Whilst there can be no argument that long-term, sustained profit has to be the goal of any commercial organisation, there is a growing realisation that if profit is the end, then we should spend more time examining the means whereby it is achieved. So many management boards begin their weekly meetings with a review of the financial position — in other words, before anything else is discussed revenues will be examined and costs detailed at some length. Ratios, production efficiencies — these are the currency by which the business is measured and therefore controlled. These conventional measures have tended to monitor functional performance and to be focused upon efficiency. Process-orientated measures, on the other hand, emphasise such things as customer satisfaction, throughput times and cost-to-serve.
Conventional cost accounting systems reflect the functional/efficiency bias, and were originally geared to the requirements of mass- production manufacturing. They incorporated assumptions of stable and predictable markets, long product life cycles and large production runs, with a generous proportion of direct variable costs incorporated into total product costs.
Logistics activities were simply not high enough up the managerial agenda to warrant significant attention in the organisations for which conventional cost accounting systems were designed to serve. The emphasis was on the need to understand product costs, not the costs associated with servicing particular customers.
Today it is clear that the assumptions underpinning traditional cost accounting methods no longer hold true for an increasing proportion of organisations. The methods themselves have been shown to be inappropriate and incomplete ways of assessing performance in a process-driven, market-orientated organisation. Instead companies are turning to activity-based costing (ABC) and throughput costing to understand the true costs of processes, which can provide a basis for establishing performance indicators in marketing logistics.
ABC focuses on the identification of cost drivers so that costs can be attributed directly to the activities that create them. In doing so, it links costs to processes instead of attributing them to individual units on an almost arbitrary basis. By focusing on activities it allows differences in ordering behaviour, distribution, product mix requirements and merchandising support to be identified, as well as the costs of invoicing and collection. Throughput costing is the end-to-end application of ABC; it calculates the total cost along an entire process. The result is a clearer picture of the true ‘cost-to-serve’, and hence the profitability of customers. Its use makes it possible to identify the aspects of service that create cost and, where necessary, to modify the service package on a customer-by-customer basis. It can also focus attention upon ways in which the order fulfilment process can be amended to improve overall Economic Value Added (EVA).
EVA is a relatively simple but useful financial performance measure. It is the difference between the company’s net operating profit after taxes and the cost of capital. If the difference is positive, the company is creating wealth for its shareholders; if negative, it is destroying wealth! Whilst it is a simple concept, it is not always fully understand. Sometimes the true cost of capital is underestimated. Properly speaking, the cost of capital to an organisation is the weighted average cost of its debt and its equity. The cost of its debt is easy to identify, but the cost of equity is more debatable. The appropriate cost concept to use here is ‘opportunity cost‘ — the return a shareholder could expect to get elsewhere — with some adjustment for the ‘riskiness’ of the business.
The definition of capital employed should also be broadened to include R&D, intellectual capital and brand building activity.
Once the concept of EVA is accepted and understood within the organisation, it can then be applied to the various activities of the business — for example, serving different markets or distribution channels. It is particularly helpful in measuring logistics performance. Shortening end-to-end pipeline time can, for instance, significantly improve EVA by reducing the inventory in the pipeline whilst simultaneously reducing costs. Similarly, programmes that focus on improving ‘perfect order’ achievement build EVA by minimising invoice queries and adjustments, and hence reducing accounts receivable.
There is a saying that ‘what gets measured gets managed’, implying that the choice of performance measure determines behaviour. Thus whatever tools and techniques may be used, the fundamental question is: are we measuring the right things and using the appropriate metrics? For example, in a business where employees are required to ‘clock’ in and out of work each day, punctuality may be improved but their willingness to work more than the agreed hours may be reduced. Hence the importance of understanding what the critical performance criteria are, and therefore what we should be measuring. The underlying logic of this viewpoint is that performance drives profitability — if we get the right performance, then profit will follow.
One approach to measuring, monitoring and improving process performance is benchmarking. By examining in detail how other organisations create value for their customers and how they manage the value-creation processes, we can learn a great deal about our own processes and their effectiveness when measured against appropriate key performance indicators (KPIs).
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