Misadventures in Supply Chain Management

Just because everyone says its so, doesn’t mean that conventional wisdom is always right. We put six examples of conventional wisdom under the microscope and ask: Is it true or is it a myth? The results may surprise you. By Steven A. Melnyk & Colin M. Seftel

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February 08, 2016

Before Galileo’s death nearly 400 years ago,Conventional Wisdom held that the earth - and not the sun - was the center of the universe.

More recently, Conventional Wisdom held that smoking, drinking, stress, and diet caused peptic ulcers.

Then, two Australian scientists, Robin Warren and Barry J. Marshall, showed that bacteria caused ulcers.

Meanwhile, The Wisdom of Crowds, a book by James Surowiecki, contends that the collective conclusions by groups of individuals are often better than those made by any single member of the group.

Well, maybe; maybe not. Remember that Galileo’s belief that the sun was the center of the universe was ultimately proved correct. Maybe conventional wisdom isn’t always right.

The same can be said of supply chain management. Since it was first introduced in 1982, supply chain management has experienced a series of transformations. Initially seen as a better way of reducing costs and leveraging resources, it has gone from being a function (purchasing, for example) to being a cross-functional, strategic capability.

More importantly, it is now transforming from an art - something that is learned only through trial, error, and experience - to a science. A hallmark of science is the continuous testing of commonly held beliefs.

These beliefs often take the form of conventional wisdom - or CW - a body of ideas generally accepted as the truth by people or experts in a given field. Indeed, conventional wisdom can be anchored in truth, but these ideas often reflect an incomplete or incorrect understanding.

In examining these examples of conventional wisdom, we not only dispel those that are myths, but we also develop a better understanding of what is taking place - an understanding that often leads to improvements and sometimes even breakthrough discoveries.

In this article, we examine six issues:

1. Negative Working Capital
2. Economic Order Quantities (EOQs)
3. Safety Stock
4. Performance Measurement
5. Standards
6. Change Management

For each, we present the conventional wisdom, identify the rationale, and then we put it to the test and ask the question: Is it truth or myth? The results will surprise you.

1. Conventional Wisdom: Negative working capital is good because your suppliers fund your needs and growth
Negative working capital occurs when a firm’s current liabilities exceed its current assets. Traditionally viewed as an indicator of an unhealthy financial state, some firms have figured out that, if managed currently, negative capital can be healthy and good for the firm.

This occurs when the firm funds its operations by paying its suppliers slowly (say net 90 days or net 160 days), while getting payment from its customers relatively quick­ly. For some financial writers such a practice is attractive. By getting paid as quickly as possible, and by taking a little longer than average in paying vendors, these companies are seen as being more adept at raising cash. Their customers and suppliers are effectively financing their operations at a zero percent interest rate. Companies such as Digital Globe, Sirius XM radio, Comcast, and Verizon have successfully employed this strategy.

Yet, the use of negative working capital over the long term is a myth. Ultimately, suppliers realize that they are lending money to their customers and respond in one of two ways. First, suppliers will raise the prices charged to their customers to cover the borrowing costs of the capital they have to raise to cover their operating expenses.

Alternatively, the suppliers decide to downgrade their relationships with their customers. That is, they may decide to no longer do business with these buyers (and in today’s environment, good suppliers can and do fire bad customers). They can also do business with these firms but not treat them as preferred customers. As a result, suppliers may be slow to correct problems with slow-paying customers; they may not send their best people to these customers to deal with problems; or they may not share new technical or process innovations with these customers.

Ultimately, such customers suffer through lower operating income. To illustrate, consider the results of the latest Supplier Working Relationships Index study reported on May 2015.

According to John W. Henke, if Ford, Nissan, FCA, and GM had improved their relationships with their suppliers by 8.7 percent, they would have realized an estimated $2.02 billion collective improvement in operating income (For more on Henke’s research, see “Lost Supplier Trust” from the May 2014 issue of Supply Chain Management Review).

