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Integrating the Value Chain
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VALUE-BASED DEMAND

This new metric should be used for determining whether an additional customer's demand is a value-based demand or simply an increase of production. The interdependence of sales ratio to supply capacity, cost of capital, and the shareholder value added (SVA) must all be taken into consideration to understand the relationship between selling more volume or choosing not to supply this incremental demand. SVA will be defined as the profit generated after the cost of capital to produce those sales is taken into consideration. Today a good value to use for the cost of capital is 12 percent. This concept will come into impor­tance when an earnings shortfall is solved by the generation of oppor­tunistic revenue from sales that can actually destroy market value. The following example explains the use of these concepts in identifying value-based demand.

Suppose that a hypothetical plant operation is making Products A through L, as seen in figure 7. Products on the left have higher SVA per pound and are currently being sold in the quantities as noted on the hori­zontal axis. Products A through G have positive SVA, and Products H through L have negative SVA. The actual product SVA becomes the area of the box on the horizontal axis. Even though all products could be generating a positive variable margin, the lower margin sales would be more desirable at low sales to capacity ratios and become undesirable as the sales to capacity ratio reaches the high 90 percent range. Asset effec­tiveness is a common measure used to increase the productivity of fixed permanent investment, e.g., the factory assets. Investment in Products H through L, just like any other products, typically would require a capital expenditure to improve the asset effectiveness. The critical decision is whether it is a good idea to spend new capital on generating more sales volume in Products H through L or not. As long as the cost of capital is 12 percent, the return on this investment would be negative. In this case the answer is no—such an investment will not be adding desired value to the business. However, the problem gets compounded when additional volumes of Products H through L are placed on the market—value of these products becomes even less. As obvious as this may seem, the functional reward and recognition process of the business could actually drive this behavior. Manufacturing is rewarded for reducing the cost of production. Improving the yields in these lower margin products could be easier per pound to improve than the higher margin Products A through G. The lack of the holistic business model thinking will drive to the incorrect solution, and even more damage will occur when this behavior is actually rewarded. Investment in yield improvements in Products A through G is desired.

New business wisdom would not invest capital in the lower margin products that have SVA below the cost of capital. This would be an opportune time to prune the bottom feeders from the product line to allow more renewal of healthier products and give the new products a chance to grow. Had the business continued to be focused on just vol­ume, more share and more less-desirable revenue, an even worse-case scenario would result. Given additional investment in more produc­tion capability, additional volume would be necessary. Which prod­ucts would the sales department find easier to sell? Would the short-range tactics be to sell any product in order to increase the sales to capacity ration of the new permanent investment? What would the re­sulting impact on permanent investment turnover be? These activities will destroy market capital and will result in a business trying to sell more and more and getting less and less for its efforts.

 

Another way to examine this concept is to compare different prod­uct families or different production lines to the permanent investment required to produce such products. In figure 8, the SVA is compared to the amount of permanent investment required. A similar analysis is possible to drive the business to wiser selections for capital expendi­tures. The individual production line SVA is the total area of the box on the horizontal axis.

Value-based demand does not have a single metric that is capable of fully defining what is good business. However, in concert with ca­pacity, SVA, and volume, a better decision can be made that will drive favorable economic value growth. A one-number metric will not fully provide the answer.

 

SUMMARY

Supply chain management by itself will not move the business to the higher value-added business. This paper has attempted to introduce some simple new terms that will allow business leadership to have a more balanced measurement of where to move the supply-demand dynamics to a higher zone for more profitable business. Size alone, market share by itself, perceived low cost of manufacturing, and higher revenues can actually destroy the potential of the business, and the markets that it chooses to participate. However, by using the value-driven model for a more holistic, interdependent business process and employing new tools, movement to that more effective business state is possible. Sometimes this is achieved with less, not more revenue. 

For balance of this article, click on the below link:

Lean Manufacturing Articles and click on Series 11


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