How using digital factory models in product cost management software can help your company overcome the supply crisis from the global pandemic and ensure disruption is mitigated in the future
In the past 30 years, a tremendous amount of outsourcing has occurred to foreign nation including overseas options such as China and Vietnam. Although there have been many struggles and hiccups along the way, the thumping drumbeat of globalism has driven the march unimpeded. However, recently we have found out that global supply chains are not immune from pandemics, such as Coronavirus, and other events that cause massive economic shocks. Companies that manufacture in one region where labor costs are lowest are particularly vulnerable.
In general, the longer the supply chain, the higher the risk of disruption. Consultants have preached for decades that manufacturers should source suppliers based on multiple considerations outside of price (including quality, delivery, and risk). However, the overarching driver in the multiple metric analysis for the last few decades has been cost. When an economic shock arises, the term balanced scorecard brings on a whole new meaning.
If your supply chain has been disrupted recently, you are not alone. According to the Institute of Supply Management, 75% of companies interviewed in late February and March reply that they had experienced some sort of supply chain interruption. Moreover, 44% of these did not even have a plan to deal with it, let alone something they could actually execute on rapid notice.
Is it wrong to focus primarily on the cost of outsourcing your manufacturing? No. However focusing on cost to the exclusion of other metrics is risky and manufacturers need to understand the Total Cost of Acquisition (TCA) to understand risk over reward.
The following 6 steps walk manufacturers through overcoming the supply chain crisis today and in the future.
1. Identify the Problem
For the purposes of this article, let’s take on the identity of a category manager and his team whose source has been disrupted by the pandemic. We need to select a new source and a secondary source, and we need to do it quickly. For this example, our product is a steel casting that is subsequently machined, anodized, and then shipped to an assembly plant in the United States.
Starting with a manual approach, our team draws a supply chain diagram using a whiteboard. When the numbers are set aside and the focus is on conceptualizing the problem, the chances of identifying the problems earlier are better. Together the team can quickly identify many hidden costs and will get an early warning of potential challenges in the supply chain design. The team can work to mitigate these challenges, while determining the TCA of each chain. For our product, the supply chain diagram for three potential options might look like Figure 1.
2. Assemble a Toolbox
The diagram shows us there are many different types of cost to consider. Although it would be convenient, realize there is no tool on the market today that can cost all of these different elements. A product cost management (PCM) tool may be able to cost 70-90% of these costs, but there may be other tools or offline analyses you need in addition.
Simply list each type of cost on the supply chain diagram, and then map to the tool(s) that can help you calculate it. If you have them internally, great. If not, you can ask your organization to invest in what you need or hire an expert consultant in PCM to help you calculate that element of cost. For more information on what to look for in a product cost management software, check out this article here from aPriori.
3. Recognize Changes Across Geographies and Suppliers
Global supply chains are very tricky to compare, because some factors in the cost calculations change from country to country, or even region to region within a country. A PCM platform should have the ability to simulate this if it has a robust set of regional data libraries that includes costs for materials, machines, labor, and overhead in different countries around the globe. An ideal PCM platform utilizes digital factories as a way to represent the physical manufacturing plant, such as regional costing data, process routings, feasibility rules, and logic that characterize a specific (or generic) supplier or factory in a given location. (Other PCM software may contain some of the individual costing factors, but it is not pre-connected so that you can instantly calculate cost at supplier 1 in China vs. supplier 2 in Mexico with a simple selection from a pull-down menu.)
If your firm has invested in building digital factories for your current or potential suppliers, wonderful. If not, that is not a problem at this point in our investigation, some of the leading PCM solution providers to provide out-of-the-box generic supplier VPEs by region. These should provide a solid first-order analysis for our purposes. We would simply run a scenario with a current supplier VPE or a regional proxy. Even if the cost is not precisely your negotiated quote, that does not matter, because you are interested in the relative (percentage) difference between your current option and new options.
4. Invest Your Time Accordingly
Continuing on the previous theme, not all costs are created equal. Many category managers assume that most costs are the same among supply chains (except labor), or they obsess on making models having much higher fidelity than what is needed to make a good business decision. The former leads to expensive mistakes; the latter takes too much time and resources. We want to focus our precious time where it matters. The advantage is that we already source this part today, so we probably know the relative size of the elements that add to the total cost (e.g. material, labor, machines, transport, etc.).