The truth is that there is a benefit to buyers that earn preferred customer status from their suppliers. By paying promptly and by working closely with their suppliers, buyers are rewarded by getting access to the supplier’s best people, by being the first to benefit from a supplier’s innovation, and by learning from the supplier about changes taking place in the market or learning about a competitor’s actions. By turning to negative capital, such firms are “penny wise, but pound foolish.”

Our verdict? This conventional wisdom is a myth.

2. Conventional Wisdom: Economic Order Quantity should be used whenever possible because it is optimal
Usually, we promise there will be no math, but the EOQ formula, originally developed in 1913 by Ford W. Harris, is still widely used in inventory management to calculate the optimum production run or purchase quantity.

After more than 100 years, the EOQ has been taught to thousands of undergraduate and MBA students. It offers an attractive approach to ordering inventory - one that can be shown to be optimal. Its logic also makes sense at face value:

• as the order quantity increases, inventory holding costs rise;
• as the order quantity decreases, inventory costs fall;
• as the order quantity increases, ordering costs fall; and
• as the order quantity decreases, ordering costs rise.

Therefore, the best or optimal order quantity must be the one that balances the total inventory holding costs against the total ordering costs - exactly what the EOQ shows.

Yet, there are several problems with this approach. The first is that it limits attention to only ordering and holding costs. Ignored are issues such as the availability of adequate storage space for the excess inventory; challenges of obsolescence and perishability; or adequate shipping capacity to move the inventory from the supplier to the customer.

More importantly, the EOQ implicitly assumes that management can easily determine the costs of ordering and holding inventory.

Myth

• Push systems are best and further enhanced by the use of EOQ ordering logic.
• Sustainability comes at the cost of profit.
• Fashion clothing must be ordered in advance from low-cost suppliers located in low wage countries such as China.
• Quality manufacturing is costly to achieve.

The Supply Chain Breakthrough

• Toyota uses a production system with an emphasis on pull scheduling and order quantities of one.
• Unilever shows profit and sustainability can be simultaneously achieved.
• Zara employs fast fashion supply: Let’s build fashion clothing quickly in a location close to the market and let actual demand drive production.
• Phillip Cosby: Quality is free.

In many cases, especially when it comes to ordering costs, such costs are difficult to determine precisely. As Cecil Bozarth wrote in Economic Order Quantity Model, ordering costs should reflect only true variable costs incurred in placing the orders - not allocated ordering costs (for example, “last year, it cost our firm some $400,000 to place 10,000 orders; therefore the ordering costs are $40 per order or $400,000/10,000”).

Ordering costs also reflect purchasing practices and contract terms. Current strategic purchasing practices have resulted in situations where sourcing is not carried out per order; prices and costs are linked to long-term usage, not the quantity on a single order. Furthermore, due to the impact of technology, other costs such as stationery, order preparation, and postage have effectively disappeared.

In a world characterized by Lean, e-procurement, and long-term strategic purchasing contracts, the goal is not to use the EOQ but rather to move to a strategy of building what is required, when required, or ordering the minimum shipping quantity (if this is larger). Furthermore, as we see the adoption and spread of additive manufacturing (3D printing), we can expect a stronger movement to procuring what is needed when needed.

Our verdict? This conventional wisdom is also a myth.

3. Conventional Wisdom: Safety stock should be used because it is an important tactic for dealing with uncertainty
There is something very attractive about safety stock. As managers, we face uncertainty and change. Because there is a cost to being wrong (such as lost orders and unhappy customers), it makes sense to have extra inventory on hand just in case.

For most firms, the cost of a lost sale often outweighs the cost of the excess inventory. Finally, if there is one thing that we have learned from our research into supply chain risk, it is that such risk can have significant negative financial and operational impacts for the firm. Therefore, it makes sense to use safety stock.

Before going any further, we accept that there is a need for safety stock if it is used properly. That said, there are several potential problems with safety stock. One is that few firms use it properly. First, by using safety stock, we recognize that we are unable (or unwilling) to identify the underlying causes for the variance.

