. flexible working hours) Reduce setup and waiting times, increase capacity utilization Etc.

Reduce indirect cost

Increase flexibility of staff (flexible working hours)

Outsource activities Increase productivity of indirect company functions (service functions)

Etc.

Etc.

Fig. 5.2 Focus areas of cost management (Charifzadeh and Taschner 2017, p. 64, adapted)

increases as well. It is therefore only natural to extend cost management efforts to the supply chain level—which leads to the concept of inter-organizational cost management. Inter-organizational cost management, or IOCM in short, can be defined as coordinated efforts by supply chain partners to actively influence and reduce costs. It is a structured approach to coordinating the activities of firms in a supplier network so that total costs in the network are reduced. (Cooper and Slagmulder 1999, p. 145)

Coordination in this sense typically happens through a set of disciplining mechanisms (setting cost targets for individual supply chain members and transmitting cost pressure throughout the network) and enabling mechanisms (opening opportunities for partners to pool their skills and coordinate their efforts, Cooper and Slagmulder 1999). IOCM Application Scenarios IOCM plays a pivotal role for several core tasks in a supply chain, which all depend on joint efforts of several partner firms from different layers in the value creation process and are typically strategic in nature (see also Kulmala 2003; Agndal and Nilsson 2009): 1. Supplier evaluation and selection This task is not necessarily a question of identifying the cheapest offer. From a strategic perspective, it is rather about selecting the supplier whose business processes and suggested solutions offer the best possibilities to be integrated with the processes and solutions of the buyer and subsequently allow a cost-efficient joint offering.

5.2

Inter-organizational Cost Management: An Overview

99

2. Concept discussion Whenever complex products or solutions need to be developed, several supply chain partners contribute to the final customer offering—making it necessary to search for a solution concept that realizes the joint cost optimum—which in turn is based on a costefficient allocation of sub-tasks among partners. 3. Joint product design Since the largest share of product cost is determined at the design stage, partnering firms need to identify opportunities for cost optimization at this early stage in the product life cycle—making it necessary to look for cost reductions that span across several partners’ tasks. 4. Joint process development This task is similar to case 3 above, with the only difference being that the cost optimization object is not a physical product, but rather a process spanning several supply chain partner organizations and thus requiring a joint optimization effort. These could be manufacturing or after-sales service processes, for instance. 5. Pricing and offer calculation Although the most downstream firm in the supply chain is the only partner with direct contact to the end-customer, competitive pricing and offer preparation will not be possible without the input and cooperative efforts from partner firms further upstream in the supply chain. Their cost structure and cost level need to be managed as well in order to ensure truly competitive pricing since badly managed cost structures upstream are all but impossible to compensate further downstream in the supply chain. 6. Product mix selection Different product variants can be realized by combining contributions (components, parts, and sub-systems) from different suppliers. Modern cars offering a plethora of add-on features and supplementary equipment are a typical example. The profitability of individual product variants depends not least on the cost structure of suppliers contributing different features and components. The decision to offer or to suspend a particular product variant, therefore, is directly linked to the suppliers’ ability to achieve certain cost targets. 7. Price revisions Arrangements with a long duration, such as multi-year frame contracts between a manufacturer and its supplier, might provide for regular adjustments of prices charged by the supplier in order to maintain competitiveness against products from rival supply chains or to induce continuous improvement actions within the supplier’s perimeter. Such challenging, but still realistic, price levels must be jointly determined. 8. Product and process redesign Changes in market demand and customer expectations, or new rival offerings might make it necessary to redesign products and processes in order to maintain competitiveness. In a supply chain setting, this inevitably leads to the need to jointly look for cost optimization opportunities.

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IOCM Prerequisites The non-exhaustive list above should have made it clear that inter-organizational cost management is not simply a voluntary, additional, exercise for some firms that can afford the extra effort needed. Instead, IOCM has become an absolute must for many firms and their supply chains in order to remain competitive. If and when supply chain partners genuinely want to engage in IOCM, they should ensure that (Kulmala et al. 2002, Kulmala 2003) . . . 1. . . . their respective cost accounting systems can produce relevant, accurate, and usefully presented information. As outlined above, cost accounting is a necessary precondition for successful cost management. If supply chain partners cannot produce the required cost information in their own cost accounting systems, IOCM is bound to fail. If cost accounting systems cannot adequately measure and allocate supplier and customer-related costs, for instance, exchanged cost info will be distorted by inappropriate overhead allocation charges that make it very difficult to derive adequate cost management actions. The true causal factors of these cost elements remain blurred and cannot be managed effectively across supply chain partners (Slagmulder 2002). 2. . . . they share at least part of their cost information with those suppliers and customers that are directly involved in IOCM efforts. Joint management of cost will not be possible without at least a minimum of own cost information being available also to IOCM partners. This requires trust, but also agreement on the type and format of the cost information that is shared between partners. IOCM, therefore, can be a trigger for at least some limited form of open book accounting. 3. . . . they are willing to open some bits and pieces of their cost information multilaterally, i.e. to firms that are not directly involved in IOCM yet but might be able to identify additional cost reduction opportunities and might, therefore, become IOCM partners in the future. It is important to note that IOCM is not only cross-organizational (i.e. involving several firms), but also participatory and cross-functional (Kajüter 2002). Even within the single firm, many different employees performing many different functions need to be involved in order to make IOCM a success. IOCM typically requires cross-organizational teams, but also cross-functional teams within the organizations involved (Ellram 2002). Cost information must now be made available to organization members who have not been recipients of it in the past. IOCM, therefore, promises significant benefits to the engaged companies but also makes high demands on them. Ideally, the partners possess a set of different characteristics that help make IOCM a success (Ellram 2002): a dedicated customer and supplier focus (not only inward-looking), a culture of continuous improvement (continuous quest for cost improvements), the willingness to involve supply chain partners early on (e.g. already during product design and development), and attentive management that allows the exchange of cost information across partners—certainly not an easy task!

5.3

Chained Target Costing

101

We outline the most important IOCM techniques in the following sections. As mentioned earlier, our focus is on their application in a supply chain environment.

5.3

Chained Target Costing

Target costing is a cost management technique that has been developed by Japanese manufacturing companies in the 1960s, with companies in other world regions following suit thereafter (Charifzadeh and Taschner 2017). Notwithstanding its name, target costing focuses less on cost than on customers’ requirements. Cost is viewed as a result only, whereas customer requirements are viewed as binding competitive constraints, which companies need to take into account (Lockamy and Smith 2000). Target costing’s main line of reasoning can be summarized in a simple statement: “It’s not cost that determines price—it’s the customer who determines allowable cost!” The selling price of a product must match customers’ willingness to pay for that particular product (Charifzadeh and Taschner 2017). Target costing simply reverses the logic of traditional cost accounting, which starts out with determining and allocating cost items to products and charging prices to customers that match cost—irrespective of product benefits provided (see Fig. 5.3). Target Costing Process In order to realize the postulated customer orientation, target costing typically follows a clear sequential process (Charifzadeh and Taschner 2017): 1. Determine the target price for the market offer in question. In most cases, this step involves at least some market research and an exploration of customers’ willingness to pay. It is therefore also termed the “market-into-company” approach to target costing. Alternatives would be to take competitors’ prices as reference (“out of competitor”), or own cost incurred in similar products (“out of standard costs”). 2. Set an expected profit margin. Profit expectations might be unique for individual products or might be set for larger parts of a firm’s offering. Target profits will be influenced by historical profit margins, the product’s expected life-cycle cost or the overall long-term profit objectives of the firm (Cooper and Slagmulder 1999). In any case, this step is not target costing-specific, since profit expectations must be clarified in any case. 3. Determine target cost. This step is simply determined as the product’s target price minus the expected profit margin. 4. Determine estimated current cost for the market offer. This current cost estimate is called “drifting cost” and denotes the company’s cost estimate for the product using the information from the available cost accounting system. This estimate is based on the company’s current cost structure and productivity level.

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Traditional costing accounting …

Product characteristics Production process Input prices

Production cost

Expected selling price

Purchasing power

Willingness to pay

Expected margin

Alternatives

Total utility

Part utility

…

Part utility

Target costing

Fig. 5.3 Target costing logic (source: Charifzadeh and Taschner 2017, p. 76)

5. Determine the cost gap. The cost gap is defined as the difference between target costs and drifting costs. It indicates how challenging it will be for the firm to realize the target cost level. 6. Split target costs between product components. Target costing is based on the idea that cost of individual product components should match these components’ benefit contribution. If a certain component contributes more to the product’s overall customer benefit, it is also allowed to cause higher costs. This is often expressed by the concept of “value engineering (VE)”: Products provide benefits or value to the customer only, if they fulfill expected functions. The contribution of a particular product component to fulfillment of these functions determines its value. When designing and engineering a component, therefore, care must be taken that the costs incurred do not exceed the component’s contribution to the overall product value. Both target costs and drifting costs, therefore, need to be split by product component. This is usually done with the help of a so-called “target cost matrix” that combines benefit contributions of product functions or product characteristics (as perceived by customers) with a company-internal assessment of product components’ contributions to these functions. Using this “function-component bridge”, target costing teams can estimate the target cost as well as the drifting cost of individual product components. This step is crucial for target costing applications in a supply chain environment, as we will outline later in this section. 7. Determine the cost-functionality optimum. A combined cost-functionality optimum is found, when each product characteristic accounts for a cost share that roughly matches its relative contribution to overall product attractiveness (utility) for customers.

5.3

Chained Target Costing

103

Target Costing Across Multiple Supply Chain Layers The overall rationale of target costing can be applied not only within a single firm but also across multiple firms in a supply chain. In such a setting, the market offering is the result of a coordinated effort of several companies. The end-customer will determine his willingness to pay based on that offer’s expected benefits. These are realized through a combination of product characteristics and product components, which have been contributed by different supply chain partners. For the supply chain’s offer to be competitive, it is important to know the benefit contributions of each partner as perceived by the final customer. Target costing, therefore, has a clear application field in supply chains. It can help the supply chain avoid unnecessary costs for features, components, and functionalities that are not valued by the end-customer. Using the supply chain logic, the supply chain partners will incur whatever cost is necessary to satisfy customers’ expectations—but not more. Cost rationalization, not minimization, is the goal in supply chain target costing (Lockamy and Smith 2000). Target costing is applied across multiple supply chain levels by “chaining” the target costing systems of supply chain partners (Cooper and Slagmulder 1999; Slagmulder 2002). The target cost of a specific component of the manufacturer constitutes the target price for the partner supplying that component—who repeats the target costing exercise for this component, breaks it further up and passes target cost information on to its own suppliers (see Fig. 5.4). This effect can basically continue all the way through the chain up to the raw materials suppliers (Goldbach 2002). Chained Target Costing Scenarios The focus on setting component target costs based on their respective benefit (or value) contribution is in fact not the only perceivable application area of target costing in supply chains. Smith and Lockamy have developed four different application scenarios for supply chain target costing, based on two key supply chain characteristics (Smith and Lockamy 2000): 1. Stability of customer requirements (dynamic or static): speed and frequency of changes in customer expectations. 2. Agility of supply chain (high or low): speed and frequency of changes in supply chain composition (member firms) and task allocation between supply chain partners. Combining these two characteristics, a four-field matrix can be set up with four different application areas for target costing (see Fig. 5.5). In a quadrant I scenario, target costing is a key tool for continuous effective supply chain configuration: Which potential partners can contribute effectively to changing customer demands? Which competencies are required, and can partners contribute these competencies at an acceptable cost to the supply chain? How should tasks be allocated across partners in order to ensure an optimal cost-benefit outcome to the supply chain and eventually to end-customers?

20%

Total benefit

...

...

35%

0%

Function Z

Cost gap

100%

18% (=25,40€)

TOTAL

Actual cost

Target price (=25,40€)

Expected margin

Target cost

Tier “n+1” SC Partner

Tier “n” SC partner

…

5

Fig. 5.4 Chained target costing (source: authors)

60%

Component n

10%

…

...

40%

...

Target cost

Function B

0%

15%

Function A

Component 2

Component 1

Target price

Expected margin

104 Cost Management in Supply Chains

5.3

Chained Target Costing

105

Low

Supply Chain Agility

High

Customer Requirements Dynamic

Static

I Value-Based Target Costs

II Price-Based Target Costs

Assembling a supply chain capable of creating superior customer value

Assembling a price-competitive supply chain

III Value-Based Target Costs

IV Activity-Based Target Costs

Performing value engineering analysis of supply chain activities

Establishing the cost of low-value, low quality, inefficient supply chain activities

Fig. 5.5 Supply chain target costing scenarios (source: Smith and Lockamy 2000, p. 72, adapted)

In quadrant II, customer expectations do not change often and the supply chain can work towards the most cost-effective configuration. Target costing now becomes a central tool for setting acceptable prices between supply chain partners and negotiating profit margins for all supply chain partners. Reconfiguration is possible, but not the primary goal in quadrant II target costing. Target costing in quadrant III scenarios is faced with rigid supply chain configuration, i.e. members cannot be switched—or only at a prohibitively high cost. If target costing identifies cost gaps, supply chain partners must engage in joint value engineering projects to look for possible ways of cost reduction. This is all the more important since customer requirements are not stable and previously developed solutions tend to become inefficient over time. Target costing is a key tool to safeguard sustainable competitiveness of the supply chain in a dynamic market environment. Last, but not least, quadrant IV situations are characterized by stable configurations and stable customer requirements. In such a scenario, target costing must be focused on identifying the least-cost (lean) implementation opportunities for key supply chain tasks and activities. Competitiveness is mostly ensured through achieving utmost efficiency in necessary, but low-value, activities. Example Imagine a car manufacturer who plans to introduce a new model with innovative functional features and characteristics that will differentiate it from competition. Preliminary concept testing with potential customers has provided valuable data on customers’ value

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assessment of these features. The manufacturer can use the target costing method for several purposes: In the design and engineering phase, target costing can help determine the final product specifications. Based on these, the manufacturer will be better able to assess whether current suppliers can be contracted for the new model or whether new partners with a different competency set need to be found. After supplier selection, target costing will constitute a key input for subsequent negotiations with suppliers in order to define the optimal cost/benefit combination for the components and sub-systems provided by key suppliers. Chained target costing initiatives follow a top-down logic. Target costs are determined by the more down-stream supply chain partner (e.g. the manufacturer) and then communicated to the upstream partner (supplier). Irrespective of the specific application area (“quadrant”), both partners need to agree on three central issues when engaging in a joint target costing exercise (Cooper and Slagmulder 1999): 1. Should the target cost for the supplier be treated as a basis for subsequent negotiation only or is the target cost imposed on the supplier and contractually fixed? If negotiations are allowed, the supplier might ask for modifications in the component’s quality or functionality specifications, for instance, in order to reach the expected target cost level. 2. Does the supplier have full autonomy in implementing appropriate cost reduction measures or is the manufacturer engaging as well in the supplier’s cost reduction initiatives? In the first case, the manufacturer will not monitor the supplier’s actions, but simply tracks the cost savings realized. If the supplier is allowed a low degree of autonomy only, the manufacturer will actively influence the supplier’s activities (e.g. by sending his own cost reduction project team to the supplier’s premises). 3. In case one supplier is responsible for multiple components, the manufacturer might agree on a bundled cost target (holding the supplier responsible for the total cost of the bundle, not the individual target costs for each component). The alternative would be separate cost targets for each component, which are tracked and monitored separately.

5.4

Kaizen Costing

While target costing supports the cost reduction process in the design and development phase of a product or market offering, Kaizen costing supports cost reduction in the manufacturing phase of already existing products. The Japanese term “Kaizen” refers to continuous accumulations of small betterment activities (Monden and Hamada 1991). Kaizen costing, therefore, is about small, incremental rather than radical, innovative improvements—driven by the overall philosophy that processes in production, engineering, and management can and should be improved continuously. The second element of Kaizen in addition to continuous improvement is the participation of all employees who are

5.4

Kaizen Costing

107

the source of such improvement ideas (Charifzadeh and Taschner 2017): Performance levels can be continuously improved only if employees are motivated to look for incremental improvements in their own work area. In Kaizen costing, management will set the cost reduction targets for the product (Modarress et al. 2005). But these cost reduction targets must be linked to an incentive system that spurs creativity and invokes a sense of continuous change for the better among all staff involved. Kaizen activities typically are of an incremental nature and hence must often be implemented at lower, departmental levels. This distinguishes Kaizen activities from more radical, fundamental, cost reduction initiatives in a product’s design and engineering phase. During design and engineering, the biggest portion of a future product’s cost structure is already fixed (“locked-in”). Materials and components to be used are specified, target quality tolerance levels are set, manufacturing technologies to be used are determined, etc. Although certain cost items might appear during manufacturing only, they have effectively been fixed during the design phase already. It is only natural, then, that more radical cost reduction initiatives focus on these early phases in the product life cycle, while the manufacturing phase is characterized by smaller Kaizen cost reduction initiatives. Kaizen costing takes actual cost of the latest period as the benchmark (the so-called “Kaizen cost budget”), which has to be improved further in the successive periods in order to meet target profits (Monden and Hamada 1991). Kaizen cost targets account for future productivity increases, learning effects, and economies of scale, for instance, to determine the cost level for the next period. This logic can be applied to purchased material or manufacturing processes as well as to support activities. There is a clear link between target costing and Kaizen costing since cost reduction targets for individual Kaizen activities (in particular at the departmental level) are typically the result of a target costing analysis. Both approaches try to ensure that a product meets or exceeds customer requirements for quality, functionality, and prices to sustain product competitiveness (Modarress et al. 2005). With value creation processes becoming more and more intertwined across companies, Kaizen costing today is no longer restricted to the perimeters of a single firm. Similar to target costing, the Kaizen costing principle can also be extended to the entire supply chain. At the supply chain level, Kaizen costing can be implemented in three different variants (Cooper and Slagmulder 1999, see also Fig. 5.6). Item-Specific Kaizen Costing This variant focuses on reducing the direct costs of a specific component or a specific product. It might well be that a previously profitable product shows deteriorating returns. Such a situation will typically occur, whenever changing customer expectations, technological progress, or new competitor offers increase price pressure and lead to lower margins of existing products. The firm—together with its suppliers—must then work towards re-establishing profitability through adequate cost reduction measures. This might happen through moderate changes in product functionality or an easing of product specifications that allow the use of cheaper components or simpler manufacturing techniques, for

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Cost Management in Supply Chains

Itemspecific

Reduce costs of a specific product or component

Change functionality and specifications, use economies of scale

Periodspecific

Reduce direct costs of product portfolio

Increase efficiency, reduce labor and material consumption

Reduce costs of support processes

Reduce complexity, simplify processes, standardize interfaces

Overheadspecific

Fig. 5.6 Kaizen costing variants (source: authors)

instance. In other cases, an increase in manufacturing output might help reaping economies of scale. Depending on whether the focus is on the manufacturer’s product itself or on a specific component supplied by its partner, the focus of Kaizen cost initiatives will be with one of the two firms. Period-Specific Kaizen Costing In this type of Kaizen costing, cost reduction focus is not on a single product or component, but rather on the profitability of the company’s entire product portfolio. The object of cost reduction measures is now direct labor and direct material consumption of the firm as such. Cost reduction can be achieved by general efficiency improvements, i.e. by finding ways to reduce waste or idle times in manufacturing, for instance. Although the focus is on the manufacturing firm, there is ample room for contributions from the suppliers. Lean production methods or the introduction of just-in-time delivery processes between supplier and manufacturer can help achieve such cost reductions, for instance. Overhead-Specific Kaizen Costing In this third variant of Kaizen costing, the focus turns to support processes that generate indirect (i.e. overhead) costs. In modern manufacturing environments, these costs account for a considerable part of total product costs. As a result, overhead cost improvements can have a significant effect on the overall profitability of the single firm and the entire supply chain. In a cooperative supply chain environment, supply chain partners will try to reduce overhead cost of support processes by standardizing IT systems and interfaces, for instance. They can also jointly work towards simplified processes (e.g. for planning and order handling). In general, reduced complexity will eventually translate into reduced cost. If, for instance, the manufacturer and the supplier can agree on reducing the number of different parts and components used in the manufacturer’s various products, both firms will eventually save resources in their purchasing and order handling processes.

5.5

Life Cycle Costing in Supply Chains

109

While Kaizen costing as such is always a concerted effort, the initiative can come from either the supplier or the buyer / manufacturer (Cooper and Slagmulder 1999). Buyers will typically take the leading role whenever they have a need to involve their supplier in cost cutting efforts or see the opportunity for educating their suppliers in order to improve the overall profitability of the joint market offering. Suppliers, in turn, might initiate coordinated Kaizen actions, when they need their customer’s approval for realizing cost savings—e.g. when product re-design would be necessary or specifications need to be changed.

5.5

Life Cycle Costing in Supply Chains

The basic tenet of life cycle costing is that products cause costs as well as income in all phases of their life cycle (Charifzadeh and Taschner 2017). The life cycle cost of an object is the sum of all resources consumed by that object, from its initial development and production through its operation until the end of its useful life. Therefore, a complete picture of a product’s financial performance and profitability cannot be given by looking at its market phase only (see Table 5.1). Life cycle costing (LCC) has to be distinguished from life cycle assessment (LCA). LCC compares the cost-effectiveness of alternative business decisions or objects from the perspective of an economic decision maker (e.g. a producer or a consumer of a specific product). LCA, in contrast, evaluates the relative environmental performance of a product or system. This environmental performance is assessed as holistically as possible, aiming at considering all important processes and all important resource and consumption flows (Norris 2001). These will also affect the cost and revenue structure, but profit effects are not the focal point of interest in LCA. Both concepts, however, can be subsumed under the umbrella notion of “life cycle management (LCM)”. In fact, life cycle management (LCM) has conceptual overlaps with supply chain management (SCM) and both concepts are inter-related, although not synonymous (Rebitzer 2002; Seuring 2004). Life cycle management focuses on the design and manufacture of a sustainable product that keeps environmental factors in mind. Supply chain management, in turn, shifts the focus to the operational activities needed along the supply chain to satisfy customer expectations. These might—and will—comprise environmental aspects, but are not limited to these (see Table 5.2). Life cycle costing is a somewhat narrower approach. The LCC line of thinking is used to assess overall financial attractiveness of a market offering over its entire life cycle: Whether a new car is financially attractive to a customer, for instance, depends on its total cost for that customer—comprising not only initial purchase cost but also costs that are incurred in later stages of the car’s life cycle (e.g. fuel and insurance cost, maintenance and repair, etc.). A rational customer, therefore, will apply a holistic assessment when deciding in favor or against a certain market offer.

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Table 5.1 Cost and revenue elements across the product life cycle Development phase (pre-market phase)

Market phase

Service phase (aftermarket phase)

Costs – R&D cost – Market research cost – Preparation cost (e.g. for manufacturing equipment) – Cost for product tests – Manufacturing cost – Cost for market introduction – Product-specific sales and administrative cost – Maintenance and repair cost (e.g. in service contracts) – Cost for stocking repair items – Recycling and phase-out cost – Warranty cost

Revenues – Subsidies (e.g. for R&D activities that are in the public interest) – Tax refunds for R&D activities

– Sales revenues

– Revenues from service contracts – Revenues from repair orders – Recycling refunds – Licensing revenues

Source: Charifzadeh and Taschner (2017), p. 85 Table 5.2 Comparison of LCM and SCM Distinctive Feature Actor Network System Boundaries Time Frame

Life cycle management Product design as most important decision phase All production stages involved in designing and producing the product All material flows that are related to a product’s life cycle Entire product life cycle (months to years)

Supply chain management Managerial activities within the actor network All production stages involved in fulfilling customer demand Material, monetary, and information flows required to satisfy customer needs Supply chain development and delivery cycle

Source: Seuring (2004), p. 314, adapted

Example In many countries, electric vehicles still hold merely a small market share and most consumers drive cars with conventional combustion engines. The purchase of an electric car readily lends itself to life cycle costing, because cost patterns differ significantly between electric vehicles and vehicles powered by liquid fuels. Kara et al. (2017) use a Nissan Leaf electric vehicle purchased and operated in Australia as an example for a consumer-perspective LCC. For the end consumer, the main cost components are: – Acquisition phase: suggested retail prices of the car + price for charger and charger home installation (incl. warranty) + cost for tax, registration, and compulsory insurance – Operation phase: cost or recharging (electricity) + planned and unplanned maintenance + insurance + battery replacement + tire replacement – Disposal phase: scrap value of vehicle + battery recycling cost

5.5

Life Cycle Costing in Supply Chains

111

Many of these cost items differ significantly between an electric vehicle and a fuel-based vehicle. Purchase prices are still higher for electric cars, but subsidies are available in many countries (e.g. tax exemptions or outright cash payments at the time of purchase). Fuel cost is a major differentiator between electric and liquid fuel cars. A major distinguishing factor is the expected replacement of the battery in an electric car, which has a shorter life span than the car itself. Recycling costs can also differ significantly, depending on the legal framework the car is operated in. In any case, consumers are well-advised to take a holistic view and to not base the purchase decision on the car’s retail selling price only. At the same time, this opens the way for manufacturers of electric vehicles to improve the attractiveness of their offering with the support of other supply chain partners, such as battery manufacturers, service garages, but also partners offering easy and free-of-charge re-charging locations to customers. The link to supply chain management becomes clear when taking into account that the activities and tasks that cause costs and revenues in the different life cycle stages often do not rest with a single firm only. While one firm might be responsible for manufacturing the car and selling it to the customer, another firm takes care of maintenance and after-sales service, for instance. Overall financial attractiveness of that car, therefore, depends on the contributions of many different supply chain partners. This is true both for the cost/benefit consideration of the end-customer as well as for the product’s attractiveness to individual supply chain partners. A life cycle perspective on cost can help supply chain partners identify new opportunities for joint product optimization and consequently improved competitiveness of the joint market offering (see Fig. 5.7). Through a change in the product layout, the manufacturer can make replacement and maintenance easier for its service partner. The service partner will benefit from lower operating costs in each maintenance or service incidence. If the cost-benefit is (partly) passed on to the final customer (through lower maintenance and repair bills), the product’s total life cycle cost for the end-customer will improve as well and might lead to higher market demand—which will have positive effects for all supply chain partners. An improved component design developed by the supplier can reduce the energy consumption of the product and consequently lower the total life cycle cost for the end-customer. Customers, in turn, will react with higher demand for the product, which has positive effects for the manufacturer as well as for the supplier. These two examples again show that it is very difficult to quantify the cost-benefit effects of supply chain activities across all partners. The life cycle cost perspective helps identify indirect effects which other supply chain partners might profit (or suffer) from. This information can subsequently be used for negotiating a fair distribution of the supply chain rent generated.

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5

Supplier

Service Company

End Customer

Changed product layout makes replacement and maintenance easier

Maintainability Energy consumption

Manufacturer

Cost Management in Supply Chains

Lower cost per maintenance incidence Potentially lower cost per maintenance

New component design reduces energy consumption

Product's total life cycle cost improves for customer Demand for product increases

Demand for component increases

Fig. 5.7 Life cycle cost effects in supply chains (source: authors)

5.6

Activity Based Costing in an Inter-organizational Setting

Traditional cost accounting approaches typically use direct cost as an allocation basis for indirect (overhead) costs (Charifzadeh and Taschner 2017). This approach works best when a large part of costs is direct. But this is no longer true for most modern companies that are diversified and more complex. Under such conditions, overhead cost allocation based on direct cost introduces considerable bias, leads to very high overhead allocation rates and blurs the true origins of overhead costs. Management accounting has long recognized these deficiencies and has developed alternative models of overhead cost allocation and overhead cost management, with activity-based costing (ABC) being one of the most popular ones. ABC acknowledges the fact that ultimately it is activities and tasks, rather than volume of output directly, that consume valuable resources and thus lead to costs. Thereby, it follows a strict cause-and-effect logic. It’s the activities that cause the costs, not the number of units sold. Consequently, ABC allocates costs to cost objects (such as products and services) on the basis of the activities undertaken to produce each product or service (Charifzadeh and Taschner 2017). ABC groups all activities in a four-level scheme: – Unit-level activities are performed for every single unit of output—e.g. packaging and labeling a finished product or performing a final quality inspection before packaging it. The number of units will typically serve as the central cost driver for these activities (i.e. the more units handled or produced, the higher total cost for this activity). – Batch-level activities are performed for individual product batches or production runs. Setting up a machine prior to or cleaning it after completion of the production run would

5.6

Activity Based Costing in an Inter-organizational Setting

113

be typical batch-level activities. The actual number of units is unimportant since the activity needs to be performed for small batches as well as for large batches and the resource consumption (e.g. the time it takes to clean the machine) does not differ between batches of different size. Consequently, cost drivers have to be found among the activities that deal with entire batches rather than units. – Product-level activities take an even higher conceptual perspective. These are activities that are performed once for individual product lines or product variants. Design and engineering activities need to be performed irrespective of the eventual number of product units produced. R&D for a mass product, therefore, will lead to lower unit cost than R&D for a highly customized product that is manufactured in very small quantities only. – Facility-level activities, finally, comprise all those activities that are not performed for individual products but focus on the business organization in its entirety. General management tasks, as well as accounting or housekeeping, fall in this category. The cost of these activities must be recovered by the entire product portfolio. These activities typically comprise what is often called “general administration overhead”. Facility-level activities will take a larger portion of total cost in highly centralized organizations. Lean, de-centralized, organizations, in turn, try to keep this cost item as low as possible. A company can use ABC for two interrelated, but distinct, purposes: 1. Product costing With ABC, the company can determine cost for a particular product by determining the respective cost driver amounts consumed by that particular product in the accounting period (number of units produced, number of production batches run, number of new product types introduced, etc.) and by using the overhead allocation rates of each cost pool (or sub-pool) to determine the total amount of overhead costs to be allocated to the particular product (Charifzadeh and Taschner 2017). 2. Cost analysis ABC can be used for an activity and process analysis that is independent of specific products or customer orders. Using ABC, the firm can assess the true costs of certain activities. By linking these activities to the firm’s value drivers (e.g. component quality, product availability, etc.), it can assess whether these costs are justified in financial terms, i.e. whether the activity ultimately creates value to the company (Pohlen and Coleman 2005). ABC in Supply Chains The ABC logic can easily be applied at the supply chain level. In a supply chain setting, product costs are determined both by activities within a single firm as well as by crossorganizational activities—the latter typically leading to transaction costs (Goldbach 2002). In order to adequately identify, measure, and manage these activity costs, supply chain partners need to collaborate: activities must be identified and properly delineated across

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supply chain partners, activity data (amount of resources consumed, number of occurrences per task and activity, etc.) must be collected and exchanged in order to determine total cost for different cross-organizational activities. In fact, also many “intra-firm” activities have a clear supply chain relation, although they are not directly performed across firm boundaries: activities such as demand forecasting, inventory management, material handling, packaging, or warehousing, are clearly affected by supply chain partners’ decisions and actions and conversely, have effects on partners’ business and financial performance. Example Examples of cross-organizational effects of intra-firm activities are easy to find: – If a supplier, for instance, agrees to change its packaging, its own packaging costs might increase, while the manufacturer might profit from easier unwrapping and consequently saves costs. Instead of looking at single tasks at the firm level only, partners interpret wrapping and unwrapping as two tasks of the same process: The cross-organizational process can be streamlined, if partners’ activity costs are consolidated and used as an object for joint optimization. – If the retailer engages in a more detailed and more frequent demand forecasting process, this can help the manufacturer plan production runs and inventory levels accordingly. As a result, stock-outs can be avoided and product availability is improved. This has financial benefits for both the retailer and the manufacturer—while costs for the changed demand forecasting process remain with the retailer only. – A vendor-managed inventory (VMI) agreement basically stipulates that inventory is managed by the supplier while inventory objects physically remain at the manufacturer’s premises. Inventory-related activities are partly performed by the manufacturer’s staff (e.g. picking), partly by the supplier’s staff (e.g. inventory planning and forecasting). Both activity costs, as well as financial benefits of an improved inventory management process, are noted by both partners.

Traditional cost accounting techniques are not able to adequately capture costs and financial benefits of such cross-organizational activity chains and networks. ABC and process-based costing, in turn, provide a suitable conceptual basis for cost management across supply chain partners’ organizational boundaries. The extent and depth of this crossorganizational approach can again differ (Hofmann and Bosshard 2017): 1. ABC can remain a mostly internal tool without the intention of cross-company adoption and cooperation. Nevertheless, occasional references to single supply chain functions, such as manufacturing or logistics, are made in individual analyses. 2. ABC can be employed with a “dyadic” view (i.e. looking at the own company and the immediate partner only), where implications of own activities to supply chain partners

5.6

Activity Based Costing in an Inter-organizational Setting

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are systematically recognized, but no coordination is intended—thus basically keeping the focus on own cost optimization (and consequently missing out on potential network benefits). 3. Finally, ABC can be merged with a genuine SCM attitude where supply chain coordination is intended and supply chain profitability gains are envisaged. Activity-Based Cost Management in Supply Chains Linking it with SCM, ABC can again be used for both purposes outlined above, (1) determining cost of a product or market offer that involves contributions from multiple supply chain partners (product costing), or (2) analyzing the cost/benefit ratio of certain activities and the objects “consuming” them (e.g. determining profitability of a particular sales channel or distribution agent). For this purpose, the focus will be on larger processes rather than on single activities. Processes can be defined as chains of activities—which might often span multiple organizations. In a supply chain analysis, the initiative will typically start at the higher process level (e.g. “handling customer returns via our distribution partner”), which is then broken down into several well-defined activities that allow for a better analysis of the cost of the cross-organization process (Lin et al. 2001). Example An ABC perspective can help identify transaction cost that has remained blurred in traditional product costing systems. Imagine a simple dyadic setting of a supplier serving a manufacturing customer. Based on a longer lasting frame contract, the manufacturer initiates frequent call offs for various parts and components which are then picked, packed, shipped and invoiced by the supplier. The manufacturer, in turn, follows a standard goods receipt process, comprising tasks such as unloading, unwrapping, sample quality inspection, putting into storage, etc. These tasks are typically treated as overhead cost both by the supplier and by the manufacturer. They are not allocated to individual orders or products. Neither the supplier nor the manufacturing customer can reliably determine the true cost of one purchase and delivery transaction. Nor can the trading partners identify the most important cost drivers: picking and packing might be mostly influenced by quantity of items to be shipped, activity cost of invoicing is rather driven by the number of shipments, quality inspection might depend on the number of different products or parts per shipments, etc. If the supply chain partners truly want to find a cost-optimal ordering and shipping scheme (How many different items per order in which quantity and in which cycles?), they need to revert to an activity based cost analysis. Activity-based costing can significantly improve cost management across the supply chain but is not easy to implement. Some key findings and recommendations can be summarized as follows (Hofmann and Bosshard 2017):

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– ABC improves cost transparency along the supply chain which, in turn, improves efficiency and effectiveness. But a successful implementation requires a solid data basis, organizational readiness, and commitment from senior management. – To profit from competitive advantages at an inter-organizational level with ABC, supply chain partners should share cost information via open book accounting or similar practices. Principal-agent problems and other implementation hazards must be mitigated through appropriate institutional arrangements and economic incentive systems. – In order to retain supply chain partners’ willingness to engage in cross-organizational ABC, costs and benefits should be distributed among the involved supply chain members appropriately, i.e. according to the costs’ and benefits’ origin and cause.

5.7

Glossary and Key Terms

Activity based costing

Batch-level activities Chained target costing

Cost management Facility-level activities Inter-organizational cost management Item-specific Kaizen costing Kaizen costing

Life cycle assessment Life cycle costing

Overhead-specific Kaizen costing

A cost management technique that views the tasks and activities rather than output as the sources of resource consumption and ultimately cost. Activities that are performed for individual product batches or production runs. The collaborative linking of partners’ target costing systems, with target cost of a specific component of the manufacturer constituting the target price for the partner supplying that component. The combination of all activities and tools used to influence cost in order to achieve company goals. Activities that are performed for the business organization in its entirety. The structured approach to coordinating the activities of firms in a supply chain so that total costs in the network are reduced. A Kaizen costing variant that focuses on continuously reducing the direct cost of a specific product or component through concerted efforts of both supplier and manufacturer. A cost management technique in the manufacturing phase of a product, introducing continuous, incremental, cost improvements through future productivity increases, learning effects, and economies of scale, for instance. An analysis technique that evaluates the relative environmental performance of a product or system over its entire life cycle. A cost management approach focusing on optimizing a product’s total cost over its entire life cycle from its initial development and production through its operation until the end of its useful life. A Kaizen costing variant focusing on reducing overhead cost of support processes through concerted efforts of both supplier and manufacturer. (continued)

5.8

Review Questions and Exercises

Period-specific Kaizen costing Product-level activities Target costing

Unit-level activities

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A Kaizen costing variant focusing on general efficiency improvements through concerted efforts of both supplier and manufacturer. Activities that are performed once for every product or product variant. A cost management approach that tries to match the costs of products and components with the benefits these provide to the final customer. Taking a market-based view, a maximum allowable cost is defined by determining a market price and deducting the desired profit margin. Activities that are performed for every single unit of output.

