Saturday, December 22, 2007

The ROI of Supply Chain / Value Chain Improvement - The Need for Multiple Measurements

Return on investment, ROI, has become a mantra for organizations when they evaluate, initiate, and manage projects to improve their value chain or supply chain performance. Consulting companies, technology providers, and system integrators sell their products and services with promises based on ROI calculations. While the promise of ROI is seductive, determining what the real return for a project can be extraordinarily difficult. Promised ROI is frequently never realized.

In many cases ROI is calculated when projects are evaluated, proposals are awarded, and budgets are agreed upon. In many (most?) cases, once the project is completed, actual ROI is not tracked. As a result, there is little accountability for results - at least among those not responsibile for the business. While it can be challenging to meet budgets and schedules for a business improvement project, it can be far more challenging to meet overly ambitious business plans that may not depend just on a successful project.

For the small business or the large practitioner, the ROI calculation is essentially the same.

Return on investment is calculated as (the benefit of the project) minus (the cost of the project) divided by the cost of the project. The vast majority of the time, project improvements in supply chain or value chain operations are sold on cost savings or cost avoidance. So, a project that saves $1000 and costs $500 to implement, has an ROI of 1000 - 500 /500 or 1.0 (100%). If the project doesn't realize its promise and saves only $600 the ROI is 600-500/500 or .2 (20%).

For the business owner or executive, using the calculated ROI appears to be easy. If the calculated ROI is negative, it means the project is going to cost more than its "worth." So, you do not approve projects with a negative ROI. If one project has an ROI of 20% and another has an ROI of 50% the second project is given a higher priority. It may be more difficult to make decisions if a project is strategic, or produces positive and negative results. It may be that deploying a direct to cosnumer distribution system eliminates substantial logistics costs but may also threaten revenue when distributors are no longer motivated to sell.

Using an ROI calculation becomes more difficult when you compare projects and outcomes that extend over multiple years. Comparing a short term project with large (one-time) savings with a project that will last 18 months and generates small benefits (or savings) for the next 10 years requires a bit more sophistication. To help address this issue, the ROI calculation can be expressed in Net Present Value or NPV. (NPV is included in Excel worksheet forumulas). The NPV forumula allows an executive or an analyst to compare projects with multiple year time frames. Investopedia has an excellent description of how to calculate the value of money when time is a factor.

The real issue in supply chain and value chain ROI calculations lies in the assumptions. Supply chain and value chain operations include multiple functions and effect multiple business and financial results. If cost reductions lead to a reduction (or appearance in the reduction) of customer service, the result can be lost sales. As a result, a cost savings project can meet all of its ROI objectives and, if revenue is not considered, can produce a real financial loss.

So, how do you reduce the risk of inaccurate or incomplete assumptions? While there is no guarantee that your business executive, business analyst, or project manager will predict the right outcome, there are steps that can be taken to insure they consider different perspectives. One way is require the review of a project using multiple measurement dimensions. While cost and cost savings are almost always considered it is important to consider: impact on product positioning, impact on service level performance (as expressed in meeting customer commitments or expectations, impact on time / velocity, impact on the ability to adapt to marketplace changes, and the impact on the effective use of assets. It may be difficult to trace some operational project results to specific contributions (positive or negative) in revenue, however, the analysis will frequently identify project objectives and risks that would otherwise go unnoticed.

Likewise, not recognizing and accounting for the risks in implementing and deploying a solution can produce painful business outcomes. A company that invests in automating and modernizing a warehouse or manufacturing line and calculates how much it will save in the next 5 years loses its "return" if market conditions or strategy force the an early closing of the facility.

Perhaps one of the most important steps an organization can take to ensure they use ROI effectively is to measure their business performance consistently - before, during, and upon the completion of projects. The proliferation of executive dashboards and business intelligence solutions may be a sign that more and more businesses are learning that monitoring the right metrics and managing the business based on the results provides a competitive edge.

Is this a short term technology fad? How does a business know what or how to measure?

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