To help us understand how to invest in modification of our cost models (e.g. a digital factory) place each cost element on the following 2×2 matrix in a team discussion, by asking two questions:
- How large of a percentage of the total cost could this be in the most expensive supply chain?
- Regardless of the size of the cost element, how much does this typically vary among our possible supply chain options for supplier or geography?
Here too, we do not need extreme precision; a simple “high, medium, low” scale for each question will do. Using this technique, a quick discussion with your cross-functional team will take you from “I have no clue where to focus; this is overwhelming!” to “I think we have a pretty good idea where to start.” If you were to apply this approach to building a digital factory model for a new supplier instead of focusing on all the various cost model assumptions that can be configured, you can focus on a handful that require any modification to create a fair representation of a specific potential supplier. This is as simple as cloning a general proxy digital factory for that supplier’s region and then modifying the few elements that get us to the 80/20 rule.
5. Build Insurance into Your Supply Chain
So far, we have discussed the Total Cost of Acquisition, but this is only one consideration (albeit a big one) in setting up a new supply chain. Other considerations should include:
- Quality risk
- Delivery risk
- Geopolitical risk
- Intellectual property security risk
- Communication risks
Instead of thinking about the lowest price, we should be thinking about the risk-adjusted lowest price. In other words, we should be viewing the supply chain as an investor views a security: risk over reward.
For example, consider our three new potential sourcing options identified in Figure 1 above. Now illustrated in Figure 3 below, the original option (brown dot) has been disrupted by some macroeconomic event. We need to add one or more new options to stabilize supply (represented by the three orange dots in Figure 3 below). If we are too risk-averse (left side of the graph), there is a lot of money left on the table. The middle region is where we should target our search for new options, because here we can trade off the TCA (reward) vs. the risk we are assuming. The right region, similar to the left, is a flat part of the curve. Here we have to accept a lot of incremental risk to get a small amount of incremental reward.
In the case of our three new potential options, we see that the new China/overseas option is inefficient (it delivers tiny reward for a lot more risk). The Mexico/nearshore option costs a bit more in that we pay a little more in TCA to meaningfully reduce risk. This can be thought of not as waste, but as a small premium to a supply chain insurance policy. Insurance is essential to protect us from catastrophic events. The US/domestic option has a bigger insurance premium to remove risk by using a tighter, perhaps higher quality, supply chain, but it is in the linear trade-off region, where we can decide whether or not the risk is worth the insurance premium.
6. Build Resiliency into Your Supply Chain
Manufacturers must deal with the emergency at hand today that is driven by the pandemic. A good product cost management tool can help firms make a fast, informed decision on how to shore up the supply chain in the near term. But we should also consider the lesson for the future. As IndustryWeek recently wrote, there is a BIG difference between having a “contingency plan” (plan = nothing tangible in place) and a true second source in place to mitigate supply chain disruption. Yes, a second source requires an investment in tooling, management, etc. (the insurance premium), but many companies now wish they had a qualified second source rather than just a plan.
A PCM tool can help manufacturers future-proof supply chains from disruption. If a company invested in a technology solution that includes digital factory capabilities, it would be relatively easy to to create a few viable competing supply chain options, that could really illuminate the reward axis illustrated in Figure 3. Companies would use other existing methods to fill out the risk axis.
For a deeper dive into how digital factories can help to mitigate supply chain issues today and in the future, register for our upcoming webinar by clicking the button below.
Using Digital Factories to Model Supply Chain Changes
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About the Author: Eric Arno Hiller is the managing partner of Hiller Associates, the leading consulting firm specializing in Product Cost Management (PCM), should-cost, design-to-value and software product management. He is a former McKinsey & Company engagement manager and operations expert. Before McKinsey, Mr. Hiller was the co-founder and founding CEO of two high technology start-ups: aPriori and TADA.today. Before aPriori & TADA, he worked in product development and manufacturing at Ford Motor Co., John Deere, and Procter & Gamble. Mr. Hiller is the author of the PCM blog www.ProductProfitAndRisk.com. He holds an MBA from the Harvard Business School and a master’s and bachelor’s degree in mechanical engineering from the University of Illinois Urbana-Champaign.