Enterprise Profit Optimization: Creating Shareholder Value through Integrated and Optimized Decision Processes
Overview
Business objectives center on creating shareholder value, and business leaders routinely conduct strategic planning efforts that focus on defining a vision that will build shareholder value. Ultimately, these efforts result in a business plan coordinated across the organization's supply activities and demand activities. At the strategic level, business leaders face the key challenge of establishing the right business vision. By contrast, at the operating level, the challenge of achieving coordination between supply and demand is often difficult. Strategic planners have the luxury of time to test alternative sets of forecasts and assumptions, consider multiple scenarios of supply plans and market plans and, ultimately, commit to a business plan that aligns supply and demand activities - including investment priorities that will deliver the greatest expected shareholder value. These plans are then turned over to those groups accountable for execution. Sometimes these are the same groups that developed the plans; sometimes not. In either case, the final result often doesn't resemble the original intentions.
Why? Because as plans move from the strategic time frame toward tactical and operational decisions, the challenges of coordinated decision-making rise tremendously. As decision cycle times shorten and decisions are pushed lower in the organization, it becomes increasingly difficult to achieve consistent and balanced decision-making across supply and demand functions. However, it is the successful execution of these tactical and operational decisions that drives sustainable value. Some simple examples illustrate how the difficulty of coordinating supply and demand decisions leads to lost profit opportunity and other business pains.
A computer hardware manufacturer offers customers a discount on a line of servers. The demand response overwhelms the company's ability to deliver from inventory or planned production. The results: too many units sold at too low a price - and disgruntled customers due to missed shipping dates.
A computer game manufacturer develops a breakthrough product that is highly regarded in the marketplace. However, because of initial demand estimates that are incorrect and an inflexible supply chain, supply of the product becomes limited. Also, perceived competitive pressures force the company to price the product on parity with competition. Because of the product's superior appeal, demand outstrips supply and revenue opportunities are lost, potentially forever.
These examples share one key characteristic — the inability to accurately anticipate demand response to pricing actions and integrate that response with supply chain actions. But the business problem is more subtle and pervasive than these extreme examples indicate. Every day, organizations make disconnected decisions regarding their supply chains and demand chains. These decisions cost the organizations real cash flow but the symptoms of the misalignment of supply and demand are not serious enough to attract management attention. This is reinforced because current information systems and incentive plans are not consistently aligned with objectively achieving optimal operating decisions.
The mark of a truly outstanding corporation is its ability to consistently
link its tactical and operational decisions to its shareholder-value-focused
strategies in order to capture maximum economic value in a dynamic marketplace.
To forge these all-important links between day-to-day decisions and shareholder
value, companies must take two crucial steps simultaneously:
• Respond to operational and tactical supply and demand opportunities with the
objective of maximizing operating cash flow
• Take advantage of sophisticated capabilities in supply chain management
technology, powerful new pricing and revenue optimization (PRO) technology,
and the recent trend toward combining them in order to achieve enterprise-wide
optimization
The result: a powerful set of tools and processes that work in a coordinated fashion to monitor both supply and demand conditions and recommend decisions with the objective of maximizing operating cash flow and thereby enhancing shareholder value.
The Metric: Shareholder Value and Operating Cash Flow
Shareholder value has become a common measurement framework for corporations, and several approaches enhancing shareholder value have been introduced and widely adopted. Each includes a proxy for income and cash flow, a capital base, and a metric for cost of capital. However, many of these frameworks are best suited for strategic decisions; otherwise, they are too far removed from everyday operating decisions. The ability of operating managers to affect the capital base is limited to the few times a year when capital budgeting decisions are made. This is mainly a function of effective tax planning and financial engineering. Net operating income is largely credited to the sales organization, but that doesn't take into account the impact other functions can have on increasing or reducing costs. For these reasons, getting back to the basics of operating cash flow may be a better gauge of management performance and therefore the best objective way to balance supply and demand decisions. A simple flow of funds diagram illustrates this point (Figure 1).
Figure 1 - Flow of Funds
Sales generate receivables, which are turned into cash. The cash is used to pay operating expenses like materials, salaries, and other operating costs. A portion of these costs is translated into cost of goods manufactured (COGM) as products are produced. Finished products are held in inventory and translated to cost of goods sold (COGS) when sales occur. The difference between the COGS and sales produce operating income. No doubt, this simple example omits many non-operating activities and capital effects, but it does demonstrate the key activities for generating operating cash flow. Each of these activities occurs at the operating level and requires coordination between supply and demand decisions. Sales require the balancing of pricing decisions that directly affect volume. Current assets help generate cash through inventory reduction, cost reduction, and cost containment. More efficient operations produce a lower demand on cash. Effective production planning and forecasting further reduces inventory, thereby increasing cash flow.
