00:00:07 Introduction of a new approach in supply chain optimization: economic analysis.
00:01:22 Explanation of how service level is not enough to make a supply chain decision.
00:02:52 Explanation of why a monetary target is needed to balance the supply chain decisions.
00:03:21 Practical example of how financial analysis works in supply chain.
00:06:41 Explanation of why service level is a popular KPI in the industry.
00:08:00 Discussion on the number of skus and their stock levels.
00:08:21 Explanation on how service level can be easily monitored in ERP systems and Excel.
00:09:00 Importance of financial metrics in optimization.
00:10:01 Explanation on why dollar-driven approach is crucial for optimization.
00:14:29 Discussion on the challenge of implementing financial analysis in retail networks.
00:16:00 Discussion of different ways to make stores more attractive without adding more stock.
00:16:59 Mention of the problem of looking at one aspect of the company while neglecting the bigger picture.
00:17:21 Discussion of the possibility of a turf war between departments due to financial optimization.
20:19:47 Explanation of the benefits of financial optimization, such as increased profits and the ability to invest more in the future.
00:21:00 Importance of proper execution in financial optimization.
00:22:24 Explanation of the simplicity of financial optimization.
00:23:08 Potential for an employee to be a hero for the company through financial optimization.
00:24:34 Discussion on how supply chain optimization can lead to rewards from the company.
00:25:18 Summary of the importance of optimizing dollars of return to become a hero for the company.
Summary
Lokad’s founder, Joannes Vermorel, discusses the company’s approach to supply chain optimization with Kieran Chandler. Lokad uses a dollar-driven approach to balance service level with minimizing inventory write-offs, by expressing all factors in monetary terms to allow for more effective optimization and strategic decision-making. Vermorel explains that most supply chain problems are driven by tail events, where traditional service level optimization falls short. A dollar-driven approach is crucial for optimization because it provides a unified numerical target, and without financial metrics, companies mistakenly think they are optimizing. Despite challenges, Vermorel highlights the benefits of adopting an economic-led approach, such as increased profitability.
Extended Summary
In this interview, Kieran Chandler speaks with Joannes Vermorel, the founder of Lokad, about their approach to supply chain optimization using financial analysis. Traditionally, supply chain optimization has focused on service level, but Lokad’s approach is to optimize based on the economic implications of a decision. This allows for the comparison of seemingly unrelated factors, such as inventory write-offs and service level agreements, by expressing them in monetary terms.
Vermorel explains that most supply chain problems are driven by tail events, which are either unexpectedly high or low demand situations. In these situations, the traditional focus on service level falls short, as it doesn’t fully address the real pain points. Instead, Lokad’s approach emphasizes balancing high-quality service with minimizing inventory write-offs by using a unified monetary target.
To do this optimization, Lokad’s system requires a target that can apply cross-functionally for the entire company, which has to be a monetary target. This involves assessing the payback of a decision by considering various factors such as the cost of purchase, generated margin, stockout penalty, inventory write-offs, and carrying costs.
Vermorel stresses the importance of taking a dollar-driven approach for two main reasons. First, a numerical optimizer is needed to optimize supply chain decisions, and a non-financial target, like service level, is insufficient for this purpose. Second, optimizing service level alone can lead to excessive inventory and significant write-offs, which is why a financial target is necessary for a more balanced approach.
Lokad’s innovative approach to supply chain optimization uses financial analysis to better address the challenges of tail events and find the right balance between service quality and cost efficiency. By expressing all factors in monetary terms, this method allows for more effective optimization and strategic decision-making across the entire company.
They focus on the importance of service level as a key performance indicator (KPI) and the benefits of using a dollar-driven approach in supply chain optimization.
Vermorel explains that service level became a prominent KPI because it can be easily calculated with a simple SQL query or even in Excel. He also states that it was trivial to implement in most enterprise software and ERP systems, which contributed to its widespread adoption. However, he argues that relying solely on service level is not sufficient for true optimization, as it overlooks the downsides of increased stock levels, carrying costs, shrinkage, and inventory write-offs.
The dollar-driven approach is essential for optimization, as it provides a unified numerical target. Without financial metrics, Vermorel believes that many companies mistakenly think they are optimizing when they haven’t even started. He also emphasizes the diminishing returns associated with increasing service levels, as higher levels may require significantly more stock while only marginally improving customer service.
