CHAPTER 1
The Supply Chain Costing Journey: Why You Need to Take It

Understanding the supply chain's role in the profitability of your company, and the ability to use that knowledge to your company's advantage, can be your best weapon in the economic battles ahead.1

COST VISIBILITY ACROSS A supply chain can open new opportunities for driving cost reductions and improving performance. Many internal costs are driven by external trading partners' behavior and business practices. Improved cost visibility enables managers and executives to better understand how supply chain relationships drive costs within their firm and with each trading partner. Visibility would also facilitate more effective cost trade-offs and optimized networks within the firm and across a firm's network of trading partners. Despite the importance of externally driven supply chain costs, managers and executives currently have very limited visibility of their trading partners' costs and little insight into what actually drives their costs. Tremendous potential exists to achieve significant cost reductions and higher levels of performance within the supply chain. The visibility and management of costs across trading partners can take supply chain management to a higher plateau of value creation.

Many companies may find it near impossible to track supply chain costs, but it is a requirement for properly tracking, reporting, and measuring item performance. And it is a true prerequisite for advance supply chain and retail optimization.2

To complicate matters, many managers and executives do not trust the profit and cost information reported by their CFO and accountants. We are not referring to the external financial statutory and compliance accounting and reporting for government regulatory agencies and for investors. We are referring to internal management accounting providing insights and cost information to help managers make better decisions. An example of the lack of trust involves cost allocations of indirect expenses, commonly called "overhead." Managers recognize that simplistic cost allocations with basis, such as the number of direct labor hours or number of units produced, do not have a cause-and-effect relationship in most situations. They are like spreading peanut butter across bread. Hence, the reported costs are inaccurate, flawed, and misleading.

To further complicate matters, managers observe that the internal managerial accounting information is incomplete. It does not provide a full picture of their firm's costs. The accountants stop at simply calculating and reporting the costs of product and standard service lines. They do not calculate costs below the gross profit margin line in an income statement. Managers need to also have visibility regarding how much their customers consume of distribution channel, selling, marketing, customer service, and administrative expenses. Managers desire seeing a profit-and-loss report for each customer.

Some executives may believe that they know their own internal supply chain costs and are not suspicious of the accuracy of those costs. Leaving that problem aside, research reveals a different problem, that most firms have limited knowledge of their trading partners' costs and the influence of the partners' actions on the firm's cost. Think about how you would respond to the following questions about your firm's knowledge of its supply chain costs.

• How good are your firm's measures of supply chain costs?
• Do you know, with confidence, which products and service lines are truly making or losing money-and by how much?
• How good is your understanding of your trading partners' supply chain costs?
• Do you know what costs to your firm are caused by your suppliers, aside from the purchase price to them?
• Does your firm calculate and report customer profitability?
• Do you know which types of customers are more attractive to retain, to grow, and to acquire as new ones-and which types are not?
• Does your analysis enable accurate predictions of how changes in customer behavior will drive costs within your firm and the supply chain?
• Does your firm exchange cost information with key trading partners to help effectively manage these external costs?
• Is available cost information adequate to support supply chain decisions and understand how these decisions drive costs within the firm, its trading partners, and the entire supply chain?
• Are you measuring the correct key performance indicators (KPIs) to align the priorities and actions of managers with the executive team's formulated strategy?
• Do managers even understand what the executive team's strategy is?

  The answer of most firms is "Probably not!"

Volatility in the global economy and fluctuations in transportation costs have increased the importance of having cost knowledge within and across the supply chain. Supply chain cost professionals are operating in a dynamic business environment: increased globalization, expanding product and service variety, growing end-user demands, rapidly changing technology, volatile transportation costs including fuel prices, periodic pandemics, and sustainability requirements. This environment has altered end-user demand and is changing how organizations function and interact with their trading partners. Measuring and managing existing and prospective supply chain costs is essential for sustaining profitability and remaining competitive in this increasingly complex environment.

Supply chain costing in this dynamic environment poses a significant management dilemma. Executives require targeted, precise cost information by product, service line, distribution channel, and customer and supply chain. However, the general ledger cost accounting systems firms use does not provide this information. Traditional cost systems provide detailed information about the input expenses incurred with labor, material, freight, or other natural expense accounts, but they fail to provide the output cost information most needed by management. For example, managers seeking to improve their supply chain processes, such as order fulfillment, need information on the total cost of the end-to-end business processes, the cost of the individual activities performed within those processes (internally and the cost of the activities performed by external trading partners), and estimates of how these costs will change in response to any process changes.

COMMONLY ACCEPTED OBSERVATIONS

Executives and their managers will agree that the visibility and management of costs across trading partners offers tremendous potential for value creation within the supply chain. However, few firms today have cost visibility beyond their own four walls and far fewer have visibility of their immediate upstream supplier and downstream customer trading partners' costs. The external visibility of cost information is very limited and does not produce the transparency required to achieve the full potential from an effective supply chain management system. Exhibit 1.1 displays what most supply managers observe about supply chain management.

EXHIBIT 1.1 Common Observations

• Common definition of supply chain management missing
• Costing considered an essential supply chain competency
• Level of trust and dependency affect the exchange of cost information
• Limited focus on the suppliers' indirect costs
• Management perceptions of cost influenced by the information provided
• Standard cost systems being adapted to reflect supply chain complexity
• Cost estimation models used to overcome trading partners' reluctance to exchange cost information
• Cost information requirements vary by position within the supply chain
• Very limited two-way sharing of cost information
• Supply chain costing increases the complexity of cost systems
• Supply chain costing includes a wide range of costing tools employed to support supply chain management
• Firms at multiple steps along the journey toward supply chain costing

The adoption of supply chain management and a process view requires a much different perspective regarding cost management than exists in most firms. A supply chain perspective shifts the focus from determining and analyzing only the costs incurred within a single firm to the total costs incurred by all trading partners in delivering the final product or service line to the end customer. Based on the need for a broader costing perspective, supply chain costing can be defined as:

Supply chain costing is the collection, expense assignment, and analysis of cost information across all of the work activities comprising a supply chain for the purpose of identifying opportunities to obtain a competitive advantage through a combination of reduced costs, increased revenues, and improved performance.

This definition recognizes that supply chain executives require an extended view of costs. Companies do not operate in isolation and many costs incurred by the firm are driven by the business practices of external trading partners. The cost incurred by the end-user customers represents the sum of the activity costs performed by all the trading partners plus their profit margins. Supply chain managers need a better understanding of these costs and...