Evaluating internal operations and supply chain performance using EVA and ABC

SAM Advanced Management Journal, Spring, 2005 by Terrance L. Pohlen, B. Jay Coleman

Most firms know that the performance of their supply chain partners directly affects their own performance, and vice versa. Nevertheless, most analytical tools are focused internally. By combining dyadic economic value added analysis (EVA) with activity-based costing (ABC), it is possible to analyze operations decisions so they can be aligned with supply chain objectives. This novel framework allows managers to trace the financial and nonfinancial effects of decisions, even those affecting the shop floor, on their own operations and those of their supply chain partners. These partners must be persuaded to perform a similar analysis. While the analysis has some shortcomings, it should help assure that decisions will result in the highest value-added for the end customer and superior competitive positions for the firms involved.

Introduction

Firms cannot exist in isolation and must rely on other firms to perform a complex chain of interdependent activities from source-of-supply to the end-user. One company rarely controls an entire supply chain, and success depends on how well the combined capabilities of these firms can be integrated to achieve a competitive market-place advantage (Cook, DeBree, and Feroleto, 2001). Managers must extend their "line of sight" to understand system-wide performance and the contribution of each firm (Lummus and Vokurka, 1999). They subsequently need to develop measures for on meeting end-user requirements and aligning firm behavior with supply chain objectives. The ability to develop such measures is a major challenge to supply chain management (Pohlen, 2003).

Performance measures are critical to the success of the supply chain (Deloitte, 1999). Companies can no longer focus on optimizing their own operations to the exclusion of their suppliers' and customers' operations (Lummus, Vokurka, and Alber, 1999). By tying manufacturing and supply chain activities to performance outcomes, operations managers and senior executives can make more informed decisions regarding the allocation of scarce resources and the initiatives and partners that are best for the overall supply chain. Managers across an entire supply chain must collaborate to improve performance and obtain the greatest mutual benefit. Performance measures are needed to keep the trading partners aligned with the enterprise-wide goals so supply chain performance can be optimized.

Effective supply chain management requires measures capable of capturing inter-firm performance (van Hoek, 1998) and integrating the results to depict overall supply chain performance (McAdam and McCormack, 2001). Performance must be measured simultaneously across multiple firms, and the measures must demonstrate how each firm's behavior affects the others and the value delivered to the end-user. Supply chain performance measures must translate nonfinancial performance into financial terms and shareholder value (Ellram and Liu, 2002). Supply chain management will affect more than costs, and managers must be able to sell the value created to senior executives, trading partners, and shareholders. Although most managers acknowledge the importance of designing metrics and rewards, they lack an adequate framework for developing suitable performance measures (Kallio, 2000, Simatupang and Sridharan, 2002).

Few firms have measures capable of capturing performance across multiple companies (Keebler, 1999, Lambert and Pohlen, 2001, Lee and Billington, 1992, McAdam and McCormack, 2001, and Simatupang and Sridharan, 2002), and most are not satisfied with the measures they currently use for supply chain performance (Deloitte, 1999). In many instances, the measures identified as supply chain metrics are actually measures of internal operations or logistics performance (Lambert and Pohlen, 2001). Other approaches, such as the total cost of ownership (TCO) or the supply chain operations reference (SCOR) model, measure the effect of suppliers or other trading partners on performance within the firm. They do not measure performance across multiple firms or the overall supply chain.

In an effort to address this shortcoming, we apply a general framework introduced by Lambert and Pohlen (2001) to show how operations performance can be evaluated with a multi-firm, supply chain perspective. The framework can help operations managers achieve supply chain objectives such as "increased shareholder value" and "improved customer service" by providing a concrete roadmap. The focus is on increasing shareholder value for each firm in the supply chain by establishing within-company and cross-company links between actions (i.e., prospective value drivers) and profits. Senior executives can use the framework to determine whether operational-level actions did, indeed, create value, to demonstrate what requires measurement, to focus attention, and to align behavior within each firm with supply chain objectives. The framework differs from other approaches by simultaneously measuring and analyzing interfirm performance and linking operational performance measures directly to the drivers of shareholder value.