When asked why the dollar-driven approach isn’t more commonly used, Vermorel explains that cost optimization through mass production was a major discovery in the 20th century, enabling companies to provide superior quality goods at lower prices. However, he also notes that the introduction of computer systems in supply chain management initially focused on basic tasks, such as bookkeeping and stock tracking, rather than numerical optimization.
Early computer systems struggled to keep up with even the basics, let alone perform complex numerical optimizations. Vermorel suggests that the shift towards computer systems may have inadvertently led companies to overlook the importance of using financial metrics in their optimization efforts.
Vermorel explains that traditional systems, such as relational databases, are not well-suited for complex numerical optimization, leading many companies to move away from financial indicators. This makes it difficult to incorporate financial analysis on a large scale, and as a result, supply chain problems often get displaced rather than resolved.
Using a retail network as an example, Vermorel illustrates the dual purpose of stock: servicing clients and making the store look appealing. He emphasizes that while a portion of the stock is there for servicing purposes, another portion is there for marketing purposes, making the store more attractive. When implementing financial drivers, companies should assign budget for supply chain and marketing accordingly.
However, optimizing from a supply chain perspective alone may lead to removing stock used for marketing purposes, which could negatively impact the store’s appeal and sales. Companies need to consider the bigger picture when making optimizations. This may lead to conflicts between departments, as financial optimizations could shift budgets and responsibilities.
Despite these challenges, Vermorel highlights the benefits of adopting an economic-led approach, such as increased profitability. Companies that are more profitable than their competitors will be better positioned for long-term success, with more resources to invest in better products and marketing. The key to achieving this is by taking a holistic approach to supply chain optimization, considering the needs of various departments and the overall goals of the organization.
Vermorel emphasizes that optimizing the bottom line is crucial for modern capitalistic companies and neglecting it puts them at risk of being outperformed by competitors. He highlights that proper execution of financial optimization can lead to significant growth, using Amazon as an example.
Vermorel believes that the real challenge in financial optimization is going against the status quo, traditions, and potentially opposing managers. However, the payback can be substantial. He reassures employees that supply chains are not infinitely complex in their economic drivers, and the amount of financial engineering required is limited.
The real difficulty lies in overcoming resistance and delivering massive results. Vermorel encourages employees to be ambitious and focus on optimizing dollars of return. In doing so, they can become heroes for their companies, potentially doubling their salaries and achieving impressive results. He acknowledges that this path may not be universally popular and could create some enemies, but emphasizes that it is a transformative and beneficial approach for the company.
Vermorel urges supply chain professionals to focus on financial optimization, even if it means challenging traditions and taking risks. By optimizing dollars of return, employees can make a significant impact on their companies, while also advancing their own careers.
Full Transcript
Kieran Chandler: Today on Lokad TV, we’re going to discuss this financial analysis and how it means you can compare apples to oranges. So Joannes, I’m not sure how we’ve made it this far without discussing economic drivers. What’s the whole idea behind this?
Joannes Vermorel: It fits in the sense that most of the problems in supply chain are driven by the tail events. It’s the unexpectedly high demand that generates stockouts, and it’s the unexpectedly low demand that generates inventory write-offs. In the middle, things just work fine – inventory rotates gently, and asset utilization is roughly as expected. But when you go to the tail, things start to get progressively bad until it’s completely ugly. If you focus on the middle, it doesn’t tell you much.
Service level is already steering your focus towards the tail, as it’s about your quality of service and the few percent of the time when you don’t meet your clients’ expectations. So, service level is a step towards something that is a bit closer to the real pain. However, if you want to really balance, for example, high quality of service with the inventory write-offs you might have at the end of the season, year, or product generation, you need something to balance, and indeed you have apples and oranges.
On one side, you have write-offs that are quantities of units, and on the other side, you have service level, which is the quantity of requests that you will serve in time according to your service level agreement or whatever you’ve agreed with your clients, even if it’s an implicit agreement. So, when we started to look at the various constraints and the values, and when we wanted to steer the decisions towards something aligned with strategy, we realized that we had no way but to express everything in dollars or maybe euros and optimize from there. We need a unified monetary target; otherwise, we can’t do the optimization. To do an optimization, you need a target, and if you want a target that can apply cross-functionally for the entire company, it has to be a monetary target.
Kieran Chandler: Okay, so how does this actually work in practice then? What do you mean by optimizing a dollar of decision and a dollar target?