As a measurement, operating cash flow captures both the effectiveness of management's operating decisions and - by encompassing areas such as revenue generation, cost management, and current asset productivity - demonstrates management's ability to adapt to changes in the marketplace. Operating cash flow is a primary component of budgeting and planning decisions as well as the foundation for any valuation metric. By focusing on improving operating cash flow, the enterprise is better able to manage the balance between supply and demand decisions, especially as such decisions move down in the organization from the strategic level through the tactical to the operational. This is the emerging business discipline of enterprise profit optimization (EPO) - the simultaneous optimization of the supply-side and demand-side of a business.
Integrated Supply and Demand Decision-Making
To achieve this enterprise-wide profit optimization by managing the business against the shareholder value metric, businesses must develop plans and make decisions across three time frames: the strategic (months to years), the tactical (days to months), and the operational (hours to days). Figure 2 illustrates two key points concerning integrated decision-making.
Figure 2 - Integrated Decision-Making
Decisions first must be integrated and coordinated across the three time frames. Decisions made at a higher level define the scope of activities for lower levels, and determine the business plans, decision guidelines, policies and procedures, investments, and other commitments at that level. In turn, results tracked at the lower levels are communicated back up the time frame hierarchy to measure performance and periodically update plans and guidelines. Note that this hierarchy maps closely to the organizational hierarchy. Executive management controls the strategic decision level, mid-management controls tactical decisions, and staff executes operational decisions. The policies and guidelines passed down the hierarchy are the means for linking decisions back to the organization's overall strategy.
At each level, supply decisions and demand decisions must be consistently coordinated. At the strategy level, achieving alignment between supply and demand plans is relatively straightforward, since planners have the luxury of time to work through alternative scenarios and to come to grips with trade-offs among supply actions and demand actions. As decision cycle times shorten in the tactical and operational time frame, coordination of supply and demand decisions becomes increasingly difficult. Short decision cycle times are exacerbated by information gaps, ill-defined cross-functional coordination processes, and the absence of intelligent decision-support systems that can simultaneously evaluate supply and demand decisions and recommend the optimal set of actions. Consequently, companies often find it difficult to consistently manage and execute at the tactical and operational levels against their objective of maximizing operating cash flow and therefore shareholder value.
The Means: Merging Supply Chain and Pricing Technology
Visionary executives have long dreamt of the simultaneous optimization of the demand side and supply side of their enterprises. Until very recently, it has remained only a dream. With the development of powerful pricing and revenue-enhancing techniques on the demand side, the continuing evolution of SCM technology on the supply side, and recent trends in tying the two together, the dream is coming closer to reality.
The continuing development of supply chain management tools spanning every aspect of the supply side is a familiar story. Less well known is the emergence over recent years of powerful new pricing and revenue optimization technology. Powered by sophisticated algorithms, these new tools have the ability to recommend pricing actions that balance the likelihood of winning the business with the maximum contribution to profit or other strategic goals such as sales, volume, revenue, or market-share targets. PRO techniques apply differential pricing strategies and the smart allocation of capacity in order to match supply with demand. By segmenting the market and predicting the buying behavior of each segment, PRO predicts what different segments are willing to pay for what goods and services, and optimizes product availability accordingly. As pricing and revenue optimization tools merge with SCM tools, companies have an even greater opportunity to simultaneously optimize both sides of the enterprise.
By taking advantage of these developments, companies can acquire the four key
capabilities for meeting the challenge of balancing supply and demand decisions
across the enterprise:
• Alternative decision choices - whether they are supply actions, demand actions,
or a combination
• Decision-support for evaluating and recommending the optimal set of actions
• Business processes integration for coordinating execution of these actions
• Performance measurement and monitoring for reporting on KPIs.
Identify Alternative Decision Choices
Supply chain management tools provide the framework for identifying the array of potential supply actions that enable the company to better meet its customers' demands. These tools help enable the company to optimize the sourcing of materials, production of goods, and their delivery through the distribution system to customers. They also measure the costs associated with each of these activities. Traditionally, SCM tools have taken demand as a fixed quantity and determined the optimal supply chain actions to service that demand.
Pricing and revenue optimization tools help identify potential demand actions such as changing prices or altering product availability that will affect the quantity of demand to be served. PRO solutions are built around four steps. First, they take as their starting point a micro-market segmentation of customers and channels. This segmentation differs from traditional needs-based segmentation schemes in that it focuses solely on identifying differences in customer buying behaviors. It enables pricing changes to be used for precise targeting of segments. Second, using this micro-market segmentation, PRO solutions estimate the impact of price changes on volumes and revenues. Third, optimal pricing is determined considering the costs of serving demand and the organization's strategic objectives.
