Supply chain disruptions are wreaking havoc on balance sheets. What’s a CFO to do?

It’s time to take a new look at material flow and its role in profitability.

It can be tempting for those of us in corporate finance to replace the accountant’s iconic green eyeshades with rose-colored glasses when reflecting on the past. With the nostalgia of hindsight, it’s easy to visualize times that we now wistfully look back on as “normal”—times when manufacturing processes were routine, when the costs of doing business were stable, when markets were predictable and when product features were standard.

In reality, of course, business has never been that tranquil. But compared to the turbulence of this past year, it almost seems as though it were. Today, international trade disputes are jerking manufacturers around, disrupting supply chains, alienating trading partners and impacting revenues. Parts shortages, price spikes, port delays and labor issues are all conspiring to ignite a potentially grave inflationary spiral and make supply disruptions the “new normal.”  Plastic resins, computer chips, wooden pallets, chicken wings and just about everything that goes into manufacturing has been in short supply. And Covid-19 has hammered entire sectors of the economy, exacerbating labor shortages, distorting markets and forcing the urgency of extreme agility onto organizations more familiar with constancy.

Corporate leaders have tried to track these developments and their impacts using familiar financial tools including cash flow statements, balance sheet reports and P&L statements—all of which are valuable, at least up to a point. But what the rapid-fire series of market disruptions that occurred this past year have made clear is that the financial performance of manufacturing companies is much more closely tied to their material flows and the costs associated with them than to any other single factor.

A Materials Ledger

While financial ledgers are valuable for measuring and understanding what has happened, what’s missing from most manufacturing companies is a materials ledger—a system with the granularity needed to track material attributes, quality variances, energy use, waste, inventories, production bottlenecks and all the other factors affecting how money is spent transforming materials into products, as well as for calculating and managing the cost of goods sold as they occur. ERP systems have attempted to provide more real-time visibility, but they are limited by their historical roots and course summarized transaction viewpoint. These are questions that can’t be answered using financial ledgers alone.

The problem, for many organizations, is that manufacturing has long been viewed as fixed-asset intensive. An exceptional amount of accounting attention is focused on the equipment, the money tied up in it, and how—or whether—that equipment is actually being utilized. And frankly, it’s much easier to measure around equipment than it is to measure around material flow.  However, that’s not really where the money is.  The primary driver of financial performance has to do with the cost of goods sold. The money tied up in raw materials, intermediates and finished goods has everything to do with determining the ultimate cost of doing business for the manufacturer. And reducing those costs can have a huge impact on the company’s bottom line.

To be sure, some of this is captured in a company’s financial statements. An income statement, for example, subtracts the cost of goods sold from the revenues coming in. But those costs are typically aggregated in ways that provide little visibility into the materials which, in many cases, represent the single greatest expense involved in production. A balance sheet includes inventories, equipment and other manufacturing assets. But here again, the level of detail is frequently insufficient to manage material uses more effectively. And cash flow statements can show how, when more money is tied up in inventory, less can be taken out in cash—an incentive for reducing material and energy costs—but one generally lacking in specificity.  Furthermore, the typical financial systems are focused on measuring the past so a business can apply past learnings to future events.

Tracking in Real Time

What is really needed is a way to view and evaluate what is happening in the manufacturing supply chain in real time that impacts overall financial performance, assists in risk management and ultimately improves product quality and customer satisfaction.

For example, you need to know: are you really buying the right material? Are you paying a premium for material qualities that don’t actually provide value for you or may ultimately increase cost or lower quality? Are you applying energy correctly or excessively? Are you adhering to the appropriate production recipes? Are you consuming too much material or too little? What are the costs of regulatory compliance? What are your product tracing capabilities in the event of a recall? And what is the cost of waste in your process? Even a small amount of waste (2-3%) can result in millions of dollars of lost profits, but some companies waste 20-30% of their material; that has a massive impact on their P&L.

One way of thinking about it would apply some basic principles of physics. For example, look at product ingredients and how they are transformed in the manufacturing process and supply chain in the way you look at a double-entry financial ledger. Balancing the inflows with the outflows over a period of time becomes a fundamental principle. But, as in accounting, when they don’t match up there are well-defined practices to help you determine what went wrong. And observing those principles makes as much sense for a small company as for a multinational giant.

In much the same way, measures of physical mass need to balance. If the amount flowing in doesn’t match the amount that flows out, there’s a problem. If the outflow is less than the inflow, there may be alternative explanations: leaks, spills, evaporation, misdirection, theft and so on. But if the amount flowing out outweighs what flows in, it can be more serious. In either case, though, it’s a sign that something needs to be looked into.  At the same time, however, commercial technology is becoming available to help manufacturers get their arms around material flows. Using it, companies can capture, visualize, integrate and transform material-related information into smarter, and sometimes even fully automated, Industry 4.0 manufacturing operations.

Using these technologies to create a material-centric view through the use of a detailed material ledger, just as finance professionals maintain financial ledgers, is a powerful way that products can be built, that issues can be identified and that problems can be surgically excised before they result in product recalls or even business failures. That doesn’t mean the supply chain issues of today will somehow go away. But it does mean that companies can survive and even thrive in turbulent times without resorting to misplaced nostalgia about the past.