For example, we use safety stock because our forecasts are so bad. Yet, forecast accuracy can be improved by reducing lead time or by working more closely with our key customers. In other words, safety stocks encourage supply chain laziness. Second, safety stock is dead stock - once it’s there, it is always there. As soon as it is used, we have to replenish it.

Third, few firms revisit their safety stock policies once these policies have been set. Safety stock encourages a “set and forget” mentality.

Things change: It makes sense to regularly revisit and review such decisions. Maybe we can now reduce the need for safety stock because we can eliminate and control the reasons that gave rise to it in the first place. The need for such a review makes even more sense today because of the emergence of new and better planning tools and procedures.

As Carol Ptak and Chad Smith described in Orlicky’s Material Requirements Planning, the introduction of Demand Driven MRP (DDMRP), with its use of flexible buffers, continually adjusts the safety stock to reflect both present and future demand. It has even been shown to provide 100 percent customer service levels in the face of highly random patterns.

In other words, our verdict is that the use of safety stock is partially plausible.

4. Conventional Wisdom: The primary role of performance measurement is monitoring and control
Performance measurement plays a critical role in most organizations. As noted by What Management is: How it works and it’s everyone’s business by Joan Magretta, measures (or more appropriately metrics, which include not only the measures but also a standard and the consequences or reward/penalty for actual performance relative to the standards) make the strategic mission concrete and meaningful for everyone in the firm.

Yet, many managers see performance measures acting like a thermostat. That is, we set the standard (the minimum level of acceptable performance), the measure (how we are going to keep track), and the consequences. Measures tell us how we are doing. If the performance is below the standard, then we put pressure on the appropriate areas or people to improve performance; if it is above the standard, then we reward. Using measures, we keep the organization on track.

The problem is that this view is plagued by numerous misconceptions. First, while it is true that measures can be used to monitor performance, this is not the most critical role of performance measurement. Rather, performance measurement is used to communicate. It translates higher-level strategic objectives into specific tasks and actions that have to be carried for these objectives to be achieved. It tells everyone not only what is important, but also (more importantly) what is not important (if it is not measured, then it is not important).

It also identifies an acceptable level of performance and what can be expected to happen if that standard is not met or exceeded. Second, the thermostat analogy suffers from a critical flaw: It is backward looking, focusing attention on past actions. The problem is that the past is the past and cannot be undone. Rather, in today’s environment, the focus is on the future. Management is often engaged in forwardcasting or identifying the desired future state.

We are asked through our actions to make this future state a reality. When our actions do not meet expectations, the critical question for management to ask is whether the future state is still relevant and, if it is, then what actions and resources are needed to attain this desired future state. While we cannot change the past, we can shape the future.

Third, measures and metrics are often proxies or imperfect indicators of what is intended to be measured. Consequently, there is error inherent in the measures. That means that we are really not sure of whether what is being measured is really taking place or if it is indicative of what has to happen for us to achieve the desired future state.

Our verdict? This conventional wisdom is largely a myth.

5. Conventional Wisdom: If we use best practices, then we should improve performance and our competitiveness
The argument for this is fairly simple and very convincing: If we want to improve our performance, then what we have to do is to draw upon best practices. After all, these practices are drawn from the market leaders; we know that they work. If we too use them, then we will improve.

The problem with this line of logic is that it is flawed on so many different planes. First, if we and everyone else in our industry applies the same best practices, then over time we see a conver­gence to a common mediocrity - like the children in Lake Wobegone, everyone is above average; no one better or worse than the others.

Competitive advantage only occurs when you differentiate yourself from your competition. It makes sense to study best practices because they tell you not only what the competition can do well but what it has difficulty with. That is what Unilever did in 2010 when it focused on sustainability. But rather than mimic P&G’s emphasis on innovation, Unilever chose to differentiate itself - and so far, the strategy has worked.