Finally, results are tracked and used to update the underlying demand/price sensitivity models. Traditionally, PRO tools have viewed the supply situation as fixed and used demand levers to optimize profitability given that fixed supply.
Recommend Optimal Decisions
In isolation, SCM and PRO solutions deliver significant value by reducing costs, increasing revenue, and improving customer service. As these tools come together in the enterprise profit optimization (EPO) framework, companies gain a further step improvement in performance by improving coordination of supply-side and demand-side processes.
Combining the proven cost-reducing power of SCM with the profit-enhancing power of PRO, enterprise-wide optimization meshes the disparate parts of the supply/demand chain into an efficient instrument of profitability. Pricing actions are tightly integrated with front-end applications as well as with the complex and ever-changing conditions of the supply chain. PRO capabilities make the most of the complexity, flexibility, and efficiency of the supply chain, while SCM optimization helps enable more effective pricing.
Moving beyond attempts to optimize the demand and supply sides in parallel and improve their coordination, EPO simultaneously optimizes both ends of the value chain at once. In other words, it coordinates supply and demand decisions in the tactical and operational time frames to extract maximum economic value from the supply chain. Because EPO solutions consider potential demand and supply side actions in concert, they can help identify the most profitable mix of actions consistent with longer term objectives.
Cross-Functional Coordination
One of the key challenges in implementing solutions that balance demand and supply side decisions is forming processes that effectively execute the optimal set of actions. At the tactical and operational decision levels, decision-making is typically pushed relatively low in the organization. Also, decisions tend to be made within functional areas by staff with expertise in their function, but limited knowledge of other areas. The challenge is to break down barriers between functional areas so that decisions are coordinated and focused on effecting cash flow.
Breaking down these barriers usually requires significant cultural change within the organization. Often, new organizations are created. These organizations have the autonomy to look across the business system to identify the supply and demand opportunities and make the trade-offs to achieve optimal results. Coincidentally, these new organizations resemble those in the industry that pioneered revenue management - airlines. Airlines have been successful in breaking down these barriers and have created "command centers" or virtual centers of excellence. They are strong on the fundamentals of finance and marketing. They also have access to sophisticated planning and decision-support tools that allow them to make informed choices about the supply and demand opportunities that are presented daily. Recently, leading manufacturing and services companies have begun to adopt this model, and placed a specific focus on developing central pricing management functions. They are building these organizations with cross-functional, multi-tasking leaders who are able to manage across the organization.
Measure Performance
The final key to enabling the balancing of supply and demand decisions in the service of shareholder value is the ability to continually measure actual results. Performance results are used in two ways. Traditionally, they are used to evaluate the success of the business strategy, measure performance against plans, and guide adjustments in the strategy and specific business plans. They are used to continually refine the statistical algorithms built into the SCM, PRO, and EPO technology. This is particularly important for PRO components. Since the PRO components are used to measure and predict how customers will respond to pricing actions, it is critical to update the underlying statistical models so they reflect current market and customer behavior.
Most importantly, by using PRO, SCM, and EPO tools, companies can make operating cash flow much more than a measurement framework. It becomes the objective function for achieving optimal results. Through the application of optimization methodologies, decisions made under the constraints of operational and tactical business issues can result in optimal operating cash flow.
Implications and Key Challenges
EPO solutions have the capability to improve the economic performance of companies.
The technology exists today to plan and make decisions at the tactical and operational
level that are:
• Consistently coordinated across supply and demand
• Focused on optimizing actions against the shareholder value levers
• Tied directly to the longer-term objectives of the organization
Achieving these gains, however, requires a comprehensive strategy for implementing EPO capabilities. The strategy must incorporate close integration across decision time frames, with clear plans and guidelines communicated from the higher levels, and data (e.g., capture of KPIs) consistently passed up the hierarchy.
Just as important is integration across functional areas in each decision-making time frame. This is a significant change-management issue that requires clear definition of cross-functional coordination processes, implementation of consistent performance incentives, and continuing executive management commitment.
The effort is well worth it, as the technology for simultaneously optimizing
the supply-side and demand-side is emerging now. In fact, end-to-end optimization
throughout organizations and their extended trading networks is likely to form
the next great wave in enterprise management. Companies that use this technology
have an opportunity to dramatically improve their performance. By focusing on
shareholder value with an emphasis on operating cash flow, they can ride that
wave to success.