Review Questions and Exercises

Review question 5.1: Explain the conceptual differences between cost accounting and cost management. How do both disciplines relate to each other? Review question 5.2: What are the distinctive features of cost management when compared to cost account ing? Name and describe the three key focus areas of cost management. Review question 5.3: How can cost management be employed in a supply chain environment? Name and briefly explain typical inter-organizational cost management (IOCM) application scenarios in supply chains! Review question 5.4: Name and describe the most important prerequisites for successful IOCM implementa tion. Which factors make IOCM success more likely? Review question 5.5: Explain how target costing differs from traditional cost-plus product costing. Review question 5.6: Explain the generic target costing process. Review question 5.7: Discuss the applicability of target costing in supply chains and describe possible application scenarios. Review question 5.8: Explain the overall logic of Kaizen costing and outline possible usage scenarios of Kaizen costing in a supply chain environment. Review question 5.9: Explain the conceptual differences between life cycle costing, life cycle assessment, and supply chain management.

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Review question 5.10: Describe how SCM can help improve life cycle cost for a product. Review question 5.11: What are the typical activity levels that are relevant for activity-based costing? Review question 5.12: Explain the conditions for employing ABC in a supply chain network.

Exercise 5.1: IOCM in market entry Easyrider Inc. is a Germany-based manufacturer of motorbikes. Easyrider’s reputation is mostly built on enduro bikes in the high-priced market segment. Easyrider has decided to enter the promising market segment of e-motor bikes. This strategic move needs to be aligned with Easyrider’s most important suppliers. Some of them will certainly be involved again in the design and manufacturing of the new e-bikes, but new partners must be found for the new electric powertrain. Easyrider Inc. is now investigating possibilities to use IOCM techniques in this strategic portfolio expansion until the market introduction of the new e-models. Critically discuss which IOCM tools Easyrider might find useful in this situation and develop short usage scenarios for each. Exercise 5.2: Activity based costing in a project environment “Bohrer & Schaufler AG” is an Austria-based manufacturer of high-precision drilling solutions in the oilfield and exploration industry. Its customer base is global and mostly consists of multinational companies in the oil exploration and extraction industry. Bohrer & Schaufler’s products are often combined with accompanying services and the company is generally treated as a partner by its customers. Engagement is mostly via multi-year project contracts. Failure-safe, reliable products with high availability are essential since down-times are extremely costly in the oil exploration and extraction business. At the same time, the industry is under heavy cost pressure and is constantly looking for ways to increase efficiency. Bohrer & Schaufler, therefore, wants to look into possibilities to apply activity-based and process-based costing methods for the identification of future synergies between itself and its main customers. Discuss the applicability of such approaches in Bohrer & Schaufler’s customer-project environment and briefly outline possible application areas.

References Agndal H, Nilsson U (2009) Interorganizational cost management in the exchange process. Manag Account Res 20(2):85–101

References

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Charifzadeh M, Taschner A (2017) Management accounting and control—tools and concepts in a Central European Context. Wiley, Weinheim Christopher M, Gattorna J (2005) Supply chain cost management and value-based pricing. Ind Market Manag 34(2):115–121 Cooper R, Slagmulder R (1998) Strategic cost management: what is strategic cost management. Manag Account 1998(1):14–16 Cooper R, Slagmulder R (1999) Supply chain development for the lean enterprise: interorganizational cost management. CRC Press, Portland Ellram LM (2002) Strategic cost management in the supply chain: a purchasing and supply management perspective. CAPS Research Goldbach M (2002) Organizational settings in supply chain costing. In Seuring S, Goldbach M (eds) Cost management in supply chains. Springer, Heidelberg, pp 89–108 Hofmann E, Bosshard J (2017) Supply chain management and activity-based costing—current status and directions for the future. Int J Phys Distrib Logist 47(8):712–735 Kajüter P (2002) Proactive cost management in supply chains. In: Seuring S, Goldbach M (eds) Cost management in supply chains. Springer, Heidelberg, pp 31–51 Kara S, Li W, Sadjiva N (2017) Life cycle cost analysis of electrical vehicles in Australia. Proc CIRP 61:767–772 Kulmala HI (2003) Cost management in firm networks. Tampere University of Technology Publication 418, Tampere Kulmala HI, Prenko J, Ruusi-Rauva E (2002) The role of cost management in network relationships. Int J Prod Econ 79:33–43 Lin B, Collins J, Su R (2001) Supply chain costing: an activity-based perspective. Int J Phys Distrib Logist 31(10):702–713 Lockamy A, Smith WI (2000) Target costing for supply chain management: criteria and selection. Ind Manag Data Syst 100(5):210–218 Modarress B, Ansari A, Lockwood DL (2005) Kaizen costing for lean manufacturing: a case study. Int J Prod Res 43(9):1751–1760 Monden Y, Hamada K (1991) Target costing and Kaizen costing in Japanese automobile companies. J Manag Account Res 3:16–34 Norris G (2001) Integrating life cycle cost analysis and LCA. Int J Life Cycle Cost Anal 6 (2):118–120 Pohlen T, Coleman J (2005) Evaluating internal operations and supply chain performance using EVA and ABC. SAM Adv Manag J 70:45–58 Rebitzer G (2002) Integrating life cycle costing and life cycle assessment for managing costs and environmental impacts in supply chains. In Seuring S, Goldbach M (eds) Cost management in supply chains. Springer, Heidelberg, pp 127–146 Seuring S (2004) Industrial ecology, life cycles, supply chains: differences and interrelations. Bus Strat Environ 13(4):306–319 Slagmulder R (2002) Managing costs across the supply chain. In: Seuring S, Goldbach M (eds) Cost management in supply chains. Springer, Heidelberg, pp 75–88 Smith WI, Lockamy A (2000) Target costing for supply chain management: an economic framework. J Corp Account Finance 12:67–77

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Supply Chain Finance

SC Working Capital Management

Collaborative C2C Cycle Management

Need for Supply Chain Finance

SC Finance Instruments Collaborative SCF Instruments - Overview

Learning Objectives After completing this chapter, you should be able to: 1. Understand the link between physical flows and financial flows in a supply chain 2. Explain how the supply chain finance focus on cost of capital and transaction cost contributes to supply chain success 3. Discuss the concept of net working capital in general and explain its constituent elements 4. Explain the relevance of net working capital for financial management 5. Relate the individual net working capital elements to operational management 6. Understand the conceptual elements of the cash-to-cash cycle and explain their relevance for supply chain management 7. Explain how collaborative efforts can improve the overall cash-to-cash cycle of a supply chain 8. Name and describe the major differences between collaborative supply chain finance instruments and traditional trade finance instruments (continued) # Springer Fachmedien Wiesbaden GmbH, part of Springer Nature 2020 A. Taschner, M. Charifzadeh, Management Accounting in Supply Chains, https://doi.org/10.1007/978-3-658-28597-5_6

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9. Explain reverse factoring and dynamic discounting as typical supply chain finance instruments and exemplify their benefit for supply chain partners 10. Understand the basic principle of netting and pooling between supply chain partners 11. Describe the concept of vendor leasing and name typical application areas in a supply chain We have emphasized in Chap. 1 that supply chain management no longer focuses on physical flows only, but extends its view to information flows and financial flows as well. When firms engage in trade (exchange of goods), they inevitably also establish a flow of related information and financial transactions. The “financial supply chain”, therefore, can be viewed as the sequence of financial events and processes that take place in parallel to the commercial transactions between supply chain partners (Lamoureux and Evans 2011). These comprise finance-related information (e.g. terms of payment, bank account data) as well as actual financial flows (transfers of cash, liabilities, and other financial assets). In any case, the financial supply chain is not detached from physical flows—rather the contrary: A financial intervention or action (a payment, a capital transfer, etc.) in the financial supply chain is driven by an event or an action in the physical supply chain (Euro Banking Association 2014). Supply chain management (SCM) has been defined as comprising all three types of flow concepts. Strictly speaking, therefore, there is no need for a separate concept such as “financial SCM” or “supply chain finance”, since SCM by definition integrates financial considerations as well. Both business practice and academia, however, tend to treat management of financial considerations in a supply chain as a distinct subtask of SCM. While management of physical flows requires logistics and engineering expertise, management of financial flows is often entrusted to staff with an accounting and finance background. The difference between the terms “financial supply chain management” and “supply chain finance (SCF)” is not clear-cut (see Liebl et al. 2016 or Gelsomino et al. 2016 for an overview of different definitions). We consider such differences as minor and will use both terms interchangeably in this book. Following the Euro Banking Association, we define SCF as . . .the use of financial instruments, practices, and technologies to optimize the management of the working capital and liquidity tied up in supply chain processes for collaborating business partners. (Euro Banking Association 2014, p. 44).

Similar to SCM, SCF clearly is inspired by the idea that cooperation among partners can generate financial benefits that would not be possible in a single firm and that are reflected in lower debt costs, new opportunities for obtaining capital, or reduced working capital within the supply chain (Gelsomino et al. 2016).

6.1

The Need for Supply Chain Finance

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SCF can be viewed from a conceptual perspective (optimizing working capital and cost of capital as a contribution to overall supply chain success) and from an instrumental perspective (which finance-related instruments are available). This chapter will deal with both perspectives. We start out by discussing the concepts of SCF, collaborative working capital management and collaborative cash-to-cash cycle management, respectively. Second, we provide an overview of typical financial instruments that are used to optimize financial flows across supply chains, finally describing some important instruments in more detail.

6.1

The Need for Supply Chain Finance

It is obvious that proper financial management is of utmost importance for firms. No company would survive—let alone achieve its financial goals—without management of its liquidity position, effective deployment of required capital, or monitoring financial risks that occur when doing business. This logic also applies when we move from the single firm to the entire supply chain as the object of management attention. There as well, typical aspects of financial management, such as cash flows, payment terms, and working capital, play an important role in business success (Hofmann and Kotzab 2010). Note that we refer “success” here not only to individual firms but also to the supply chain network in its entirety. Financial flows are not simply a side effect of physical flows between partners, but a genuine management object themselves. The notion in supply chain finance, therefore, is the same as in supply chain management in general: Management and optimization attempts no longer focus on the single entity only but take the entire network into account (macro perspective): Firms . . .that establish strong collaborative structures may benefit by adopting a supply chain approach to their financial management techniques. A supply chain financial management approach means smartly extending classic firm-oriented practices dealing with cash-to-cash cycles, cash flow, and weighted average cost of capital (WACC) as they manage their supply chain partnerships (Randall and Farris 2009, p. 669).

Similar again to SCM, SCF entails coordination not only between companies (supply chain partners) but also between different functions within a single company (e.g. between the purchasing and the finance department). A lack of internal alignment and coordination will have negative effects on financial performance just as a lack of external coordination has (Wandfluh et al. 2015). The need for financial management across the supply chain has increased in the recent past due to the following economic developments (KPMG 2016):

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– Global competition has put margins even more under pressure – In the aftermath of the global financial crisis, banks are increasingly reluctant to provide financing to smaller companies with lower credit ratings – Large companies, in turn, seek profitable investment opportunities for surplus cash Financial management focuses on liquidity as well as on cost. Liquidity (i.e. the ability to meet payment obligations when they become due) is a necessary condition for any firm. Illiquidity will force a business entity into bankruptcy and eventually out of business altogether. Liquidity, therefore, has to be maintained at all times. Financial managers will strive to reach this goal at minimum cost—thus helping the firm to reach the other overarching financial goal: generating financial surpluses. The “true” object of financial management, therefore, is cost rather than liquidity. Cost, in turn, comes into focus of financial management in two distinct variants: 1. Cost of capital (cost of the scarce resource “capital” that is needed to run the business) 2. Transaction cost (cost incurred while raising capital from third parties and deploying it within the firm) Cost of capital and transaction cost can be viewed as two different types of financing cost. Their impact on the cost of goods sold (COGS) experienced by the end-customer of the supply chain can be significant (Randall and Farris 2009). Supply chain managers, however, typically do not focus on these costs—SCF does! Let’s briefly look at these two cost types and their relevance for supply chain finance. Cost of Capital The levers of supply chain finance for managing cost of capital are basically the same as in any single firm (Pfohl and Gomm 2009): 1. The volume of financing is determined by the amount of capital employed for doing business 2. The duration of financing depends on the mix of different financing sources available 3. The cost of capital rate is mostly influenced by general market rates and perceived risk of individual firms Cost of capital is then determined as: Capital costs ðEURÞ ¼ Volume ðEURÞ  duration ðtimeÞ  capital cost rate ðEUR=timeÞ

ð6:1Þ

Supply chain finance focuses on the minimization of capital cost across the entire supply chain. This can be achieved, for instance, by reducing overall volume of financing (required capital) or by shifting financing requirements to a supply chain partner that exhibits lower cost of capital rates.

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Working Capital Management Across the Supply Chain

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Transaction Cost In Chap. 2 we have defined transaction costs as costs that are incurred for the initiation, execution, and monitoring of a transaction. The transactions in focus here are financing transactions. Identifying possible financing sources, negotiating and actually implementing financing agreements, or monitoring supply chain partners’ compliance with these agreements all cause transaction costs. SCF will strive to reduce transaction cost by making financing transactions between supply chain partners, but also with other business entities outside the actual supply chain network more efficient. A key lever in this respect is increasing automation of SCF through IT-based platforms and networks that directly support the provision of financing solutions (Euro Banking Association 2014). Such IT-based solutions tie all SCF parties together (Association of Corporate Treasurers 2010): – – – –

The buying organization The organization supplying goods / services A technology platform provider A funding institution providing the capital

While the buying and the supplying organization are part of the physical supply chain as well, the platform provider and the funding institution become part of the supply chain only through their involvement in financial flows. The reader should note that increased efficiency in financing transactions can have a positive spill-over effect on the physical domain of the supply chain: SCF can help reduce transaction costs. Reduced transaction costs can be leveraged to increase functional specialization between supply chain partners. This, in turn, can subsequently lead to lower manufacturing costs for partners (Vázquez et al. 2016).

6.2

Working Capital Management Across the Supply Chain

We start this section with a somewhat more comprehensive discussion of the net working capital concept in general before turning to working capital management in supply chains. Readers will certainly be familiar with the overall structure of a company’s balance sheet, which provides a consolidated overview of company assets and the equity or debt required to finance these assets. Companies employ fixed assets and current assets in order to run their business. Our focus here is on current (short-term) assets. Current assets primarily comprise cash, accounts receivable, prepayments, and inventories. These asset types are necessary in regular business operations (Charifzadeh and Taschner 2017): Firms hold cash in order to pay bills and salaries, they have receivables from selling goods and services to customers and they hold inventories in order to be able to deliver on short notice when customers place orders. This is all part of the company’s regular operating cycle and no firm could operate without at least a minimum level of current assets.

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Both fixed and current assets must be financed by employing capital. Different types of capital entail different cost: equity, for instance, bears higher business risk and therefore is typically costlier than debt (meaning that investors that provide equity expect a higher return than parties that provide debt). Consequently, companies try to optimize their capital structure by employing less costly types of capital, such as advance payments from customers or credit extended by suppliers (for deliveries that have not yet been paid). In these cases, the firm effectively uses capital that has been provided either by its customers or suppliers for a limited time period at no direct cost. Short-term capital of this kind is called “current liabilities”. This category comprises accounts payable, accrued liabilities like salaries payable and customer advances. Current liabilities are mostly of a non-financial nature and come at no or very low financing cost (except for short-term loans, which also count towards current liabilities) (Charifzadeh and Taschner 2017). Net working capital (NWC)—or often simply called “working capital”—is calculated by deducting current liabilities from current assets: NWC ¼ Current assets  current liabilities

ð6:2Þ

NWC is positive if current assets exceed current liabilities. It is negative if current liabilities exceed current assets. Would a company try to have a positive or negative NWC? The answer is not entirely straightforward. NWC as a Liquidity Measure First, remember that both current assets and current liabilities are short-term in nature. Current assets are “liquid”, i.e. they either directly constitute cash or can be turned into cash rather quickly (accounts receivable (A/R) are expected to be settled by customers, inventories are expected to be sold). High liquidity ensures the firm’s ability to pay—a key constraint for any business as we have outlined earlier. Current liabilities, in turn, are due for payment in the near future as well: accounts payable (A/P) need to be settled, customer advances must be offset by delivery of goods and services, etc. Settling current liabilities, therefore, consumes current assets. If current assets exceed current liabilities (positive NWC), the firm can be pretty sure that its liquidity level is sufficient to serve its current liabilities. On the other hand, if current liabilities exceed current assets (negative NWC), the firm would have to liquidate (sell off) fixed assets (machines, real estate, etc.) in order to serve its short-term debt. Liquidating fixed assets bites into a company’s productive capacity, though, and it endangers its ability to pursue regular business operations in the future. After all, how should the company continue to serve its customers after it had to sell off valuable fixed assets in order to pay back short-term liabilities? From a liquidity point of view, therefore, a positive NWC is the preferred option. It ensures that short-term payment obligations can be met without endangering the company’s long-term productive capacity.

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NWC as an Efficiency Measure This is only half of the story, though. When current assets exceed current liabilities, the remaining balance (positive NWC) needs to be financed with more expensive types of capital, such as long-term loans, bonds, or equity. These types of capital ask for a higher return than current liabilities because they involve a higher degree of risk and or a longer duration until payback (driving up opportunity cost). In this view, having a large amount of current assets simply means that lots of capital is tied up in cash, inventory and accounts receivable—capital that comes at a fairly high cost since it is long-term in nature. Consequently, the firm can reduce its cost of capital if it manages to operate its business with lower NWC—thus reducing the need for costly financing of short-term assets. In this perspective, NWC is a measure of capital usage efficiency: A positive NWC has to be financed by long-term funds, which usually bear a cost. The above considerations can be summarized in a simple statement: NWC is necessary, but it is also expensive. Working capital management, therefore, has to find a compromise between two conflicting goals: Positive working capital (holdings of A/R and inventory exceed A/P) strengthens liquidity since these current assets are easily convertible into cash. This mitigates risk, but harms overall profitability because of a large capital commitment, leading to higher inventory and financing costs. Negative working capital (holdings of A/P exceed A/R and inventory) leads to lower funding costs and thereby increases profitability, but bears risks and insufficiencies. A possible loss of production and supply shortage because of insufficient inventory might both harm growth and result in a loss of goodwill towards customers. Additionally, tighter liquidity might harm creditworthiness and hinder refinancing (Hofmann and Belin 2011, p. 6).

Having this inherent conflict in mind, managers often try to maintain a small, but positive NWC in order to ensure liquidity without giving up too much on capital efficiency. It should be noted, though, that typical NWC not only depends on company size but to a large extent also on industry characteristics. The key levers for NWC management can be directly derived from looking at its components: 1. Cash Stockpiling cash is a very inefficient form of capital usage. In fact, cash does not earn any return at all. In times of inflation, cash actually loses part of its purchasing power, resulting in a negative return in real terms. Cash, therefore, should only be held to the extent that is considered to be necessary to ensure a firm’s immediate ability to pay. Excess cash should be reinvested, i.e. turned into other types of (fixed) assets that can generate a surplus for the company in the long-term. Everything else being equal, lower levels of cash will result in lower NWC.

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2. Accounts receivable Accounts receivable denote capital that is tied up in invoices that customers have not yet settled. When extending credit to its customers (leading to an increase in accounts receivable), the firm actually uses own capital to finance its customers’ operations. Such payment terms might be common in certain industries or might have been imposed on the firm by customers with high bargaining power. But whenever possible, a firm will try to reduce accounts receivable by collecting cash as soon as possible, thereby decreasing its NWC. 3. Inventory In a manufacturing firm, inventories can come in various types: raw material, semifinished goods, finished goods, merchandise, etc. In any case, inventories have a value: raw materials had to be purchased from suppliers (with the purchase cost denoting inventory value), semi-finished or finished goods consumed valuable resources (labor, material, energy, etc.) when raw material was converted into marketable goods (with conversion cost typically being used as value indicator for inventory), etc. Inventory ties up capital. This capital can be “released” only once inventory has been sold and converted back into cash through customer payments. Firms, therefore, will try to speed up this process and realize a speedy, efficient order fulfillment cycle. The less capital is tied up in inventories, the lower NWC will be. 4. Accounts payable Accounts payable denote payment obligations the firm has towards its suppliers and other business partners. They belong to short-term liabilities. The line of reasoning that has been outlined for accounts receivable can be used again—with reversed signs, though. High accounts payable denote the company’s ability to use its suppliers’ capital for own operations: raw materials have been purchased and are used in the manufacturing process before they have to be paid for. Inputs, therefore, create value in the own firm before any cash has to be paid out for them. Customer advance payments have a similar effect: Cash is being collected before valuable assets (finished goods or merchandise) have to be released towards the customer. Hence, everything else being equal, higher accounts payable will reduce NWC. Cash Management Cash management is concerned with ensuring a firm’s optimal degree of liquidity at all times. Cash management must make sure that temporary cash shortages, as well as times of excess cash, can be avoided. Avoidance of cash shortages ensures liquidity and thus reduces the risk of insolvency. Avoiding excess cash tries to minimize the opportunity cost caused by idle cash that is not put into other productive uses. Cash management oscillates between these two conflicting goals of liquidity/risk avoidance on the one hand and efficiency/profitability on the other. Corporate cash management relates both to the firm’s operating business process and to its financing processes (Werdenich 2009). In its operating domain, the firm tries to actively manage operating cash flows (cash flowing in from customers, cash flowing out to

6.2

Working Capital Management Across the Supply Chain

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suppliers). We briefly deal with this issue in the following sub-section. In its financing domain, the company tries to ensure efficient and flexible provisioning of short-term funds from third parties (financial institutions) as well as continuous availability of short-term investment opportunities (deposits). Large corporations, in particular, have established complex in-house banking facilities and netting/pooling facilities across their subsidiaries to allow central cash management. We will not deal with these topics further since they are beyond the domain of SCM and SCMAC, but constitute a core task of corporate finance. Managing Accounts Receivable and Accounts Payable Accounts receivable occur whenever a firm supplies goods or services to a customer who, in turn, does not immediately pay for them. The company then effectively provides credit to its customer, bearing the financing cost on the customer’s behalf. Firms, therefore, try to keep accounts receivable low by speeding up the payment process after delivery. This is partly an operational issue (i.e. making sure that invoices can be raised and sent to the customer quickly), but the most important factor typically is the payment terms that have been agreed between seller and buyer. Depending on their bargaining power and industry practices, companies will try to avoid deferred payments from their customers in order to speed up cash inflows and reduce accounts receivable. A similar, albeit reversed, logic applies to accounts payable. Now the company will try to postpone payment to its suppliers as much as possible, effectively profiting from credit provided by these trade partners. Again, this can be done through procedural measures (e.g. delaying invoice matching and approval) and through the negotiation of extended terms of payment. It is important to note that accounts receivable and accounts payable are simply two sides of the same coin in a business transaction: a seller’s accounts receivable equal the buyer’s accounts payable. Reduce Inventories and Inventory Values Many inventory reduction initiatives and tactics applied by SCM and purchasing intend to influence NWC in the company’s favor (Templar et al. 2016, p. 58): – Postponement Delaying the conversion of raw materials or work in progress into finished goods until the very last moment. Since raw materials have a lower value than finished goods (these are valued at conversion cost!), inventory values will decrease accordingly. – Just-in-time production Delivery of components by a supplier to the customer at the agreed time and in synchronization with the manufacturing process, thus avoiding unnecessary buffer stock at the manufacturer’s premises. – Cross-docking Avoiding inventories at transshipment centers by receiving pre-picked and pre-packed inbound deliveries from suppliers that can be easily prepared for onward delivery in smaller shipments to their final point of sale.

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– Vendor-managed inventory Stocks that are physically located at the customer’s premises, but are managed and owned by the supplier. Ownership passes to the customer only at the time of actual consumption, thus reducing the time that inventory is actually held. So far, we have not yet moved beyond the single firm’s perspective. However, all initiatives and instruments available for managing working capital of a single business entity inevitably have effects on that entity’s business partners as well. The link between accounts receivable and accounts payable is probably the most obvious one. But shifting cash or inventories between business partners will also affect NWC—not only of the initiating firm but also of its partner(s). A collaborative view now recognizes that single-firm attempts to optimize NWC might, in fact, have a net negative effect on the entire supply chain. The losses incurred by supply chain partners more than outweigh the NWC gains achieved by the initiating firm—the supply chain in its entirety is worse off than before and its competitiveness declined! Large companies with considerable purchasing power often extend payment terms at the expense of their suppliers: When large buyers unilaterally impose new payment terms on their suppliers, they are essentially shifting the working capital burden further up the supply chain. But in doing so, they add significant risk to the supply chain, including business continuity risk, supplier viability risk, material cost inflation, relationship deterioration, lack of support from suppliers and more. (Fernandes and Ellram 2017, p. 15).

These inherent goal conflicts are not easy to resolve and we will come back to this issue in the following sections. As previously outlined, working capital management has a financial as well as an operational aspect. In operational terms, a collaborative approach focuses on increased process efficiencies and reduced transaction cost—which can potentially provide benefits to all supply chain partners involved. In the financial field, however, goal conflicts are more difficult to resolve: Financial objectives make all companies want to become “late payers” and “early collectors”. This situation, however, can increase transaction costs in the form of credit risk, with capital costs being transferred from certain levels to others in the supply chain. (Vázquez et al. 2016, p. 324).

A key lever for supply chain-integrated working capital management is collaborative cash-to-cash (C2C) cycle management, which we turn to in the next section.

6.3

Collaborative Cash-to-Cash Cycle Management

The cash-to-cash cycle (also called “cash conversion cycle” or simply C2C cycle) is a measure of the time difference that exists between the moment cash leaves a company to pay suppliers and the time it takes to convert inventory to cash through customer payments

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Collaborative Cash-to-Cash Cycle Management

131

(Lamoureux and Evans 2011). This time difference leads to a financing need since the firm must cover the temporary outflow of financial funds until these are recovered through cash collections from customers. The longer this temporary gap is, the higher the refinancing need and—all other things remaining equal—the higher the refinancing costs will be. Measuring the C2C Cycle Time The C2C cycle is typically measured in days and consists of three constituent elements (with slightly varying terminology being used in different sources): 1. Days inventory The time it takes on average for inventory to move through the company’s valueadding process from goods receipt until delivery of the final product to the customer. Days inventory is calculated as: Average inventory value in period  365 Cost of goods sold in period

ð6:3Þ

2. Days receivable (or sales) outstanding The time it takes on average to receive payment after delivery from customers that have purchased on credit terms. It is calculated as: Average value of accounts receivable in period  365 Total sales in period

ð6:4Þ

3. Days payable outstanding The time it takes for the company on average to pay for goods and supplies it has received on credit terms. It is calculated as: Average value of accounts payable in period  365 Cost of goods sold in period

ð6:5Þ

The three elements are combined into the composite measure “cash conversion cycle” (also called “days working capital”): Days inventory þ Days receivable outstandingDays payable outstanding ¼ Days working capital

ð6:6Þ

Example Imagine a manufacturing company that deals with its business partners on credit terms (see Fig. 6.1). Customers typically pay open invoices with a time gap after receipt of goods. The company itself also settles open invoices from its suppliers only after some time has elapsed. The timing of payments depends on a number of different factors, such as common

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Buy inventory

44 days payable

Collect cash

48 days inventory

Pay for inventory

85 days working capital

Sell product

81 days receivable

Fig. 6.1 Example C2C cycle (source: Charifzadeh and Taschner 2017, p. 218, adapted)

payment terms in the particular industry, bargaining power of trade partners, individual incentives such as cash discounts, etc. The company has determined days receivable to be 81 days while days payable stand at 44 days. On average, therefore, customers pay later than the company pays its own suppliers. Days inventory has been determined at 48 days, i.e. it takes on average 48 days to convert newly received raw materials or components into finished products that are finally delivered to the customer (i.e. leave inventory again). Days working capital can, therefore, be calculated as 48 + 81 – 44 ¼ 85 days. Thus, the company has a temporary financing need of close to 3 months’ value of cost of goods sold in order to conduct its regular business operations. Note that there is a slight inconsistency in the calculation of these figures. Strictly speaking, C2C components cannot simply be combined, because they refer to different amounts of capital: while days inventory and days payable are determined using cost of goods sold as the denominator, days receivable is based on sales revenues as the denominator. It is immediately obvious that these two numbers will not match since sales revenues will exceed cost of goods sold (if not, the firm has a dramatic profitability problem!). One day of days receivable, therefore, is not the same amount of capital tied up as one day of days inventory or days payable. A more precise way of measuring C2C would explicitly factor in this difference by re-weighting C2C components (Gentry et al. 1990). Business practice, however, always takes the simplified approach outlined above—mostly because the information that is needed for determining a weighted C2C cycle cannot be taken from publicly available financial accounts data.

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Collaborative Cash-to-Cash Cycle Management

133

The reader should further note that C2C cycle components do not explicitly consider cash—which is a current asset and thus affects NWC. Pure financing transactions, such as taking out or paying back a loan, will affect NWC, but not C2C cycle time. C2C cycle, in turn, cannot be managed without affecting NWC at the same time. Operational managers might find it more intuitive to pay attention to C2C mostly since the management levers available to them will always show C2C effects. Finance and accounting managers, in turn, might be more focused on NWC, since the effects of some of their (financing and investment) decisions will not be adequately reflected in C2C cycle time. Optimizing the C2C Cycle and Managing Liquidity From a purely financial point of view, shorter C2C cycles (and accordingly, lower NWC) are preferable, since this reduces the need for interim financing of business operations. However, operational considerations might just as well be used as arguments for a C2C extension: new business might be won when offering longer payment terms to customers, stock-outs might be avoided if inventory levels are higher, etc. Defining the optimal C2C cycle time, therefore, is an ongoing trade-off between financial and operational considerations (Farris and Hutchinson 2002). When aiming for a certain C2C target value, company managers must balance out liquidity constraints of the firm’s suppliers, customer satisfaction and the need for the firm to increase its own profitability: If the inventory conversion period is too short, the firm risks lost sales resulting from stockouts. If the receivables conversion is too short, the firm may lose sales from customers who require longer payment periods than the firm allows. If the firm increases the payables conversion period too much, discounts for early payments are lost and suppliers might face financial problems. (Grosse-Ruyken et al. 2011, p. 16)

Optimizing C2C cycles relates to optimizing the liquidity levels of a firm. There is an indirect relationship between C2C and a company’s cash position. Remember that C2C cycle time is a measure for the firm’s ability to quickly recover cash spent on inputs by collecting payments from its customers. The shorter the C2C, the faster the cash is flowing back into the company. We can determine the so-called “cash turnover” rate (Farris and Hutchinson 2002) by dividing the number of days in the year (365) by the C2C cycle: Cash turnover rate ¼

365 days Cash conversion cycle time

ð6:7Þ

Example Thus, if the C2C cycle is 85 days as in the above example, cash turnover equals 365 / 85 ¼ 4.29. Relating the firm’s total annual cash expenditures to its cash turnover provides an indicator of the minimum cash balance that is required to provide sufficient liquidity. If the company has annual cash expenditures of 1 million €, its liquidity position should be

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1,000,000 / 4.29 ¼ 233,100 €. Shortening the C2C cycle will increase cash turnover and reduce minimum liquidity requirements. Improved operating efficiency, therefore, has an indirect effect on liquidity. At the same time, an improved C2C cycle is an expression of a firm’s ability to make better use of the capital employed. In fact, the firm can perform its operational business with a smaller capital base, since it turns its working capital over more frequently. This will lead to an improved return on capital employed (ROCE) (GrosseRuyken et al. 2011). NWC and C2C Management at the Supply Chain Level The above considerations have shown that NWC and C2C are conceptually linked to each other and both provide guidance for finance and operations management. So far, however, we have not looked beyond the firm’s boundaries. When extending the view to the entire supply chain, one recognizes that single-firm attempts to improve NWC and C2C, respectively, often lead to opposite effects with other supply chain partners that might wipe out benefits for the supply chain in total. Consider the combined C2C cycles of supply chain partners as depicted in Fig. 6.2. The supplier’s days receivable match the OEM’s days payable, as do the OEM’s days receivable and the retailer’s days payable. In an un-coordinated setting, supply chain partners will try to optimize their individual C2C cycle time—at the expense of the other partner. One partner’s improvement translates into a C2C deterioration at the supply chain partner—a zero-sum game! The supply chain in its entirety would not improve its efficiency. On the contrary: recurring negotiations and bargaining efforts will consume valuable time and resources and might keep supply chain partners from realizing other, more beneficial, initiatives instead. Operating Cycle (OC) of Supply Chain Cash-to-Cash Cycle (C2C) of Supply Chain OC Retailer OC OEM OC Supplier

C2C Supplier DSI Supplier DPO Supplier

Resources in at supplier

Payment resources by supplier

C2C OEM DSI OEM

C2C Retailer DSI Retailer

DRO Supplier

DRO OEM

= DPO OEM

= DPO Retailer

Sale supplier to OEM

Payment OEM to supplier

Fig. 6.2 Supply chain C2C (source: authors)

Sale OEM to retailer

Payment retailer to OEM

DRO Retailer

Sale retailer to final customer

Payment final customer to retailer

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Collaborative Cash-to-Cash Cycle Management

135

Strictly speaking, the zero-sum game result will occur only, if all supply chain partners operate with the same cost of capital (weighted average cost of capital, or WACC). Remember that C2C cycle time translates into financing requirements for capital employed: a longer C2C cycle increases NWC and—all other things being equal—also cost of capital. Shifting NWC between supply chain partners (through attempts to manage partners’ C2C cycle time) will have no effect on the total cost of capital across the supply chain if all partners face the same cost of capital rate. This is very unlikely, however. In particular, bigger companies can often profit from higher bargaining power in financial markets, a stronger reputation (reflected in credit ratings) and possibilities to leverage synergies by pooling financing needs across different legal entities (e.g. subsidiaries in different countries). Their smaller suppliers, in turn, cannot profit from the same effects and will typically face higher financing cost—reflected both in higher transaction costs and in actual cost of capital employed. In a collaborate perspective, therefore, three different scenarios can be distinguished (Hofmann and Kotzab 2010): – In the first scenario, the supplier has a lower WACC than its customers. Having the lower WACC, the supplier should bear more of the financing need (i.e. accept a longer C2C cycle time and a higher NWC, respectively), since cost of capital is lowest for him and the entire supply chain can profit by shifting capital employed to the supplier. The supplier would accept that its customers pay late, payment terms would be relaxed. Such an approach is more likely in an industry where large, dominant, suppliers or manufacturers support their distributors and customers through favorable payment terms and credit arrangements. – In the second scenario, the roles are reversed and now the customer can operate with lower a WACC than its suppliers. Consequently, the customer should accept higher NWC and a longer C2C cycle, helping its suppliers by settling open invoices early and shifting financing requirements away from them. – In scenario 3, supply chain partners operate with a similar WACC. Cost of capital differences might be more than offset by transaction costs that arise when engaging in complex trade financing arrangements. Supply chain partners do not stand to gain much by collaborative C2C cycle management. Inventory management across supply chain partners follows a similar logic. A shift of inventory away from the own firm toward a supply chain partner has an immediate one-time cash effect by releasing inventory and thus reducing NWC amounting to inventory’s cost of goods sold value. If this inventory shift is permanent, the firm will also profit from a sustained lower inventory carrying cost (Randall and Farris 2009). Whether these positive effects for the own firm are offset by corresponding negative effects at the supply chain partner depends on the partner’s WACC and its efficiency in handling inventory as reflected in its inventory carrying cost.

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Take note that this line of reasoning does not apply to supply chain partners’ efforts to reduce days inventory through internal process improvements or similar efficiency gains. If one supply chain partner manages to improve the efficiency of its own operations, translating into lower inventory levels, the entire supply chain will profit from a corresponding improvement in the cross-partner C2C cycle time independent of each partner’s cost of capital. Collaborative C2C cycle management makes perfect sense not only between supply chain partners of different sizes, but also between different industries. As many empirical studies have shown (see, for instance, Farris and Hutchinson 2003, Losbichler and Rothböck 2008, or Mayer 2013), cost of capital and average C2C cycle times differ significantly between industries. Many supply chains are cross-industry by nature, i.e. supply chain partners belong to different industries and are, therefore, confronted with different market environments, different risk structures, and different business dynamics. These factors all give rise to different cost of capital, which, in turn, open possible leverage points for collaborative management of NWC and C2C cycles with the ultimate goal of reaching a cross-company optimum. The set of specific instruments available for such a collaborative supply chain finance approach has grown in recent years. We will turn to these instrumental questions next.