Joannes Vermorel: The way we think of it is, let’s say, for example, you want to source a few more units of a given product that you’re going to transform or sell. So basically, you’re placing a purchase order with one of your suppliers. At the moment you’re doing that, you’re anticipating some future demand that may or may not happen. It’s an anticipation, and you’re also anticipating some inventory rotation.
Kieran Chandler: Certain lead times may or may not happen again if you anticipate a certain demand at some point of time. If the goods arrive, for example, after the seasonal peak, you had correctly anticipated the demand, but the goods that you’ve just ordered arrive too late, and so basically you can’t serve the demand.
Joannes Vermorel: There are multiple uncertainties, and if you want to assess the payback of your decision, you can, after the fact, look at how much the cost of your purchase was, what the payback in terms of generated margin was, and what the payback in terms of stockout penalty was. It’s not something that strictly ends up in your accounting books, but it’s something that you model to reflect the fact that there is an incurred cost of not servicing the client properly, and so on. You might even have, at the very end of the life cycle of the product, the inventory write-off where you actually lose the value of the product. Plus, you have the carrying costs and other economic drivers.
Kieran Chandler: So why is it so important to take this dollar-driven approach? It sounds like a bit of a soulless financial analysis.
Joannes Vermorel: There are two main reasons for that. One is mundane, which is that you have a numerical optimizer. Any software, regardless of the class of algorithm, is optimizing something numerically speaking for your supply chain. But in order to optimize anything, you need to have a target, a metric, something that you optimize. So you need to have this target. If you have a non-financial target, like service level, it’s completely one-eyed. For example, with service level, you can’t really optimize anything because it’s one way: more service level is always kind of better. But if you have super high service levels, you end up having massive stock levels and massive inventory write-offs. So you need to have the financial perspective to encompass all of that. That’s the first pillar, to drive the optimization.
Kieran Chandler: But the thing about service level is it’s something that’s being used almost throughout the industry. Why is it such an important KPI?
Joannes Vermorel: I believe that the prominence of service levels can be explained because it can be written in a two or three lines statement in SQL. Remember, modern digital supply chains started at the end of the 70s, beginning of the 80s when companies started to introduce ERPs, even though the name was only found in the 90s.
Kieran Chandler: But basically when they started to introduce what would be later called ERPs to run their supply chains, in a typical ERP, you have a table that contains the stock levels for every single product that you serve. So, literally, you have one table with product stock quantity as a vanilla design. And then if you want to assess your average stock level, you’re just going to count how many products have a zero stock level and how many products still have stock left.
Joannes Vermorel: Literally, in one line, you can get a query that tells you what your average service level is. Today, if you have 1000 products, and you have 950 SKUs that still have stock left, you can say, “Okay, I have a 95% service level if I look at the total of my portfolio.” One of the reasons why it became so prominent was because it was literally trivial to do in most enterprise software, ERP software. And by the way, it’s trivial with a relational database, but it’s also trivial in Excel, which is good. So basically, people can either do that in their ERP system if the ERP system supports stock level monitoring. If the system can’t, then they can also trivially do that in Excel. But, you know, the fact that it’s super easy was certainly a big factor in the massive adoption of those practices. It’s not necessarily that it’s really what truly makes sense for companies.
Kieran Chandler: Okay, a bit of a digression there. So we’ll get back to the main idea about why the dollar-driven approach is so important.
Joannes Vermorel: Literally, first, if you don’t have dollars, you don’t know what to optimize. And again, if you look at service level, you’re blind from one eye. You only look at the positive outcome of having a higher service level, which is a better service for a client. It’s good, but you have downsides, such as extra stock, extra carrying costs, extra shrinkage, and extra inventory write-offs. So you can’t just say, “I’m going to go completely crazy on the service level.” It’s something where you have diminishing returns. If you have, let’s say, a 98% service level, maybe you need to double the amount of stock you have to go to a 99% service level, and you’re only going to serve 1% more of your clients better. So there are strongly diminishing returns.
So you need this metric to do the optimization. If you don’t have the financial metrics, in my book, it’s not even possible to start optimizing, which may come as a large surprise to many companies because many companies think they are optimizing, but they don’t even have a target. So in my book, they haven’t even started to do an optimization because they are lacking some of the most basic ingredients for the optimization, which is a unified numerical target.
