One of the principal arguments this blog makes is that financial and risk analysis in SCM must develop onto a much higher plane than is common today. A recent paper suggests ways in which this development can take place. A recent paper by Moritz Leon Gomm* notes the following:
Finance in general and the capital cost rate in particular are two areas where SCM has not developed its full potential. This is surprising when considering the leverage it has on the financial performance of a company. This might be due to the fact that the financial department is traditionally one of the strongest, and it is not expected that it might be able to find new ways of better financing with non-financial functions such as SCM. Another reason is that finance is thinking in terms of companies and is oriented on fixed dates such as quarter or year end. Logistics and supply chain managers on the other hand think in terms of flows and networks of corporations.
This last point is especially relevant. In my work with finance specialists one of the concepts they find interesting is the idea of the supply chain as a series of parallel flows (products, information, cash, risk, etc.) and that the goal of the SCM is to make that flow as predictable and efficient as possible. Where finance specialist tend to think in terms of static investments and defined period of returns, within SCM cash is constantly being consumed and produced, creating both positive cash flows for the enterprise as well as liabilities and risks. These risks are ultimately all financial, since either directly or indirectly a risk to a supply chain is really a risk to the cash flow that supply chain produces. Interestingly, most finance departments do not have a sound understanding of the nature of the material flows that generate the cash that produces profits nor the nature of the risks inherent within and without those structures.
As Gomm notes, “In practice, the financial aspects of SCM are mostly left to corporate finance and accounting, which ‘thinks’ in terms of single companies or affiliated groups rather than supply chains…taking into account the numerous SCM collaboration initiatives in areas such as procurement, transportation, distribution, R&D, marketing, and sales, it is remarkable how little research is undertaken on collaboration in financial aspects, even more so considering how high the potential cost savings might be.” Moreover, there is more often than not a poor allocation of risk back to its source in SCM. Take, for example, demand risk. Every customer generates demand risk and attempts to transfer at least some of it to its suppliers/producers. Yet very few companies have a risk-adjusted view of demand by customer, since most customer rankings are done relative to revenues or, less commonly, profitability. Gomm notes that allocating demand risk is one of the most critical aspects of supply chain risk management and provides the following example from the semi-conductor industry to illustrate his point:
It is important to note that the production cycle in the chip industry is very long (up to 120 days) while the order and delivery cycle is much shorter (20 days). So the production of chips has to be started long before there is an actual order (make-to-stock). Big customers give forecasts that are not obligatory. But from a risk point of view, the inventory (unfinished and finished products) from specific moments on can be economically assigned to some of the big customers. If it is possible to use this information to finance this inventory with an interest rate, this can be adapted to the rating of the specific customer, and the cost of capital can be reduced. For a simple finance model, four steps of value creation can be separated:
- Producing chips without a specific customer (general business risk).
- Producing chips according to a forecast (risk of the customer actually ordering).
- Producing chips according to an order (risk of goods perishing).
- Delivering chips (risk of not receiving payment).
While the first risk cannot be assigned to any customer, for the other three it is at least partly possible. The question is which percentage of the forecast, orders, and delivered chips will eventually lead to a cash flow. This percentage steadily increases from steps 2 to 4. If the information is convincing to the provider of capital such as a bank, a financing model can be set up that is related to the flow and progress of goods in the supply chain and which takes into account the information in the supply chain to turn it into value.
I worked to create just a demand-risk model with a high tech manufacturer a few years ago and we looked at several factors to assign a “demand risk” score to the top 100 customers. Among the factors in our model were:
- Demand quantity volatility
- Demand specification volatility
- Order delay/cancelation history
- Financing ratios of whole orders
Once these factors were considered a much different picture emerged of who was a “good customer” that went beyond just dollar value of orders. Gomm’s model goes further and such models have great value for supply chain risk managers looking beyond physical and to the complete analysis of where risk is created and transferred in today’s global operations.
Likewise, other areas such as supply financing, which Gomm discussed at length, are also worth considering as not just outbound cash flow optimization but also as risk management tools. For example, with today’s open account structures, exemplified by networks such as Syncada (www.syncada.net), companies are able to see in almost real time not just payment flows but the adjustment of payment flows by finance organizations within their supply base. This information can be a great source for risk managers since the acceleration/deceleration of cash flows is a principal indicator of overall financial health in a supplier. Yet few finance organizations are not just encouraging but mandating the use of automated payment networks, which should be standard practice not just for financial but also for risk management purposes.
In summary, as more and more work is done exposing the value that is to be gained by fully integrating SCM and finance, SCM will become the most important focal point for financial and risk analysis within today’s distributed and complex globalized product and service creation networks.
*Moritz Leon Gomm (2010): Supply chain finance: applying finance theory to supply chain management to enhance finance in supply chains, International Journal of Logistics Research and Applications, 13:2, 133-142),