I then turned and wrote the following definitions on the whiteboard in his office:
1. Growth: Year-over-year revenue improvements
2. Profitability: Operating margin (OM), cost of goods sold (COGS), and earnings before interest, taxes, depreciation and amortization (EBITDA)
3. Cycles: Cash-to-cash, inventory turns, and order cycle times, days of receivables, days of payables, and production cycle times
4. Complexity: Increase in products or channels
After replacing the eraser in its holder, and laughing with Joe about my poor handwriting on the board, I said, “Joe, companies want to power a profitable growth strategy, but often find themselves trapped at the intersection of operating margin and inventory turns. It is a battle of cost versus cash. Leaders like you must forge the operating strategy to help others understand the trade-offs.”
“As complexity rises, the potential of the organization decreases. To maintain the status quo, you must constantly redesign operations. As you know, there are many elements that affect operating complexity, like product proliferation, platform complexity, and changes in manufacturing operations.” I then paused and looked him in the eye. “As you know very well, these impacts on complexity usually have a negative effect on revenue per employee, return on assets (ROA), return on net assets (RONA), or return on invested capital (ROIC).”
Joe nodded in agreement and said, “This is our struggle. We are constantly being asked to reduce costs and improve working capital, and do more with less, while complexity escalates in the organization. We have no way to push back and manage the metrics that matter. We are not thinking about it holistically as a complex system.”
About the Effective Frontier
It is important to note that the name of this model is not the Efficient Frontier. Readers who have taken economics courses may have even read it as the Efficient Frontier when speed-reading the page. This mistake is common. Often when I share this model in a lecture, someone will come up and try to correct me.
It is deliberately not named the Efficient Frontier. Why? The efficient organization is not necessarily the most effective. This is an important principle that underlies the research of this book. A singular focus on productivity or cost management can throw an organization out of balance. (An efficient organization is usually defined as one with the highest productivity per employee or the lowest cost per case.)
I had hit a nerve. I started the conversation by passing a piece of research to Joe that is shown in Table 1.1, and saying, “Today, nine out of ten companies are stuck. As shown in the table, when we analyze corporate balance sheet data for companies sorted by Morningstar sector, we find that nine out of ten companies have been unable to move forward for more than three years of sequential improvements on these two metrics. They are not stuck in a good way like a label to a bottle; instead, they are stuck in a bad way like a car in a massive traffic jam going nowhere. They may have made progress on a project, or a focus on singular metrics, but not in the delivery of a balanced metrics portfolio.”
Table 1.1 Percentage of Companies Demonstrating Consecutive Improvement on Both Operating Margin and Inventory Turns for 2000–2012
Source: Supply Chain Insights LLC.
Joe flashed his contagious grin and said, “This is certainly the case in my organization.”
“Take a look at how industries have changed,” I said, shuffling a sheaf of papers and handing to Joe what is shown in Table 1.2. “Growth is slowing; and as growth slows, organizational tension for metrics improvements increases. Balance and resiliency on the Effective Frontier is tougher with slowing growth. This has been the struggle of many companies in the past three years.”
Table 1.2 Industry Growth Patterns
Industry Average comprised of public companies (automotive industry: NAICS 336112), (brand apparel industry: NAICS 31522 %, where % is any number from 0 to 9), (combined food & beverage industry: NAICS 3112 %, where % is any number from 0 to 9, 311320,311520,311821,311941 & 312111), (chemical: NAICS 325188 & 325998), (consumer packaged goods: NAICS 3256 %, where % is any number from 0 to 9), (grocery retail industry: NAICS 44511), (hospital industry: NAICS 62211), (mass retail industry: NAICS 452 %, where % is any number from 0 to 9), (medical device industry: NAICS 339112), (pharmaceutical industry: NAICS 325412), (retail apparel industry: NAICS 44812 %, where % is any number from 0 to 9) reporting in One Source with 2012 annual sales greater than $5 billion.
Source: Supply Chain Insights LLC, Corporate Annual Reports 2000-2012.
“Okay, I get it,” said Joe. “But what do I do? What is my call to action? My organization is clearly stuck, and I see that you are saying it's a mistake to focus on only a single metric like inventory. Help me with the next step. What do I do now?”
I loved Joe's natural curiosity and openness to learn. It was something that I do not see often. I leaned forward and continued, “Getting unstuck requires the management of the Effective Frontier as a system. The metrics are interrelated. There are finite trade-offs. As you learned firsthand in your meeting the other day, the organization must resist the temptation to focus on piece parts, or a singular metric in isolation.” I shook my head, “The Effective Frontier needs to be managed as a complex system with complex processes with increasing complexity. As the business increases in complexity, the system needs to be continually redesigned.”
“As a leadership team, you must keep a focus on outputs, not just inputs. To drive change, one of the first distinctions that you need to adopt as a leadership team is the difference between functional and corporate performance metrics. This is important if you are to determine the sustainable metrics framework to improve cross-functional success.”
Joe nodded in agreement. “This is one of our major issues. We are so entrenched in functional metrics that it's hard for us to also focus on corporate performance. Our incentives are based on what is good for the function. Our sales leader, Frank, is focused on volume while I am incented on cost; and every time that I engage with Lou, our controller, the discussion is about cash. It is impossible for us to maintain a steady course and be balanced. We want to do the right thing by our corporate objectives, and we talk about these at quarterly and annual meetings, but we are not incented to make progress on what you call the Effective Frontier. Shouldn't this be cross-functional as a team?”
“Yes,” I said, “You are not that different from other companies that I work with. Trust me, I understand.”
“For best-performing companies, it is a series of conscious choices to improve capabilities and push to a new level of the Frontier. However, it happens slowly. It is only after achieving balance and resiliency in the current state that companies can push to a new level of performance. I define this as increasing ‘organizational potential.’ For this reason, the decision to move to a new level of the Effective Frontier is the last stage in the model,” I said, while pointing to what is shown in Figure 1.3.
Figure 1.3 Moving from