6.4

Supply Chain Finance Instruments: An Overview

Financing considerations have always been an integral part of trade transactions. No matter how attractive the price-performance ratio of a product might seem to the customer, the transaction will not be realized, if the buyer and seller cannot agree on payment and financing terms. Monetary arrangements, therefore, always accompany the actual sale of goods and services. In international trade, in particular, these monetary arrangements and activities are subsumed under the notion of “trade finance”. Trade finance arrangements deal with financing (Who is funding the trade deal to what extent and up to what point in time?) and related risks (Who has to bear the risk of non-payment or default risk and which collaterals are available?). Trade finance provides funds to suppliers to help them produce goods and to buyers to help them purchase these goods, respectively (Lamoureux and Evans 2011). The payment instruments commonly used in international trade transactions such as letters of credit and documentary credits are examples of trade finance. They combine funding with risk management since they are used to . . . safeguard the interests of buyers (who want to ensure receipt of the right goods) and suppliers (who want to ensure they are paid). (Lamoureux and Evans 2011, p. 295)

In that sense, SCF instruments do not entirely differ from traditional trade finance, but they add a collaborative component that is typically not present in traditional trade finance

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Supply Chain Finance Instruments: An Overview

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agreements. Collaborative behavior attempts to leverage synergies and gain advantages that would not be available to firms when acting on their own. Benefits from collaborative finance can be reaped only if trade partners coordinate their activities. In the following, we will assume SCF to comprise all those financial instruments that require some type of cooperative agreement between parties for the financing aspects of a trade deal. Although being a subset of trade finance, SCF instruments are a rather inhomogeneous group themselves. Different categorization approaches are possible to further structure the toolset and we will briefly elaborate on these before moving on to the SCF instruments themselves. Traditional trade finance instruments that lack the collaborative nature will not be covered in this text. Categorization Based on the Triggering Event in the Order Fulfillment Process Instruments can be distinguished according to which phase in the order fulfillment process triggers the financing activity (Zhao and Huchzermeier 2018). Pre-shipment finance instruments provide funding for the supplier during the procurement and production phase, i.e. before actual delivery. The triggering event might be the customer’s purchase order, a signed purchase contract, or the supplier’s final decision to accept the customer order. The only collateral available in this phase is typically the buyer’s purchase order. So-called “in-transit” finance instruments can be used when the product has been shipped and is on its way to the buyer. Finally, post-shipment instruments apply once the product has effectively been delivered and the invoice has been issued to the customer. As a general rule of thumb, it is safe to say that the associated credit risk diminishes in later phases of the order fulfillment cycle. Financing cost, therefore, tends to be higher in the pre-shipment and in-transit phase than in the post-shipment phase. Categorization Based on Focal Point of Credit Risk Another possible categorization of SCF instruments focuses on the party that is actually seeking funding and therefore is the focal point of credit risk in the financing arrangement (Association of Corporate Treasurers 2010; Euro Banking Association 2014; Zhao and Huchzermeier 2018). Buyer-related financing arrangements depend on the buyer’s creditworthiness and credit rating to assess the associated credit risk (which in turn determines financing cost). The funded object typically is the buyer’s accounts payable. Supplierrelated instruments, in turn, focus on the supplier’s accounts receivable. Depending on whether these receivables are secured or unsecured, funding parties might look at either the supplier’s or the buyer’s creditworthiness when assessing credit risk. Finally, inventoryrelated financing provides funding for sold or unsold goods and takes the goods’ intrinsic value as the main collateral. Since inventory-related finance is not linked to the credit rating of a specific business entity, funding institutions will agree to such a financing arrangement only in the case of marketable commodities or finished goods for which a purchase order has already been issued (Euro Banking Association 2014).

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Categorization Based on Availability of Hard Data and Collaterals Funding parties in a financing arrangement will always try to assess the associated credit risk before engaging in the deal. Credit risk assessment and subsequent credit risk management can be either based on “hard” data only or can include “soft” information (NavasAlemán et al. 2012). A financing arrangement that is based on “hard” data only can be called “arm’s length finance”. The funding party will base its financing decision on balance sheet data or availability of collaterals. It can assess creditworthiness from a distance, analyzing the available information without engaging in any closer relationship with the funded party. Relationship finance, in turn, might still involve some hard, verifiable, data and tangible collaterals. In addition, though, relationship finance contracts are based on soft information and require a certain level of trust between lender and borrower (Navas-Alemán et al. 2012). A business partner, for instance, might have information on the borrower’s creditworthiness and trade history from a long-lasting business relationship. This background information might complement or even substitute “hard” balance sheet data and allows proper evaluation and management of credit risk (Zhao and Huchzermeier 2018). It is easy to see that SCF instruments mostly fall into this category of relationship finance. Categorization Based on the Balance Sheet Item in Focus A last possible categorization approach addresses the balance sheet object that is in the focus of the financing arrangement (Zhao and Huchzermeier 2018). Strictly speaking, any business transaction or arrangement must have effects on more than one balance sheet item (remember the basic rule in double-entry bookkeeping that transactions must always lead to both debit and credit entries). The categorization is merely used to highlight which balance sheet item determines most of the nature of the arrangement. Equity-related financing arrangements include all those instruments that either lead to a change in equity of a firm or to an exchange of equity between firms. A business partner might help its supplier finance a big transaction by acquiring a stake in the firm, for instance. Partners might also create a new joint venture, both contributing equity as well as management capacity to the new entity. Equity-related financing rarely happens at a transactional, but rather at an institutional level. Other financing arrangements do not involve equity but are debt-based. These can be further distinguished into arrangements that focus on financing fixed assets or working capital elements (current assets), respectively. As the names already suggest, fixed asset financing deals with funding of objects that are intended to remain in the firm’s possession for a longer time period. Working capital financing, in turn, funds objects that typically remain with the company for a limited time only and are intended for (re-)sale or use in subsequent value-adding steps. A General Overview of SCF Instruments Applying the categorization concepts outlined above, the main trade finance and supply chain finance instruments are listed in Table 6.1. Note that not all instruments can be clearly categorized and for some instruments, several category items are marked. The next

Source: authors

SCF instrument Reverse factoring Dynamic discounting Receivables finance Factoring Forfaiting Inventory finance P.O.-based finance Letter of credit Netting and pooling Asset-shifting Vendor leasing Joint venture / SPV

x

x

(x)

(x)

x

(x)

(x) (x)

x

x x

x (x)

x

x

x x x

x

x

x

x

x

Inventory

Availability of hard data Arm’s length Relationship x

(x)

(x)

x x

(x)

x x

Supplier

x

x

Buyer x

Focal point of credit risk

x

x

Order fulfillment process phase PreInPostshipment transit shipment x

Table 6.1 Categorization of SCF instruments

x

x x

x

Balance sheet item Fixed Equity assets

x x

x

x

x

x

x

Working capital x

6.4 Supply Chain Finance Instruments: An Overview 139

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sub-chapter will describe the main SCF instruments in more detail. We do not cover traditional trade finance and equity-related financing schemes here but focus on collaborative SCF approaches only.

6.5

Selected Collaborative Supply Chain Finance Instruments

A key characteristic of most SCF instruments is the involvement of other players in addition to the actual trading parties. The supply chain partners typically do not have the necessary financial expertise themselves to structure financial arrangements that go beyond trading on open account terms or take recourse to standard instruments of trade finance (e.g. bills of exchange in international trade). Instead, they involve additional partners that support SCF arrangements by combining specialized financial services (providing actual funding plus related services) together with modern technology platforms that ensure reliable and cost-efficient realization of such SCF deals. Because of the mixed financial and technological nature of their services, these firms are often called “fintech companies” or simply “fintechs”. Fintechs play an important role in realizing SCF arrangements. Their automated and digitalized solutions help supply chain partners achieve lower transaction costs, faster cash transfers, and consequently a more effective supply chain in general (McCrea 2017). The financial and technological expertise need not be combined in a single entity, but could also be provided by two separate firms. In fact, several specialized technology platform providers are active today in the global SCF solutions market (see Table 6.2). Apart from these, many multinational firms have created their own financial subsidiaries (holding banking licenses) that can offer SCF solutions to their partners (suppliers and buyers): IBM Global Financing, GE Capital, or Siemens Financial Services are just a few examples here. Of course, one can also find globally operating banks such as HSBC, Deutsche Bank, or UBS in this market. In any case, a typical SCF solution needs three key elements in order to be efficient and attractive to supply chain partners (KPMG 2016): a trusted advisor (providing expert know-how), a funding partner (providing the funds required for interim financing), and a reliable technology platform. While the supplier and the buyer (i.e. the actual trading partners in the supply chain) constitute the “demand side” of the SCF solution, the parties offering funds, advice, and the technology platform constitute the “offer side” (Templar et al. 2016). Demand side parties are looking for a SCF solution that supports their supply chain and hopefully leads to a win-win situation for all supply chain partners involved. Offer side parties, in turn, pursue SCF deals as part of their core business. In summary, modern SCF solutions are characterized by the following key elements (Hofmann and Belin 2011, p. 16f):

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Table 6.2 SCF platform providers SCF platform Global Supply Chain Finance Prime Revenue Orbian Finacity The Receivables Exchange

Headquarters Zug (CH) Atlanta (US) Norwalk (US) New York (US) New Orleans (US)

Target customers Large multinationals Large multinationals Large multinationals Middle market SMEs

Source: Hofmann and Belin (2011), adapted

1. Dematerialization and automation: The elimination of paper and automation are important prerequisites for the acceleration of financial and informational flow and timely solutions. 2. Transparency: Transparency derives from the fact that automation assimilates a wealth of information by enabling internal and external sources to exchange data. Due to the better shared visibility of supply chain events, the risk is mitigated—since better forecasting and transparency create certainty—as more information becomes available. 3. Predictability: Whereas paper-based processes inhibit predictability, automation facilitates it by providing access to various sources of data. 4. Control: Control is derived from the elements above: transparency and predictability are necessary to identify exceptions and confirm the actions, adequate control mechanisms and results that comply with both internal and external standards. 5. Collaboration: The aim of inter-company optimization is to create trust-based win-win situations considering the end-to-end supply chain and stable trading relationships, as well as to encourage collaboration within the procurement, logistics, finance and treasury departments. Collaboration encourages companies to connect with internal and external partners within a supply chain. Reverse Factoring Factoring is a widely used financing technique both in international and in domestic trade. In its original form, factoring denotes a financing arrangement where a firm (the seller in a trade transaction) receives cash from a specialized institution (the “factor”, often a specialized subsidiary of a bank) in exchange for its accounts receivable that originate from the sale of goods or services (OECD 2015). The factor advances cash to the supplier in return for the right to collect cash from the supplier’s customers once the open amounts become due. The amount that the supplier receives from the factor equals the open invoice amount minus an administrative handling fee and interest (discount). Factoring is a short-term financing instrument because accounts receivable typically have a maturity shorter than 12 months. It can be an attractive option, especially for smaller companies, since the factor also takes care of the actual invoice collection activities. The supplier also passes the credit risk on towards the factor, who, in turn, will now also take

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care of credit risk assessment. Factoring, therefore, has a financing element and a service element (justifying the administrative fee). Reverse factoring maintains this basic logic but reverses the initiative of the financing deal (hence the term “reverse factoring”). Instead of a (small) supplier approaching the factor for financing, it is now typically a large customer that initiates the deal: Under reverse factoring, the purchasing firm enters into an umbrella contract with a factor, specifying which of its payables are eligible for factoring. The suppliers falling under the big customer firm’s umbrella contract can then collect advance payments from the factor. Since the big customer firm typically has a good credit rating and is well-known in financial markets, credit risk is low for the factor. In addition, the customer firm has approved open amounts, adding even more payment security to the factor. Reverse factoring, therefore, is also referred to as “approved payable finance” (Euro Banking Association 2014). The collaborative nature of reverse factoring becomes evident when looking at the typical situation where a large, low-risk, firm establishes an umbrella contract with a factor that provides access to receivables finance for its many small, possibly higher-risk, suppliers. Financing terms offered by the factor are based on the large firm’s credit rating, effectively providing much cheaper refinancing opportunities for the small suppliers than would be possible, if the suppliers were to enter into separate factoring arrangements on their own (OECD 2015). In a reverse factoring scheme, suppliers still retain the flexibility to present open invoices for early payment to the factor at their own discretion. Depending on its shortterm liquidity requirements, a supplier can decide either to take advantage of the reverse factoring facility or to keep open accounts with the large customer in its own books until the due date. This financing flexibility is another benefit for the supplier. The large customer firm, in turn, will expect its suppliers to pass on some of the financial gains through lower prices. Reverse factoring even offers benefits to the factor itself, since it enables the factor to make a profit through service-related fees and cross-selling opportunities. In addition, the factor might be able to decrease its credit portfolio risk—which leads to lower capital reserve requirements (Lekkakos and Serrano 2016). Although reverse factoring is not a sure-fire success in all circumstances, empirical evidence suggests that companies can reap financial benefits from it through a reduction of working capital, lower financing costs and simpler cash collection processes (Seifert and Seifert 2011). Despite its potential benefits, however, many smaller companies still do not make use of reverse factoring. The reasons are manifold and range from simple lack of knowledge, unclear payment and invoicing processes, to tax or regulatory barriers (common in cross-national trade) or simply a lack of willingness to collaborate on the part of the large buyer (De Goeij et al. 2016; Liebl et al. 2016). Dynamic Discounting Dynamic discounting is another SCF tool focusing on the supplier’s accounts payable. Different from (reverse) factoring, however, in a dynamic discounting scheme it is the

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Selected Collaborative Supply Chain Finance Instruments

143

(typically large) customer firm itself that provides financing opportunities by offering variable discounts to its suppliers for early payment of their invoices. The necessary funds are not provided by a third party (e.g. bank) but come directly from the buying organization itself (Euro Banking Association 2014). Cash discounts are very common in business-to-business (B2B) transactions. They are based on a fixed combination of discount value and payment date. A payment clause reading “2%/10, 30 days net”, for instance, means that the buyer can choose between two different payment options: either deduct 2% from the supplier’s invoice value, if the amount is settled within 10 days, or pay the full invoice amount within the next 30 days. In a traditional cash discount scheme – The payment terms are fixed (“static”) and the payment decision is binary only: take advantage of the cash discount yes/no? – The decision trigger lies with the purchasing firm because it has to pay the open invoice. Dynamic discounting introduces more flexibility. First, the purchasing firm extends its purchasing terms by offering a whole range of early payment discounts at various timedependent rates to its suppliers. Immediate payment triggers a larger discount, later payments offer smaller (or no ) discounts—i.e. the discount rate gradually decreases over time (Zhao and Huchzermeier 2018). Second, the trigger is now put in the supplier’s hands. Whenever a new invoice from the supplier has been recognized and approved by the buyer, the supplier can set an individual payment date for the open invoice. If the supplier is short of cash, it might prefer early payment and therefore will accept a higher discount in return for an early cash inflow (settlement of invoice). If there is no immediate need for cash, the supplier can wait with cashing in the open invoice and profit from a higher payment amount instead. In this sense, dynamic discounting works like a flexible credit facility for the supplier. Similar to reverse factoring, the buying firm can expect to profit from the scheme through better prices or delivery terms and a more stable, trustworthy relationship to its suppliers. Netting and Pooling Netting and pooling are two common cash management instruments in multinational corporations. Pooling involves aggregating balances for multiple bank accounts to minimize both idle funds and bank borrowing (Botek 2012). Instead of holding small cash balances in multiple accounts, these balances are consolidated (“pooled”) in one single account. Physical pooling effectively leads to loan transactions between the legal entities involved. Therefore, also “notional” pooling is commonly used (Botek 2012). In notional pooling, funds are not transferred between accounts, but they are handled as if they had been (e.g. when determining the interest-bearing account balance). The extent of pooling depends both on national tax and currency exchange regulations as well as on the technology platform available.

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When firms engage in netting, they consolidate and offset multiple payments into one consolidated (net) payment. Imagine a buyer having to settle individual invoice amounts one by one. Instead of initiating separate cash transfers for every single invoice, all invoice amounts of a specified period are consolidated, credit notes issued by the supplier are offset, and the remaining balance is paid in a single transfer. Netting reduces payment volumes and consequently also transaction costs (bank fees, process cost, etc.). It simplifies the business relationship and reduces risks (e.g. foreign exchange risk, Botek 2012). Both netting and pooling can be used in supply chains. Internal supply chains (i.e. supply chains involving affiliated companies) fall in the general category of “multinational companies”. But both instruments can be used in external supply chains as well. Their implementation between non-affiliated firms requires some more effort but is nevertheless possible. Supply chain partners can always agree on a netting scheme that will help both the buyer and the supplier to reduce transaction costs. A pooling scheme might be introduced by establishing a “master account” that bundles all payments from the supply chain members to outsiders—giving rise to economies of scale and potentially higher bargaining power (backed by higher payment volumes). Both netting and pooling not only require the willingness to collaborate, but also a shared and well-developed IT platform for realizing and monitoring the inter-related cash flows and account balances (Hofmann 2007). Equipment Financing and Vendor Leasing Other than the previously described SCF instruments, equipment financing and leasing solutions do not target working capital (inventory and accounts receivable or payable, respectively), but focus on collaborative financing of fixed assets. A typical case is a (large) manufacturer, which supports its (smaller) supplier by collaborating in financing capital costs (Templar et al. 2016). Both supply chain partners might have agreed on a long-term frame contract, which requires capital investments on the part of the supplier (e.g. new machines that need to be purchased in order to produce the components which will subsequently be sold to the manufacturer). Smaller suppliers often face constraints when it comes to pre-financing such frame contracts: initial investment in new equipment and fixed assets is required at the beginning of the contractual relationship, while return cash inflows will be realized only over several periods in the future—opening a sometimes serious financing gap for the small supply chain partner. In such cases, the manufacturer can advance funds to its supplier through different schemes: – The manufacturer can purchase tools or molds on the manufacturer’s own account and subsequent provisioning of these capital goods to the supplier against a compensation or fee. The supplier integrates the contract-specific tools and molds in its machines. Such a setup is not untypical in plant engineering or injection molding, for instance. In legal terms, the item remains in the ownership of the manufacturer, but it is used by the supplier in the supplier’s premises. The manufacturer, therefore, could withdraw the

6.6

Glossary and Key Terms

145

tool or mold from the supplier in case he decides to switch suppliers or terminates the frame contract early (Templar et al. 2016). – The manufacturer might finance entire equipment (machines), operating facilities and other durables by purchasing the capital goods at own account and subsequently leasing them out to its supplier. The capital goods are directly installed at the supplier’s premises and are used for production. Such leasing arrangements are based on the insight that not the ownership, but the use of an object is crucial (Hofmann 2007). The supplier does not only profit from a reduced capital investment burden, but also from more stable planning of future operating expenses since leasing fees are fixed between both partners. Both cases follow the same logic: the bigger manufacturer can profit from lower cost of capital (since it typically has better access to financial markets and also has a better credit rating) and has a broader capital base, to begin with. The manufacturer, therefore, is in a better position to finance capital investments that are required to sustain the supply chain relationship. The financial benefit realized by the manufacturer can then be split between both parties through contractual arrangements, leaving both parties better off than in a supplier-financed scenario. It must be noted, however, that equipment financing and leasing arrangements give rise to numerous tax and accounting issues that need to be considered before actually engaging in such an SCF transaction.

6.6

Glossary and Key Terms

Accounts payable

Accounts receivable

Cash conversion cycle

Cross-docking

Days inventory

Days payable

A payment obligation the firm has towards its suppliers or other business partners, effectively constituting a short-term loan granted by the firm’s business partners. Capital that is tied up in invoices that customers have not yet settled. Accounts receivable can be considered a loan extended by the selling firm to its customer(s). A measure of the time difference that exists between the moment cash leaves a company to pay suppliers and the time it takes to convert inventory to cash through customer payments. Also called cash-to-cash cycle or days working capital. Avoiding inventories at transshipment centers by receiving pre-picked and pre-packed inbound deliveries from suppliers that can be easily prepared for onward delivery in smaller shipments to their final point of sale. The time it takes on average for inventory to move through the company’s value-adding process from goods receipt until delivery of the final product to the customer. The time it takes for a company on average to pay for goods and supplies it has received on credit terms. (continued)

146

Days receivable Dynamic discounting

Factoring Fintechs Just-in-time production

Liquidity

Netting Net working capital (NWC)

Pooling Postponement

Reverse factoring

Supply chain finance

Trade finance

Vendor leasing

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Supply Chain Finance

The time it takes on average to receive payment after delivery from customers that have purchased on credit terms. An arrangement where a purchasing firm extends its purchasing terms by offering a whole range of early payment discounts at various time-dependent rates to its suppliers. Suppliers can dynamically set individual payment dates for open invoices. A supplier sells its accounts receivable to a financial services firm (e.g. a bank) and, thereby, collects cash immediately. Financial services companies that provide automated and digitalized banking or financing solutions. Delivery of components by a supplier to the customer at the agreed time and in synchronization with the manufacturing process, thus avoiding unnecessary buffer stock at the manufacturer’s premises. A term for the sum of the liquid assets of a firm such as cash and other assets that can be converted to cash within a short time. Thus it is an indicator of the ability to meet payment obligations when they become due. The consolidation and offsetting of multiple payments into one consolidated (net) payment. In accounting terms, the balance between the sum of all current assets and the sum of current liabilities. NWC is both a liquidity and an efficiency measure. Aggregating balances for multiple bank accounts to minimize both idle funds and bank borrowing. An inventory reduction initiative of delaying the conversion of raw materials or work in progress into finished goods until the very last moment in order to keep inventory values low. An arrangement where a purchasing firm enters into an umbrella contract with a factor, specifying which of its payables are eligible for factoring and allowing the supplying firms to flexibly decide whether open accounts are held until maturity or are cashed in with the factor at the pre-specified terms. The use of financial instruments, practices, and technologies to optimize the management of the working capital and liquidity tied up in supply chain processes for collaborating business partners. Monetary arrangements that accompany the actual sale of goods and services (in particular in international trade) and specify the financing and risk-sharing arrangements of the transaction. An arrangement where a firm finances (purchases) entire equipment (machines), operating facilities and other durables at own account and subsequently leases them out to its supplier for further use. (continued)

6.7

Review Questions and Exercises

Vendor-managed inventory

Weighted average cost of capital (WACC)

6.7

147

Stocks that are physically located at the customer’s premises, but are managed and owned by the supplier. Ownership passes to the customer only at the time of actual consumption. The cost of capital of a business firm that is comprised of the cost of debt and the cost of equity, weighted by the corresponding share of equity and debt capital.

Review Questions and Exercises

Review question 6.1: How are physical flows and financial flows linked in a supply chain? Why must a supply chain always combine both types of flows? Review question 6.2: What are the main influencing factors of cost of capital in a firm? Explain, why a company’s cost of capital is not independent of its supply chain partners. Review question 6.3: Provide examples for typical types of transaction cost in financial arrangements. Review question 6.4: What is net working capital (NWC) and what are its constituent elements? Review question 6.5: Explain how NWC can be used as a measure for liquidity and financial efficiency? Review question 6.6: How can a company use inventories, accounts payable and accounts receivable as the main levers to reach an optimal level of NWC? Review question 6.7: Explain the three conceptual elements of the cash-to-cash (C2C) cycle. Review question 6.8: Why do an individual firm’s attempts to improve its C2C cycle not always lead to a corresponding improvement for the entire supply chain? Review question 6.9: Explain how collaborative efforts can improve the overall C2C cycle of a supply chain. Review question 6.10: How do collaborative SCF instruments and traditional trade finance instruments differ? Review question 6.11: Which parties are typically involved in an SCF arrangement? What are their respective roles?

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Review question 6.12: Explain the conceptual difference between normal factoring and reverse factoring. When does reverse factoring make sense for supply chain partners? Review question 6.13: Explain the conceptual difference between traditional cash discounts and dynamic discounting. Review question 6.14: How can netting and pooling be used in a supply chain? Why are these instruments more beneficial to internal supply chains that link firms/subsidiaries of the same group? Review question 6.15: Describe the concept of vendor leasing and name typical application areas in a supply chain.

Exercise 6.1: Determine NWC and C2C for an individual firm The financial accounting department of your company has provided you with the following figures, showing key annual accounts data. Determine net working capital and the cash-to-cash cycle time for year 2! Exercise 6.2: Collaborative C2C management A supply chain consists of three partners, the focal OEM with significant bargaining power and two smaller partners, an upstream supplier and a downstream retailer. Each supply chain layer holds some inventories, which are currently managed by the respective partner. The value per unit, average number of units held as well as the WACC for each supply chain partner are given in the below table: Starting scenario Supplier OEM Retailer

Value/unit 5 8 12

Avg. no. of units in inventory 80,000 35,000 10,000

WACC (%) 8 7 8

The OEM as the focal firm is concerned about the high cost of inventory and considers two alternative moves: (a) Forcing the supplier to accept a vendor-managed inventory scheme, where the supplier would retain ownership of inventory until actual use in production by the OEM. This would effectively shift inventory cost from the OEM to the supplier— possibly in return for a slightly increased sales price per unit supplied.

Revenues Cost of goods sold Gross profit Sales and marketing expenses R & D expenses Administrative expenses Depreciation and amortization Other operating expenses Earnings before interest and tax ("EBIT") Interest income Interest expenses Other financial items Earnings before tax ("EBT") Income taxes Net profit

Income Statement

Assets Intangible Assets Tangible Assets Financial Assets Fixed Assets Inventories Trade Receivables Cash and Cash Equivalents Current Assets Deferred Expenses Total Assets

Year 2 14.019 9.762 4.257 627 537 753 693 435 1.212 26 62 23 1.153 594 559

Year 2 384 2.534 66 2.984 2.016 2.064 1.014 5.094 69 8.147

Year 1 14.226 9.878 4.348 624 528 780 687 510 1.219 8 82 53 1.092 617 475

Equity and Liabilities Subscribed Capital Retained Earnings Net Profit Equity Short Term Provisions Long Term Provisions Provisions Long Term Financial Obligations Trade Payables Other Short Term Obligations Liabilities Deferred Income Total Equity and Liabilities

Balance sheet Year 1 384 2.455 66 2.905 1.956 1.865 966 4.787 75 7.767

Year 2 550 2.775 559 3.884 1.140 1.237 2.377 488 903 468 1.859 27 8.147

Year 1 550 2.564 475 3.589 970 1.190 2.160 543 899 555 1.997 21 7.767

6.7 Review Questions and Exercises 149

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(b) Pressing both partners to increase forecast transparency and improve order handling efficiency. The OEM expects inventories to decrease to 60,000 (supplier), 30,000 (OEM), and 10,000 (retailer), respectively. But these efficiency gains would be possible only after one-time efforts expected to amount to a minimum of 10,000 Euros. Estimate the potential financial effect of these two alternatives for the supply chain and discuss their usefulness.

References Association of Corporate Treasurers (2010) Supply chain finance—report of the Supply Chain Finance Working Group. ACT, London Botek M (2012) Cash pooling and netting as levers for optimizing cash and reducing risks. Global Finance 26(9):10–11 Charifzadeh M, Taschner A (2017) Management accounting and control—tools and concepts in a Central European Context. Wiley, Weinheim De Goeij C, Onstein A, Steeman M (2016) Impediments to the adoption of reverse factoring for logistics service providers. In: Zijm H et al (eds) Operations, logistics and supply chain management, lecture notes in logistics. Springer, Berlin, pp 261–277 Euro Banking Association (2014) Supply chain finance—EBA European market guide. EBA, Paris Farris MT II, Hutchison P (2002) Cash-to-cash: the new supply chain management metric. Int J Phys Distrib Logist Manag 32(4):288–298 Farris MT II, Hutchison P (2003) Measuring cash-to-cash performance. Int J Logist Manag 14 (2):83–92 Fernandes R, Ellram L (2017) Unlocking the potential of supply chain working capital finance. Supply Chain Manag Rev May/June:12–19 Gelsomino LM, Mangiaracina R, Perego A, Tumino A (2016) Supply chain finance: a literature review. Int J Phys Distrib Logist Manag 46(4):348–366 Gentry J, Vaidyanathan R, Lee HW (1990) A weighted cash conversion cycle. Financ Manag 19 (1):90–99 Grosse-Ruyken P, Wagner S, Jönke R (2011) What is the right cash conversion cycle for your supply chain? Int J Serv Oper Manag 10(1):13–29 Hofmann E (2007) The flow of financial resources: an inevitable part of supply chain design activities. In: Delfmann W, Klaas-Wissing T (eds) Strategic supply chain design. theory, concepts and applications. Kölner Wissenschaftsverlag, Köln, pp 173–201 Hofmann E, Belin O (2011) Supply chain finance solutions: relevance—propositions—market value. Springer, Heidelberg Hofmann E, Kotzab H (2010) A supply chain-oriented approach of working capital management. J Bus Logist 31(2):305–330 KPMG (2016) Optimizing working capital for the financial supply chain. Available online at https:// taulia.com/kpmg-taulia-optimizing-working-capital-for-the-financial-supply-chain/ Lamoureux J-F, Evans T (2011) Supply chain finance: a new means to support the competitiveness and resilience of global value chains. SSRN Electron J. Available at SSRN: https://doi.org/10. 2139/ssrn.2179944 Lekkakos SD, Serrano A (2016) Supply chain finance for small and medium sized enterprises: the case of reverse factoring. Int J Phys Distrib Logist Manag 46(4):367–392

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Liebl J, Hartmann E, Feisel E (2016) Reverse factoring in the supply chain: objectives, antecedents and implementation barriers. Int J Phys Distrib Logist Manag 46(4):393–413 Losbichler H, Rothböck M (2008) Der Cash-to-cash Cycle als Werttreiber im SCM—Ergebnisse einer europäischen Studie. Zeitschrift für Controlling & Management 52(1):47–57 Mayer A (2013) Supply chain metrics that matter: a closer look at the cash-to-cash cycle (2000–2012). Supply Chain Insights LLC, Hanover McCrea B (2017) Supply chain finance trends. Supply Chain Manag Rev March/April:S60–S63 Navas-Alemán L, Pietrobelli C, Kamiya M (2012) Inter-firm linkages and finance in value chains. Working paper, Inter-American Development Bank, Washington OECD (2015) New approaches to SME and entrepreneurship financing: broadening the range of instruments. OECD, Paris Pfohl H-C, Gomm M (2009) Supply chain finance: optimizing financial flows in supply chains. Logist Res 1:149–161 Randall WS, Farris MT II (2009) Supply chain financing: using cash-to-cash variables to strengthen the supply chain. Int J Phys Distrib Logist Manag 39(8):669–689 Seifert R, Seifert D (2011) Financing the chain. Int Commerce Rev 10(1):32–44 Templar S, Hofmann E, Findlay C (2016) Financing the end-to-end supply chain. Kogan Page, London Vázquez X, Sartal A, Lozano-Lozano L (2016) Watch the working capital of tier-two suppliers: a financial perspective of supply chain collaboration in the automotive industry. Supply Chain Manag Int J 21(3):321–333 Wandfluh M, Hofmann E, Schoensleben P (2015) Financing buyer-supplier dyads: an empirical analysis on financial collaboration in the supply chain. Int J Logist Res Appl. https://doi.org/10. 1080/13675567.2015.1065803 Werdenich M (2009) Modernes cash-management, 2nd ed. mi-Fachverlag, München Zhao L, Huchzermeier A (2018) Supply chain finance—integrating operations and finance in global supply chains. Springer, Cham

7

Risk Management in Supply Chains

Defining Risk

Risk Management

Risk Identification

Risk Analysis

Risk Response

Risk Response Collaborative Risk Management Planning

Learning Objectives After completing this chapter, you should be able to: 1. Define what the risk concept means in business and how it differs from related concepts 2. Name and describe some typical strategies how businesses can improve their resilience and reduce their vulnerability to risk 3. Understand the risk management process and name its typical process steps 4. Explain how standardization can support the risk management process 5. Name and describe typical risk categorization schemes that are used in the risk identification phase 6. Describe reputational risk as a supply chain-specific risk 7. Enumerate and briefly describe typical tools and methods that can be used for risk identification 8. List and explain the four focus areas of risk analysis (continued) # Springer Fachmedien Wiesbaden GmbH, part of Springer Nature 2020 A. Taschner, M. Charifzadeh, Management Accounting in Supply Chains, https://doi.org/10.1007/978-3-658-28597-5_7

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9. Explain the difference between qualitative and quantitative risk analysis 10. Explain the concept of value-at-risk as a key risk measure 11. Understand different risk response techniques and analyze their applicability in different business situations 12. Explain how supply chain design can contribute to strategic risk response planning 13. Name and briefly describe strategic risk response options other than supply chain design 14. Describe the concept of collaborative risk management Although risk cannot be readily expressed in financial terms, it is one of the key variables that need to be managed in businesses and supply chains (Bak 2018). Drawing management attention, risk inevitably also becomes an object for management accounting. Information on possible risks must be collected, analyzed, and disseminated to decision makers—a natural task for management accounting. Some companies might choose to set up dedicated risk management functions and teams that are separate from management accounting. But in many cases management accounting still remains involved or even ultimately responsible for risk management support.

