Author: Carlos Centurion

In her recent article: Supply Chains Are Stuck. How Can You Help?, Lora Cecere highlights a critical issue facing supply chains today: the continued fixation on cost of goods sold (COGS) reduction. I couldn’t agree more. The traditional supply chain strategy focuses on reducing the cost of goods sold (COGS) while delivering on a given service level. For decades, companies have leaned heavily on this strategy, believing that squeezing costs out of the system is the key to profitability. However, this mindset is no longer sufficient in today’s dynamic market environment. The future of supply chain optimization lies not in merely cutting costs but in maximizing value and operating margins.

The Limitations of a Cost-Centric Approach

The traditional approach of focusing on COGS reduction stems from the assumption that lower production costs directly translate into higher profitability. However, this view often overlooks the broader dynamics of market competition, customer demand, the product portfolio, and the risk inherent in the complexity of modern supply chains. By zeroing in on COGS, companies may inadvertently undermine their ability to respond to market changes, innovate, or align their product offerings with customer needs.

Moreover, standard costing methods often used in COGS reduction strategies can mask the true profitability of individual products or customer segments. These methods tend to average costs across the board, leading to decisions that might seem cost-effective but erode value when viewed through a more strategic lens.

But what does it take to make this shift, and how can companies truly model their businesses for value/margin maximization?

Beyond COGS: A Broader Perspective on Profitability

To move beyond COGS reduction, companies must adopt a more holistic view of profitability that encompasses the entire value chain. This means moving from a narrow focus on COGS reduction to a broader strategy considering the complex interplay of product mix, customer segmentation, market dynamics, and even sustainability. The goal is not just to lower costs but to optimize the end-to-end operation for maximum value creation, focusing on the following key areas:

1. Product/Customer Mix: Understanding which products and customers contribute most to profitability is crucial. This requires analyzing not only the true average profit margins, but more importantly the marginal profitability of each product and customer segment. By identifying high-margin products and high-value customers, companies can allocate resources more effectively and prioritize the areas that drive the most value.
2. Average vs. Marginal Profit: Traditional costing methods often focus on average costs, which can obscure the true profitability of individual products or customer segments. A shift to marginal analysis allows companies to make more informed decisions by understanding the incremental impact of each additional unit produced or sold. This approach provides a clearer picture of where the real value lies and where investments should be made.
3. End-to-End Modeling: To achieve true value/margin maximization, companies must adopt an end-to-end approach to supply chain modeling. This involves considering all aspects of the supply chain, from supplier contracts to production to distribution, and how they interact. An end-to-end model enables companies to identify bottlenecks, inefficiencies, and opportunities for improvement across the entire value chain, including sustainability and financial impacts
4. Moving Beyond Standard Costing: Standard costing has been the go-to method for decades, but it’s increasingly seen as inadequate for today’s complex supply chains. It’s a one-size-fits-all approach that fails to capture the nuances of modern business environments. Companies must move beyond standard costing and embrace more sophisticated techniques to model a business for value maximization.
5. Dynamic Profitability Models: These models allow companies to adjust their cost structures in near real-time based on market conditions, input prices, and demand changes while considering how activities and constraints impact not only cost but also revenue. This flexibility is essential for capturing different scenarios’ true costs and potential profits, enabling better decision-making.
6. Scenario Planning: By modeling different scenarios, companies can anticipate potential challenges and opportunities, allowing them to make more informed strategic decisions. This includes understanding how changes in market conditions, customer behavior, or supply chain disruptions could impact profitability and market position.
7. Value-Based Decision-Making: Companies should prioritize decisions that maximize overall value instead of focusing solely on cost reduction. This could mean investing in more expensive but higher-quality materials, optimizing inventory levels to reduce stockouts, or developing new products that cater to high-value customers.

The Ultimate Goal: Market Capitalization and NPV

While operating margin improvement is a critical step, the ultimate goal for companies should be to maximize market capitalization and Net Present Value (NPV). This requires a long-term perspective, where every decision is evaluated based on its potential impact on the company’s overall value.

Market Cap Focus: By aligning supply chain decisions to increase market capitalization, companies can ensure that they are profitable today and well-positioned for future growth. This involves focusing on innovation, customer satisfaction, and sustainable practices that enhance the company’s market reputation and long-term viability.

NPV Analysis: NPV provides a comprehensive measure of the value of future cash flows, discounted to present value. By modeling business decisions with NPV in mind, companies can make choices that deliver the highest long-term returns, even if they involve higher upfront costs.

We need to put a challenge here to the CSCO and the supply chain teams – are they value drivers that deserve a seat at the table, or simply stewards of the cost of goods sold and service level? 

Conclusion

The shift from COGS reduction to operating margin improvement—and ultimately to maximizing market capitalization and NPV—demands a fundamental change in how companies approach supply chain strategy. It’s no longer just about cutting costs; it’s about creating value across the entire value chain. Supply chain leaders are facing unprecedented challenges: Will they become strategic value drivers with a seat at the table or remain mere stewards of COGS and service levels? Now, they have a unique opportunity to move beyond COGS reduction and focus on improving the operating margin. Click here to discover how River Logic’s Value Chain Optimization is the only comprehensive solution designed to drive long-term profitability and achieve corporate goals.