Kieran Chandler: Okay, because the idea of using economic drivers is all very logical. So why is it something that isn’t more commonly used by companies? Is it a case that nobody thought of it, or is it a case that it was very challenging and nobody could actually act on it? Why is it something that’s not used?
Joannes Vermorel: It’s intriguing. I mean, if you look at the history of the 20th century, I think it was literally one of the major discoveries of building those…
Kieran Chandler: Massive companies engineer at scale, focusing on cost optimization, which leads to mass production systems. The modern supply chain that we enjoy nowadays resulted from very smart financial optimization that steered most companies toward mass production. This is because there are massive economies of scale in supply chain, production, distribution, and marketing, which allows companies to sell goods of vastly superior quality for a vastly lower price, expand their markets, and so on. Can you speak to the role of financials in this process?
Joannes Vermorel: The differentiation between a mid-century 20th-century company and a company doing the same sort of things one century before is that people were heavily paying attention to the financials, so it’s definitely not new. However, with the introduction of computer systems, people thought everything would be better, but not necessarily. Initially, companies that moved their supply chain toward computer systems, like with barcodes and the advent of the relational database, had systems capable of lifting a lot of clerical work for basic bookkeeping. But the earliest computer systems could not do any kind of fancy numerical optimization; they had a hard time keeping up with just the basics like keeping track of stock.
As a result, those systems kind of eliminated all the financial engineering because it wasn’t exactly needed. The tools that were developed for relational databases, like SQL, is a language to query and update relational databases. This language shapes how you look at the problem, and SQL is very much focused on CRUD (create, read, update, delete) operations - super basic operations. It’s not engineered to do any kind of fancy numerical optimizations. So the design is a bit at odds, and many companies moved away from financial indicators that were very hard to inject into their IT systems, so they had to live on the side.
Kieran Chandler: If it’s such a large undertaking for some of these big companies to take on financial analysis at scale, what are the areas they need to target and where should they start? Is it really that big of a challenge?
Joannes Vermorel: Yes, because most of the supply chain problems involve the curse of displacing problems rather than resolving them. Let’s take a specific example to clarify that. Let’s imagine we are looking at a retail…
Kieran Chandler: Can you explain how stores use their stock for both servicing clients and for merchandising purposes?
Joannes Vermorel: The stock in a store serves two purposes. First, it’s used to service clients who come in and expect to find products on the shelves that they can buy. Second, it’s used for merchandising purposes so that the store looks appealing and overflowing with goods. If you don’t have enough stock, the store will look sad and unappealing, like the stores in Poland during the Soviet era with empty shelves. So, modern retail requires that stores look plentiful to give clients an incentive to buy.
Kieran Chandler: Can you explain how budgeting for supply chain optimization and marketing differs in terms of stock?
Joannes Vermorel: Half of the stock is for servicing clients, and the other half is for merchandising purposes. Supply chain optimization should focus on the stock needed for servicing clients, while the budget for marketing should focus on the stock needed for merchandising purposes. The latter is a marketing expense since it makes the store more appealing, and there are many ways to achieve this without adding more stock.
Kieran Chandler: What happens if you only optimize the supply chain perspective and ignore the merchandising aspect?
Joannes Vermorel: If you only optimize from the supply chain perspective, you might remove the stock that is only for merchandising purposes, but this would make the store lose a lot of its appeal, which could lead to sales problems. You need to take into account the whole picture of the company, and this can be a challenge because there might be traditions in place where all the stock is carried by the supply chain department, and no financial optimization has been done. When you start optimizing, you might realize that millions of dollars in stock are going to end up in the marketing budget, leading to turf wars and people being unhappy.
Kieran Chandler: On the paper, it’s going to look bad for certain managers. People are going to disagree on the way you count the dollars, and I mean, it’s going to be tough. It’s not tough because of the technology stuff, but because when you start discussing money with money on the table, the discussion becomes very heated. It’s just very human. It’s such a big undertaking in doing a financial kind of analysis. It’s got to have a payback, so what’s the benefit of moving to this economic kind of led approach, and maybe how much does it change the processes of a company?
Joannes Vermorel: The benefit is literally profit. At the end of the day, the companies that survive are the most profitable ones. If you have competitors that are more profitable, they will be able to invest more, have better products, and better marketing. Just having companies in your area that happen to be more profitable than you is a threat because they will be able to invest more and ultimately get even better than you, and it’s going to compound over time.