7.1

Defining Risk

Common language often treats the terms “risk” and “uncertainty” as synonyms. However, for management purposes, the concepts should be clearly distinguished from each other. In addition, related concepts such as “disruption”, “vulnerability” and “resilience” need to be explained as well in order to outline their relation to risk and risk management. We will, therefore, start this chapter with a brief discussion of these inter-related terms and concepts (see also Fig. 7.1). Uncertainty Uncertainty describes the simple fact that there is a lack of information on future events and developments. Uncertainty as such cannot be avoided and is not purely negative in itself. After all, an uncertain future can also turn out to be more favorable than originally expected. Uncertainty not only comprises a lack of information about what might happen in the future but also missing information on the possible consequences as well as the probabilities of occurrence. The degree of uncertainty can, of course, vary (Vilko et al. 2014), but put simply, uncertainty is always multi-dimensional and comprises: – Uncertainty about future developments and events – Uncertainty about possible consequences of these developments and events

7.1

Defining Risk

155

Risk

Vulnerability

Uncertainty

Resilience

Regular business operations

Fig. 7.1 Risk-related terms (source: authors)

– Uncertainty about the probability of occurrence of these developments and events. Risk Risk as a concept is closely related to, but not synonymous with, uncertainty. Most scholars and practitioners agree that risk can be defined only if there is at least some knowledge about its probability of occurrence (Waters 2011). Different from uncertainty, a particular risk can be identified, analyzed—and potentially also controlled or handled in some way (Ivanov 2018). In other words: risk lends itself to focused management action, whereas uncertainty is uncontrollable and a basic condition of any business activity that simply has to be accepted. In its most general form, risk is defined as a deviation from a set target due to unforeseen developments or events. In general, such a deviation can be positive or negative, which, for instance, plays an important role in technical matters. When manufacturing a nut and a bolt, for instance, a positive, as well as a negative deviation from a target value, constitutes a problem. In the business context, however, the concept of risk most often refers to a negative deviation only. The vast majority of business actors views risk as “. . .an undesirable loss, i.e. an unwanted negative consequence” (Tummala and Schoenherr 2011). Unexpected positive consequences would typically not be subsumed under the risk notion, but rather be called an “opportunity”, an “upside potential”, or similar. Quantifiability of risk does not only relate to the probability of occurrence of a future event, but also to the expected magnitude or severity of its consequences. In other words: actors can make a judgment about the significance of that undesirable event, typically expressed through a figure that measures the monetary loss or damage that is expected to occur in case the risk materializes. A standard formula for the quantification of risk is the calculation of the expected loss value (Mitchell 1995):

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Expected loss value ¼ p  l

ð7:1Þ

with p ¼ probability of incurring a loss and l ¼ expected amount of the loss The expected loss value serves as an indicator of the relevance or significance of a risk for a particular business. Disruption Risks materialize as actual events that disrupt normal business operations and cause a deviation from planned activities (see Fig. 7.1). Events that do not cause disruptions or deviations, but go unnoticed, do not constitute risks in the first place: There is no need to prepare for the event in any form because planned business operations can be continued anyway. A true disruption, in contrast, endangers goal achievement. The organization must initiate counter measures to “sort things out”, regain stability, and move back to planned operations (Asbjørnslett 2009). Example Many supply chains today work on a “just-in-time” basis, i.e. components and sub-systems are supplied in synchronization with the manufacturing process and incoming buffer stocks are kept to a minimum or eliminated completely. Such a supply process can easily be disrupted if supplies do not arrive at the planned time at the manufacturing premises. Justin-time is very vulnerable to delays and the risk of delayed supplies can be significant: With no buffer stocks available, delayed supplies will often lead to a standstill in manufacturing, which, in turn, translates into late deliveries, lost orders, or penalty payments for late order fulfillment. In any case, the negative consequences (potential damage) can be high. This will translate into a high risk, even if the probability of occurrence is low (see formula above). Not all delays, however, will constitute true “disruptions”. A small delay of an incoming truck, for instance, might go unnoticed altogether. Even if the delay is noticed, processes might be flexible enough to make up for the short delay in incoming goods receipt and no changes need to be made to the planned manufacturing program. It is only when the delay exceeds a certain threshold that regular operating processes can no longer accommodate and the risk actually materializes. It is worth being noted that, just like delays, also early deliveries can cause problems. In a just-in-time system, early deliveries do not constitute “opportunities”. Goods arriving earlier than planned need to be buffered or handled in some other way—although processes do not foresee such interim stocking. Early deliveries, therefore, have the potential to constitute disruptions rather than opportunities, because they require unplanned treatment. After all, “early” is not the same as “just in time”. This is why manufacturers typically force their suppliers to avoid early deliveries in a just-in-time arrangement. Risks, therefore, materialize in critical events that have the potential to disrupt business operations and endanger goal achievement. Compared to planned operations, the disruptive

7.1

Defining Risk

157

event will lead to a deterioration of performance and consequently to an undesired loss that should be avoided or minimized (Tummala and Schoenherr 2011). The nature of these potential disruptions can vary widely and more will be said about potential risk classifications in Sect. 7.3. Vulnerability A risk or potential disruptive event can have different consequences for different organizations. An organization might be very susceptible to a specific risk, meaning that either the probability of occurrence or the impact on goal achievement is high. The same risk can have less significant consequences for another firm. The susceptibility of an organization or system to risk is commonly termed “vulnerability” (Waters 2011). Vulnerability, therefore, is not a characteristic of risk or a disruptive event itself, but rather of the system that is affected by these events. It originates from the system’s properties that . . .may weaken or limit its ability to endure threats and survive accidental events that originate both within and outside the system boundaries. (Asbjørnslett 2009, p. 18)

Put simply, vulnerability determines what is at risk for the organization in case a risk actually materializes (see Fig. 7.1). Vulnerability is a latent (i.e. not directly observable) characteristic as long as the risk does not materialize. It manifests itself only in a disturbance once the risk becomes an actual event. Example Companies that follow a global sourcing strategy will typically be more vulnerable to certain risks than companies that pursue local sourcing. The longer transportation routes become, the more likely it is that something unexpected happens. Strikes might delay flights, ships might have to take longer routes to avoid stormy weather, customs clearance might take longer than expected, etc. Local sourcing can potentially avoid or minimize such problems, reducing the firm’s vulnerability to these risks. Globally sourcing firms can try to reduce their vulnerability by implementing multiple sourcing, i.e. having alternative suppliers for the same component or input. If a risk materializes with one supplier, an alternative source can be picked and negative consequences can be reduced—thus effectively reducing the firm’s vulnerability to the risk as such. These alternative business models, however, can lead to new risks and their implementation comes at a cost. It is therefore very difficult or even impossible to determine the riskoptimal business model for a particular firm. Resilience It is a matter of fact that business organizations will never be able to avoid risks completely. Nor is it realistic to work towards a totally “invulnerable” organization that cannot be disturbed by any unforeseen event. Firms can try to limit their exposure to risk, but they can

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also work towards a certain level of robustness against negative effects, once risks materialize (see Fig. 7.1). This robustness is commonly termed “resilience”. The concept of resilience is applied in different disciplines such as ecology, engineering, sociology, psychology, economics, and organizational analysis. The overall understanding of resilience relates to the ability of the underlying system (material, network, individual, companies or corporate entities) to adjust or maintain essential functions under stressful and harsh conditions (Heckmann et al. 2015). In an organizational setting, resilience denotes an organization’s ability to cope with the consequences of unavoidable adverse events in order to return to its original operational state or to move to a new, more desirable, state after being disturbed (Radhakrishnan et al. 2018). Generally speaking, a resilient organization is more adaptive and adjustable as well as more flexible. Management can work towards higher resilience by trying to strengthen the following characteristics of their organization (Radhakrishnan et al. 2018; Ganguly et al. 2018): – Flexibility Flexibility describes an organization’s ability and readiness to change (e.g. processes or rules) and to find compromises. If a disruption occurs, an organization will have higher chances to be “back on track”, if rules and processes can be adapted according to the newly prevailing conditions. – Velocity While flexibility stresses the degree of change or adaptation, velocity focuses on speed, i.e. how fast can a system adapt or change. The faster adaptation is possible, the higher the chance that negative effects can be kept under control or losses can be minimized. – Visibility Visibility describes the degree to which the identity, location, and status of all system elements is known and transparent. If responsibilities are clear, the status of customer orders can be easily checked and verified. If information flows between supply chain partners are stable and transparent, it is easier to detect flaws, to identify possible causes and to initiate remedial actions—all potentially leading to smaller losses and less negative disruption effects. – Collaboration In a risk management context, collaboration denotes the willingness of different players to share even sensitive risk-related information. Collaborative information sharing will reduce uncertainty and will help all parties define appropriate risk management actions. Resilience can be addressed from four different perspectives (Ganguly et al. 2018): (1) preparation for a disruptive event, (2) response to an event, (3) recovery from the event, and (4) growth/competitive advantage after the event. Most efforts in risk management focus on reducing vulnerability and improving resilience.

7.2

7.2

Risk Management

159

Risk Management

We have outlined in the previous sub-chapter that organizations are not entirely helpless when it comes to dealing with risks. While general uncertainty cannot be avoided, risks can be managed—at least to some extent. Risk management is generally defined as the process of systematically identifying, analyzing, and responding to risks in an organization (Waters 2011, p. 75). It is the entirety of all activities, processes, instruments, and structures in place to cope with risk. Supply chain risk management, consequently, comprises all risk management activities in a supply chain. Its objective is to identify potential sources of risk and to implement appropriate measures to avoid or restrict negative effects of these risks on the supply chain. This means controlling the factors that can cause negative effects on the normal functioning of the supply chain (Rebula de Oliveira et al. 2017). Some of these risks might pertain to individual partners only, others can affect the entire supply chain. Risk management will focus on the two key aspects outlined in the previous sub-chapter: 1. Reduce supply chain vulnerability, i.e. the likelihood of the supply chain to be affected by risky events. 2. Improve resilience, i.e. the ability of the supply chain to return to normal working after a damaging event has materialized. The risk management process can generally be split into three broad sequential steps, which are shown in Fig. 7.2. Risk Identification Risks must be known before they can be managed. Some risks might be generic and can affect all types of businesses and supply chains, others might be relevant only to entities with certain characteristics. The risk of supplier insolvency, for instance, can affect virtually all firms. Exchange rate risks, in turn, might be highly relevant for globally active companies, but almost irrelevant for firms with local business relations only. In any case, risks must be identified and clearly described, before the organization or the entire supply chain can take any further steps. Risks that are similar to each other might also be grouped together, because the actors expect or hope to tackle these risks in a similar manner, thus reducing the complexity of the risk management task. Example If a company is doing business in more than two currencies, for instance, the exchange rate risk might differ for each currency, but risk management actions might be very similar (e.g. entering currency derivatives in order to hedge exchange rate fluctuations) and responsibilities for taking adequate measures might be assigned to one single function or person only.

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Identify and categorize potential damaging events

Quantify probability and consequences, analyse potential causes

Risk analysis

Risk response

Identify and implement possible remedial actions

Fig. 7.2 Risk management process (source: authors)

Risk Analysis Simply knowing about the existence of a risk is not sufficient for handling it in an adequate manner. Some risks might have devastating consequences for the firm or the entire supply chain if they actually materialize. Others might have less severe consequences but might occur much more frequently. In any case, the relevance of each identified risk should be assessed. Relevance is often indicated by the expected loss value, expressed as the product of the probability of occurrence and the extent of potential damage (see formula (7.1) above). The higher the relevance or significance of a risk is, the more effort must be put into adequately managing it. This also comprises a thorough analysis of its potential causes and triggering factors, because risk management ideally focuses on keeping these causal factors under control instead of simply alleviating the negative effects. Besides, in risk analysis, it is of utmost importance to avoid an isolated view on the particular risks of a business. Some risks may be linked with each other, leading to an amplifying effect, while other risks may offset each other. It is, therefore, vital to take an integrated approach and view a firm as a portfolio of risks rather than just dealing with each risk separately. Risk Response Once potential risks have been identified and their relevance has been assessed, companies must determine how they want to deal with these risks. On the one hand, adequate response options will depend on the risk significance: Insignificant risks might simply be accepted because the potential damage does not justify the effort of any further risk handling actions. Small risks will justify limited risk management efforts only, while critical risks call for

7.2

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161

comprehensive risk management plans. On the other hand, the companies’ possibilities to influence the causes of risk and risk effects will also have a strong influence on further risk responses. Risks that originate from internal company causes might lend themselves more readily to pro-active response plans. For risks that are entirely external to the company, at least insurance coverage might be available. Alternative Categorizations The outlined three-step sequence (risk identification, risk analysis, and risk response) is not the only possibility to structure the risk management process. Academics have developed more detailed suggestions, for instance structuring the process in four steps, namely (1) identification of the risks; (2) evaluation of the risks; (3) choice and implementation of actions to reduce the likelihood of risks and minimize the effects if they occur; and (4) monitoring of risks (Rebula de Oliveira et al. 2017) or six steps, which are (1) risk identification, (2) risk measurement, (3) risk assessment, (4) risk evaluation, (5) risk mitigation & contingency plan, (6) risk control & monitoring (Tummala and Schoenherr 2011). Neither academia nor business practice, however, adapt the general risk management process to different types of risk (Prakash et al. 2017). Firms implement and follow their risk management rules and procedures irrespective of the type of risk—although actions and responsibilities might, of course, differ depending on the specific risk involved. In business practice, the number of steps distinguished does not really make a difference either, as long as the sequential logic is followed and no important task in the risk management process is neglected. We will follow the rough three-step structure in the following sub-chapters, but acknowledge that the process can be split up into several, more individual, steps. Standardization of Supply Chain Risk Management Risk management is a generic business activity that is not confined to supply chains only. As such, risk management has found widespread attention and has also been the subject of international standardization efforts. Unlike other international standards, risk management standards do not impose any formally binding rules or procedures on businesses. Following an internationally established standard, however, can still be a wise decision for companies. Basing one’s own risk management efforts on a well-established and standardized framework can provide new managerial insights for the organization and can help manage supply chain risks effectively and avoid costly mistakes (Blos et al. 2016). Two international standards are of particular importance (Waters 2011; Rebula de Oliveira et al. 2017): 1. The ISO 28000 standard, published in 2007 by the International Organization for Standardization, specifies security management systems for the supply chain. Security is a somewhat narrower term than risk. “Security is concerned with actions that deliberately set out to harm a supply chain.” (Waters 2011, p. 76). Natural disasters, the

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bankruptcy of a supplier, or political turmoil in a customer’s country all constitute risks. These events have the potential to damage the supply chain, but they are not deliberately targeted towards it or initiated with the intention to do harm. Piracy, theft, or a cyberattack, in contrast, pose security threats to the supply chain, since deliberate action is taken by third parties to attack and harm the supply chain or its individual members, respectively. The ISO 28000 standard describes the general requirements of a security management system and the elements that are required from companies that want to receive a certificate of compliance. 2. The ISO 31000 standard was launched in 2009, for the purpose of standardizing risk management in general, under the name of “Risk Management: Principles and Guidelines” (Rebula de Oliveira et al. 2017). The standard does not focus on supply chains but provides general principles and guidelines for managing risks in a systematic, transparent and reliable manner. It can be applied to all types of business entities and organizations—among them entire supply chains. ISO 31000 outlines a general risk management process and lists more than 30 possible tools and techniques for risk assessment. As an additional element contributing to the standardization of supply chain risk management, the respective process in the Supply Chain Operations Reference (SCOR®) model can be mentioned. The SCOR model has been developed and is continuously updated by the Supply Chain Council (SCC), a global non-profit consortium that is open . . . to all companies and organizations interested in applying and advancing the state-of-the-art in supply chain management systems and practices. (Supply Chain Council 2012)

The SCC is not an official standardization body, but the SCOR model and its elements have found widespread acceptance among practitioners and can thus be considered de-facto standards in some areas. The SCOR model describes a specific process called “Manage Supply Chain Risk”, which covers the identification and assessment of potential disruptions (risks) in the supply chain and developing a plan to mitigate these threats to operating the supply chain (Rotaru et al. 2014). The SCOR process description explicitly makes reference to the ISO 31000 standard and adapts its logic for supply chain risk management.

7.3

Risk Identification

The risk management process starts with an identification of all relevant risks that might affect the company and its supply chain (Fan and Stevenson 2018). Such an enumeration should not only be complete (no relevant risks are omitted), but also non-overlapping. Companies will typically set up a “risk register” or “risk portfolio” (Waters 2011, p. 104) that records the relevant features of all risks. A risk register will not only describe risks

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themselves, but also highlight their possible impact (what negative consequences are expected, what is the magnitude and the financial impact of these consequences?) as well as possible mitigation and risk management actions (how can the company and its supply chain partners deal with that risk?). As such, the risk register is not only the result of this first step in the risk management process but also integrates results from later process stages (Waters 2011). The usability and the relevance of such a risk register will highly depend on the logical dimensions it uses to describe and categorize different supply chain risks. All dimensions used should be relevant for subsequent risk assessment and risk handling. Clustering risks by origin, for instance, might be relevant for choosing adequate risk handling measures. A categorization by the first letter of risk name, in contrast, is irrelevant and unnecessary, since it does not provide any useful information for the subsequent steps in the risk management process. Risk Categorization Academia and business practice have suggested and implemented a number of different descriptive dimensions for supply chain risks that can possibly all be used for subsequent characterization and categorization. We mention just a few here (see Waters 2011; Jereb et al. 2012; Punniyamoorthy et al. 2013): – Risk type according to international standards The ISO 28000 standard, for instance, distinguishes the following eight different risk types (Jereb et al. 2012): 1. Physical failure threats and risks, such as functional failure, incidental damage, malicious damage or terrorist or criminal action leading to such failures; 2. Operational threats and risks, including the control of the security, human factors, and other activities which affect the organization’s performance, condition or safety; 3. Natural environmental events (storms, floods, etc.), which may render security measures and equipment ineffective; 4. Factors outside of the organization’s control, such as failures in externally supplied equipment and services; 5. Stakeholder threats and risks such as failure to meet regulatory requirements or damage to reputation or brand; 6. Design and installation of security equipment including replacement, maintenance, etc.; 7. Information and data management and communications, 8. A threat to the continuity of operations. – Organizational entity as origin of risk A common classification distinguishes:

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1. Internal risks (arise from operations within an organization) such as accidents, equipment failure, human errors, quality issues, etc. 2. Supply chain risks (external to the organization, but internal to the supply chain) such as supplier reliability, delivery problems, industrial action (strikes), shortage of supplies, order processing problems, etc. 3. External risks (external to the supply chain) such as extreme weather, natural disasters, legislation changes, crime, etc. – Main supply chain flow affected Based on the common understanding of supply chains, risks can affect: 1. 2. 3. 4.

Physical flows (flows of goods) Data and information flows Financial flows (flows of funds) Organizational flows (processes)

– Domain of risk management In this view, organizations’ activities can be broadly characterized as either technological or commercial. Risks, consequently, either affect technological or commercial activities or both (universal risks). The logical dimensions used for describing and categorizing risks in the risk register always depend on company-specific needs and preferences. In any case, management accounting can contribute to identifying and specifying the most suitable descriptive dimensions by drawing on their own expertise about what has been causing damaging events in the past, which relevant drivers have been identified, and what remedial actions proved to be effective and suitable in those cases. Risk registers, therefore, will always be company-specific. Different risk registers will contain varying numbers of risks and risk categories, might use slightly differing definitions for similar risks, or might classify risks into different categories depending on the descriptive dimensions used. In a supply chain environment, it makes sense, of course, to aim at a certain degree of harmonization and standardization of risk registers across supply chain partners. This will simplify collaborative risk management significantly. In such a case, it is advisable to base the cross-company risk register on a supply chain-specific model such as the SCOR model mentioned above. A SCOR-based risk categorization can look similar to the one depicted in Fig. 7.3. The risk types are grouped under the generic SCOR processes as overall categories. The assignment of risks and risk categories is not unambiguous in all cases, but a SCOR-based risk register will serve its purpose, as long as supply chain partners follow the same categorization logic and ultimately work with identical (or at least closely aligned) risk registers. The SCOR-based risk types are briefly described in Table 7.1.

7.3

Risk Identification

Plan

Source

165

Make

Strategic

Supply

Operational

Inertia

Financial

Disruption

Informational

Relational

Deliver Customer

Return Legal

Other Environmental

Culture

Capacity

Demand

Fig. 7.3 Supply chain risk classification (source: Rangel et al. 2015)

Companies might identify most of the above risks even if they do not explicitly follow a supply chain thinking. After all, potentially damaging effects from natural disasters, political turmoil, disruptions in the global economy, or simply errors and failures from business partners will always be on a company’s radar screen. However, taking a dedicated supply chain perspective on risk adds value in at least two respects: First, it allows the identification of new, collaborative, risk management actions that would not be available to the single firm (we will come back to this line of thinking in Sect. 7.7). Second, several risks are difficult to identify and to assess without a supply chain attitude. A typical example for the latter is reputational risk—defined as . . .the cumulative likelihood that events resulting from exogenous or endogenous sources can occur and negatively impact the stakeholder’s perception of the firm’s behavior and performance. (Lemke and Petersen 2018, p. 67).

While endogenous sources originate within the firm itself, exogenous sources might well be the behavior of supply chain partners. A firm’s reputation, therefore, might be at risk if one of its supply chain partners (e.g. a supplier) shows misconduct and the general public attributes this behavior to other supply chain partners as well. Example The potential perils that can originate from reputational risk were felt hard by Apple Inc. in 2010 when its main supplier Foxconn was dominating news frontlines after several workers had committed suicide at their workplace. Chinese Foxconn is the main contract manufacturer of Apple products. About half of all iPhones worldwide are manufactured in Foxconn’s huge factory in the central Chinese city of Zhengzhou (New York Times 2016).

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Table 7.1 SCOR-based risk categorization Process Plan

Risk type Strategic

Inertia

Informational

Capacity

Demand

Source

Supply

Financial

Relational

Make

Operational

Disruption

Deliver

Customer

Return

Legal

Others

Environmental

Description Any event affecting the business strategy, such as a lack of or strategic planning (both organizational and supply chain-dependent) and the absence of a systemic perspective in planning across partner firms. The inability to remain in a competitive market, usually caused by the failure of the organization and/or chain to follow market changes (e.g. technology, design, function, etc.). Failure in the information system due to deficient data feed systems or electronic systems or the inability to access, receive and transfer information. Over- or underutilization of capacity, lack of flexibility to respond to changes in demand or the inability of some supply chain members to plan, schedule and control production and inventory management. Poor demand forecasting (in terms of quantity and mix), seasonality, long lead times, short product life cycles, small customer bases or information distortion due to promotions and incentives. This may result in the bullwhip effect (see Chap. 3). Inefficiencies in the supply chain process (e.g. an increase in the price of some inputs, suppliers’ lack of responsiveness, unavailability of inputs in terms of quantity and/or quality) and problems in internal product flow. Cash flow problems (product pricing, delinquencies by debtors, non-payment) and changes in the financial markets (taxes, exchange rates, licenses, etc.). Relationship among supply chain members, such as members’ lack of visibility, opportunism, trust in information transfer, sub-par cooperation and interaction among members and outsourcing (e.g. a supplier supplying the chain and its competitors or a supplier redesigning parts and creating its own product). Situations preventing the company from performing its production activities, which may be related to problems with production systems, internal policies, procedures, processes, and people. Discontinuity in the materials flow in the production process (following suspension in activities that add value to the customer), for example, arising from the reliance on a single source of supplies and labor strikes. Situations that modify customer choice, reducing the number of applications, e.g. product obsolescence, product delivery, customer service (before, during and after the order request) and confidence loss in the product or brand. Inability of the organization and/or the supply chain to comply with legal restrictions or further exposure to litigation. Events outside the supply chain, e.g. natural disasters and uncertainties in governmental (legislation, regulatory), economic, technological and social policies. (continued)

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Table 7.1 (continued) Process

Risk type Culture

Description Differences in business culture among the members of the chain or differences in the culture, language, and people in the countries in which they are located.

Source: Rangel et al. (2015)

Foxconn’s reputation as a “sweatshop” (describing a workplace that is characterized by low wages, long work hours and unfavorable work conditions) hit a blow in 2010 when several workers in its Zhengzhou factory committed suicide—presumably in desperation of their inhumane work conditions. Public attention soon turned to Apple as Foxconn’s contracting firm and the question was raised whether Apple was indirectly exploiting Foxconn workers in order to maximize own profits. The issue was clearly not perceived as a purely internal Foxconn problem by media and consumers worldwide. Media investigations continued further down Apple’s supply chain and BBC reporters found evidence that tin from illegal Indonesian mines could be entering Apple’s supply chain—although the company claimed that it was committed to the ethical sourcing of minerals (BBC 2014). It becomes evident, that Apple’s own reputation and continued business success are inseparably linked to the business conduct and the work conditions of its supply chain partners. Another typical supply chain risk has grown enormously in importance in recent years: IT-related or “cyber” risk (Gaudenzi and Siciliano 2018). Supply chain partners are increasingly interconnected through shared ERP (enterprise resource planning) systems, Internet platforms, EDI (electronic data interchange), and various other IT systems. These systems provide multiple benefits to supply chain partners, such as reducing transaction costs, shortening lead times, or facilitating information exchange in general. At the same time, however, partners become vulnerable to an entirely new category of supply chain risks. These cyber risks go beyond pure IT interruptions (Gaudenzi and Siciliano 2018). In most cases, cyber-attacks are much more critical, where human hackers intentionally access an organization or a network with the goal of either gaining an economic advantage or causing sabotage. Example China Ocean Shipping Company, also known as COSCO, is one of the largest dry bulk shipping operators worldwide, operating more than 1100 ships. On July 25th, 2018, COSCO was hit by a cyber-attack that stalled its North American operations for several days (The Wall Street Journal 2018). Malicious software (so-called ransomware) blocked COSCO’s network, e-mail accounts and phone connections in the USA and several other countries in Latin America.

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It took the company several days until the systems could be restored. During that time, customer requests could not be handled, bills of loading and invoices could not be issued. With COSCO being a major player in global supply networks, this temporary black-out also affected many of its customers worldwide, delaying shipments, new orders, and customer complaints significantly. Risk Identification Methods When setting up their own risk register, firms should not rely on ready-made lists of possible risks only. Such lists can be a valuable starting point, but the context of business operations will differ for each company and each supply chain. Therefore, own efforts should be put into identifying—and possibly also categorizing—relevant risks. Both research and business practice have developed and adopted a number of tools and methods for risk identification and risk categorization (Waters 2011; Tummala and Schoenherr 2011; Fan and Stevenson 2018): – Checklists Checklists are forms that record how often a specific failure or damage was attributed to a specific event. Checklists are used to simplify and standardize data collection. The information can subsequently be used to identify common (and previously maybe undetected) causes behind certain damaging events. – Event tree / fault tree analysis Event trees or fault trees order initiating events and their subsequent effects in a multilayered, tree-like, order. Each event or failure is split up into two or more triggering events, with each trigger receiving a probability of occurrence. Triggering events or failures can subsequently be further analyzed, thus leading to pathways across multiple layers of events or failures with their respective triggering events. By combining the respective probabilities along a specific pathway, risks cannot only be identified, but also assessed in terms of likelihood of occurrence. – Process engineering and process analysis Process analysis breaks down a specific process (e.g. order fulfillment across supply chain partners) into a sequence of distinct activities. A formal description of each activity (e.g. resources used, stakeholders responsible, time taken, etc.) is typically added. The deeper granularity of activity chains and their detailed descriptions allow better identification of possible risk sources and interrelationships between them. – Supply chain mapping This approach is basically an application of the generic process analysis concept to the specific supply chain environment. A supply chain map visually depicts the supply chain and its flows of goods, information, and money from upstream suppliers throughout the focal firm to downstream customers. The granularity is lower than in a typical process analysis, but the map crosses organizational borders and visualizes interfaces

7.3

–

–

–

–

Risk Identification

169

between supply chain partners—which can turn out to be major sources of supply chain risks. Ishikawa diagrams Named after their conceptual father, the Japanese organizational theorist Kaoru Ishikawa, these diagrams show the causes of a specific event in a fishbone-shaped order. With the event or effect being the “head”, first-order causes are aligned as fishbones. Second-order causes (i.e. variables that can explain the first-order causes) can branch out from these fishbones. Ishikawa diagrams are often called “fishbone diagrams” or “cause-and-effect diagrams”. They can be used to identify possible root causes behind an observed or hypothesized event or negative effect. In the risk identification stage, Ishikawa diagrams can help identify possible risks that have been overlooked so far. Expert interviews / Delphi studies The Delphi method extends simple questionnaires be adding the possibility of iterative adjustments of previous opinions and answers. A Delphi study asks a group of identified subject matter experts (e.g. people who are knowledgeable about supply chain risks) to answer a questionnaire. Individual responses are collected and analyzed, a summary of all responses is sent out to all respondents. These have the possibility to revise or adjust their own answers based on the opinion of other respondents. These iterative revisions can be repeated several times, allowing experts to integrate other experts’ opinions and inputs into their own responses and thus gradually working towards a group consensus that is expected to reflect the combined expertise of all expert respondents. Failure mode and effect analysis (FMEA) FMEA is a tool for systematic failure analysis, which can basically be applied to any type of object or system that is subject to possible malfunctions or failures—among them entire supply chains or individual processes within a supply chain. The “failure mode” describes the way the failure occurs or shows in practice (e.g. “supplier delivers wrong quantity of ordered goods”), the effect describes the consequences of this failure. An FMEA typically describes failures along three dimensions: probability of occurrence, severity of consequences, and possibility of failure detection. Failures receive a “risk level” score by combining these three dimension values into a single indicator. Value stream mapping Value stream mapping (VSM) has its origins in lean management and is a tool to visualize the flows of information and materials within a production system (SuarezBarraza et al. 2016). By displaying the activities that take place and the times they take, respectively, VSM is originally focused on identifying waste. But the detailed process analysis can also create opportunities to identify potential risk factors in the value stream, which might lead to delays, process failures, or other potentially damaging effects. VSM can also be applied on a cross-organizational level, interpreting the value stream as a process that integrates supply chain partners.

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The above considerations show that the risk identification stage is a mix of structured and standardized tools and activities (e.g. defining and standardizing a risk register) as well as creative and more qualitative tasks (e.g. brainstorming about possible risks). Management accounting can help setting up the risk identification process itself, can provide expert support when applying risk identification tools, and can act as the custodian of the company’s or the entire supply chain’s risk register.

7.4

Risk Analysis

The focus of the risk analysis phase is on the assessment of the following risk characteristics (Dani 2009; Fan and Stevenson 2018): 1. The probability of occurrence of an identified risk, 2. the extent of the potential damage caused by its occurrence (with points 1 and 2 often being used for risk prioritization), 3. interrelationships with other risks that might give rise to “domino effects” and thus increase potential damage, 4. potential root causes of the risk that might give indications for proper risk handling and risk management. Somewhat contrary to conventional wisdom, most firms do not see natural disasters (such as flooding, volcano eruptions, or earthquakes) or political events (such as strikes, terror attacks, or civil unrest) as the most critical risks affecting their supply chains (Wagner and Bode 2009). Instead, volatile and unexpected customer demand or price fluctuations in supply markets, for instance, are perceived as much more critical. The good news about this assessment is that such risks are not beyond firms’ control. On the contrary: they readily lend themselves to collaborative risk management across supply chain partners. As outlined earlier, risk management is possible only after the risks have been identified and properly assessed. Such an assessment can focus on the impact on a more operational level (i.e. potential damaging effects on company assets, people, and processes) or on a strategic level, focusing on the firm’s (or supply chain’s) ability to achieve its mission or to survive altogether. The latter case is sometimes also called a “vulnerability analysis” (Asbjørnslett 2009). Risk Map The result of a risk analysis is often depicted in a risk map that combines the two dimensions “probability of occurrence” and “potential impact” (Khojasteh and Irohara 2018). A risk map places each identified risk in a quadrant of the risk map. In many cases, the risk map dimensions are divided into broad intervals only, such as “high – medium – low” (see Fig. 7.4). Risks with a high probability of occurrence and a high potential impact are shown in the upper right of the matrix and will be categorized as “critical” or “category

Risk Analysis

A risks

Low

Probability

Fig. 7.4 Risk map (source: authors)

171

High

7.4

B risks

C risks

Low

Potential damage

High

A” risks. These risks require more intensive consideration and more comprehensive risk treatment. Risks in category C, in turn, have a low probability of occurrence and only a small impact on goal achievement. Such risks do not justify elaborate risk treatment activities since the benefit of risk management actions might be too small to justify the effort. Category B risks take a middle position. Firms will typically engage in a combination of both qualitative and quantitative analyses to generate the required risk information. In fact, combining “objective” data and “subjective” expert judgment can result in more robust analyses than relying on one single approach only (Fan and Stevenson 2018). Qualitative Risk Assessment Many different tools and methods are available for qualitative risk assessment. First, a firm’s risk register can already give valuable information on potential causes and influencing factors of a particular risk (Waters 2011). Qualitative information can also come from other tools and methods that have been used for risk identification. Delphi surveys (asking experts to quantify risk probabilities and expected damages), FMEA (which typically rates severity on a discrete scale from 1 ¼ no effect to 10 ¼ hazardous effect, Dani 2009), or an ABC analysis (which groups risks in three different categories based on the observation that 20% of the risks typically cause 80% of concerns or damages, Waters 2011) can all provide useful input for risk assessment and analysis. It is also possible to use questionnaires or checklist-type tools to assess the probability of occurrence for different risks (Punniyamoorthy et al. 2013). Quantitative Risk Assessment A quantitative analysis of risk tries to determine specific values both for probability of occurrence (expressed as a percentage) and potential impact (expressed as a monetary amount). Such an approach is possible, for instance, when a potentially large number of objects or elements are subject to the same risk. The risk of a defaulting customer, for instance, can affect any customer. If the firm deals with a large number of different customers, it possibly has access to a correspondingly large set of data describing its

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customers: previous business transactions, volume, and type of business, previous payment delays or similar problems, etc. The firm can apply statistics or data mining techniques to extract patterns that explain why customers default (descriptive use of data mining) and to assess the probability of future customers defaulting based on these patterns (predictive use). Data mining will work all the better, the larger the available data set is. Using this pertinent data, the firm can uncover sources of risk exposure that may otherwise remain obscure or unnoticed (Dani 2009). Where no extensive data is available, firms might try to employ other methods to derive “hard” outputs from limited input data. Possible methods include the following (Tummala and Schoenherr 2011): – Let experts develop probability distributions in an iterative (Delphi-type) survey process. – Feed limited amounts of data into a causal model of risks and risk effects and subsequently apply simulation techniques to determine a possible probability distribution for the risk impact (damage). – Approximate probabilities through statistical correlation or regression. Value-at-Risk The potential impact of a risk can be expressed as a deviation from expected monetary objectives (Heckmann et al. 2015): What effect would a materialization of this risk have on our financial goals and results? By how much would our net income be reduced? What is the effect on our cash position? A prominent measure of financial risk impact is the so-called “value-at-risk” (VaR) metric. VaR is a hypothetical daily loss expected to be breached once every hundred days—in other words: the probability that tomorrow there will be a loss larger than the VaR is 1%. (Auer 2018, p. 1).

In statistical terms, VaR is the (1-α)-quantile of a profit and loss distribution. Value-atrisk can be calculated as follows (see also Fig. 7.5): 1. The probability distribution of a risky event must be estimated. This estimation can be based on an analysis of past values (time-series analysis) or just be a subjective expert opinion (see above). 2. Depending on its shape, this probability distribution can be described by a small set of statistical parameters. For convenience purposes, probabilities are often assumed to follow a normal distribution—which can be described by its expected value and its standard deviation. 3. Following a normal distribution, a risk is not interpreted as an entirely negative possibility—outcomes can lie well above or below the expected value. In fact, normal distributions do not have clear upward or downward limits. Extremely high (i.e. positive

7.4

Risk Analysis

173

Probability distribution of gains and losses from an uncertain event

49%

50%

1% probability

- 2.33 σ Losses

-x = VaR (€) [1%]

μ

Gains

Downside risk

Fig. 7.5 Value-at-risk (source: authors)

deviations) as well as extremely low (i.e. negative deviations) values are still possible— they are just very unlikely (i.e. their probability is very low). 4. Value-at-risk focuses on the negative side of the probability distribution, i.e. it measures the downside risk, see also Fig. 7.5. VaR determines that value x in the probability (or density) function that has a cumulative probability of 1%. In other words: the probability to have a negative deviation of x or more is exactly 1%. Other percentage values can be selected, but the 1%-VaR is a common threshold value. 5. Given a normal distribution, a 1%-VaR can be calculated as VaR ¼ μ-standard deviation  2.33—a very convenient and easy way to quantify the financial impact of a given risk—provided it can be modeled as a normal distribution.

Analyzing Interconnections of Risks Risks should never be analyzed from an isolated perspective only. Sometimes, certain risks are interconnected, which is why versed risk managers always analyze risks for stochastic interdependencies. Firstly, some risks may trigger domino effects by increasing the probability that other risks materialize as a direct consequence. Secondly, and in contrast, some risks may offset each other, thus limiting the potential damage (Meulbroek 2001). In a third case, some risks may be independent of each other, but they may—if by accident appearing at the same time—amplify each other and their subsequent damage. It is, therefore, vital to consider a business as a portfolio of risks and not just to look at each risk in separation. Example Imagine a manufacturing company that is confronted with a hacker attack. Thousands of datasets have been stolen including sensitive customer data. At first sight, this is a case of IT risk, involving data security issues. In the following, the firm might have to deal with police investigations and other security authorities. Additionally, this case may turn out to

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be a legal risk as well, as the company might face a variety of legal allegations by affected customers and lawsuits. Another type of risk that this situation might trigger is an operating risk in logistics. The hacker attack and the defense activities might have led to a shut-down of the central IT system, which would disable the web-based ordering system. As a result of this, not only the informational but also the physical flows in the supply chain could come to a stop. Example Another, albeit much more far-reaching, example of interconnected risks is the 2011 earthquake of Fukushima, Japan. On March 11th, 2011, an earthquake measuring 9.0 on the Richter scale hit the Tohoku region. While the earthquake itself caused substantial damages, it was mainly the subsequent tsunami that severely damaged the nuclear plant Fukushima Daiichi. The following core meltdown in four reactor units led to radioactive contamination of vast areas around the plant. About 18,500 people died in the tsunami, 470,000 had to be evacuated, 160,000 lost their homes (Lpb 2020). Tepco Inc., the operator of the Fukushima nuclear plant incurred a loss of 10.6 billion € in the fiscal year ended March 31, 2011. The example shows that natural and environmental risks, and their consequences on people, society and businesses, are often interrelated. Example In contrast to risks that trigger or amplify each other, Meulbroek (2001) provides an example of mutually exclusive risks that allow for netting off. The US conglomerate Honeywell was able to substantially reduce its risk costs by consolidating its risk exposure. Honeywell’s risk management took an integrated approach when analyzing risks, including product liability, property, or employee crime, but also market-related risks such as exchange rate risk. With this approach, they were able to identify mutually exclusive risks. For instance, “a fire that destroys a factory eliminates the chance that the company will have to pay out on defective products that the factory might otherwise have produced” (Meulbroek 2001, p. 23). Reserves put aside for insuring against fire can be offset against reserves put aside for product liability. Bundling Honeywell’s risk allowed the company to save more than 15% of its overall risk abatement costs. An analysis of risk interrelations is all the more important when expanding the view from a single firm to a network. Our assessment of both the probability of occurrence and of the potential impact of a particular risk will differ between the individual firm or the entire supply chain as analysis objects. In fact, through the interconnectedness of risks in a network, the probability of risk occurrence typically increases when moving from the single firm to the entire supply chain: the more partners are involved, the more likely it is that some partner is affected by a particular risk. The so-called “ripple effect” describes negative consequences affecting one firm that propagate upstream and downstream in the supply chain and thereby cause even higher negative consequences with other partners. This effect of risk transmission in supply chains needs to be considered in risk analysis (Swierczek 2018). However, the impact is not always clear. In fact, the transmission of

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risks to other supply chain partners can either lead to its amplification (risk has more severe effects) or to its (partial) absorption (effects are reduced in partners’ organizations). Example European car manufacturers are hardly exposed to natural disasters such as earthquakes or tsunamis (see example above). Nevertheless, many of their supply chain partners across the globe are located in critical regions that are affected by disastrous events. With supply chains being tightly interconnected, a damaging event affecting a supplier in Japan, for instance, will inevitably have an impact on other partners. The European manufacturer might be confronted with a supply interruption of critical components that eventually leads to a complete stand-still of its own production facilities (amplification). The North American car dealer, in turn, might face delays in the delivery of certain car models, but can continue normal business with other models (risk absorption). As outlined above, risk analysis is not only done to learn more about the nature and potential impact of risks as such. A key goal of this step in the risk management process is risk prioritization. Prioritization helps a company to focus decision making and risk management efforts on the most important risks (Punniyamoorthy et al. 2013). Such prioritization is absolutely indispensable since company resources are limited and not all risks can be treated in the same way—even if the company wanted to. In any case, quantification of probabilities and likely damages is always subject to forecast errors, subjective biases, and information gaps. Decision makers, as well as management accountants, must keep in mind that no risk analysis (no matter which tools and methods are employed) can provide a complete and totally reliable picture.