Second, best practices are designed to achieve certain goals. These goals may not be the ones that are critical to you and your company. If I implement best practices drawn from Toyota’s Lean system, then these practices are supportive of goals dealing with reducing cost and variance. However, they may not be appropriate to my company’s goals if my strategy is to compete on responsiveness and flexibility.

Third, best practices are the most visible vestige of why some firms do well. But, they are only one component of a total system solution - a solution that includes strategy, culture, performance measurement, and training. By ignoring these other, less obvious elements, we doom ourselves to fail. Just because you use the same golf clubs as Jordan Spieth, Jason Day, or Rory McIlroy - all world class golfers - does not mean that you will be as good as they are.

Or, as Taiichi Ohno, the father of the Toyota production system put it:

“The key to the Toyota Way and what makes Toyota stand out is not any of the individual elements…But what is important is having all the elements together as a system. It must be practiced every day in a very consistent manner, not in spurts.”

Finally, focusing on best practices encourages companies to focus on what and how things are done, not why. Understanding the why is often more important because if we can understand the underlying logic, then we can apply these lessons to our situation in ways that work for our company and our specific situation (even when the practices do not work). It also forces us to understand the goals and limitations of the specific approaches (giving rise to the best practices) being implemented. That is an important insight.

Our verdict? This conventional wisdom is also a myth.

6. Conventional Wisdom: Show your employees a better way and they will use it
It goes without saying that we are in a period of turbulence and rapid change. What this means is that we expect to see existing procedures and processes replaced by newer, better approaches. Consequently, we have to be prepared to identify these better approaches and to introduce them into the appropriate settings.

The method is fairly straightforward: explain what we need to change, identify and describe the new approach, and let the people who are to use it, work with it. After all, they will see the advantages of the new approaches. Training then becomes the key.

Here’s the problem: Just because you expose someone to a new approach (especially when there is an existing system that appears to work) does not mean that they will accept it. In fact, often they don’t.

Upon trying, you will see three responses:

1. lip service (we say we use it even though we do not);
2. selective hearing (the person picks up on those practices or approaches consistent with the current ways of doing things, while not hearing the other approaches that are different); and,
3. gaming through measures (using the measures to show that the desired results are being achieved even if the people are not using the desired new approaches).

To bring about change, you must first discredit the current ways of doing things. The people who are to use the new approaches must see for themselves that the current approaches no longer work. This can be done through a crisis (the company declares bankruptcy; clear evidence that the current approaches don’t work), or by having your people work closely with the actual key customers or by introducing into the firm people from other companies who have worked with the new approaches.

Finally, bringing about change also means having a public execution or two - that is, firing highly visible people from within the firm who do not support the new approaches. Such actions strongly signal a desire to change and how the firm will deal with those who do not support the shift. In other words, changing management is not additive (we introduce one more new tool); it is substitutive (we replace the discredited old by the new).

So, again: This conventional wisdom is a myth.

The Importance of Myth Busting
In this article, we explored six examples of conventional wisdom, only to find that five were myths. In exposing each myth, we uncovered the seeds for new approaches. For example, in the negative working capital myth, we found that by being a good customer and paying quickly, the firm had an opportunity to build a closer relationship with its suppliers - a relationship that offered many potential benefits. These five myths are not the only ones that exist in supply chain management. Yet, why do such myths exist?

Myths exist because they explain what happens around us in a way that makes sense. They help identify what to look for next and how to deal with problems. Myths also affect our ability to deal with change. Myths, unfortunately, reflect either old thinking (the approach may have been right in the past but it is no longer appropriate) or incomplete or incorrect reasoning.

The problem with myths is that they get accepted as truth. When this occurs, they become mental prisons - discouraging people from challenging and rethinking current approaches and practices. It takes courage to challenge myths. Yet, when myths are challenged and the underlying “truth” exposed, we experience the opportunity for breathtaking success, as can be seen from the examples below