Back to why you should do it, well, first, if you really care about your company, if you don’t optimize your bottom line, then what are you optimizing? The core purpose of modern capitalistic companies is to generate wealth that ends up measured through the profit that you accumulate at the end of the year. And then, it’s not actually a big undertaking. It’s difficult because it requires fortitude, going against tradition and status quo. As an employee, if you want to push these sorts of things, you will have to go against many other managers, possibly. But the payback is usually gigantic.
If you take a situation where there is no financial optimization in place and you start to play that game, well, that’s exactly what Amazon started to do two decades ago. Nowadays, they are a 500 billion dollar company and they are still going super fast. When you start to play that game and you execute it correctly, the company that does it usually ends up completely crushing the entire competition.
Kieran Chandler: If we start wrapping things up a bit, if I was an employee watching this in a company, why shouldn’t I be intimidated by the complexity of financial optimization?
Joannes Vermorel: You should not be intimidated.
Kieran Chandler: Can you talk a little bit about supply chain optimization? Some people might be intimidated by the complexity.
Joannes Vermorel: Well, it’s not that complex. Yes, supply chains are not infinitely complex in their economic drivers, you know. Things that you buy cost money, transforming them costs money, moving them around costs money. Distributing them costs money, and when you sell them, you make a margin. Your selling price minus your cost, and you have your net margin at the end of the day. The drivers keeping things in stock cost money. The drivers are not exceedingly abstract. This is not like advanced financial engineering, as if you were playing with advanced structured products on commodity markets. So from this regard, the amount of financial engineering that is needed is very, very limited. Where there is a real difficulty is, why should you do that? Well, the short answer is, because probably that’s one of those things where you can be a hero for your company. You can be the man of the year that literally generated one extra percent of margin company-wide in absolute terms. So, it’s not one extra percent, so it’s not like the margin goes from 1 million to 1.1. It’s literally if you’re a billion-dollar business, one percent can mean 10x to a million dollars. So you can, it’s one of those areas where as an employee, you can generate returns on investments that are like a thousand times your salary.
Kieran Chandler: And how do you suggest someone start with supply chain optimization?
Joannes Vermorel: My advice would be, yes, it’s risky, but if you want to be ambitious and to be able to negotiate that next year, you want to double your salary, then you need results, and you need relatively impressive results if you want to negotiate those kinds of things. If you want to be able to progress enormously in your career, you need to deliver massive results as well. In supply chain, usually, you can, due to scaling effects and due to the fact that a little financial optimization can go a long way.
Kieran Chandler: Generating revenue is key for any business. Joannes, could you share your thoughts on how supply chain optimization can contribute to a company’s bottom line?
Joannes Vermorel: Just due to the fact that you’re operating in a potentially relatively large company, you can have a leverage effect where your actions just save millions for the company. If your employer doesn’t want to consider a pay raise even after you’ve brought such significant value to the company, then you need to change your employer. But usually, large companies are not idiots. When a team delivers fantastic results, it’s just common sense to keep them on board. Large companies might have a lot of defects, but this is not the sort of problem that many large companies offer. My observation is that large companies are pretty capable of rewarding very generously people who bring stones of money back to the company. So my suggestion is that as a supply chain person, you can be a person who optimizes processes that nobody cares about, or you can optimize dollars of return. And if you do it well, even the CEO of your company will pay attention. So my suggestion is, yes, there is a lot of risk, yes, it’s very difficult, but if you really care about your company and if you have ambition, go for those dollars of return.
Kieran Chandler: Interesting perspective. Could you elaborate on the risks involved?
Joannes Vermorel: You will probably not be liked by everybody for that. Sorry, but overall, I believe that can be something very transformative for the better for the company.
Kieran Chandler: Okay, we’ll have to wrap it up there. But I guess that’s a good tagline - “optimizing dollars of return.” You can become a hero of your company and double your salary. It’s not bad. You might make a few enemies along the way, but you know, it’s hard to do anything if you never make any enemies in your life. It’s probably that you never did anything in your life either. So, you have to accept that that’s the downside of actually achieving anything.
Joannes Vermorel: Agreed.
Kieran Chandler: Okay, we’ll have to wrap up then. Thanks very much for watching, and we’ll see you again in the next episode. Thanks for watching.