7.5

Risk Response

Once risks have been identified and their significance (or criticality) has been assessed, firms must decide on appropriate response actions. As outlined in the previous sub-chapter, the nature of the response and the effort put into it will depend on the perceived criticality of a particular risk. Risks that are perceived as uncritical (or even neglectable) might not receive any particular treatment at all. Note that “no response” of course also is a response! In such cases, the firm simply has (implicitly) decided that it will not take any precautionary measures and therefore it will have to take the risk and its negative consequences in case it still materializes. Of course, ignoring risks is often not the best strategy. Firms can choose between a number of generic risk response options (Waters 2011): 1. 2. 3. 4.

Accept risk Reduce risk Transfer risk Avoid risk

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We will elaborate on these options in more detail below. Accept Risk Accepting a risk without devising any counter measures is arguably the easiest risk management option. The firm is prepared to bear all negative consequences if the risk actually materializes and no effort or resources are spent on mitigating or avoiding the risk. It should be noted that “accepting” a risk is not synonymous with “ignoring” it. The decision to accept a particular risk has been taken on the grounds of a previous risk analysis, that is, a rational decision. The risk, therefore, has been identified and assessed—and is certainly not ignored! A risk will be accepted if the firm considers the cost of other risk response options to be higher than the potential benefit gained. Furthermore, a risk may be accepted if management has no other option. Some risks cannot be avoided, reduced or transferred. In such a case, accepting the risk is the only option. In any case, the risk should continue to be tracked to ensure the accepted consequences do not escalate in the future (Fan and Stevenson 2018). Example Virtually all firms are confronted with defaulting customers now and then. As long as customer defaults remain infrequent and insignificant in size, firms often chose not to take any explicit action. Taking out insurance against customer defaults can be costly, checking new customers’ credit ratings might shy off customers or delay the order fulfillment process, etc. In such cases, the firm might consider the risk of occasional customer defaults as small enough to be accepted without any further precautions being taken. Reduce Risk Reducing the negative consequences of a risk can target its probability of occurrence, the expected negative impact, or both. The probability of occurrence can be reduced by avoiding or mitigating the root causes that give rise to the risk in the first place. If certain shipping routes are subject to frequent piracy attacks, for instance, the firm might switch to other, more secure, routes. Risky business operations can be changed, immature technologies can be replaced by tested ones, etc. Firms can also take precautions to limit the potential damage, e.g. by making processes more robust. A multiple-sourcing strategy is a typical risk diversification approach that attempts to limit the negative consequences of supplier failure: if one supplier stops delivering necessary inputs, the firm can turn to its remaining suppliers and thus limit (if not entirely avoid) the negative consequences of supplier failure. Transfer Risk Risks can be moved in part (risk sharing) or in full to third parties that are willing and more capable of dealing with that risk. Taking out insurance is a typical approach of risk transfer. An insurance company can spread the risk across a potentially large number of customers and thus benefits from a portfolio effect: although some insurance contracts will actually

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lead to a damage and consequently to a (potentially large) payout, these negative consequences are balanced by many other insurance customers that pay their fee, but do not cause any damage. The insurance company, therefore, can handle risk more efficiently and more effectively than the single firm would ever be able to. Of course, the risk transfer will be possible only against payment of a compensation (the insurance fee), which reflects the estimated risk severity. Risk transfer through insurance is typically more appropriate for disruptive risks with a small probability and high impact rather than for operational risks with a high probability and low impact (Fan and Stevenson 2018). Risks can also be transferred to other partners in the supply chain. Two conditions must hold in order to make such a risk transfer feasible: First, the supply chain partner must be willing to accept the risk—either because it receives compensation or because its negotiating power is too low to fight it off. Second, the supply chain partner must be in a better position to deal with it (lower probability of occurrence, lower damage expected). If a firm possesses specific expertise in handling a particular risk, all supply chain partners will profit from transferring their own risk exposure to the partner against a compensation. This “pooled” risk handling will be more efficient across the supply chain than each partner firm handling the risk itself. Example Supply chains have often established a complex network of task sharing and division of labor based on the respective expertise of each supply chain partner. The physical movement of goods, for instance, most often is entrusted to freight forwarders. These firms not only can provide transportation services at lower cost than non-specialized firms, but are also in a better position to deal with typical risks that result from shipping and transportation tasks. Freight forwarders, too, have to take precautions against specific transportation risks. But they can typically do this in a more efficient and more effective manner than manufacturers or suppliers. Freight forwarders will carry over the costs of risk handling to their customers through higher fees, but this will leave manufacturers and suppliers still better off than if they had to implement their own risk handling plan. Avoid Risk If a risk is considered to be so significant that other responses are inadequate, the firm can also try to avoid it altogether. Such a move can entail significant changes to company strategy and operations. If a country is considered to be too unstable, the firm might stop doing business with customers and suppliers in that country. If the risk of damages to human health is too high, a product might be discontinued. Such moves often will cause negative financial effects themselves, but these are considered less significant than the

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potential damage if the underlying risk materializes. Risk avoidance strategies try to remove the root causes of the risk (Fan and Stevenson 2018). Example German chemicals and pharmaceuticals company Bayer announced a takeover bid for its US-American rival Monsanto in 2016. The mammoth transaction, worth approximately 63 billion €, was finally approved by relevant authorities in 2018. Monsanto’s key product was the weed killer glyphosate (marketed under the label Roundup). The product, however, is suspected of being carcinogenic. At the time of takeover approval, the first court rulings against Bayer hit the news. Since then, Bayer is faced with more than 11,000 potential lawsuits and several more trials have already been lost. Total damages could add up to more than 5 billion € for Bayer—an amount that can threaten the company’s very existence (Spiegel 2019). Given hindsight, one might argue that the risk has been underestimated and avoiding it (by not taking over rival Monsanto) might have been the better option.

7.6

Risk Response Planning

Accepting risk or retaining (parts of) a risk because it was not fully transferrable does not mean that businesses remain in paralysis. Companies can prepare for risks they identified and evaluated by defining a risk response strategy. Such a plan comprises all activities, processes, and structures in place that help the organization to cope with a particular risk— in case it materializes. A company’s risk response strategy is not only dependent on the risks themselves, but also on the company’s general attitude towards risks. Similar to humans, organizations can be “risk takers”, who are willing to accept higher risks in return for potentially higher profits, or risk avoiders, who are satisfied with lower returns as long as these come with lower risks. A company’s overall risk attitude will influence its entire risk response behavior and will be documented in a general risk management plan. Focusing on supply chain relations, such a plan will typically comprise the following elements (Waters 2011, p. 82f): – A review/summary of the organization’s general attitude towards risk (“How do we deal with risks in general?”), – The target to be achieved by supply chain risk management (“Why are we doing it?”), – Responsibilities for supply chain risk management (“Who is doing it?”), – A review of resources, tools, and systems available for supply chain risk management (“What can be employed and used?”), – The procedures, methods, and tools for each stage of the risk management process (“How is it to be done?”).

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In some cases, risk responses need to be of a short-term nature only and resemble a typical “firefighting” activity. The risk was known, but its actual materialization came unexpectedly at this point. Now the firm and its supply chain partners need to find a quick fix and prevent further damage. Preventive measures will be considered later only—you need to put out the fire first and think about fire protection later! However, short-term actions are certainly neither the most effective nor the most efficient way of handling supply chain risks. Firms and supply chains, therefore, need to think about pro-active, strategic, risk management approaches to improve supply chain robustness and resilience. Standard recipes do not exist, of course, but we discuss some possible options in the following. Adapt Supply Chain Design Supply chain risks can never be entirely avoided, but the supply chain design can be adapted in order to reduce the probability and the damaging effects of existing risks. One alternative of adapting the supply chain design is to establish parallel structures that make the network more robust and flexible. A typical strategy here is the implementation of multiple sourcing, which is, in essence, a diversification strategy. In multiple sourcing, a company purchases a service or a good from several, distinctly independent, sources (Blome and Henke 2009). The alternative strategy of single sourcing focuses on one source only, although other adequate suppliers are available and a choice would be possible. While single sourcing can typically realize cost advantages through bundling, higher standardization and a reduction of transaction costs, it is also the riskier option, since a disruption in the realm of that single supplier cannot be compensated. Multiple sourcing, in contrast, might also lead to lower prices (through competition between suppliers), but will typically entail higher transaction costs. A key advantage of multiple sourcing, however, is the firm’s ability to reduce dependence and thus improve robustness of supply. If supply from one source is interrupted or slowed down, negative effects can be reduced or possibly avoided altogether by increasing supply from the existing alternative sources. This view is not undisputed, though. If both the supplier and the customer in a single sourcing scenario highly depend on the business relationship, cooperative behavior will be more likely. The mutual dependency can result in higher flexibility of the supplier in fulfilling the buying company’s needs and a higher motivation to avoid any damaging events to this relationship (Blome and Henke 2009). Engaging with one motivated partner only, who is highly dependent on that business relationship might actually be less risky than dealing with multiple suppliers who are less motivated to maintain the relationship. In addition, the probability of risk occurrence increases with the number of suppliers: if the company is dealing with several alternative sources and sourcing routes, the chance of something going wrong somewhere in the complex sourcing network is higher than if the company is dealing with one supplier only. In other words: multiple sourcing is not automatically the best option to reduce supply chain risk, its consequences have to be considered in detail before taking the strategic decision in favor or against it.

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Another aspect of the overall supply chain design that has a significant impact on risks is the spatial distribution of supply chain partners. Modern supply chains are often spread across several countries and even continents. The quest for low manufacturing cost, proximity to global customers, or the possibility to leverage favorable legal and tax regulations has led many companies to build up supply and distribution networks that span the world. Strategies such as “offshoring” (i.e. the relocation of business activities abroad) or “outsourcing” (transfer of business functions and activities to a third party) are typical examples. The geographic dispersion of a supply chain will inevitably affect its risk structure: Transportation risks increase as distances grow, new political risks evolve as supply chain partners in unstable countries are added to the network, etc. Companies, therefore, sometimes follow a “nearshoring” strategy, i.e. they transfer business activities to nearby countries instead of more remote locations and hope to reduce some supply chain risks when distances are cut and operations are pooled in countries with similar work ethic, legal systems, and cultural attitudes. A key question in supply chain design is also the distribution of responsibilities among supply chain partners. The key question to be answered is: which partner is in the best position to perform a particular task in the most efficient and effective way? Responsibility for managing and holding inventories, raising financial funds for new initiatives and investments in the supply chain, or configuring the market offer to customer needs, for instance, can be shifted between firms in order to realize a more efficient and possibly less risky, task configuration. Example Vendor managed inventory (VMI) is an approach to make inventory management more efficient. In a VMI agreement, the manufacturer typically shares demand data from its own customers with the supplier. Using this end-customer demand data, it is the supplier, who assumes responsibility for refilling and administering the inventory, although it physically remains with the manufacturer. In VMI, the risk of delays in inventory replenishment or stock outs caused by wrong forecasts can be significantly reduced. Add Buffers and Redundancy to the Supply Chain Redundancy—understood as an organizational setup where certain resources or means are available multiple times—is a standard risk handling strategy. Hospitals run stand-by emergency power generators in order to be able to continue operations in case the power supply breaks down. Most of the time, though, this emergency system is not used at all and therefore is redundant in the original sense of the word. In fact, approaches such as the multiple sourcing strategy discussed above are ways to introduce redundancy in the supply chain. Other examples of redundancy are buffer stocks (inventory levels that are higher than needed during regular operations in order to secure business continuation also when supply is limited or interrupted altogether) or spare operational capacity (additional staff, additional production equipment that is kept idle

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during regular operations, etc.). Many companies have experienced in the Corona pandemic 2020 how valuable multiple sources, buffer stocks and spare capacities can be. Redundancy strategies increase the capacity of a supply chain beyond the normally required level. These buffers reduce the risk of a mismatch between demand and supply (Li et al. 2015) but inevitably increase the cost: more capital is tied up, higher inventory levels need to be managed, more equipment must be maintained and depreciated, etc. In addition, buffers often lead to inefficiency, since the negative operational effects of wrong planning, increased waste, or delayed task completion do not surface, but are compensated by buffer supplies. Inventory and operational buffers, therefore, are a two-edged sword in supply chain management. Many firms value these disadvantages higher than potential positive risk effects and consequently do not follow a buffering strategy. An alternative approach, therefore, might be not to increase inventory or operating capacity as such, but to place it at strategic positions within the supply chain (Wiengarten et al. 2016). Standardize and Reduce Variability Risk originates from uncertainty. Uncertainty, in turn, often is a result of variability (Waters 2011). Variability in this context denotes deviations from the intended result. This can be, for instance, deviations in the quality of output (products and services), or deviations from standard processes (e.g. sequence of tasks, scheduled time taken to complete a task, etc.). Small deviations typically do not pose a problem and might even remain undetected. But the bigger the deviations become, the more likely they will lead to negative consequences: customers might return products because of inferior quality or missing functionality, manufacturing jobs might have to be stopped because of delayed resources, processes cannot be completed because of wrong or missing inputs, etc. The obvious strategy to counter variability is standardization. Firms try to make sure that deviations are kept to a minimum by reducing discretionary freedom and by clearly describing desired processes and outputs. Process standards define the tasks to be performed and the responsible functions, interfaces are defined and implemented in IT systems, contractual agreements define the nature and quality of inputs and outputs that are exchanged and shared between supply chain partners. Example All companies in a supply chain rely on at least a minimum amount of data and information exchange between partners. The information exchanged can relate to forecasts, orders, stock quantities, or any other information that is relevant for joint business transactions. If supply chain partners use their proprietary formats, the exchange of data and information not only becomes slow and troublesome. The necessary “translation” of one data format into another one is a constant source of errors, omissions, and misunderstandings. Standardization of electronic data interchange (EDI) between businesses, therefore, promises significant improvements in the quality and speed of information transfer as well as a reduced risk of variability in cross-company information exchange. Such standardization efforts have led to the EDIFACT standard (Electronic Data Interchange

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for Administration, Commerce and Transport), which was approved by the International Organization for Standardization (ISO) in 1987. The EDIFACT standard provides rules on how to structure data and how to standardize messages for multi-industry and multicountry exchange. Using the EDIFACT standard, firms can be sure that data exchanged can be readily processed by their supply chain partner. It is for this reason that EDIFACT has found widespread adoption worldwide. Some industries have developed their own, specific electronic data interchange standards (such as ODETTE in the automotive industry), but the purpose and intention are the same as in the more generic EDIFACT standard. Variability in the above sense increases operational risks. It should not be confused with flexibility—which is the ability of a system or organization to adapt to changing environments and conditions and thus absorb the negative consequences of risks. Introducing flexibility can help mitigate a number of different supply chain risks (Tang and Tomlin 2009), but essentially is a different strategy than standardization: standardization tries to avoid variability and consequently materialization of risks, flexibility tries to minimize the negative impact of risks once they have materialized. Increase Collaboration Risks often occur because supply chain partners do not work closely together (Waters 2011, p. 165): information is not shared and the firm is taken by surprise when an unexpected event occurs at the supply chain partner, best practices are not known and risks materialize although supply chain partners would have remedies available, etc. We have already outlined multiple times the paramount importance of collaboration for the success of a supply chain. This also applies to risk management: through collaboration, transparency is improved, uncertainty can be reduced and remedial actions can be made more effective when taken together. The involvement of suppliers in own forecasting processes is a typical example, the joint sharing of responsibilities across supply chain partners another one. Collaborative risk management is the risk response strategy that is closest to the idea of supply chain management. We will look at this approach in more detail in the following section.

7.7

Collaborative Risk Management in Supply Chains

Collaboration across companies describes governance settings where previously independent firms give up some of their discretionary freedom and agree to act in alignment with each other in order to leverage synergies and to reach goals that would be unachievable when being pursued separately:

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The best approach to supply chain risk management does not have each member of a chain working in isolation but has them working together in a coordinated effort to reduce the overall vulnerability of the whole supply chain. (Waters 2011, p. 181)

Within a supply chain framework, the case for coordinated risk management across partners is even more profound. After all, disruptions affecting one partner firm often lead to a domino effect along the supply chain and affect other partners as well. On their way downstream and upstream in the supply chain, the effects can even propagate and gain momentum: what might have been a comparatively small event at the origin leads to major disruptions and significant damage for other supply chain partners. This so-called rippling effect (Zhu et al. 2017) makes a coordinated risk management approach all the more useful since firms themselves stand to gain a lot by helping to avoid or mitigate risks at their partners. An obvious collaboration strategy consists in sharing of risk-related information between supply chain partners (Li et al. 2015). Partners agree on a regular exchange of risk-related information and their own respective risk management practices in order to avoid redundant risk management actions being taken by other partners and to increase transparency across the network in general—thus helping partner firms avoid certain risks altogether or identify appropriate own risk management actions more easily. As outlined at various other occasions in this book, though, firms are often reluctant to share information since they fear to become victims of opportunistic behavior by other partners. Another strategy of joint risk management consists of explicit risk sharing mechanisms—often implemented in contractual arrangements (Li et al. 2015). Partners not only set the prices, quantities and quality levels of goods and services to be exchanged in a contract, but also define the way in which the risks arising from different sources of uncertainty (mainly time, demand, and price) are shared among the firms (Giannoccaro and Pontrandolfo 2004). Example Buyback contracts are a typical example of contractual arrangements that try to introduce a sharing of demand risk. In a buyback contract, the upstream supply chain partner (e.g. the manufacturer or wholesaler) agrees to buy back items that the downstream partner (e.g. the distributor or retailer) has not sold after a specified time (e.g. at the end of the season). In such an arrangement, the risk of low end user demand is partly or entirely shifted back to the upstream partner. Without such an arrangement, the downstream partner will be reluctant to place larger orders, since he might be left with unsold stock. Lower orders from the retailer, in turn, increase the risk of stock-outs and lost sales in case end-user demand is higher than expected. Both the retailer and the manufacturer, therefore, stand to gain, if the retailer orders larger quantities and can avoid stock-outs altogether. Knowing that unsold stock can be returned or sold back to the manufacturer, the retailer will be prepared to order higher volumes. Partners can additionally profit from larger batch ordering and can jointly initiate marketing campaigns to increase end-user demand, thus

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effectively increasing total supply chain profit. While the benefits of such arrangements seem obvious, this agreement is, in essence, a transfer of risk. The downstream partner shifts the demand risk upstream to the supplier. Finally, modern IT systems can also greatly facilitate joint risk management for supply chain partners (Ivanov 2018). Advanced planning and scheduling (APS) systems or standard interfaces between enterprise resource planning (ERP) systems allow an exchange of demand and supply-related information between firms and provide transparency on the order fulfillment process across multiple supply chain stages. Cloud-based IT solutions serve as shared information platforms and avoid potential risks stemming from a loss of data or unavailability of local IT systems. It is probably safe to say that collaborative risk management is relatively easy to implement, if and as long as the firms have built up a sufficient level of trust and are prepared to make their own actions more transparent to supply chain partners. Technical and contractual issues can be overcome if firms show the willingness to cooperate.

7.8

Glossary and Key Terms

Disruption Flexibility Resilience

Ripple effect

Risk

Risk analysis

Risk identification Risk management

An event that is significant enough to disturb normal business operations and cause a deviation from planned activities. An organization’s ability and readiness to change (e.g. processes or rules) and to find compromises, if a disruption occurs. The ability of an organization or system to adjust or maintain essential functions under stressful and harsh conditions. Applied to risks, resilience denotes the ability to cope with the consequences of risk events in order to return to the original operational state or to move to a new, more desirable state after being disturbed. The effect that negative consequences affecting one firm can propagate upstream and downstream in the supply chain and cause even higher negative consequences with other partners. Technically, an undesired deviation from a set target. In a business context, an undesirable loss or an unwanted negative consequence resulting from an uncertain future event or development. The assessment of the probability of occurrence and the extent of the potential damage of a particular risk as well as the identification of the causal factors behind the risk. The detection and description of unfavorable events and developments that can pose a risk to the organization and its supply chain partners. The process of systematically identifying, analyzing and responding to risks in an organization. (continued)

7.9

Review Questions and Exercises

Risk map Risk register Risk response

Uncertainty Value-at-risk (VaR) Vulnerability

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A matrix tool for analyzing risk, combining two dimensions: (1) probability of occurrence and (2) potential impact. A systematic and structured record of the relevant features of all risks potentially affecting an organization or supply chain. The definition and implementation of appropriate actions to deal with the risks that have been identified. Risk response actions can be consolidated in a risk response plan. Any situation where information on future events and developments is lacking. The maximum loss that is not exceeded with a given probability and within a given time period. Formally the (1-α)-quantile of a profit and loss distribution. The susceptibility of an organization or system to risk, typically expressed by the probability of the risk affecting the organization at all and quantification of the negative consequences if the risk materializes.

Review Questions and Exercises

Review question 7.1: Define the risk concept. How do “risk” and “uncertainty” differ? Review question 7.2: What is the difference between “vulnerability” and “resilience” and how do both concepts relate to risk? Review question 7.3: Name and describe three typical strategies of how a business can improve the resilience of its operations. Review question 7.4: Name and briefly describe the three main steps of the risk management process. Review question 7.5: How can international standards support the risk management process across companies? Review question 7.6: Name and describe typical risk categorization schemes that are used in the risk identifi cation phase. Review question 7.7: What is “reputational risk” and why is it particularly important in a supply chain context? Review question 7.8: Enumerate and briefly describe three typical tools and methods that can be used for risk identification.

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Review question 7.9: What are the four focus areas of risk analysis? Review question 7.10: Explain the difference between qualitative and quantitative risk analysis. Which tools and methods can be used, respectively? Review question 7.11: Explain the concept of Value-at-risk (VaR) as a key risk measure. How is VaR typically calculated? Review question 7.12: Explain why diverse risks of a business should never be considered in isolation but in an integrated approach. Review question 7.13: What is the difference between accepting and ignoring a risk? Why is risk ignorance not a suitable risk response? Review question 7.14: Explain the concept of insurance as a typical risk transfer strategy. Review question 7.15: When should firms transfer risks to other partners in their supply chain? What are the key factors to consider when transferring risks to other parties? Review question 7.16: How can supply chain design decisions contribute to strategic risk response planning? Review question 7.17: What are the pros and cons of buffers or redundant resources from a risk perspective as well as from an efficiency perspective? Review question 7.18: How does collaborative risk management differ from company-centric risk management? Exercise 7.1: Improving partnership resilience Jummy Fruits is a German manufacturer of packaged dried fruit snacks that are sold in food retail chains across several European countries. Its main supplier is “Pacific Dream”, a large operator of plantations for tropical fruits that has business relationships with many food manufacturers across the world. Both companies are determined to improve the resilience of their business partnership against risks even further. Discuss the options that both companies could pursue under the specific circumstances of their business. Exercise 7.2: Risk transfer among supply chain partners Jummy Fruits is considering a change in its general purchase terms that would stipulate Euros as the standard currency for all purchase contracts. The business relationship with

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Pacific Dream is currently based on US-Dollar contracts. By this move, Jummy Fruits hopes to be able to transfer exchange rate risk to its supplier. Discuss under which conditions this risk transfer could make sense for both partners. What could Jummy Fruits do to make Pacific Dream accept the changed purchase conditions?

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Lpb—Landeszentrale für politische Bildung Baden-Württemberg (2020) Katastrophe von Fukushima. https://www.lpb-bw.de/fukushima#c48038. Retrieved 14 June 2020 Meulbroek L (2001) A better way to manage risk. Harv Bus Rev 79(2):22-23 Mitchell VW (1995) Organisational risk perception and reduction: a literature review. Br J Manag 6 (2):115–133 New York Times (2016) An iPhone’s journey, from the factory floor to the retail store. NYT, 29 Dec 2016. https://www.nytimes.com/2016/12/29/technology/iphone-china-apple-stores.html. Retrieved 12 June 2020 Prakash S, Soni G, Rathore A (2017) A critical analysis of supply chain risk management content: a structured literature review. J Adv Manag Res 14(1):69–90 Punniyamoorthy M, Thamaraiselvan N, Manikandan L (2013) Assessment of supply chain risk: scale development and validation. Benchmark Int J 20(1):79–105 Radhakrishnan S, Harris B, Kamarthi S (2018) Supply chain resiliency: a review. In: Khojasteh Y (ed) Supply chain risk management—advanced tools, models, and developments. Springer, Singapore Rangel DA, Kamel de Oliveira T, Leite MSA (2015) Supply chain risk classification: discussion and proposal. Int J Prod Res 53(22):6868–6887 Rebula de Oliveira U, Silva Marins F, Rocha H, Pamplona Salomon V (2017) The ISO 31000 standard in supply chain risk management. J Clean Prod 151:616–633 Rotaru K, Wilkin C, Ceglowski A (2014) Analysis of SCOR’s approach to supply chain risk management. Int J Oper Prod Manag 34(10):1246–1268 Spiegel (2019) Bayers Monsanto-Übernahme: Stationen des Niedergangs. Spiegel 14 May 2019. https://www.spiegel.de/wirtschaft/unternehmen/bayer-das-monsanto-desaster-und-seinegeschichte-a-1267399.html. Retrieved 14 June 2020 Suarez-Barraza M, Miguel-Davila J, Vasquez-García C (2016) Supply chain value stream mapping: a new tool of operation management. Int J Qual Reliab Manag 33(4):518–534 Supply Chain Council (2012) Supply chain operations reference model. Revision 11.0, SCC, Chicago Swierczek A (2018) Supply chain risk management in the transmission and amplification of disruptions. In: Khojasteh Y (ed) Supply chain risk management—advanced tools, models, and developments. Springer, Singapore, pp 155–178 Tang C, Tomlin B (2009) How much flexibility does it take to mitigate supply chain risks? In: Zsidisin G, Ritchie B (eds) Supply chain risk—a handbook of assessment, management, and performance. Springer, New York, pp 155–174 The Wall Street Journal (2018) China’s Cosco Shipping Hit by Cyberattack in U.S.. WSJ, 25 Jul 2018. https://www.wsj.com/articles/chinas-cosco-shipping-hit-by-cyberattack-in-u-s1532548557. Retrieved 13 June 2020 Tummala R, Schoenherr T (2011) Assessing and managing risks using the supply chain risk management process (SCRMP). Supply Chain Manag Int J 16(6):474–483 Vilko J, Ritala P, Edelmann J (2014) On uncertainty in supply chain risk management. Int J Logist Manag 25(1):3–19 Wagner S, Bode C (2009) Dominant Risks and risk management practices in supply chains. In: Zsidisin G, Ritchie B (eds) Supply chain risk—a handbook of assessment, management, and performance. Springer, New York, pp 271–290 Waters D (2011) Supply chain risk management, 2nd edn. KoganPage, London Wiengarten F, Humphreys P, Gimenez C, McIvor R (2016) Risk, risk management practices, and the success of supply chain integration. Int J Prod Econ 171:361–370 Zhu Q, Krikke H, Caniëls M (2017) Integrated supply chain risk management: a systematic review. Int J Logist Manag 28(4):1123–1141

8

Performance Measurement in Supply Chains

Performance Measurement Intro

SC Targets

„Good“ Performance Measures Financial Performance of Single Entities

Financial Performance of Entire SC

Operating Performance of Single Entities

Operating Performance of Entire SC Relation-Oriented Performance

SC Performance Measurement Systems

Weaknesses of Performance Measurement in SC

Learning Objectives After completing this chapter, you should be able to: 1. Understand why companies engage in performance measurement 2. Know the features of good performance measures, and be able to analyze measures accordingly 3. Identify goals of businesses in a supply chain context that can be measured 4. Know a selection of financial and operating performance measures of single entities in supply chains 5. Know a selection of financial and operating performance measures for the entire supply chain (continued) # Springer Fachmedien Wiesbaden GmbH, part of Springer Nature 2020 A. Taschner, M. Charifzadeh, Management Accounting in Supply Chains, https://doi.org/10.1007/978-3-658-28597-5_8

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6. Know a selection of relation-oriented performance measures 7. Discuss ways of making trustworthiness of suppliers measurable 8. Understand the importance and measurement of information flows within supply chains 9. Discuss the use of performance measurement systems in supply chains 10. Discuss the balanced scorecard and its adaption to the supply chain context 11. Present a supply chain (balanced) scorecard together with a strategy map 12. Outline common weaknesses of performance measurement in supply chains In Chap. 3 we have already outlined some challenges in measuring the performance of supply chains. We will elaborate on these issues in more detail in the present chapter. Without any doubt, performance measurement is a pivotal task in management accounting. There is hardly a business firm that is not engaged in measuring its own performance. However, just like “internal” management accounting differs from accounting for interorganizational relationships, performance measurement differs when extending the view beyond the company’s borders. Compared with controlling activities and measuring performance within a single organization with hierarchical structures, inter-organizational performance measurement takes place between legally independent businesses that have no formal hierarchical authority relationships in place. Changing the perspective from the single entity to the entire supply chain adds several layers of complexity. This complexity stems mainly from two factors. The first factor is the importance of operating performance in supply chains. Supply chain management as a discipline is strongly related to operational aspects (Shi and Yu 2013). One strong stream of performance measurement in supply chains is consequently concerned with operational or even technical aspects. Operational supply chain measures deal with procurement (supplier satisfaction, reject rate (%), etc.), with production (output, defect rates, etc.), or logistics (order picking accuracy, on-time shipments, delivery times, etc.). Performance measurement in for-profit organizations, however, ultimately refers to financial success. Thus, operating performance has to be translated into financial performance at some stage. The link between operating excellence and financial success, though, is often more than fuzzy (Ketchen and Giunipero 2004). In fact, linking operating performance to financial measures has been one of the great challenges in management accounting for decades. Performance measurement systems incorporating operating and financial measures provide a potential answer to the quest for connecting both perspectives. We will come back to this question later in the chapter. The second factor adding complexity is the multitude of involved parties. Naturally, a supply chain involves more than one entity, typically at least three (supplier, manufacturer, customer). When adding this factor to the scene several questions arise. Is it fair to gauge the performance of each player in the supply chain individually? Or should we rather

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Performance Measurement: An Overview

191

evaluate the performance in a holistic manner, that is, by evaluating the supply chain as a whole? Other questions refer to the feasibility of evaluating the performance of the entire supply chain. Is the performance of a supply chain simply the sum of the individual performances of each player involved in the chain? How is the performance of the entire supply chain linked to the performance levels of each individual member? Does the improved performance of one member automatically increase the performance of the entire supply chain? To answer these and other questions, performance measures must be implemented with a focus on three different perspectives (Weber and Wallenburg 2010): 1. The individual firm-perspective: any entity in a supply chain can measure its own performance (operating and financial, micro view). Examples are a company’s own inventory turnover or its profit margin. 2. The bilateral perspective: any entity can measure the bilateral relationship and trust between itself and a business partner up- or downstream the supply chain. Examples are the average response time of a supplier or the creditworthiness and payment behavior of a customer. 3. The supply chain-perspective: performance measurement can encompass the entire supply chain (macro view). Such measures try to depict the success (or failure) of the supply chain as a whole. Examples are total cycle time or total landed cost. We will address each of these three perspectives in the course of this chapter. However, first, we have to lay some foundations of performance measurement before we come back to the challenges that supply chains pose.

8.1

Performance Measurement: An Overview

Performance measurement is one of the core elements of management accounting. Accountants spend a lot of their time measuring, analyzing and reporting the performance of a business (Charifzadeh and Taschner 2017). In a general sense, performance is about goal achievement. Performing means accomplishing a task, meeting certain expectations, reaching a set goal, or fulfilling an obligation. In business practice, the ultimate goals typically are of financial nature and performance, therefore, is often expressed by financial indicators. But as mentioned above, in the context of supply chains, operational performance is equally important. As we will demonstrate later in this chapter, operational performance is usually a driver of financial performance. In other words, operational performance is a leading indicator of financial performance. Performance measurement is a process or activity that aims at collecting, analyzing and evaluating data about the success of an individual, a department, a division, a business organization, or even an entire supply chain. Having transparency about performance is vital for managers and accountants. Without such transparency, one has no control over the

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organization. Without performance measurement, one would not know how the business, how a particular employee, or how a business partner is performing. An often-cited quote is “what gets measured, gets managed”, which is attributed to Peter Drucker, an Austrian-American management guru. Measurement helps us to identify areas we should focus on. People in an organization will pay more attention to an activity or a business relationship whose performance is tracked. As a consequence, activities, processes, and relationships which are tracked (and thus talked about) often improve in performance. Catasús et al. (2007) demystified this relationship by revealing that the positive effect comes from mobilizing resources. When measuring performance, an organization moves from a state of passiveness to a state of activeness: Mobilizing is the act of summoning attention, resources and strategies for acting (Catasús et al. 2007, p. 509).

In other words: people focus on things that they know somebody else (e.g., our boss, or our supply chain partner) is keeping an eye on. Measuring and tracking performance alone is not enough, though. Usually, we need a point of reference that is used to compare the scores. Without such a comparison, it is almost impossible to say whether an observed or measured performance is strong or poor. Reference Points in Performance Measurement Three points of reference are commonly used in businesses. The first and very obvious one comes from a comparison with other companies in the field, so-called peers. Peers are similar to the company with respect to the industry sector, the product offering, the size, and the business organization. In other words, they are competitors of the business. Such a peer group analysis is also called benchmarking. We will come back to this at a later stage in this chapter. Example Practitioners often have a distinct opinion about performance levels. For instance, an experienced supply chain manager employed by a company in the US home furnishings industry may easily know whether his company’s inventory turnover of 3 denotes strong or weak performance in this business. What has shaped his opinion, though? Through his extensive experience he knows about the past performance of his own company, he knows about the industry average and he may know the performance of the best players in the market. In fact, the average inventory turnover in the home furnishings industry is around 5—thus, his company isn’t performing very well (US data, source: https://www.msn.com/ en-us/money; retrieved 10 June 2020). Another point of reference is historical performance. A comparison can be made against past performance. So-called time-trend analyses evaluate the performance of the same

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Performance Measurement: An Overview

193

object over time. For example, a company may track the development of a particular performance measure over the last 5 years. The third possible point of reference is a budget, that is, a quantitative plan of performance, which is usually set up by the business itself. A budget may include financials, such as a pro-forma income statement and a pro-forma cash flow statement, but may also include non-financial scores such as logistics or production performance indicators. A company can then compare its actual performance against its own plan and determine whether it has reached the budget or not. Measures vs. Indicators Measuring the performance of a company or a supply chain requires measurement tools. The most basic tools we have are performance measures and indicators—sometimes also called metrics or scores. More sophisticated tools are performance measurement systems that combine a selection of different measures or indicators (see Sect. 8.9). The terms performance measures, indicators, performance metrics, or scores are often used synonymously in practice. However, we want to offer some structural guidelines at this point. The terms metrics and scores are usually synonymous with measure. However, there is an often ignored, but distinct, difference between a measure and an indicator that is rooted in their use and interpretation (Charifzadeh and Taschner 2017). With a measure, we obtain direct information about an object. An indicator, in contrast, usually provides only indirect information about the object. As such, an indicator does not measure a precise activity or result—it rather indicates the performance. Indicators are linked by a hypothesized cause-and-effect relationship with the element to be measured. Example Measuring the speed of a vehicle is usually done with a ratio comparing distance and time, such as kilometers per hour. Kilometers per hour is clearly a measure of speed, not a mere indicator. We could use kilometers per hour, though, as an indicator of something else. For instance, we could use kilometers per hour of a vehicle to draw conclusions about its fuel consumption. Here, the assumption is that the faster a vehicle goes, the more fuel it is likely to consume. In the absence of a fuel gauge, this may, in fact, serve as a feasible proxy. Another interpretation of kilometers per hour could allow us to conclude about the safety of its occupants (implying an inverse relationship: the faster the vehicle goes, the less safe it is). Thus, the speed measure becomes at the same time an indicator of safety. An example in a supply chain context is a company’s backorder. In the first place, it is simply a measure of the company’s backlog, representing customer orders that have not been filled at the moment, measured in units or Euros. However, backorder can also be used to indicate the effectiveness of the inventory management of the business or the quality of the company’s customer service (a too high backorder indicates low effectiveness or poor customer service). In a supply chain context, many performance measures are actually

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rather used as indicators, because many relevant aspects of supply chain management cannot be measured directly. Note that in practice, most of these terms are used interchangeably. Especially the term “key performance indicator” (KPI) is very popular and managers use it permanently to refer to their selection of instruments for performance measurement. Whether they actually measure something or rather indicate the performance of an object doesn’t play a major role in naming the tools. We are aware of this pragmatic use of terms in daily business but will try to use the conceptually correct terms in the right sense in this chapter.

