Logistics Network Modeling Yields Higher ROA
Fortune 500 firms
anticipate 11 percent cost reductions.
by Richard F. Powers, Ph.D.
Your board has asked you to increase your company's return
on assets (ROA) to at least 20 percent. Your current ROA is 15 percent, with
sales of $1 billion, assets of $667 million, profits of $100 million, and
logistics costs of $100 million.
You recommend a logistics network modeling project to
generate and quantify options.
Your justification is the immense economic value to be
gained, especially with a cross-organizational goal, such as maximizing
shareholder value.
• Why
model? Fortune 500 companies reduce annual logistics costs by $23 million or 11
percent.
• To what
end? A logistics infrastructure must maximize both profit and capital turnover
while meeting customer demand and service objectives.
• How
best to begin? Commit to providing policy guidance and supplying information.
•
Corporate benefits are these: increasing ROA, decreasing logistics costs
and achieving higher after-tax profit.
Ingredients
Successful logistics optimization requires the following:
•
Logistics network modeling software that handles global complexity;
• Data
defining the existing logistics network;
•
Corporate policies and in-country plans for production and distribution;
• A
working group charged with carrying out the global logistics strategy study;
•
"Make or buy" evaluations covering products, distribution
centers, transport, etc.;
•
Modeling expertise.
Using capital investment to raise profits
An oil company targets entry into Asia with new products.
Prior experience suggests marketing through a local distributor, but the tax
structure is not favorable. Significant tax reductions are available if certain
levels of capital investment are made in the host country. The crucial
determination is product volume, or throughput, in the host country that reaps
tax reductions and raises profit margins to outweigh reduction in capital
turnover. The result: higher profitability.
Try a test. How can a $1 billion firm raise ROA by 49
percent?
Here's a simple exercise in logistics finance. A global
manufacturing company has:
Annual sales, $1B (assume no increase)
Total assets, $667M
Profit, $100M
Logistics cost, $100M
From these, we compute:
ROA = Profit Margin x Capital Turns
ROA = 10% x 1.5
ROA = 15%
The board expects a 20 percent ROA
One director attended a CLM (Council of Logistics
Management) conference and learned that savings in logistics operating costs
are typically in the 10 percent to 15 percent range from conducting a logistics
network optimization project. Further, substantial reductions in assets are
achieved by outsourcing logistics functions, rationalizing logistics
infrastructure, and eliminating non-productive inventory.
The logistics network modeling project is approved. After
four months of careful data collection, the optimization model is validated and
scenario modeling begins. In two weeks, 30 scenarios are run and evaluated.
Off-line analysis tests feasibility. The recommendations project these results:
Assuming no increase in sales (a conservative consideration,
because of the element of better service):
Sales, $1B
Total Assets, $500M
Profit, $112M
Logistics cost, $88M
Adding new values into ROA calculations:
Profit margin = 11.2%
Capital turns = 2.0
ROA = Profit Margin x Capital Turns = 22.4%
Rationalizing logistics infrastructure and practices exceeds
the original ROA of 15 percent and even the target ROA of 20 percent, attaining
an ROA of 22.4 percent, an increase in ROA of 49 percent! In a survey,
INSIGHT's clients, (a large group of FORTUNE 500 companies) saved 11 percent of
logistics costs representing $23 million annually.
What shapes global strategy?
Given demand for all products we make or sell at any level,
what logistics infrastructure will maximize profit and capital turnover, while
meeting customer service objectives? This objective implies specific issues or
questions:
Should we make or buy certain products or components?
Specific concerns:
•
Manufacturing locations;
•
Products at specific location;
• Sources
of raw material and components;
• Modes
of transportation for product lines;
• Private
fleet of vehicles.
Distribution facilities: Which? Where? How many? Decisions
needed:
• Mission
of each distribution center (DC);
• Size of
DC and material handling equipment;
• Own DCs
or use third-party providers;
• How to
deploy inventory throughout the logistics network;
•
Full-line or partial-line distribution centers;
•
Cross-dock operations to reduce inventory while saving on freight cost;
• Additional factors: taxes, duties, drawback, local
content, in-country investment, or offset trade.
Success begins with you
The first, and most critical, ingredient of success is
support and commitment from top management. A steering committee of senior
executives sets the policy and decision parameters for modeling. It must
represent each key functional area and supply data and resources as required.
The committee establishes a working group to perform both data collection and
modeling analysis.
A final step comes in determining whether outside help is
required. The company may own a license for logistics network optimization. If
you go with outside help, licensing software, included as part of the
consulting project, enables in-house modeling capability developed during the
project to serve on a continuing basis.
The steering committee's initial decisions guide the scope.
Policy issues must be resolved to guide the working group. Examples:
• Buy
(OEM), contract out, or manufacture own products?
• Run
distribution centers (DCs) or evaluate third-party logistics (3PLs)?
• Foreign
operations-joint ventures, marketing agreement, infrastructure expansion?
Material handling requirements
If all manufacturing and distribution is in-house,
significant material handling requirements exist for the optimal network. If
you outsource everything, then material handling is a third-party
responsibility. Material handling questions include:
• How do
customers receive products? (full pallets to DCs or individual pieces directly
to customers?)
• Do we
"make to order" or "make to stock?" Should final assembly,
labeling, kitting, etc., be done at DCs close to customers?
• High
percentage of demand from a small percentage of fast-moving items? Must we
guard or refrigerate? Seasonal issues such as fertilizer for spring? (Perhaps
one large DC stocks everything, and several highly automated DCs stock fast
movers.)
• Decide country
locations, component sources or assembly operations? Tax and duty information?
How much investment is required for local operations or tax incentives? Where,
within countries, is the best target area because of availability of parts,
roads, rail, labor, material, etc?
For example, say a large pharmaceutical company is faced
with the classic issue of doing business in European Union countries. There was
a manufacturing operation, or DC, in almost every country in Europe due to tax
and duty requirements, or because of market perceptions and cultural
differences among countries. Unified regulations justify a new logistics
strategy for Europe. Labeling, and perhaps packaging, requires localization,
because of language. Greatly reduced handling and inventory costs make a single
larger, more complex facility a big contributor to profit in Europe.
Higher ROA guaranteed
A sound, well-developed logistics strategy virtually
guarantees better ROA. Developing such a strategy, without using advanced optimization
modeling tools, is next to impossible because of the complexity, amount of
data, and time required to conduct manual analysis.
About the author
Dr. Richard F. Powers is co-founder, president and CEO of
INSIGHT, which develops and implements optimization-based management support
systems. Prior to founding INSIGHT, Dr. Powers was awarded the Defense Superior
Service medal for his management of the largest distribution system study ever
undertaken by the Department of Defense, which included computer modeling. He
was awarded a Ph.D. in management information systems from U. Minnesota, an
M.B.A. in distribution management from Michigan State, and a B.A. from Rice.
Call INSIGHT offices in Virginia at (703) 366-3061 or in Oregon at (541) 388-6998. On the Web, visit www.INSIGHT-MSS.com.