8.2

Characteristics of Performance Measures in Supply Chains

Evaluating performance measures and identifying the most suitable ones for own purposes is critical to a business. In practice as well as in academia, a vast number of performance measures are in use. Not all of them, though, are useful to control relationships, operations, or financials in a supply chain context. Often, firms use measures simply because they are easy to determine or because they have been available already for a long time. “We have always been using these KPIs in our reports”, is a likely answer when a new skilled management accountant scrutinizes a long-established reporting system and identifies some useless metrics. Tradition alone, however, is rarely a good signpost for designing a sound performance measurement system. Before introducing a selection of useful measures and indicators, we will lay a foundation by outlining some general guidelines for defining measures or indicators. Features of “Good” Supply Chain Measures In the following, we introduce a scaffold of attributes that should be considered when selecting performance measures and indicators (Table 8.1). Some of these characteristics apply to performance measurement in general, others specifically address the supply chain context. A good performance measure should be quantifiable (Gunasekaran and Kobu 2007). As such it conveys quantitative information to a decision maker. It requires numeric input and possibly involves a calculation or a combination of other quantitative measures. The term “metric” is often used to express purely quantitative performance measures. Quantitative information is a crucial prerequisite for precise performance measurement. Following the above-mentioned key success factor of performance measurement: what gets measured (usually) gets managed. Management accountants prefer quantitative data over purely qualitative information because measurement typically is based on numeric data. Note that “quantitative” does not necessarily mean “financial” information. A measure may be based on monetary data, but it can also represent non-financial data, such as number of units, time, or distance. Qualitative information is better suited for evaluating perceptions, relationships or behavior. However, even here, skilled accountants try to back up a qualitative indicator with quantitative data. For example, a supplier may be ranked

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Characteristics of Performance Measures in Supply Chains

195

Table 8.1 Attributes of good performance measures 1. Quantifiability 2. Decision usefulness 3. Understandability 4. Visibility 5. Cost-benefit 6. Link with long-term strategy 7. Fit with the system 8. Compatibility

Can be operationalized and expressed in numeric terms Relevant in the decision-making process Conveys easily what it is measuring and how it is derived Easy access to performance measures Benefits of the measure outweigh the costs of collecting and analyzing it Has a long-term focus and is future-oriented Should be embedded in a performance measurement system Can be shared with others in the supply chain—and the others consider it important, too

Source: Adapted from Coyle et al. (2017), extended

“excellent” (a qualitative mark), if at least 95% of deliveries arrive on time, complete and damage-free (a quantitative measure). Decision usefulness is a key guideline in accounting. It postulates that information is only relevant if it is useful for making decisions. A simple rule to investigate whether the information is relevant is the following check: information is relevant if it is capable of making a difference in a manager’s decisions (Mishra et al. 2018). The same applies to performance measures. Often, operations generate huge volumes of raw data that allow for calculating hundreds of different measures. The majority of these are irrelevant, though. Performance measures that are worth considering are those that support decisions. Understandability is vital for any tool used in controlling performance. A major contributor to understandability is the way how information is presented. Performance measures should be presented in a clear and easy to understand format. Measures or indicators that are too complex and difficult to understand will be ignored in the best case. In the worst case, however, they can create confusion and misunderstandings, if different parties interpret a measure differently and draw inconsistent conclusions from it. Experience has shown that individuals understand performance measures best when they have been involved in its development or selection, and in its implementation (Coyle et al. 2017). Note that, in a supply chain context, understandability must be a crossorganizational effort. Supply chain trading partners must have the same understanding of a shared performance metric. Visibility of a metric refers to a state in an organization where measures are readily available to decision makers. Those who use the measures should have easy access to them. Performance measures are often delivered in routine management reports. When extending the perspective to a supply chain network, business partners may engage in cooperative reporting (Charifzadeh and Taschner 2017). Cooperative reporting denotes the alignment of management reporting and the exchange of information across network partners (including performance measures). Thereby, performance measures that have been identified for sharing become visible to the supply chain trading partners. Open book accounting (see

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Chap. 5) typically involves some cooperative reporting and therefore improves visibility of (cost) indicators across supply chain layers. The cost-benefit criterion is a standard yardstick in accounting. It is logical that a performance measure only makes sense if the effort devoted to collecting the data, and computing, analyzing and interpreting the metric does not exceed its benefit. Sometimes, sophisticated performance measures are generated, but their impact is minimal. It might be difficult, however, to determine both the cost and benefits of a particular measure. Good performance measures should not only have a short-term perspective (Weber and Wallenburg 2010). Ideally, they have a conceptual link to the strategy of the firm (and the supply chain) and as such are future-oriented. They should connect to the long-term goals of the firm. This is not a rigorous criterion, though. A balanced metrics program should include both short and long-term measures. Using only measures with a short-term or even past focus, though, is not advisable. A single performance measure rarely provides good insights. It is the holistic view, generated by the interplay of several measures, that provides a true and fair view of a company’s performance. Therefore, performance measures should be incorporated into a system of performance measures (see Sect. 8.9 in this chapter). Selected measures become useful when they fit with the system that is installed in a company. A good fit, in turn, is usually given when a measure links with other measures in the system and supports the strategy of the firm. In a network of supply chain trading partners, performance measures should be compatible. To create transparency across company borders, effective performance measurement requires that partners share the same measures. Moreover, the measures and indicators that the partners use should follow exactly the same definitions. This can be achieved by involving supply chain partners at an early stage when a performance measurement system is designed. Early involvement also assures the acceptance of the selected performance measures among partners. In fact, performance measures that are shared across a supply chain should be considered equally important among the partners. Compatibility has to deal with the technical aspects as well. Performance measures are nowadays shared via IT systems such as enterprise resource systems (ERP). In a well functioning supply chain network, communication of performance measures among the partners works without frictions and performance measurement data can be seamlessly shared via IT interfaces. Logical as these criteria might seem as such, they lead to a multitude of problems when measuring performance in a supply chain context. It can be very difficult to define and to implement performance measures that are quantifiable, understandable, relevant, as well as compatible and fitting to supply chain partners’ systems, as we will see in the following sub-chapters.

8.3

Measuring the Performance in Supply Chains

8.3

197

Measuring the Performance in Supply Chains

We have already outlined that performance measurement in supply chains is more complex than in a single firm setting. Performance measurement in a supply chain context can involve financial as well as operating measures. Apart from measuring the performance of a single entity within a supply chain, it can target at measuring the bilateral relationship between two cooperating entities, and it can comprise the performance of the entire supply chain as a whole (Shepherd and Günter 2006). Remember, that, in Chap. 1, we defined supply chain management as the management of financial flows, physical flows, and information flows. This refers to the objects of measurement. Thus, performance measurement in supply chains can involve 1. Measuring the financial performance of a single entity within the supply chain as well as of the whole supply chain. 2. Measuring the operating performance of a single entity within the supply chain as well as of the whole supply chain. 3. Measuring the intensity and quality of relationships, and the basis of trust among the entities in a supply chain. This involves measuring the degree of cooperation among partners. 4. Measuring the information exchange between the business partners. Sharing information between business partners is vital for a well-functioning supply chain. Business Goals in Supply Chains The measures and indicators that companies use (be it for controlling their organization, supply chain performance, the relationships to partners, or the information flows) must support one or more business goals. In an ideal case, these goals have been set in a conscious strategy process. Typically, goals in a supply chain context circle around the three dimensions of cost, quality and time. In this book, we will enlarge the perspectives by five more attributes, which we believe to be relevant in modern supply chains: – – – – – – – –

Increase efficiency/ reduce costs Increase quality Increase speed / reduce time Increase agility and adaptability Increase service focus Increase collaboration Increase basis of trust Increase information exchange

Efficiency is often seen as synonymous with cost reduction (or at least measured by this), i.e. this can be considered a financial goal. Quality, speed, or service focus, in turn, are rather of an operating or technical nature. Collaboration, trust, and information

198 Table 8.2 Supply chain performance goals

8 Performance Measurement in Supply Chains

Efficiency / costs Quality Speed/ time Agility and adaptability Service focus Collaboration Basis of trust Information exchange

Financial Operational

Relational

Source: authors

exchange are the third group of goals that address the relationship and cooperation between supply chain partners (see Table 8.2). Unfortunately, it is often not possible to optimize all performance goals simultaneously. Multiple trade-offs must be accepted when optimizing some of the goals (see Fig. 8.1). For instance, increasing quality might interfere with efficiency and thus cost reduction. In turn, increasing speed may harmonize with agility, but it may hamper service focus, information exchange, or even quality. Adaptability may conflict again with cost-efficiency. In practice, therefore, managers always need to prioritize goals. Example For example, a manager may decide to maintain an upside production flexibility of 20% over the normal production levels to be able to react quickly to increasing customer demand. As a result, the business has to maintain idle capacities of assets and human capital, which lowers asset use efficiency and increases fixed cost. Despite trade-offs between them, all supply chain-related goals ultimately try to support one overarching goal: financial success (see Fig. 8.2). Financial success can be considered the main goal of any enterprise (we exclude non-profit organizations here). This follows simply from the given fact that companies first and foremost have to achieve economic success in order to continue operations. Without financial welfare, managers [. . .] will not seriously consider other perspectives (Charifzadeh and Taschner 2017, p. 260).

Note that financial success is not as easy to measure as it may seem at first glance. Profitability is often the first choice to operationalize financial goals. However, it is frequently a short-term oriented goal and it is subject to financial accounting regulations (e.g. IFRS vs. local GAAP). Shareholder value is generally considered the top financial goal of any business enterprise, which holds true in a supply chain context as well.

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Measuring the Performance in Supply Chains

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Information

Cost

Trust

Quality

Collaboration

Time

Service focus

Agility

Fig. 8.1 Trade-offs between supply chain goals (source: authors)

Financial sucess e.g. increase profit, save costs, increase shareholder value

Increase efficiency

Increase information exchange

Increase quality

Increase trust

Increase collaboration

Increase speed Increase adaptability and agility

Increase service focus

Fig. 8.2 Goals of businesses in supply chains (source: authors)

After having defined the goals, we discuss in the following a selection of supply chain performance measures that link with the above mentioned objects and support the goals of businesses working in collaborative networks.

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8 Performance Measurement in Supply Chains

Measuring Financial Performance of Single Entities in Supply Chains

When looking at a single entity within a supply chain, there is a wealth of financial performance measures available. They usually concentrate on the efficient input of resources (Beamon 1999). We will focus on two aspects of efficiency to measure the financial perspective: cost and asset management. Cost Measures of a Single Entity A major part of financial performance deals with costs. Measuring cost is often the first choice when evaluating efficiency in an organization. In a logistics and supply chain context, there are dozens of cost measures available that a firm may use to control for its efficiency (Beamon 1999; Shepherd and Günter 2006). A company may, for instance, analyze several cost measures for particular (sub-) processes within the entity. Examples are – – – – –

Total procurement cost Total logistics cost Cost of goods sold General and administrative cost Cost of information systems

These cost measures are straight forward and do not require much explanation. Care must be taken, however, that the measures and the underlying cost objects are properly defined. “Logistics”, for instance, can comprise different corporate functions and activities. Attributing individual cost items to “logistics cost” as the more general cost term, therefore, depends on the definition and delimitation of the logistics function in a given organization (Taschner 2016). Example When comparing empirical surveys that measure the ratio of logistics cost to total sales revenues of companies, Taschner (2016) finds significant differences in the underlying definitions of logistics cost: While transportation and warehousing cost are considered a part of logistics cost in all surveys examined, no general agreement can be found on other potential elements of logistics cost: packaging cost or insurance cost, for instance, are considered to be part of logistics cost in some surveys, but are excluded in others. A similarly divergent approach can be observed for cost of capital employed in logistics functions. Taking such differences into account, it is clear that a direct benchmark of logistics cost between companies can be misleading. Even within the same organization, changing cost definitions and cost allocation rules can make it very difficult to properly track logistics cost performance over time.

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Measuring Financial Performance of Single Entities in Supply Chains

201

A more complex, multidimensional, measure is total delivered cost: – Total delivered cost The measure is identical with total landed cost (TLC). Total delivered cost (TDC) represents the amount of money it takes to procure the material, produce the goods and deliver them to customers. TDC is the complete cost of sourcing, manufacturing, and delivering products to their final destination. Cost of goods þ þ

Transportation cost Inventory carrying cost

þ

Material handling cost

¼

Total delivered cost ðtotal landed costÞ

ð8:1Þ

Managers can use this performance measure in their decisions on sourcing, production, warehousing, transportation, and distribution. These costs are usually interdependent and not free of overlaps. A challenge of determining TDC, therefore, is to gather all necessary cost inputs. Firms have to rely on their cost accounting system, but often cost accounting utilizes simplified cost allocation rates for overhead that make it very difficult to clearly separate TDC-related cost items from general overhead cost. A related concept is total cost of ownership (TCO). However, in contrast to TDC, TCO is applied rather in the context of acquiring long-term assets and considers all costs along the lifetime of an asset. It may play a role, though, for the cost of goods when calculating TDC. – Cost to serve Cost to serve (CTS) is a less holistic measure to determine a firms’ supply chain cost. Unlike TDC, it focuses on the cost of servicing a particular customer. Thus, it computes the cost of all activities for preparing and executing the distribution of a product. This is done on a customer or product level, which allows for a distinct customer or product profitability analysis. Cost of order processing þ Cost of picking and packing þ Cost of delivery þ Cost of invoicing ¼

Cost to serve

ð8:2Þ

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Example Imagine a family-owned coffee roasting house that supplies coffee to a large retail chain as well as to small downtown coffee shops. The large retail chain orders roasted coffee beans in large quantities. For instance, the retailer orders a truckload, twice a week, which is delivered to a central logistics hub of the retail chain. Delivery to the individual stores is handled by the chain’s own logistics operation. By contrast, the roasting house serves the various coffee shops upon demand. Depending on their coffee sales, they only order small quantities. Invoicing is handled manually. The quantities are not only much smaller, but they also fluctuate extremely. The cost of servicing these small customers is most probably several times higher than serving the large retail chain. Knowing the true cost of servicing the large and the small customers will help the management of the coffee roasting house when making decisions about offer prices, discounts, or special marketing activities. Like the coffee roasting company in the example, many businesses are not aware of or even neglect the variation in cost to serve across their—often diverse—customer base. CTS is a concept that can shed light on varying cost of order processing and distribution. In practice, many companies apply a “one-size-fits-all” approach when charging supply chain costs to their customer orders. In the example above, however, it is very likely that the roasting house overservices the small customers and overcharges the large customer. As a result, the small coffee shops are probably low margin customers. In contrast, large customers allow for economies of scale in supply chain and logistics costs. Two more cost measures that indicate efficiency at the entity level deal with capacity: – Cost of excess capacity Excess capacity refers to a situation where a business is producing at a lower scale of output than it has been designed for. Excess capacity can be measured by comparing the actual output to standard capacity. Excess capacity ¼ standard outputactual output

ð8:3Þ

Standard capacity is not identical to maximum capacity. Standard capacity is often considered to be the output level that can be sustained for a long time. In exceptional circumstances, however, the firm can temporarily increase output beyond standard capacity, e.g. by working overtime, postponing maintenance shut downs, or increasing process speed. This higher output level, however, is not sustainable as it overstretches the available resources. – Cost of capacity shortfall In contrast to excess capacity, capacity shortfall is computed as

8.4

Measuring Financial Performance of Single Entities in Supply Chains

Capacity shortfall ¼ required outputmaximum output

203

ð8:4Þ

This is a situation where the operations cannot fulfill the desired output. Both situations—excess as well as shortage—can be of temporary nature, but they can also be a chronic problem of a business. Financial measures focus on the costs that arise from such problems. There are costs to excess capacity as well as insufficient capacity. However, measuring these is highly dependent on the particular business and the industry. In a production setting, for example, cost of excess capacity comprises (opportunity) cost of capital, lease cost of assets or rent for floor space. Cost accounting typically summarizes such cost items under the heading of “idle cost”, i.e. cost that is incurred by idle (non-productive) resources. Cost of capacity shortfall, in turn, can include lost profits from unfulfilled orders, or even lost customers who disappointedly switched to a different supplier. But it can also include the additional cost of acquiring or securing additional capacities on short-term conditions, such as rent for additional storage or overtime labor cost. Asset Management: Net Working Capital An alternative perspective of efficiency deals with asset management. This perspective evaluates how efficiently a company manages its assets and, in a supply chain context in particular, its net working capital. We cover net working capital (NWC) extensively in Chap. 6 on supply chain finance but address the concept again here as a key driver of efficiency at the entity level in supply chain management. Net working capital is usually defined as the difference between the current assets and the current liabilities of a firm. NWC ¼ Current assets  current liabilities

ð8:5Þ

We have outlined in Chap. 6 that NWC can serve as an indicator of an efficient asset and liability management. Managers try to minimize NWC to save on capital cost. The main drivers of NWC are inventories, accounts receivable and accounts payable. We can measure these input factors separately with the following distinct performance measures. Inventory Turnover Inventory, although traditionally being regarded as an unwelcome and costly aspect of manufacturing and supply activity, is one of the most important asset types (Webster 2002). Inventory turnover is a ratio that indicates the efficiency of inventory management: Inventory turnover ¼

Cost of goods sold in period Average inventory value in period

ð8:6Þ

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Example For example, a book store at the downstream end of a simple supply chain has cost of goods sold at the end of a year of 150,000 €. The average inventory (books in stock at the beginning and at the end of the period) is 20,000 €. Thus, inventory turnover is 150,000/ 20,000 ¼ 7.5. This can be interpreted as follows: the book retailer’s business model is to buy books from suppliers and to sell it to end-customers. As books are sold, the book store orders new books from the suppliers. Assuming that the book store keeps on average books worth 20,000 € in the store, this amount of inventory is sold 7.5 times per year. In other words, the store has turned over its inventory 7.5 times in a regular business year. Note that inventory turns is one of the six central measures of Gartner’s annual supply chain top 25 study (Gartner 2019). Managers typically try to increase inventory turnover by either selling more or by optimizing inventory levels. The latter is discussed extensively in Chap. 6 on supply chain finance. Holding inventory is costly because of storage cost and cost of tied-up capital. Many activities to reduce inventory in procurement and supply chain management aim at increasing the performance of the single entity in terms of inventory turnover. Days Working Capital and Its Components NWC is a measure of the operating capital that is required to keep a business running. Thus it measures the amount of capital that is tied-up in operations. From an opportunity cost perspective, this means that the capital is not available for other uses. Instead, it is “captured” in inventories of raw materials, work in progress or in short-term loans to customers (accounts receivable). The efficient management of NWC and its components can be evaluated by considering the time dimension, i.e. how long the particular asset or liability remains on a firm’s balance sheet. We have introduced and discussed the following concepts already in Chap. 6: – Days inventory A measure of the time it takes on average for inventory to move through the company’s operations from goods receipt until delivery of the product to the customer. Note that days inventory can also be calculated by dividing 365 days of the year by the inventory turnover ratio. – Days receivable outstanding The time it takes on average to receive payment from customers that have purchased on credit terms. – Days payable outstanding The time it takes for the company on average to pay its suppliers. – Days working capital The combination of the three elements above into one composite measure, which is a measure of the cash conversion cycle (cash-to-cash cycle or C2C):

8.5

Measuring Operating Performance of Single Entities in Supply Chains

Days inventory þ Days receivableDays payable ¼ Days working capital

205

ð8:7Þ

Days working capital (DWC) measures how long it takes for a company, from the beginning of the operating cycle (purchasing inventory) until the final collection of cash (payment by the customer). Thus, DWC is a measure of the time that capital is tied up in the operations of a business. Other Financial Measures of a Single Entity Of course, there are countless other financial measures that can be used as indicators for single firm financial performance. Measures such as profit margins, return on assets or return on equity (profitability measures), total debt ratio or debt-to-equity ratio (capital structure or leverage measures), and current ratio or quick ratio (liquidity measures) are standard performance indicators in financial statement analysis and are surely important measures of financial success at the single entity level. However, they have rather indirect links to supply chains only. We do not address them here in detail, but reveal some of these connections later in this chapter when we discuss performance measurement systems.

8.5

Measuring Operating Performance of Single Entities in Supply Chains

A large part of supply chain management deals with operational and technical aspects. Operating activities usually comprise the procurement of goods or material (sourcing), the production of goods (making), their distribution and logistics (delivering), and after-sales service. Earlier in this chapter, we have determined increases in quality, speed, agility, and service focus as key operating supply chain goals. Measuring the attainment of these goals can again draw on a myriad of performance measures. Logistics, for instance, deals with the activities of making sure that the right goods, in the right quantity and quality, are available at the right time, at the right place, and with the right sustainable impact (Zijm et al. 2019). It is obvious that this involves various aspects that can and must be measured when looking at operating performance. In the following, we present a selection of performance measures that address the mentioned attributes. Note, that they may partly overlap with other categories. Table 8.3 provides an overview of the operating measures and indicators presented in this section. Quality Quality is probably the most frequently considered goal among the operating performance attributes in supply chain management. Controlling for quality is essential as high quality of products and services increases the customer’s willingness to buy and willingness to pay. The following performance measures and indicators can be adopted by supply chain trading partners to align their performance with the quality goal:

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Table 8.3 Operating performance measures of single entities in supply chains Operating goals Quality

Time/speed

Agility/adaptability

Service focus

Performance measures – Customer satisfaction – Number of product returns per unit sold (reject rate) – Number of warranty claims per unit sold – Number of defects per unit procured – Number of defects per unit produced (scrap rate) – Number of suppliers used (quality certified) – Forecast accuracy – Perfect order fulfillment (delivery reliability) – Throughput time – Delivery performance – Replacement time – Order fulfillment cycle time (response time) – Backlogs – Inventory turnover – Downtime due to machine breakdowns – Lead time from defect detection to correction – Time to market – Upside flexibility – Upside/downside adaptability – Annual R&D investment – Order fill rate – Customer satisfaction – Average service response time – Number of days to process special or rush orders – Number of stockouts per product – Average number of hours spent with customers by engineers – Courtesy ratio

Source: authors

– Customer satisfaction Although being a multidimensional measure, customer satisfaction at the single firm or interfirm level is a strong indicator of quality. It is often measured using (online) questionnaires that cover different features of a product and the perceived relevance of these features. Individual survey items are then consolidated into a satisfaction index, which may take a score from 0 to 10 (highest satisfaction). Such scores are usually highly entity-specific and not comparable across firms. In an extra effort, it makes sense, though, to push through a consistent definition and methodology across all trading partners in a supply chain. An alternative (and popular) way of determining customer satisfaction is to apply indirect measures. For example, companies evaluate (or simply count) their customer complaints, while a decreasing number would indicate increasing customer satisfaction. Alternatively, customer churn rates or customer loyalty measures can be used as an indicator of customer satisfaction.

8.5

Measuring Operating Performance of Single Entities in Supply Chains

207

– Number of product returns per unit sold (reject rate) This measure counts the rejected or returned products in a period and is also called reject rate. It is calculated by relating the quantity of returned output units due to defects, insufficient quality or other problems to the total quantity of sold units. The measure can be expressed as a percentage ratio and is an excellent indicator of (technical) product reliability. Note, however, that customers may return products also for other than technical reasons. It is therefore important to properly categorize and record the causes for product returns. – Number of warranty claims per unit sold This measure is similar to the percentage of product returns but refers more stringently to technical problems with sold products that are still covered by warranty claims. – Number of defects per unit procured This is a central measure in accounting for procurement and relates the number of defect or dysfunctional items procured from a supplier to the total number of items procured from the supplier (in a given period). The measure is often determined separately for different items or components. It is a measure of the quality and reliability of a supplier, rather than evaluating an organization’s own quality processes. However, poor performance in this ratio will also have a negative effect on an organization’s own output quality. – Number of defects per unit produced (scrap rate) In production management, this is a central measure of production quality. A variant is the so-called scrap rate that measures the percentage of scrap produced in a period compared to the total number of units produced. This ratio is also used in Six-Sigma, a quality management methodology. The aim of Six-Sigma is to reach a zero-defect production (Tjahjono et al. 2010). Note that reject rate and scrap rate are not identical. The reject (or return) rate is an indicator for poor quality as perceived by customers, while the scrap rate indicates poor quality originating in the manufacturing process as detected by the firm’s own quality assurance processes. – Number of suppliers used As a very simple measure, the number of suppliers used can be an indicator of quality in certain settings. The higher the number of suppliers, the more likely variances among product specifications and quality might occur. A more refined measure would be number of suppliers that are quality certified. – Forecast accuracy This is not a straightforward product quality measure, but rather an indicator of process quality. However, high forecast accuracy will also have a positive impact on product quality. Good demand and production forecasts reduce uncertainty in a supply chain. In manufacturing, distribution and store replenishment, good forecasting leads to high product availability, allows for reduced inventory levels, and minimizes waste. Further up the supply chain, precise forecasting allows suppliers to secure the availability of relevant materials and to operate more efficiently. A high forecasting accuracy can reduce the “bullwhip effect” (see Chap. 3) and allows suppliers to produce with lower capacity, time and inventory buffers.

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Forecast accuracy can be measured at the single entity level by the mean absolute percentage error (MAPE), a commonly known statistical concept to express variations between forecasts and actuals. MAPE can be calculated as follows:  n  1 X  Actualst  Forecastt  Mean absolute percentage error ðMAPEÞ ¼  n t¼1  Actualst

ð8:8Þ

– Perfect order fulfillment (delivery reliability) This ratio, which is also called delivery reliability, measures the average percentage of orders of a firm that are delivered by a supplier as specified, i.e. they arrive complete, on time, and damage-free (Charifzadeh and Taschner 2017). Perfect order fulfillment ¼

Volume of items deliverd as specified  100% Total number of delivered items

ð8:9Þ

Perfect order fulfillment is a very comprehensive measure that covers more aspects than just quality. It includes also the time/speed dimension that we cover next. Besides, it can be used for two perspectives. A supplier can assess its own performance in a supply chain. At the same time, the ratio can be used for evaluating the performance of business partners upstream. Time and Speed We have considered efficiency so far mainly under the cost perspective. However, since “time is money”, efficiency is linked to time and speed of processes as well. The following measures consider those two attributes. – Throughput time This measures how long it takes to pass through a manufacturing process, i.e. to finalize a product from the first work operation until the last step in production. The lower the throughput time, the more efficient an organization, because the same output (products) can be produced with less input (time). Manufacturing throughput time comprises productive as well as unproductive times. It may include processing time (transforming materials to finished goods), inspection time (inspecting raw materials, work-in-process, and finished goods), move time (moving items between workstations as well as into and out of the manufacturing area), and queue time (waiting for processing, inspection and moving).

8.5

Measuring Operating Performance of Single Entities in Supply Chains

Throughput time ¼ processing time þ inspection time þ move time þ queue time

209

ð8:10Þ

Companies try to shorten throughput times by speeding up processing time and eliminating idle times. This is also a focus of Lean Production (Womack et al. 1990). Especially queue times include a high potential for improving efficiency because their reduction or elimination can decrease inventory levels and opportunity costs. A shorter throughput time may reduce net working capital requirements and shortens the cash-tocash cycle. – Delivery performance Logistics is a particular concern in almost any supply chain. Supply chain delivery performance allows monitoring the reliability of an entity in terms of speed and time. This measure focusses on the delivery performance at the interface between two parties. Supply chain delivery performance measures the percentage of orders that are delivered by the supplier on or before the requested delivery date (Wisner et al. 2016).

Supply chain delivery performance ¼

Volume of orders on or before requested date Total order volume  100% ð8:11Þ

At the same time, a firm can measure its own performance and how well it cooperates with its trading partner downstream in the supply chain. Note that delivery performance and perfect order fulfillment (delivery reliability, see above) are not identical. Delivery performance focuses on the time aspect only, while delivery reliability comprises several aspects, which taken together are considered to be constituent for a perfect (error-free) order fulfillment. – Replacement time This measure takes a single entity’s purchasing perspective. Replacement time measures how long it takes from placing an order at a supplier to receiving the good at the intended location. On the one hand, it allows for evaluating a supplier’s performance (speed and flexibility). However, on the other hand, it may also evaluate the purchasing company’s internal purchasing processes and procurement strategy (Charifzadeh and Taschner 2017). – Order fulfillment cycle time (response time) Unlike the throughput time or replacement time, order fulfillment cycle time (OFCT) is a comprehensive and multidimensional measure. OFCT, also called response time, represents the time it takes from a customer placing an order to the receipt of the product or service by the customer. Thus, it covers the time of sourcing material, manufacturing

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a product and distributing it to the customer. OFCT can be decomposed into the single time measures sourcing cycle time, make cycle time, and delivery cycle time. Order fulfillment cycle time ¼ source time þ make time þ delivery time

ð8:12Þ

OFCT demonstrates the speed at which a company can satisfy demand. As such, it can be an important leading indicator for customer satisfaction and, ultimately, for competitiveness in general. – Backlogs Although not being a direct measure of time, backlogs indicate how quick (or slow) an organization is in its operations. Backlogs express work that still needs to be completed and is measured in units or in Euros, with a high backlog indicating problems in the operations. The most common type of backlog measure is order backlog— indicating the volume of orders that have already been placed by customers, but still need to be processed by the company. When knowing the average output time or the inventory turnover, one can easily calculate an order backlog time (i.e. the time it will take to handle the orders). Unfortunately, it is not a very distinctive measure since backlogs can arise from various factors. Thus, the backlog alone is not an adequate performance measure. Example A high backlog may result from problems in procurement (e.g. a supplier drops out) or from production failures (e.g. a machine breakdown). Also, poor forecasting might be a reason for high backlogs. Consequently, high backlogs are typically a lagging indicator of various difficulties in operations. However, backlogs may also be an indicator of unexpectedly high demand and as such a positive sign. As Tesla unveiled its Model 3 in March 2016, the interest in the new electric compact limousine was huge. Already in the morning of March 31, 2016, over 16,000 people waited in lines only in the US and Canada to place a 1000 Dollar deposit to reserve a Model 3 for 2017 delivery (Lambert 2016). By the end of the day, Tesla reported that over 180,000 people had reserved the Model 3—more cars than Tesla had sold in total by that time (Stoll 2016). This broke an old record for advance deposits on a car when 80,000 deposits had been made for a Citroën DS during the 10 days of the Paris Auto Show back in 1955 (Randall 2016). In July 2018, Tesla confirmed still having a backlog of about 420,000 Model 3 reservations, which would take about 19 months to deliver at the current production rate (Lambert 2018). Just like a high backlog may be good or bad, a decreasing backlog may be an ambiguous sign as well. A shrinking backlog can result from a company speeding up processes, production, or fixing manufacturing problems. It may, however, also be caused by dropping demand for the product.

8.5

Measuring Operating Performance of Single Entities in Supply Chains

211

– Inventory turnover We have introduced inventory turnover, together with days inventory, already among the financial measures above. Inventory turnover and days inventory measure how quickly a company sells its inventory in a period and as such can also be considered a measure of speed. – Downtime due to machine breakdowns In many manufacturing settings, machines are a bottleneck in production. Measuring the downtimes in a period due to machine breakdowns reveals problems in a firm’s manufacturing processes and may serve as an indicator of the general technical vulnerability of a business. – Lead time from defect detection to correction This is a performance measure for companies that aim for zero-defect production processes. Manufacturing defects usually lead to producing scrap. We have already introduced instruments to measure the scrap rate (see above). With this measure, however, a firm can focus on the time dimension of a defect. It measures how long it takes to fix a technical problem in manufacturing. Agility and Adaptability The goal of agility in a single entity context refers to the ability of a business to respond quickly to market changes. It evaluates the maneuverability of an organization to react to changed conditions or changed rules. In a supply chain context, agile businesses can respond rapidly and flexibly to changing demands of supply chain trading partners (Beamon 1999). A business can try to measure agility with several concepts. We present a selection in the following. Note that agility and adaptability often deal with speed (see above), which is why the two goals are not free from overlaps. Slow operations will often be detrimental to agility and adaptability, too. – Time to market This is a rather holistic measure. Time to market (TTM) measures the total elapsed time (in days, weeks or months) from customer requisition to providing a product or service in the market. This measure is by nature multidimensional as it covers several stages, starting from identifying a customer demand until satisfying it with a new market offering. TTM can be determined for any entity within a supply chain network and indicates its individual agility performance. TTM should not be confused with order fulfillment cycle time (OFCT, see above). While OFCT covers the time span from a customer placing an order for an existing product until receiving it, TTM focuses on new product offerings. As such it deals with an organization’s ability to react to new or changing market demand. When a company identifies an economically attractive customer demand, it will start a research and development process, followed by a design phase, leading to production and finally distribution to the customers. TTM covers the complete time span.

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TTM is not easy to interpret for businesses that provide heterogeneous products. Since the development phase may substantially differ, average TTM for a company’s product offerings may not be a very meaningful measure. In contrast, it makes sense for businesses that provide similar products in large quantities and frequently engage in updates, “facelifts”, or add new features. Examples are the fashion industry or consumer electronics. Measuring the time it takes the company to provide a new style or a new version may help management to monitor and evaluate the agility and adaptability of the firm. – Upside flexibility This measure deals with the ability of a business to react to an unforeseen upside in demand for its products or services. It is usually measured as the time it takes (in days) to accommodate an unexpected increase in demand by 20% without a significant increase in unit cost (van Aken 2011). The measure may encompass several processes in a business including sourcing, production, and distribution. Thus, upside flexibility can be decomposed into several sub measures, evaluating the performance of the subprocesses in question. Upside production flexibility, for instance, measures the time it takes the entity to increase production output by 20%. We can apply similar measures for sourcing or distribution capacity. Example Upside flexibility is usually determined by the individual subprocesses. For instance, a firm’s production capacity may be able to deal with a 20% increase reasonably fast, but its supplier of raw material may turn out to be the bottleneck. Assume manufacturing is able to adjust to the increase in demand within 10 days, but the supplier is not able to deliver earlier than in 30 days. Consequently, the long order fulfillment cycle time of one of the suppliers may be the reason for the poor performance of the business in total upside flexibility. It is usually the duration of the longest subprocess that determines upside flexibility (in this example 30 days). – Upside/downside adaptability A similar measure to upside flexibility is upside adaptability. In contrast to the measure of flexibility introduced above, adaptability deals with changes that can be forecasted and planned. Upside adaptability is calculated as the number of additional items, or instances of services that a firm can produce, deliver and maintain within a given time period. Similar to the flexibility measure, adaptability can be decomposed into the subprocesses of sourcing, producing, delivering and servicing. Likewise, upside adaptability is determined by the first limit you hit (van Aken 2011). Unlike the flexibility measure above, adaptability can also deal with a downside adjustment. Downside adaptability is defined as the decrease in demand a company can cope with while still avoiding a substantial increase in cost per unit. The higher the number of reducible units the better is an entity’s downside adaptability.

8.5

Measuring Operating Performance of Single Entities in Supply Chains

213

– Annual R&D investment Although measured in Euros or Dollars, investment in research and development is not only a financial measure. It can be used as an indicator of adaptability in the sense of innovativeness. A firm that invests heavily in new products or services may do so in order to adapt to changed market conditions or to new customer demands. Businesses that spend high amounts on research and development are usually considered to be more innovative than those with lower expenditures in the same industry. Service Focus – Order fill rate A ratio that focusses primarily on the distribution part of logistics is the order fill rate (OFR). OFR measures the ability to ship from stock within the agreed time window (e.g. same-day, overnight or 48 h). OFR is calculated as

Order fill rate ¼

Total volume shipped within the service level window Total volume ordered for shipment within the service level window  100% ð8:13Þ

Essentially, OFR is an inventory management ratio. However, under the perspective of customer service, a high OFR indicates the rate at which a company promises to satisfy demand. – Customer satisfaction Earlier in this section, we introduced customer satisfaction as an indicator of quality. It can also be used for indicating the level of service focus of a business firm. Customer satisfaction does not only apply to end-customers. The service focus can be evaluated by customers’ satisfaction at any intercompany relationship within a supply chain. – Average service response time This is measured in hours and may serve as another indicator of the service focus of a company. Long response times to requests (or not responding to request at all!) show that a business doesn’t take its customers and trading partners seriously. Average service response time can also be used as a leading performance indicator for customer satisfaction. – Number of days to process special or rush orders Sometimes, a supply chain trading partner may request a special order or faster delivery, which is not within the normal agreements. A customer-focused organization is willing and able to provide such a service. Note that this measure may also serve as an indicator of agility, which we described above. There are similarities to the measure

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upside flexibility, however, this measure is about special orders, not simply about increasing purchase volume. – Number of stockouts per product A firm may record the shortages of inventory it encounters during a given time period (e.g. a quarter or a year). A high number is an indicator of poor service performance. – Average number of hours spent with customers by engineers This measure may be interesting for companies offering technical products or services. In highly integrated supply chains, trading partners work closely together, which may include exchanging technical knowhow. Engineers spending much time at the customers’ sites indicates a high service focus. – Courtesy ratio A special wish of a customer or a complaint may be dealt with on an ex gratia basis, that is, as a concession of the firm without a legal obligation to do so. The courtesy ratio measures the volume of settlements on a goodwill basis as a percentage of sales in a given period.

Courtesy ratio ¼

8.6

Total volume of courtesy settlements  100% Total sales

ð8:14Þ

Measuring Financial Performance of the Entire Supply Chain

In this book, we have already stressed the point of a holistic supply chain view several times. Managers first and foremost tend to concentrate on the financial performance of their own organization (Kache and Seuring 2014). However, this can be a very short-sighted view. Being a member of a supply chain involving several trading partners, the focus on the single entity might miss out on financial opportunities. Such a micro view may let go cost savings for the entire supply chain. We present a few concepts in this section that try to take the consolidated macro view. Striving for economic success is a natural goal of any business enterprise. We can logically deduce that an entity within a network should not only pursue its own financial welfare but should also have an interest in a most efficient supply chain as a whole. Provided that a fair sharing of profits is in place, a company will benefit, if the entire network can provide a good or service of high quality to a customer in a fast and most costefficient way. Furthermore, the single entity will benefit, if the network remains agile and adaptable to change, and when it is service-focused and facilitates collaboration among the partners. These are the attributes that contribute to financial success (refer to Fig. 8.2 earlier in this chapter).

8.6

Measuring Financial Performance of the Entire Supply Chain

215

In the following, some selected financial performance measures are presented that try to determine the efficiency of the supply chain from a macro perspective. Note that a general concern in the endeavor to measure financial performance across the entire supply chain is the limited access to performance data in practice. Cost Measures of the Supply Chain We have presented cost measures already for a single entity. For managing the supply chain in its entirety, the costs associated with operating the supply chain can be aggregated. In principle, any cost measure can be aggregated to represent total cost across the complete supply chain: – – – – – – – – – – – –

Transportation cost Storage cost Capital charge (cost of capital for tied-up resources) Handling cost Manufacturing cost Cost of machine breakdowns Cost of excess capacities Cost of capacity shortage Spoilage losses Service cost After-sales cost Warranty cost

This list of cost measures could be continued. Basically, any cost of procurement, logistics, manufacturing, distribution, and after-sales can be considered from a macro perspective spanning the entire supply chain. When aggregating single costs over the entire supply chain, however, one has to watch out for intra-supply chain profits and capitalized costs (see also the discussion of aggregation and consolidation of costs in Chap. 4). Period costs that do not become part of cost of goods sold can easily be summed up for the entire supply chain. This refers to research, service cost, warranty cost, or general administration, for instance. Inventoriable cost, in contrast, such as freight in, and all manufacturing costs are capitalized as inventory and become cost of goods sold once they are sold downstream in the supply chain. Such costs have to be consolidated, that is, any intra-supply chain profits have to be eliminated when calculating the entire cost over the whole supply chain. – Total delivered cost A useful comprehensive cost measure that captures the total supply chain costs is total delivered cost (TDC) or total landed cost (TLC). It has been introduced already in the single entity perspective, however, here it is used at the supply chain level:

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Aggregated cost of goods þ Aggregated transportation cost þAggregated inventory carrying costþAggregated material handling cost ¼ Total delivered cost ðsupply chain levelÞ

ð8:15Þ

This cost figure sums up the total money spent by the supply chain trading partners to procure the material, store inventory, produce goods, transport them between supply chain trading partners and finally deliver them to the end-customer. For TDC, the same consolidation requirement applies as explained above. Any inventoriable cost has to be dealt with care. Supply chain management accountants that take a bird’s eye view would try to minimize TDC or any other cost measure for the total supply chain. This could mean that some firms within the supply chain might bear more of the total costs than others. For instance, shifting transportation costs from one partner firm to another may not be “fair” from the recipient’s point of view, but it may make sense for the entire supply chain if this firm exhibits higher shipping terms than others. Yet, it would make sense from the perspective of the whole supply chain. Compensation could be realized either by shifting other costs disproportionately to the partner firm or by simply providing monetary compensation. Asset Management Efficiency in the Supply Chain The efficient use of assets has been stressed already in the single entity perspective above. Asset management efficiency, however, can also be considered at the total supply chain level. Utilizing assets efficiently within the entire supply chain is a logical goal from a macro perspective. – Supply chain asset turnover The total assets employed across the partner firms in a supply chain should be utilized as efficiently as possible. A general indicator for this is the supply chain asset turnover:

Supply chain asset turnover ¼

Total sales to end  customers Total supply chain assets

ð8:16Þ

This ratio is a “big picture” performance indicator (Charifzadeh and Taschner 2017, p. 213). The firms in a supply chain hold several assets with the overall goal to generate revenues from selling a product to an end-customer. Such assets may include cash, inventories (current assets), but also patents, machines, entire factories or retail space (long-term assets). All these assets are used to operate the supply chain. In general, the more revenues the network generates with a given asset base, the better it is. Supply chain asset turnover measures how much sales the supply chain generates with the total assets employed by its partner firms.

8.6

Measuring Financial Performance of the Entire Supply Chain

217

Example Imagine a supply chain in the automotive industry. The last member of the supply chain is the auto dealer. Assume, the dealer realizes total revenues by selling cars of 10 billion € per year. Total assets across the entire supply chain account for 50 billion €. Thus, supply chain asset turnover is 0.2. In other words, with a single Euro of assets in the supply chain, trading partners generate 20 cents of final sales per period to end-customers. Generally speaking, the higher this ratio, the better it is. A high supply chain asset turnover indicates efficient asset utilization. Whether the asset turnover of the automotive supply chain in the example above is high or low can only be determined by comparing it with other supply chains of the same industry or providing the same product. Such a comparison is part of a benchmarking analysis, which will be shortly addressed at the end of this chapter. How can the partners in a supply chain increase the asset turnover? The ratio above basically allows for two approaches. Either the supply chain can increase sales with the existing assets, or the network manages to maintain sales when employing fewer assets. The first option comes into play when there are idle capacities in the network that allow increasing the output. Examples are idle machine times, unused storage capacities or underutilized distribution facilities. The supply chain can increase production by utilizing these excess capacities. If the demand for the products is high enough to absorb additional sales, revenues would increase with the same amount of assets. If the market demand isn’t high enough for more sales, the second option may increase the asset turnover as well. Given the situation of excess capacities in the network, the supply chain can try to produce the same output with fewer assets. Idle capacities in the supply chain would have to be divested. Practice examples may include a supplier whose production capacities cannot be utilized by the supply chain. A distributor in the supply chain may not fully utilize its transportation capacities. And a retailer may reduce the number of outlets if the same sales to end-customers can be reached with a smaller branch network. As a result, the supply chain’s efficiency increases as the output is generated with a lower asset base throughout the network. The biggest problem with computing supply chain asset turnover in practice is the correct apportionment of a firm’s assets to different supply chains. Most companies belong to several supply chains at the same time by serving different customers or industries, respectively. Assets are employed for more than one supply chain and the value of a firm’s asset base, therefore, must be allocated proportionally (e.g. in proportion to sales revenues generated with each customer or supply chain). However, such allocation schemes are inevitably imprecise and complicate the computation tremendously. Net Working Capital and Cash-to-Cash Cycle in the Supply Chain While asset turnover refers to all assets employed in a supply chain, a particular focus of supply chain management lies on current assets and net working capital, as already outlined

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for the single entity in Sect. 8.4. In a macro perspective, one can measure how efficient the supply chain as a whole manages its net working capital. All measures introduced under the single entity perspective can be applied on a supply chain level as well: – – – – – –

Supply chain net working capital Supply chain inventory turnover Supply chain days inventory Supply chain days receivables outstanding Supply chain days payables outstanding Supply chain cash-to-cash-cycle time (days working capital)

While these measures are usually applied at the single entity (micro) level, they can conceptually span the entire supply chain as well. For instance, supply chain net working capital (NWC) would be the sum of the NWC of all supply chain partners. From a holistic supply chain management perspective, the objective is to reduce the supply chain’s aggregated NWC. The same idea applies to the various NWC sub-concepts, i.e. the inputs to NWC (inventory, receivables, payables, etc.). They can be optimized by viewing the entire supply chain. The same holds true for the aggregate measure cash-to-cash cycle (C2C cycle time). Supply chain management from a macro perspective should try to reduce the aggregated C2C cycle time for the entire supply chain. Optimizing NWC or C2C cycle time is not an easy endeavor since a supply chain exhibits a potential zero-sum game. The supplier’s days receivable match the manufacturer’s days payable, as do the manufacturer’s days receivable and the retailer’s days payable. In a single entity perspective, supply chain partners will try to optimize their individual C2C cycle time potentially to the detriment of the other trading partner. One partner’s improvement represents a C2C deterioration at the supply chain partner. Chapter 6 (supply chain finance) elaborates on these ideas in more detail. There are concepts in supply chain finance that create benefits for the supply chain in its entirety. Particularly, if the cost of capital varies significantly among the supply chain partners, it makes sense to shift working capital within the supply chain. Partner firms exhibiting lower cost of capital should bear more NWC than others. With these holistic concepts described above, performance measurement could determine whether efficiency from a macro perspective has increased.

8.7

Measuring Operational Performance of the Entire Supply Chain

Above in Sect. 8.6, we argued that the financial welfare of the entire supply chain should be in the interest of each individual member. The same argument applies to operating performance. Each single trading partner will benefit, if the network’s output is of high

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quality, if the network is fast and agile and if it is service-focused. Eventually, all these attributes will contribute to financial success. Consequently, instead of concentrating solely on their own operating performance, supply chain members should also have a view on the overall supply chain’s performance from a macro perspective (Kache and Seuring 2014). Similar to measuring financials across the network, there are obstacles to measuring operating performance for the entire supply chain. In practice, supply chain trading partners are hesitant to share performance data. Some of the operating data will be considered competitively sensitive and therefore is kept confidential by the trading partners. Additionally, even more than in the case of financial metrics, members might employ divergent measures or different definitions for measures that impede the aggregation of operating performance data. As a result, measuring the operating performance of the entire supply chain can become a challenge. Despite these obstacles, we suggest the following selection of measures to determine the operating performance of a supply chain from a macro perspective: – Customer satisfaction We have already discussed the importance of this performance indicator for quality and service focus at the single entity level. For the entire supply chain network, the satisfaction of the end-customer is vital, too, since satisfying end-customers drives the sales for all supply chain partners (Wisner et al. 2016). In a collaborative supply chain setting, customer satisfaction must overlay the entire supply chain to ensure that all trading partners contribute to the common goal. However, supply chain partner firms should jointly agree on an appropriate definition of measuring customer satisfaction, to ensure acceptance. – Supply chain cycle time (supply chain response time) This measure is similar to order fulfillment cycle time (OFCT) that has been introduced already for performance measurement at the single entity level. However, supply chain cycle time (SCCT) takes the entire supply chain into focus. SCCT is a comprehensive and multidimensional measure, just like OFCT. It represents the response time of the entire supply chain, starting with a customer at the downstream end of the supply chain placing an order until the delivery by the supply chain and final receipt of the product by the end-customer. Thus, it covers the entire time the supply chain takes for sourcing material, manufacturing a product and distributing it to the customer. SCCT can be a pivotal competitive factor as it demonstrates the speed at which a supply chain can satisfy demand. SCCT can be particularly important in supply chains that engage in customer-specific solutions. While demand for commodity products can often be served from available stock or through minor adjustments in production planning at the downstream end of the supply chain only, highly individualized products that need extensive configuration will

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typically involve several different supply chain layers. Such demand can be served only, if and as long as multiple partners on different supply chain layers cooperate and work hand in hand on satisfying customer expectations. A short SCCT can be a major competitive advantage. – Supply chain upside flexibility This is another measure that has been introduced already for the single entity micro perspective. In the single firm perspective, upside flexibility may not be determined by limitations within a company’s own operations, but by a bottleneck supplier that is further upstream in the supply chain. A firm’s own flexibility might be severely hampered by a poor upside flexibility performance of a business partner within the network. Thus, it makes sense to concentrate on upside flexibility also from a macro perspective. Supply chain upside flexibility measures the time it takes an entire supply chain to satisfy an unexpected increase in demand by 20% (Wisner et al. 2016). Thereby, the measure indicates the ability of the supply chain as a whole to react to unforeseen upsides in demand. Example When determining the performance, note that upside flexibility of an entire supply chain is not necessarily simply the sum of the upside flexibility performances of its individual members. When an end-customer makes an unexpectedly high order, supply chain members can simultaneously start increasing their capacities. Imagine, for example, a car manufacturer faces unexpectedly high demand for a new model and requests higher volumes of supplier parts, such as tires. Consequently, the auto company orders 20% more tires than the tire manufacturer had planned. The tire company, in turn, orders 20% more raw materials (such as rubber) from its supplier. Assuming that the car manufacturer has an upside flexibility performance of 30 days, the tire manufacturer of 12 days and the rubber supplier of 25 days, what is the supply chain’s overall upside flexibility (measured in days)? Only in the worst case, it is the sum of the individual performances (30 + 12 + 25 ¼ 67 days). In a well-functioning network, information about new, unexpected, or special orders would be passed through the supply chain immediately, so that each member can react instantly. Thus, supply chain upside flexibility would ideally be the number of days of the slowest member firm (in this case the car manufacturer with 30 days). However, if the information is not directly passed on, the supply chain loses valuable time. Whether the supply chain’s upside flexibility is closer to the maximum of 67 or to the minimum of 30 days mostly depends on the speed and ease of information flowing through different supply chain layers. Obviously, supply chain upside flexibility is linked with information flows within the network, which we will address in more detail in Sect. 8.8.

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– Supply chain time to market Also, time to market (TTM) has been introduced at a single company level already. However, this measure is useful also for evaluating the performance of the entire supply chain. How long does it take the supply chain from identifying a consumer trend until providing a product to an end-customer? As such it deals with the supply chain’s ability to react to new or changing market demand. Supply chain time to market (SCTTM) is a highly competitive performance factor. It indicates the agility of the supply chain as a whole in responding to marketplace changes in order to gain or maintain a competitive advantage. The faster the supply chain can satisfy the identified demand, the higher will be the sales for each individual member. Example Noteworthy examples of short SCTTM can be found in the fashion industry. Firms that follow the trend of “fast fashion” must excel in SCTTM to be successful. The fast-fashion business model tries to minimize the time from designing new collections to offering them in stores. Rather than changing their collections two times a year (the seasonal model), fast fashion develops new designs all around the year. Cloths are designed and produced only for a short period of time (often only 4 weeks) before a new collection enters the stores. A prominent example is the Spanish Inditex group, better known for its subsidiary Zara. Zara is considered a pioneer of the fast-fashion business model. Its success is based on perfectly managing its supply chain. About 20–30% of Zara’s products are fast-fashion with agile supporting supply chains (Gartner 2019). It has developed a highly responsive supply chain that enables extremely fast delivery of new collections as soon as a trend emerges (Petro 2012). Zara employs several hundreds of fashion designers and trend scouts who continuously observe catwalks and shopping streets. Once they identify (or copy) a trend, an extremely fast process is triggered. They continuously buy fabrics from suppliers in large quantities. Zara operates highly automated factories cutting and dyeing fabrics and creating unfinished “grey goods”. Finalizing the cloths is done just in time by a closely controlled partner network of about 300 contract manufacturers in Spain and Portugal. International distribution to the stores is handled within 48 h by air or truck. With this, the SCTTM of Zara products ranges from 10 to 15 days. As a result, Zara needs only about 2 weeks to go from the design stage to the shelf. – Supply chain perfect order fulfillment This metric measures the average percentage of orders throughout the supply chain that arrive complete, on time, and damage-free (Wisner et al. 2016). Supply chain perfect order fulfillment ¼

Volume of orders on time, complete and damage  free  100% Total order volume

ð8:17Þ

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While this measure can also be calculated for a single entity, when computed across the whole supply chain and aggregated, the measure indicates the operating performance of the entire network. Conceptually, and most comprehensively, the measure can include all intra supply chain deliveries. Alternatively, one can take the mere external view and consider only deliveries to end-customers. In any case, high scores show a competitive supply chain that excels in quality, speed, and reliability, and as such, provides an important contribution to customer satisfaction.

8.8

Measuring Relation-Oriented Performance Among Supply Chain Partners

In Sect. 8.3 it has been argued that supply chain performance measurement must address several layers of performance, or, in other words, several diverse objects of measurement. Apart from operating and financial aspects of individual firms as well as the whole supply chain, this involves measuring the relationships between two entities in such a collaborative network. Therefore, this section will concentrate on the interfaces between individual members of a supply chain. Remember that relationships in supply chains are not free from complications. The protagonists in such networks experience tensions that result from their different roles and interests (see also the discussion of agency theory in Chap. 2). These tensions are featured by trade-offs between autonomy and dependency, and between cooperation and competition (Werner 2017). Modern supply chain management accounting tries to plan, measure, and control the intensity and quality of these relationships (Weber and Wallenburg 2010). For the field of performance measurement, this includes evaluating the collaboration, the basis of trust, and the information exchange between supply chain trading partners. Table 8.4 provides an overview of the areas of performance measurement that are covered in this section. Collaboration Collaboration addresses the direct interface between two trading partners in a supply chain. Fruitful collaboration is essential in supply chain networks (Kache and Seuring 2014). The performance of the collaboration between the members of a supply chain will substantially determine the performance of the overall network. Performance measurement tries to assess the frequency and intensity of the collaboration. Direct trading partners can set mutual targets for their collaboration whose attainment will be measured in regularly recurring cycles. The following performance measures can be used for assessing the collaboration: – Number of joint projects This is a rather simple indicator of the frequency of a collaboration, to begin with. Two trading partners may agree on a certain number of projects for cooperation within a

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Table 8.4 Relation-oriented performance measures in supply chains Relational goals Collaboration

Basis of trust

Information exchange

Performance indicators – Number of joint projects – Complexity of joint projects – Duration of partnership – Number of interfaces – Benefit of opportunistic behavior – Values and morale – Loss of reputation – Surveying data exchange – Supply chain interfaces – Digital links – Number of shared data sets

Source: authors

certain time period. Such projects may include the development of a pre-product by the supplier or a simple purchase agreement of raw materials, for instance. Monitoring the number of projects they actually carried out provides an insight into how close they really collaborate. Increases or decreases can indicate how successful the past collaboration was. – Complexity of joint projects Rather than the pure number of joint projects, this measure captures the quality of the projects carried out. More complex joint projects indicate a more intense cooperation. However, an organization needs an unambiguous definition of complexity first, which typically will be assessed using a multidimensional scale (since complexity is multidimensional by nature). – Duration of partnership A simple albeit efficient indicator of the quality of collaboration may be the duration of a partnership. Rather than counting the number of projects, this measure records the time a supplier-customer relationship exists. A long partnership is considered as an indicator of a close relationship. – Number of interfaces A high number of interfaces between two trading partners can be an indication of a high service attitude towards trading partners. However, in most cases, it will also complicate matters. Often, information flows within an organization are not perfect, and too many interfaces can lead to inefficiency. Speaking in economic terms, unnecessary interfaces lead to high process cost and high transaction cost. This might eat up economies of scale and erode other benefits of collaboration (Werner 2014). The above measures focus on collaboration as an overarching governance element. Of course, collaboration is also about the more operational factors of quality (do partners deliver appropriate quality?), speed and agility (how fast are deliveries and how does a

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partner react on special orders?), and about service focus (how service-oriented is a trading partner?). Most of the measures introduced in the Sects. 8.5 and 8.7 can be used to evaluate these aspects. Example An example of a special form of collaboration between a supplier and a manufacturer is the so-called resident engineering. In this concept, suppliers delegate selected engineers for a defined time (usually 2–3 years) to work at the manufacturer (Werner 2017). During their time at the manufacturer, the delegated employees of the supplier are involved in product development. The factors cost (efficiency), time and quality of a product are often determined already in the early development and design stages of the value chain. By collaborating with and integrating the supplier into the development phase, the manufacturer allows the supplier to exert influence already at an early stage of the design and production of a new market offer. Trust In Chap. 3, we defined trust as the confidence of one party in a two-way relationship that the other party will not exploit its vulnerabilities (Ghosh and Fedorowicz 2008). Trust is essential for a successful collaboration of two business partners (Weber and Wallenburg 2010). It can be a very effective governance mechanism in cooperative settings and makes working with a partner easier for both sides (see also Chap. 3). In contrast, mistrust can destroy a cooperation, or, at least absorb large parts of the benefits, as monitoring costs will be very high. Mistrust may result from individual resentments or from structural problems in the partnership, such as a highly unbalanced market power between the trading partners. Chapter 3 has introduced the concept of relational rent, which represents the profit that is created through collaboration and that could not be reaped by individual firms in isolation. When two or more parties cooperate in a supply chain, the question of how to allocate such surpluses among the trading partners will inevitably arise. Usually, each firm will try to maximize its own benefit from the cooperation. As has been discussed in Chap. 2, agency problems and opportunistic behavior are not uncommon in supply chain relationships. If the surpluses that are created by the partnership are distributed highly unequally, the whole collaboration will be ill-fated. Firms in the supply chain will experience “value chain envy” (Mol et al. 2005). In practice, trust can help solve or at least defuse such controversies. Especially in international supply chains, where monitoring partners is more difficult due to legal barriers, cultural differences, or language problems, trust is an indispensable element of any collaboration. On the other hand, trust can also be betrayed. It is reasonable—and even indispensable—to evaluate new partnerships or existing cooperations against this background. It is supply chain management accounting that must provide this information about the trustworthiness and integrity of trading partners. Weber and Wallenburg (2010) propose that the decision to enter a business partnership should be determined by three factors:

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1. The amount of relational rent that can be generated in a collaboration in case of a trustworthy partnership 2. The cost that would result in case of the partner acting opportunistically 3. The probability of the partner taking opportunistic action Taking these three factors into consideration, in theory, engaging in a partnership is beneficial if the relational rent (1) exceeds the expected value of the cost resulting from opportunistic behavior of the partner, with the latter being calculated as the product of the cost (2) times the probability (3). However, as simple as this calculation might seem, in reality, this is far from being quantifiable. Assessing the “soft factor” trustworthiness of a business partner is a tricky task since in most cases trustworthiness can only be estimated. In fact, many supply chain managers go with their gut feeling in practice. However, there are ways to evaluate trustworthiness to some extent and make it less subjective. An alternative approach to the theoretical quantification of Weber and Wallenburg (2010) above is the following model, which is suggested for application in practice by the same authors (see Fig. 8.3). According to this model, trustworthiness can be determined by (1) the attractiveness, i.e. the benefit that a supplier earns through opportunistic behavior, (2) the values, or morale of a supplier, and (3) the loss of reputation of the supplier in case the opportunistic behavior is detected. The first factor, the attractiveness of opportunistic behavior, is determined by the profit a supplier would make when acting opportunistically and to the detriment of the business partner. This has to be weighted by the probability that opportunistic behavior is detected. Furthermore, a firm can try to estimate the degree of dependence of the supplier on the collaboration. The second factor of values or morale helps to further estimate the probability of opportunistic behavior. It deals with the question of whether the two business partners in

Opportunistic benefit

Values or morale

Loss of reputation

Attractiveness of opportunistic behavior

Values fostering collaboration

General loss of reputation

Dependence on partner

Harmony of values

Loss of reputation in particular relationship

Sanctions by market

Fig. 8.3 Quantification elements of trust (source: Weber and Wallenburg 2010, p. 303)

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a cooperation share the same collaborative values. Indicators for assessing a value fit are (Weber and Wallenburg 2010): – – – – – –

Openness of communication Honesty Understanding of specific situations of the partner Loyalty Fairness in business conduct Integrity

Finally, as a third factor, the potential loss of reputation has the power to lower the attractiveness of the opportunistic benefits. This is determined on the one hand by the general loss of reputation in the market for the opportunistically acting firm. On the other hand, the model looks at the loss of reputation within the specific cooperation. Indicators for assessing this are past experiences made with the business partner so far in terms of (Weber and Wallenburg 2010): – – – – – –

Number of joint projects Number of and relation with contact persons Familiarity and intimateness Reachability of contact persons Response times of contact persons Conflicts and solutions thereof

Measuring trust between supply chain partners is usually done by collecting experiences and impressions of operating managers in surveys. Such surveys should be done on a regular basis to monitor trends and variances. Example An example of supply chain business practices that necessitates a high amount of trust is vendor-managed inventory (VMI). In traditional inventory management, the replenishment orders are the responsibility of the party consuming the inventory, such as the manufacturer or the retailer (Webster 2002). VMI, in contrast, represents a “philosophical shift” (Murphy and Knemeyer 2018, p. 164) for organizations as the supplier takes the responsibility for inventory. Operationally, in VMI, the supplier has access to the manufacturer’s or retailer’s inventory and sales data, which is usually done electronically by automatic data exchange. VMI requires great trust because of the potential for dishonest behavior by the supplier. A supplier may abuse the autonomy by pushing unneeded inventories onto downstream parties. With a trustworthy supplier, however, the system can generate benefits through better inventory management and saving transaction costs. VMI gives suppliers more control over when and how inventory is shipped to manufacturers, which, for instance, can lead to fewer stockouts (Murphy and Knemeyer 2018).

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Information Exchange The third and final category of relationship-oriented performance measures covers the frequency, effectiveness, and efficiency of the communication between two direct partners in a supply chain. A well-functioning network requires a fast and smooth data exchange between trading partners (Webster 2002; Kache and Seuring 2014). Example Imagine a company that produces and sells clay tiles. Management accountants together with operating managers are currently budgeting sales, production, and procurement of raw materials for the next four quarters. The planned unit sales determine the production budget, and the production budget, in turn, determines the budgeted amount of clay that must be purchased over the year. In the past, the supplier had to plan clay production in isolation, that is, the supplier would set up its own budget based on own estimations of demand including historical order volumes and its previous ordering patterns. Assume, however, this year, the clay tile company shares its production and procurement budget with the clay supplier, which allows its management to optimize production. They can precisely produce the planned demand at the requested time and avoid excess inventory and obsolescence. The sharing of demand data allows a supply chain to become, in effect, a ‘demand’ chain (Webster 2002, p. 365).

This allows for substantial savings in the supplier’s planning, sourcing and storing cost. In a fair allocation of the benefits (relational rent), both sides should profit from the improved information exchange. While the supplier can work more efficiently and save costs, the clay tile company should benefit from lower purchase prices. Today, electronic information exchange between supply chain partners is the norm. While at the end of the 1990s only about 2% of all purchase orders were made over the internet, in the meantime, all major firms launch orders electronically (Wisner et al. 2016). Today, the electronic configuration of all purchasing processes (e-procurement) from ordering to billing is standard. Enterprise resource planning (ERP) systems of two partners communicate directly, for example via the IDoc standard (in case of SAP ERP systems) or the EDIFACT format (see also Chap. 7). Purchase requisitions and orders are transferred directly end-to-end. This speeds up the supply chain, reduces transmission errors, and offers huge efficiency gains. Additionally, firms invest heavily in digital solutions for marketing, communication, and research using the now available “big” data, leveraging automation, data science, and machine learning. Communication between trading partners is not without problems, though. There are cases where existing systems at two business partners have trouble exchanging data. Supplier, transportation, inventory, or production data is available but stored in

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incompatible systems, and with varying levels of granularity. Communication can still take place, but not in a very efficient manner. Example A pioneer and no. 1 in Gartner’s Top 25 supply chain ranking is global-household giant Colgate-Palmolive (Gartner 2019). The company uses an end-to-end (E2E) supply chain control tower to provide daily visibility. This is a digital supply chain model that collects all information in real-time about the flow of material and production as well as master data of suppliers, distributors, products, and customers in one central point. The system allows predicting rather than reacting to the market. By having a complete overview of the supply chain end-to-end, situations of supply shortage can be avoided completely, inventory levels are reduced, and transportation costs can be minimized. Management accounting can try to measure the frequency, the effectiveness and the efficiency of information exchange between parties in a supply chain. Generally, any firm can monitor the data exchange with its partners. Which information do we share? Which information is kept confidential? What device or system do we use for exchanging data? Does the information exchange work without friction? How frequently do we provide information to suppliers? To customers? An example of performance ratios in this context is digital links and number of shared data sets: – Digital links This measure indicates the efficiency of communication between two partners. Digital links measures the number of shared systems of two supply chain partners, in relation to the total number of systems (Werner 2017). The higher this ratio, the more likely is a speedy, effective and efficient communication. Time-consuming coordination efforts and transmission errors can be avoided. – Number of shared data sets This is similar to digital links. It may be more suitable for partners who do not share the same systems but yet can exchange datasets that are processed by their own systems. A high number of shared data records may indicate efficient communication, but also a close collaboration and a certain degree of trust between partners. Note that in most supply chains, measuring information exchange is rarely a task for routine performance measurement and management reporting. Surveying the status of information exchange is an undertaking that is rather done within a special project aiming at improving the communication between business partners, or introducing digital technologies, such as automated warehousing and production, and artificial intelligence. This requires investigating the existing interfaces between partners and their efficiency. Often, such projects are carried out with the support of external consultants.

8.9

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Performance Measurement Systems in Supply Chains

This chapter has introduced a variety of financial and operating performance measures, and the list is surely not exhaustive. Practitioners as well as researchers agree that focusing on one measure alone is not enough—it is often the interplay of various measures and indicators that provides a thorough insight into the performance of an organization (Beamon 1999). While there is widespread agreement that applying multiple performance measures in companies and supply chains is vital, the question of which measures in particular one should use is not easy to answer. Practice and academia have tried to provide guidance on the selection of measures, their order, or their interpretation. So-called performance measurement systems try to put measures into a structure by grouping or linking them. Generally, there are two types of performance measurement systems (Charifzadeh and Taschner 2017): – Systems that link performance measures to each other through mathematical relationships – Systems that group several measures according to logical relationships Measurement systems with mathematical links usually start from one top measure and then, in a deductive approach, gradually decompose measures into their components. The result is a hierarchical, pyramid-shaped, set of measures. The main advantage of these types of performance measurement systems is their accurateness and comprehensibility (Charifzadeh and Taschner 2017). Each measure can be traced back to its components, thus guaranteeing the proposed effect on the next higher-ranked performance measure in the system. The main disadvantage of these performance measurement systems is their mere focus on quantitative, often purely financial, measures. The best-known among these mathematically linked performance measurement systems is the Du Pont System of Financial Control, which will be introduced below. The second type of performance measurement systems does not require mathematically defined links between performance measures. Instead, they can link various quantitative as well as qualitative performance measures with each other on a logical basis. These links may be derived from hypothesized cause-and-effect relationships or from empirically proven correlations. The main advantage of these types of performance measurement systems is their flexibility and adaptability to the needs of an organization. Their disadvantage is the complexity and an often non-binding character of the postulated links. The bestknown representative of these kinds of performance measurement systems is the balanced scorecard, whose application in a supply chain context will be discussed in greater detail at the end of this sub-chapter.

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DuPont System in a Supply Chain Context We have seen before that supply chain performance measurement deals to a large extent with operating variables. A system that tries to combine operating drivers with financial measures is the DuPont system of financial control, named after the US chemical company DuPont de Nemours. This system has been published in the year 1919 already and belongs to the first type of performance measurement systems, exhibiting mainly mathematical links between selected financial ratios. However, some of the financial measures can be connected to operating drivers, which allows for the system to be applied in a supply chain context, too. Note, however, that the DuPont system focusses on a single entity within a network rather than a full supply chain end-to-end. Originally, DuPont’s CFO, Donaldson Brown, had developed the system for internal efficiency analyses (Davis 1950). Donaldson put the goal of profit maximization, in relation to the capital invested, on top of a performance pyramid of a business. Thus, in the system, return on assets (ROA) is in the main focus of management. While this focus on one central financial measure has often been criticized, one of the DuPont system’s achievements is the decomposition of the financial return measure into other financial and operating drivers. As shown in Fig. 8.4, ROA (¼ EBIT/Total assets) can be decomposed into the operating profit margin and the asset management ratio total asset turnover (TAT). Both performance measures, operating profit margin and TAT can be further split into its components and drivers, and the further we drill down, the closer we get to the operating drivers of supply chain performance. Following the upper path in Fig. 8.4, the operating profit margin (OPM) can be decomposed into earnings before interest and taxes (EBIT) and sales (OPM ¼ EBIT/sales). EBIT, in turn, is comprised of sales minus operating costs, which include cost of goods sold (COGS) and any other period cost (non-manufacturing cost). This is the point where the classic DuPont driver tree ends and further drilling down does not work with mathematical links. Figure 8.4, therefore, switches to operating drivers that influence financials, indicated by the dotted lines. The factors or drivers at the end of these dotted lines represent the operating supply chain goals outlined earlier in this chapter. It shows how, for example, efficiency, quality, or speed influence the financials of a company in a supply chain. Let’s discuss this with some selected examples. Management may concentrate on sales, to start with. As can be seen in Fig. 8.4, increasing sales exhibit a positive impact on the OPM, which, in turn, increases ROA. On the right side of the figure, managers can identify some influencing factors on sales in a supply chain context. Quality, service focus and agility play the biggest role here, but this is not a comprehensive list. High quality of products and services, for instance, will have a positive effect on sales of a business. Earlier, Sect. 8.5 introduced a few performance measures that may serve well as an indicator of quality, among them customer satisfaction. At the same time, the agility of a business to react to new trends or unforeseen changes in market demand will influence the sales sustainably. Time to market (TTM) is a potential performance measure that management may consider as a shorter TTM can increase sales.

Total asset turnover

x

Total assets

/

Sales

Sales

/

Noncurrent assets

+

Current assets

Operating expenses

Intangibles

+

Property, plant and equipment

Receivables and cash

+

Inventory

Period costs

+

COGS

Efficiency

Speed

Efficiency

Agility

Efficiency

Speed

Efficiency

Agility

Inventory turnover Days inventory Forecast accuracy … Days receivables outstanding Days working capital (C2C) Liquidity … Capacity utilization Excess capacities Investments Technology Outsourcing Reputation …

• • • • • • • • • • • • • • •

Throughput time Delivery performance Order fulfillment cycle time …

Cost of material Cost of labor Overhead cost Cost to serve Cost of excess capacity …

• • • • • • • • • •

Customer satisfaction Forecast accuracy Stockouts per product Time to market …

• • • • •

Fig. 8.4 Performance pyramid of supply chain drivers (source: Werner 2017, p. 370, adapted and enhanced for supply chain measures)

ROA

Operating profit margin

EBIT

-

Sales

Service focus

Quality

After-sales Distribution and logistics Production Procurement

8.9 Performance Measurement Systems in Supply Chains 231

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Another influencing factor of the OPM and thus ROA is cost. Operating expenses can be split into COGS and period costs. COGS typically represent the manufacturing cost of the goods sold, or, in case of a retailer, the cost of the purchased finished goods. Efficient manufacturing, e.g. by shorter throughput times, or economies of scale in procurement will decrease operating expenses. Various other cost measures, such as cost of personnel, and overhead cost may serve as well as measures of production efficiency. Following the lower path of the performance pyramid in Fig. 8.4, we can reconcile the impact of assets, that is, the investments, on the return of a business. The financials on this branch of the driver tree can be found on the balance sheet of a firm. Assets can be divided into current assets and non-current or fixed assets. The common scheme for both in this performance measurement system is to either economize in assets or better utilize the existing assets. Current assets, for instance, mainly include inventories, receivables, and cash. In a collaborative network, current asset utilization can be optimized by efficiency, agility, or speed. For instance, by introducing processes of lean production, waste can be minimized and thus inventory can be reduced (Charifzadeh et al. 2013). A useful performance measure could be inventory turnover or days inventory. Alternatively—or in parallel—a business could try to better utilize its fixed assets, property, plant, and equipment, or even intangibles. Idle capacities should be avoided. Instead, factories, machines, and patents should be utilized to generate as much in sales as possible. Assets that cannot be utilized should be divested. Example Imagine an automotive supplier that operates three machines in two shifts, each 8 hours a day. Thus, the three machines run in total 48 hours each day. The automotive supplier could add a third shift of another 8 hours. Thus, the same total production time of 48 hours can be achieved with only two of the three machines (2 machines x 3 shifts x 8 hours ¼ 48 hours). This allows the automotive supplier to sell off one machine and produce the same output with only 2/3 of assets. In regards to the financials, note that this would increase the TAT (sales/assets), which in turn increases the ROA (EBIT/assets), as shown in Fig. 8.4. Managing the fixed asset base requires effective planning of investments, e.g. in production facilities or intellectual property rights such as patents. However, particularly in production, this also involves questions about outsourcing and technology. Digitalization of the factory, automation in production, machines that communicate with each other, and artificial intelligence will influence the asset base of an organization. Performance Measurement in the SCOR Model The Supply Chain Operations Reference (SCOR®) model, is a hierarchical process model that describes supply chain-related processes at four different conceptual levels (process types, process categories, process elements, and activities). SCOR has been developed by

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the Supply Chain Council (SCC), an independent non-profit organization, whose mission is to continuously update, improve, and promote the SCOR model. SCOR is primarily a reference model that aims at standardizing supply chain processes across industries (Werner 2017). However, the model is more than “only” process descriptions. It describes the way processes interact, how they perform, how they are configured, and the requirements (skills) on staff operating the process. It, therefore, comprises business processes, metrics, best practices, and technology into a unified structure to support communication among supply chain partners and to improve the effectiveness of supply chain management and related supply chain improvement activities. The performance section of SCOR consists of two types of elements: performance attributes and metrics. A performance attribute is a grouping of metrics used to express a strategy. Metrics measure the ability of a supply chain to achieve these strategic attributes. SCOR distinguishes five performance attributes (see Table 8.5). These performance attributes are linked to the highest process layer (process type) in the SCOR model. SCOR defines ten so-called “strategic metrics” (level-1 metrics) for the performance attributes and provides detailed specification sheets for each one of them (see Table 8.6). We have described the majority of them in the Sects. 8.4–8.7. The strength of the SCOR model is its standardized approach that allows firms that have adopted the model to communicate and collaborate efficiently. For instance, SCOR users apply identical definitions of performance measures, they can benchmark their performances, and they usually employ compatible software systems (Werner 2017). A

Table 8.5 Performance attributes in the SCOR model Performance attribute Reliability

Responsiveness

Agility

Costs

Asset Management Efficiency Source: SCC (2012)

Definition The ability to perform tasks as expected. Reliability focuses on the predictability of the outcome of a process. Typical metrics for the reliability attribute include on-time, the right quantity, and the right quality. The speed at which tasks are performed. The speed at which a supply chain provides products to the customer. Examples include cycle-time metrics. The ability to respond to external influences, the ability to respond to marketplace changes to gain or maintain competitive advantage. SCOR Agility metrics include flexibility and adaptability. The cost of operating the supply chain processes. This includes labor costs, material costs, management and transportation costs. A typical cost metric is cost of goods sold. The ability to efficiently utilize assets. Asset management strategies in a supply chain include inventory reduction and in-sourcing vs. outsourcing. Metrics include inventory days of supply and capacity utilization.

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Table 8.6 Strategic performance metrics in the SCOR model Performance attribute Reliability Responsiveness Agility

Cost Asset Management Efficiency

Performance metric Perfect Order Fulfillment Order Fulfillment Cycle Time Upside Flexibility Upside Adaptability Downside Adaptability Overall Value-at-Risk Total Cost to Serve Cash-to-Cash Cycle Time Return on Fixed Assets Return on Working Capital

Source: SCC (2012)

weakness of the model is its relatively high degree of abstraction that results from its crosssector approach. The Balanced Scorecard In the 1990s, Robert S. Kaplan, a Harvard professor, and David P. Norton, a business executive and founder, developed an innovative performance measurement system—the balanced scorecard (Kaplan and Norton 1992). The development of the balanced scorecard was inspired by the fundamental criticism of the prevailing traditional performance measurement practices at that time (Charifzadeh and Taschner 2017): – One dimensional: performance measurement was mainly focused on financials, concentrating on only one or two measures, such as profit margins or return on investment ratios. – Missing links to strategy: performance measurement often was completely separated from the strategies of the firm. While most firms had a defined strategy in place, they did not link their performance measures with their strategic objectives (Gunasekaran and Kobu 2007). Without receiving feedback about the strategic objectives, performance measurement did not support strategy implementation. In its original form, the balanced scorecard is a multi-dimensional performance measurement system, comprising four areas (so-called perspectives) of performance: (1) financial perspective, (2) customer perspective, (3) internal process perspective, and (4) learning and growth perspective (see Fig. 8.5). Every company, division or branch that uses the balanced scorecard must fill it with its individual objectives, measures, targets, and initiatives. The balanced scorecard is an empty template in the first step that has to be customized to the specific needs. Thus, in practice, no balanced scorecard will be like another.

Customer perspective

Internal process perspective

“How do we present ourselves to our customers?”

“What operating processes must we excel at?”

Fig. 8.5 The original balanced scorecard (source: authors)

“How can we sustain our ability to change and improve?”

Learning and growth perspective

Financial perspective “How do we present ourselves to shareholders?”

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The four perspectives and the strategic objectives therein are not independent of each other. It is one of the main achievements of the balanced scorecard as an innovative tool of performance measurement that it links performance measurement with strategy. Kaplan and Norton proposed that the four perspectives and all objectives and measures therein are connected by cause-and-effect relationships. These links always go from a leading factor (a driver measure) to a lagging factor (an outcome measure). Consequently, the balanced scorecard represents the combination of several cause-and-effect chains that run like threads through the four perspectives. Starting from the learning and growth perspective, they run through the internal process and the customer perspective and finally end in the financial performance perspective. Financials are, by nature, lagging indicators. With these chains, Kaplan and Norton claim to express the strategy of a business: Strategy is a set of hypotheses about cause and effect (Kaplan and Atkinson 1998, p. 376).

In fact, these cause-and-effect links enable a company to translate their strategy into concrete objectives, whose attainment, in turn, is tracked through the performance measurement system. Following this logic, the balanced scorecard is not only measuring the performance under diverse perspectives (and thereby being a “balanced” system) but it is also a tool for implementing the strategy of a business. A central instrument for visualizing and communicating these cause-and-effect chains is the so-called strategy map. With a strategy map, management can reveal the missing links between the strategic objectives of a business and the performance measures. In other words, it is the articulation of the plan to reach the goals of an organization. We will present an example in a supply chain context in the next sections. The Supply Chain Management Performance Framework Right from the outset, Kaplan and Norton proposed that their new tool should be customized to the specific needs of organizations. Although they recommended using the above mentioned four perspectives, the balanced scorecard is generally flexible and can be adjusted or extended. Scholars and practitioners made extensive use of this proposal. An abundance of scorecards has been proposed in literature that drop or add perspectives— among them numerous scorecards that are explicitly adapted to a supply chain context. One of the early attempts to adjust the original balanced scorecard to supply chain management is the supply chain management performance framework by Brewer and Speh (2000). They maintained the four-perspective structure but modified the internal process and the learning and growth perspective (see Fig. 8.6). They transform the internal process perspective into a perspective that measures “interfirm and intrafirm functional integration, sharing and cooperation” (Brewer and Speh 2000, p. 78). They call this perspective supply chain management goals and propose that it employs the objectives of waste reduction, order fulfillment cycle time, flexible response, and unit-cost reduction. The original learning and growth perspective becomes the supply chain management improvement perspective in Brewer and Speh’s model. Like in the original balanced

Improved product/service quality Improved timeliness Improved flexibility Improved customer value

Customer benefits

Higher profit margins Improved cash flows Revenue growth Higher return on assets (ROA)

Waste reduction Time compression Flexible response Unit cost reduction

• • • •

Product/process innovation Partnership management Information flows Threats/substitutes

Supply chain management improvement

• • • •

Supply chain management goals

• • • •

• • • •

Financial benefits Financial perspective

“How can we sustain our ability to change and improve?”

Innovation and learning perspective

“What operating processes must we excel at?”

Internal process perspective

“How do we present ourselves to customers?”

Customer perspective

“How do we present ourselves to shareholders?”

Fig. 8.6 Supply chain management performance framework and the balanced scorecard (Brewer and Speh 2000, p. 85, adapted)

Supply chain performance management framework

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Original balanced scorecard

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scorecard, the perspective deals with the ability to innovate, to learn, to continuously improve, and to adapt to changes. However, the authors apply these attributes specifically to product and process design, and to the ability to leverage human knowledge within the network by improved collaboration. Furthermore, the perspective covers improved information flows that all supply chain partners should have access to. Finally, Brewer and Speh propose to evaluate the competition, which the original balanced scorecard does not consider explicitly: Each supply chain needs to monitor the external marketplace to ensure that potential threats and/or substitutes do not emerge (Brewer and Speh 2000, p. 81).

The other two perspectives are very close to the original balanced scorecard. The financial (benefits) perspective covers the typical financial objectives of profitability, cash flow, revenue growth and return on assets. In the eyes of the authors, firms that adopt supply chain management can usually improve in these measures. The customer benefits perspective focuses on improved service, improved quality, timeliness or flexibility. According to the authors, these objectives are important for all customers along the supply chain. But they stress the point that all the benefits generated by proper supply chain management must ultimately reach the end-customer, who must be satisfied. Just like with the original balanced scorecard, all perspectives and the objectives therein are to be measured by carefully chosen performance measures and indicators. Brewer and Speh’s framework has to be customized in each case. However, they provide guidelines for selecting appropriate measures according to principles that they call “HOPE”. The acronym HOPE stands for harmonized, optimal, parsimonious, and economical (Brewer and Speh 2001). – Harmonized means that the selected measures across the perspectives should not conflict with each other. For instance, measures that purely focus on time and speed in production might conflict with quality. Any trade-offs should be avoided. – Besides, optimal measures diversify the risk of overambitious employees. This criterion is similar to the postulated harmony of measures. For instance, monitoring product development cycles in contrast to time to market may prevent research and development from launching products too fast while they are not yet ready to be put on the market. – Parsimonious stands for a limited number of measures, of which only those are chosen that are useful for decision-making. For instance, when two measures correlate strongly, one can be eliminated. – Finally, with the criterion of economical measures, Brewer and Speh propose a classic cost-benefit principle. Measures should only be employed in the framework if their benefit exceeds the cost of collecting the data.

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The Supply Chain Scorecard A general critique of the original balanced scorecard is that it is primarily oriented towards the internal processes of a single entity. Inspired by this shortcoming, other authors have proposed more fundamental adjustments to the original balanced scorecard that modify the structure and even add perspectives to it. Several authors recommend adding a supplier perspective, thus covering five or more perspectives instead of the original four (e.g. Pampel 2002; Stölzle et al. 2001; Ackermann 2003). Others include a “cooperation” perspective, which is broader and fosters collaboration with all stakeholders upstream and downstream (e.g. Schweier 2000; Bornheim and Stüllenberg 2002; Weber et al. 2002). A model described by Werner (2017) comprises five perspectives. Three of them are basically identical to Kaplan and Norton’s original balanced scorecard and are just slightly adapted to a supply chain context. Werner’s supply chain scorecard combines the financial, customer and internal process perspective with two new perspectives: a supplier perspective and an integration perspective. The author drops the learning and growth perspective since it is mainly oriented towards a single entity (see Fig. 8.7). The financial perspective covers some of the most common monetary objectives of profitability, liquidity, return on investment, shareholder value, tied-up capital, and cost. Note, however, that objectives and measures, just like in the original balanced scorecard, are just examples and that the final selection has to be tailored to the individual needs. Werner (2017) proposes several common performance metrics as shown in Table 8.7. Like in the original balanced scorecard, the financials are the ultimate lagging measures. For the definitions of most of the presented performance measures, in particular for the supply chain related performance measures, please refer to Sects. 8.4–8.8 in this chapter.

Financial perspective How do we perform financially?

Supplier perspective How do our suppliers perform?

Process perspective How do we perform in our processes?

Customer perspective How do customers see us?

Vision and Strategy

Integration perspective How well do we collaborate?

Fig. 8.7 Supply chain scorecard (Werner 2017, p. 484, adapted)

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Table 8.7 Financial perspective in the supply chain scorecard Suggested strategic objectives Increase income Increase liquidity Increase return on investment Increase shareholder value Reduce tied-up capital Reduce supply chain costs

Suggested performance measures and indicators Revenue growth, gross profit, EBIT, net income Cash flow, days working capital (cash-to-cash cycle time) Return on capital employed (ROCE), return on assets (ROA), Return on sales (ROS) Economic value added (EVA) Inventory turnover, days sales in inventory (DSI) Transportation cost, total delivered cost (TDC)

Source: Werner (2017), p. 472, adapted Table 8.8 Customer perspective in the supply chain scorecard Suggested strategic objectives Customer satisfaction Customer complaints Generating new customers Market share Order fulfillment Planning security Innovation

Suggested performance measures and indicators Customer loyalty index, customer satisfaction index Perfect order fulfillment Percentage of new customers Relative market share, absolute market share Order fulfillment cycle time Forecast accuracy Percentage of new products

Source: Werner (2017), p. 475, adapted

A typical discussion in adapting the original balanced scorecard to a supply chain network circles around the question of whether the customer perspective should address only end-customers or whether it is applicable also in a business-to-business (b2b) context. Werner’s supply chain scorecard demonstrates flexibility in this context: if the product at the end of the supply chain is a consumer good, the customer perspective should be oriented towards the end-customers and their needs. In case of capital goods (institutional customers, such as business or government), however, a supplier should rather concentrate on the requirements of the next layer downstream. The customer perspective in the supply chain scorecard covers the primary strategic objectives of customer satisfaction and service, generating new customers, accurate planning, and innovating new products. Strategic objectives and potential performance indicators are shown in Table 8.8. The process perspective covers most of the vital supply chain goals outlined in Sect. 8.3 in this chapter. It deals with aspects of efficiency, time and quality. Additionally, Werner’s scorecard covers flexibility and some aspects of learning and improving. Table 8.9 provides an overview of the objectives and measures suggested in this performance perspective.

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Table 8.9 Process perspective in the supply chain scorecard Suggested strategic objectives Capacity utilization Productivity Lead times Product/process quality Order fulfillment Production flexibility Continuous improvement Employee satisfaction

Suggested performance measures and indicators Utilization rates, machine utilization (production volume per machine hour) Inventory movements per employee, picks per employee and hour Time to market, cycle times Scrap rate, rework (in parts per million, ppm) Delivery performance, delivery reliability (manufacturer perspective) Upside production flexibility Employee suggestions for improvements, employee trainings Absenteeism rate, employee fluctuation

Source: Werner (2017), p. 478, adapted Table 8.10 Supplier perspective in the supply chain scorecard Suggested strategic objectives Supplier quality/service Supplier satisfaction Productivity on receipt of goods Incoming goods inspection

Suggested performance measures and indicators Supplier rating: delivery reliability, reject rate, delayed deliveries Supplier satisfaction index Goods receiving times, consignments/ shipments per day Cost of incoming goods inspection

Source: Werner (2017), p. 480, adapted

In contrast to the original balanced scorecard, it seems logical that a supply chain scorecard should have a supplier perspective. Apart from the obviousness, this can be justified by the shared objectives of suppliers and manufacturers. Additionally, it does make sense with respect to the organizational structure of modern businesses. Procurement and distribution are typically two different functions in an organization. Finally, the order fulfillment process typically starts at the supplier. The supply chain scorecard’s supplier perspective includes availability of goods, satisfaction with the supplier, and supplier productivity and costs. Table 8.10 gives an overview. Note that, here, the scorecard takes an outwardly-directed perspective and measures how the suppliers perform, not how the manufacturer performs in the eyes of the suppliers. Finally, the fifth perspective is the integration perspective, which evaluates the performance of the interfaces. This perspective deals with the relationships between business partners, which is, in the view of Werner (2017), the groundwork of the supply chain. Objectives and measures comprise the intensity and quality of the collaboration, as well as the technical aspects of information flows (see Table 8.11).

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Table 8.11 Integration perspective in the supply chain scorecard Suggested strategic objectives Data transfer Infrastructure Organization/Trust Cooperation

Suggested performance measures and indicators Digital links Fleet links (number of shared logistics equipment and vehicles in warehouse) Confidence indicators, duration of partnership, number of staff exchange (e.g. resident engineering) Number of shared data sets, squeeze-in-time (time it takes to integrate new partners in the supply chain)

Source: Werner (2017), p. 483, adapted

The Supply Chain Strategy Map From the outset, the original balanced scorecard included links between the strategic objectives. Later, Kaplan and Norton added a so-called strategy map to emphasize this concept and to visualize the cause-and-effect chains (Kaplan and Norton 2000). In fact, a strategy map can be considered a visualization of a balanced scorecard, which helps to clarify a strategy and which can be used to communicate it to the members of the organization. While the strategy map shows the strategy, the scorecard measures its execution or more precisely the organization’s success in executing it. In a strategy map, each link (visualized by an arrow from one objective to another) represents a hypothesized cause-and-effect relationship. Like with the original balanced scorecard, these cause and effect links are often of a qualitative nature only. The strategy map requires neither firmly verified nor mathematical links. These hypotheses should be read in the form of “if-then” sentences, outlining the effect of one measure on another. The result is a web of cause-and-effect chains that link leading indicators with lagging indicators. Starting from the basis, which is the integration perspective in the supply chain scorecard, the links pass through the subsequent perspectives and finally end in the financial perspective. The supply chain scorecard—and thus the strategy map—must be adapted to the specific situation of a company. Let us take a view at an example of a car manufacturer in the following, to illustrate the supply chain scorecard combination with a strategy map. Example A major car manufacturer exhibiting mediocre financial success has been forced to rethink its strategy. An important initiating factor of developing a new strategy has been the trouble with some of its suppliers. The firm struggled with the quality and reliability of delivered parts, which ultimately resulted in suffering end-customer perception of their products. In a 3 months process, top management, together with several operating managers, and supported by selected experts, have developed a strategy map for the company. Starting from the integration perspective at the bottom of Fig. 8.8, we can read the strategy map as follows. Since the problems with some suppliers were the initiating factor in redefining

8.9

Performance Measurement Systems in Supply Chains

Financial

243

Create shareholder value

+

+

Increase profit

Decrease fixed assets and NWC

Increase contribution margin per car

+

+

Customer

Generate new customers

+ +

Increase customer satisfaction

+

Increase product image

Process +

+

-

Increase capacity utilization/productivity

Increase product quality

Decrease lead times

Supplier +

+

Increase productivity incoming goods

Increase supplier quality

+

+

Integration

Strengthen collaboration with partners

+

+

Increase trust

Intensify communication with suppliers

+

+

Fig. 8.8 Supply chain strategy map of a car manufacturer (source: authors)

their strategy, the firm identified a need to intensify the communication with its suppliers. For too long, there has been little information exchange with suppliers. Consequently, coordination was weak, resulting in delayed deliveries and high reject rates. Supplied products often did not meet the quality specifications. Intensified communication, which is to be implemented by sharing datasets and implementing shared systems, is supposed to increase trust among the partners (the first hypothesis in the strategy map in Fig. 8.8, indicated by a “+” and an arrow). Increased trust,

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in turn, should strengthen the collaboration in general. Vendor-managed inventory (VMI) could be implemented to institutionalize a closer collaboration. In VMI, suppliers manage the inventory at the manufacturer’s site independently (Murphy and Knemeyer 2018). The next set of hypotheses reaches from the integration perspective into the supplier perspective. If communication is intensified, trust is built up and collaboration strengthened, the car manufacturer expects an increase in supplier quality, reflected by an increased delivery performance and delivery reliability, for instance. Also, productivity should be increased, measurable, for instance, by lower inspection cost of incoming goods. Improvements in supplier quality (goods arrive as specified, on time, at the right amount, damage-free) should result in decreased lead times in the subsequent processes (production cycle time, distribution cycle time, etc.). Besides, product quality of cars should increase, which could be measured by defect rates, scrap rates or amount of rework. Increased productivity and supplier quality will allow the carmaker to increase capacity utilization, measurable by machine utilization and inventory management (e.g. picks per employee). A consequence of this will be a lower required asset base (fixed assets and net working capital). Decreased cycle times (indicated by a “–” in Fig. 8.8, will allow the car producer to deliver orders more quickly (shorter waiting period for customers), which should increase customer satisfaction. Furthermore, we can hypothesize the same positive effect from higher product quality of cars. Together with an increased product or brand image, higher satisfaction should allow the company to generate new customers and take market shares from competitors. New customers, in turn, should increase sales and, consequently, profits. Thereby, we finally arrive at the financial perspective. We can further hypothesize that increased customer satisfaction and shorter lead times should have a positive effect on the contribution margins of the cars sold. Pleased customers order, for instance, more options, or may right away choose the more expensive cars in the portfolio, which exhibit higher margins. To conclude, increased profits on the one hand and decreased capital employed (fixed assets plus net working capital) will result in an increased shareholder value, which could be measured by the performance metric economic value added (EVA). Note that the strategy map and the cause-and-effect links of the car manufacturer above (Fig. 8.8) are a simplified example. Additionally, like in the original balanced scorecard, the point must be stressed that the links between the strategic objectives are merely hypothesized. It does not require mathematical or empirically tested relationships. Consequently, a supply chain scorecard and strategy map, like the one in the example above, has to be tested in operation. By measuring the attainment of the strategic objectives in the balanced scorecard, an organization continuously tests the hypothesized cause-andeffect links. According to Kaplan and Norton, a scorecard provides two types of feedback (Kaplan and Norton 1996). Firstly, managers learn whether their formulated strategy is being carried out according to plan (and as designed on the strategy map). They call it single-loop learning, a process in which the objectives remain constant and any deviations

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Problems of Performance Measurement in Collaborative Networks

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from the plan are seen as a defect to be remedied. In essence, in a balanced scorecard, we do a variance analysis that compares actuals with targets. Secondly, and potentially even more important is the so-called double-loop learning. This is feedback about the validity of the strategy itself. By using a balanced scorecard, a firm continuously collects data about each objective. Thus, the firm receives feedback about every single cornerstone of its postulated strategy. Today, organizations must remain agile, since environments may change. Complex strategies, though valid when they were launched, may lose their validity as business conditions change (Kaplan and Norton 1996, p. 84).

The hypothesized cause-and-effect links between performance drivers and lagging outcome measures may not work anymore. A consequence of this double-loop learning feedback may be that a firm has to change its strategy.

8.10

Problems of Performance Measurement in Collaborative Networks

Supply chain performance measurement is not free of problems. This chapter concludes by taking a critical view, outlining the most important weaknesses in theory and practice. – Performance measures for single entities and not for the entire supply chain Most of the performance measures, and in particular, the performance measurement systems such as driver trees or the supply chain scorecard, essentially are tools for determining the performance of the single entity in a supply chain (Beamon 1999). While they do recognize the importance of cross-organizational collaboration, none of them addresses the complete macro view. A set of genuine supply chain-level indicators is not yet readily available. – Lack of information and data When considering the various concepts of measuring the performance of and in supply chains presented in this chapter, a realistic assessment is appropriate: some measures are simple, others more sophisticated. But in practice, it will often be difficult to gather the data that is needed to compute all these measures. In particular, for the concepts that address the macro perspective, i.e. the supply chain as a whole, a central body (e.g. a “supply chain steering committee”) would be required that finds a high level of openness among its supply chain members to share performance data. Such supply chain control tower concepts are still rather the exception. Referring to the characteristics of “good” performance measures outlined in Sect. 8.2, the characteristic of “visibility” will be violated in many cases, as management accountants often do not have access to all relevant data for computing the performance.

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– High cost of compiling performance measures Even if there is general access to data, it may not be readily available in the desired format. Often, accessing data requires programming interfaces or systems that feed the needed data into an accounting system. In addition, data needs to be harmonized across partner firms, cleaned from errors, and put into a format that can be further processed. This may cause high costs that eventually violate the general cost-benefit criterion (see Sect. 8.2). – Static analysis Performance measures are usually compiled at a particular point in time. Often it is a separate activity, for instance, at the end of a quarter or a calendar year. Point-in-time perspectives are snapshots of performance, though, and do not reveal the performance over time. A more dynamic view can be obtained by time trend analyses (computing a measure over longer time periods)—which again aggravate data collection and data comparability problems. – Varying definitions Quantitative performance measures often cannot be readily taken from information systems, accounting systems, or financial statements. Instead, they combine several raw data items in a pre-defined formula. Even though the formulas used are often quite simple in mathematical terms, the way how firms calculate these measures in practice may differ. Performance measurement is not always a precise science and the ways how performance measures are defined vary in practice. There is no mandatory requirement, such as generally accepted standards, how particular performance measures have to be calculated. Some industries or associations do publish performance measurement guidelines (such as the Supply Chain Council with the SCOR model) but no company is forced to stick to them. The names may vary or different firms compute an identically named measure with a different formula. As a result, the same measure, therefore, might actually mean different things at the manufacturer and the supplier. At the end of the day, there is only one thing that firms can to do about it: be vigilant. When applying a performance measure, accountants and decision-makers have to ask themselves: How is the measure computed? What is it trying to evaluate? How can this information be interpreted? – Problems of benchmarking Usually, performance measures are benchmarked against a point of reference. This may be (1) a company’s own targets and expectations (e.g. budget variance analysis), (2) a company’s own past performance (time trend analysis), or (3) the performance scores of competitors (peer-group analysis) (Charifzadeh and Taschner 2017). Benchmarking against such a point of reference is a common practice. However, this practice may also face difficulties. For instance, in benchmarking against peers, it may be difficult to find comparable supply chains. Every supply chain is different, so it will be difficult to set a common standard of performance that all businesses should strive for.

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Glossary and Key Terms

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– Conflicting goals Sometimes, a set of performance measures might conflict with each other. Maximizing one measure might come at the detriment of another measure. For example, agility measures, such as upside production flexibility, may conflict with asset management ratios, such as total asset turnover (TAT) or inventory turnover. If upside flexibility is high, this may be earned by holding idle capacities that serve as a stand-in in case of unexpected peaks in demand. This will result in lower turnover ratios, which reflect a low asset use efficiency. Such problems are aggravated since the performance measures themselves usually don’t reveal the causalities behind such trade-offs. – Subject to manipulation Performance measures, operating as well as financial ones, may serve as a basis for incentive systems and promotion. Employees being responsible for selected performance areas may be tempted to manipulate measures to their own benefit. While such behavior is unethical, in addition, manipulated performance measures hide the true performance and may lead to wrong decision making. – Strategy and measurement not connected An often criticized aspect of performance measurement is that firms operate a performance measurement system in isolation (Gunasekaran and Kobu 2007). Businesses formulate a strategy and in parallel measure their performance. However, managers and management accountants often fail to link the strategy with performance measurement (Shepherd and Günter 2006). As a result, they don’t know whether the performance of the firm is strong or weak because of the strategy or despite the strategy (see Sect. 8.2, where “fit to the system” has been defined as one criterion of “good” performance measures). While this is a practical problem of performance measurement in general, it applies to supply chain performance measurement, too. A system to overcome this weakness is the balanced scorecard.

8.11

Glossary and Key Terms

Agility Balanced scorecard

Benchmarking

Cash conversion cycle

The ability of a business to respond quickly to market changes. A strategic performance measurement system that measures business performance along four perspectives (only one of them being financial) and linking these perspectives by cause-and-effect chains. An analysis that compares company performance with comparable companies (benchmarks), mostly from the same industry (competitors). Also called peer group analysis. A measure of the time difference between the moment cash leaves a company to pay suppliers and the time it takes to convert inventory to cash through customer payments. Also called cash-to-cash (C2C) cycle or days working capital. (continued)

248

Cost to serve (CTS) Customer churn rate Cycle time DuPont system

Economic value added (EVA) Indicator

Inventory turnover Lead time Net working capital (NWC) Peer group

Performance

Performance measure

Performance measurement system Relational rent Resident engineering

SCOR model

8 Performance Measurement in Supply Chains

The cost of servicing a particular customer, including order processing, picking, distribution. The rate at which customers stop ordering from a firm and switch to competitors. The time it takes to execute a certain business process, e.g. delivery, or production. A performance measurement system, often considered the first one of its kind in history. It links several financial ratios and thus demonstrates how drivers of profitability and drivers of asset use efficiency explain the return on assets of a business. A performance indicator of shareholder value creation. EVA is a residual income measure that is calculated as the difference between the operating profit less taxes and the opportunity cost of capital employed. An indicator provides information about a subject that may not be measured directly. In a business context, the term is often used as an umbrella term and includes all kinds of quantitative and qualitative performance measures. A ratio that indicates inventory management efficiency. It measures how often a business sells its average inventory in a period. The amount of time from the initiation of a process until its conclusion. The difference between current assets and current liabilities. It represents the liquid capital required to run a business. It serves as a measure of asset use efficiency. A collection of similar companies used to compare the performance of a business. The peer group includes companies of similar size and industry (competitors). The act of doing something as well as the assessment of the skills level or the quality of this act. In a business context, performance refers to accomplishing a task and reaching a goal. A numeric measure to determine the performance of a business, a part of a business, a network, an asset or a human being. Often used synonymously with metric or score. A set of interrelated performance measures or indicators, with interrelations being either of a mathematical or logical nature. Surpluses that are created through cooperation and could not be generated by individual firms in isolation. A form of collaboration between a supplier and a manufacturer in which suppliers delegate selected engineers to the manufacturer for a defined time (usually 2–3 years) to get involved in the development of a product. The supply-chain operations reference (SCOR) model is a process reference model that has been developed by the Supply Chain Council. It is a systematic approach that describes standardized processes in supply chains and allows for evaluating and monitoring performance. (continued)

8.12

Review Questions and Exercises

Strategy map

Supply chain control tower Throughput time Time to market (TTM)

Time-trend analysis Total delivered cost (TDC) Total landed cost (TLC)

Upside flexibility

Vendor-managed inventory (VMI)

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A tool for visualizing and communicating the strategy of a business. In combination with a balanced scorecard, the strategy map visualizes the hypothesized cause-and-effect relationships. A centralized system that collects all information in real-time about the flow of material and data across a supply chain. It can provide the most visibility for steering the supply chain. The time to pass through a manufacturing process. A performance measure that evaluates an organization’s ability to react to new or changing market demand (agility). It measures the total elapsed time from customer requisition to providing a product or service in the market. An analysis that evaluates the performance of the same object over time. This cost figure represents the complete cost of sourcing, producing, and delivering products to customers. Identical with total landed cost (TLC). This cost figure represents the complete cost of sourcing, producing, and delivering products to customers. Identical with total delivered cost (TDC). A performance measure that deals with the ability of a business to react to an unforeseen upside in demand. It is usually measured as the time it takes (in days) to accommodate an unexpected increase in demand by 20%. A concept to improve performance of inventory logistics. In VMI, the supplier manages autonomously the inventory of his customer. Also called supplier managed inventory (SMI).

Review Questions and Exercises

Review question 8.1: Explain why performance measurement is especially complex in supply chain networks! Review question 8.2: What are the three different perspectives that performance measurement can take in a supply chain environment? Review question 8.3: Explain the conceptual difference between a performance measure and a performance indicator. Review question 8.4: Name and explain the features of “good” supply chain measures!

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Review question 8.5: What business goals in supply chains do exist and why do they sometimes conflict with each other? Provide at least one example of such a conflict/trade-off! Review question 8.6: Which cost components are included in total delivered cost (TDC)? Review question 8.7: Explain how cost to serve (CTS) can support management in customer profitability analysis. Review question 8.8: Explain the role of net working capital (NWC) in measuring the performance of a single entity in a supply chain (micro view)! Can NWC also be used as a performance measure on the supply chain level (macro view)? Review question 8.9: Name and describe three performance measures of your own choice that assess quality at the single entity level. Review question 8.10: Name and describe three performance measures of your own choice that assess speed or time at the single entity level. Review question 8.11: Which performance measures would you recommend to assess the service focus at the single entity level? Why? Review question 8.12: Explain which cost items cannot be easily summed up when measuring the performance of a whole supply chain (macro level). Review question 8.13: Argue why customer satisfaction should not only be monitored by the company at the end of the supply chain but also by the other supply chain partners. Review question 8.14: Explain the performance measure supply chain time to market (SCTTM). For which industries is a short SCTTM particularly important? Review question 8.15: Choose and explain two performance measures to evaluate the intensity of the collabo ration between two supply chain partners. Review question 8.16: What is “resident engineering”? Review question 8.17: How can trust be measured in performance measurement? Can trust be quantified? Review question 8.18: What is vendor-managed inventory (VMI)? Explain the role of trust in VMI. Review question 8.19: What is the advantage of performance measurement systems over the use of isolated performance measures?

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Review question 8.20: Argue with the help of the DuPont system how the avoidance of excess capacity can increase the return on assets. Review question 8.21: Explain the SCOR model and how it can be used for performance measurement. Review question 8.22: Can the original balanced scorecard by Kaplan and Norton be applied in a supply chain setting? Why or why not? Review question 8.23: Outline the supply chain management performance framework by Brewer and Speh (2000). How does it differ from a traditional balanced scorecard? Review question 8.24: Outline the supply chain scorecard by Werner (2017). What is the role of the integration perspective? Review question 8.25: What are the common weaknesses of performance measurement in supply chains?

Exercise 8.1: Holistic supply chain performance measurement Buy-Smart is a successful business-to-business wholesaler, serving the needs of traders, hotels, restaurants, caterers, and offices. They offer a wide variety of merchandise ranging from groceries, apparel, footwear, and electronics to office supplies, housekeeping, DIY and home improvement products. Until now, Buy-Smart focused on its own operating and financial performance only. Its performance measurement system includes measures of financial success (such as gross profit), and indicators of quality (such as customer satisfaction, product returns, and amount of unsaleable food). Explain why it is useful to expand the perspective of Buy Smart’s performance measurement to the supply chain as a whole (macro view)! Exercise 8.2: Selecting and defining performance measures BAT-Systems Inc. is a provider of soft and hardware solutions for battery management of electric cars, headquartered in Helsinki. While the market for battery-powered vehicles is growing sharply, this is highly dependent on the geographic region. Currently, BAT-Systems supplies just one customer, a Danish niche player that produces extravagant luxury electric cars. However, BAT Systems wants to expand and acquire new customers, including the big carmakers in Germany and France. In order to be prepared for potential new customers, BAT’s management meets with three important suppliers of electronic components to explain their expansion plan and to agree on performance measures to evaluate BAT’s and the suppliers’ ability to react to changing market demand.

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Identify and explain at least two performance measures or indicators that BAT Systems could agree on with their suppliers to evaluate and monitor the supply chain’s ability to cope with the expected but still uncertain higher demand. Exercise 8.3: Weaknesses of performance measurement Ventus Power Systems is a successful German producer of wind turbines and has gained a reputation as the market leader and technological pacesetter in the industry. Right from its start, Ventus’ strategy featured innovation and reliability for customers. Ventus produces the wind turbines inhouse but collaborates with several suppliers that provide different raw material and electronic components. The software of the wind turbines is coded by Ventus’ own programmers and engineers. In the recent past, however, Ventus had problems recruiting enough programmers. Besides, a specialized supplier’s delivery performance has dramatically dropped leading to unacceptable order fulfillment cycle times. Discuss how Ventus can solve its problems. Sketch a strategy map by using the framework of the supply chain scorecard to define a strategy that can cope with the situation long-term!

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