Supply chain: the profit prophet?

In Supply Chain by Darren Smillie

The heart of the matter

How do you know what really matters to someone? The best way to find out is to observe what they invest their time and effort in doing. Actions, of course, speak louder than words. Nevertheless, given that we may often be constrained in our ability to truly observe others, listening to what they talk about also provides an indicative, albeit a potentially more selective, picture.

So it is with businesses. Investors would love to have the ability – and time – to embed themselves within an organisation to observe where the focus really lies, how it operates behind closed doors and what kind of culture exists. In reality, other than indirectly through raw performance measures, they are forced to understand all of the above by dissecting the carefully controlled communications that a particular business decides to share.

The supply chain standing

For example, I hear much anecdotally about how supply chains are playing a bigger and more strategic role within businesses. There is even evidence to suggest board level representation for supply chains is increasing, allowing them to shape, not just to enact, business strategy. Without embedding ourselves across a swathe of companies in the industry, how else can we measure if this is really the case and, crucially, what difference this apparently increased prominence for supply chain is making to business performance?

One way is to study what businesses talk about in their annual reports. This key document is likely to represent what a business thinks is most important (either to themselves or to their investors). A great example of a company demonstrating their supply chain priorities through this medium is Unilever. Up to 2014 they reported on-shelf availability of their products in their annual reports, unlike many retailers for whom you would expect it to be an even higher priority. Unilever was progressive enough as a manufacturer to recognise that this measure of availability for the shopper should matter to investors because it directly impacts the short and long term value and profitability of their company.

Taking this as inspiration, I have done some research, gathering the annual reports over a ten year period (2006-2015) for 17 of the 30 largest retailers in the world (chosen based on those where I was able to source their annual reports for each of these years). These included: Aeon, Ahold, Amazon, Carrefour, Costco, Home Depot, Kroger, Loblaws, Metro, Rewe, Sainsbury’s, Seven & I Holdings, Target, Tesco, Walgreens, Walmart and Woolworths – retailers spanning 8 home markets across 4 continents.

Reading between the lines

So, are they talking more about supply chain than previously? Well, the first thing I noticed was they are talking more, full stop. Given they have also grown over the period, it’s fair to expect them to have more to say since they are bigger entities. Excluding Amazon, which showed an “off the chart” ten-fold growth over the decade, the number of words per report increased by an (unweighted) average of 45%, actually very close to their corresponding (unweighted) average revenue growth of 48%.

To remove the effect of this increase in words, I’ve looked at the change in frequency of their references to “supply chain” per total words, normalised to the start of the period, as shown below:

The results are mixed. For a period of time, starting around the global recession of 2007/2008 onwards, these businesses as a whole did indeed talk significantly more about supply chain. Given the increasing challenges with growth in the market, this perhaps reflected a renewed prioritisation on cost cutting and driving efficiencies in order to deliver a profit. The increase in frequency peaked in 2011, declining since then to end up most recently at much the same level at which businesses were discussing supply chain at the start of this ten year period. So, has the prominence of supply chain receded or reverted to the norm or have other newer priorities risen to take the focus?

What else has changed in what businesses are talking about and where does supply chain rank? I’ve chosen a range of words or phrases for which I expected to see a change in focus from businesses over this period, based on market trends, and did a similar frequency count per total words in their annual reports. You can see the overall change between 2006 and 2015 for each of these words (which included some of their variations, e.g. collaborate & collaboration) below:

Almost all the words increased in frequency, in some cases massively, albeit from a very low base. There is much more focus placed today, for example, on online and, subsequently, multichannel as businesses grapple with one of the key drivers of growth. At the other end of the scale, it was a surprise to see a very slight decline in references to technology given its pace of development, although references to one of its most transformative applications – automation – do increase significantly. Of this list of words/phrases, supply chain shows one of the lowest overall increases in prominence.

Why does any of this matter? Does an increased focus on supply chain deliver business success and is that effect measurable through such a rudimentary approach? The answer in both cases, I believe, is yes. Given the ability of supply chain to impact both the top line sales and bottom line costs, I looked at whether operating profit margin is linked to this focus on supply chain, continuing with the assumption that increased references equals increased prominence.

The chart below shows the operating profit margin and the relative frequency of references to supply chain for all 170 annual reports included in this data set (with a handful of those with a negative margin not shown on the chart but included in the calculations except for Tesco in 2015 which is excluded due to its extreme outlying operating profit margin around -10%).

Of all the words or phrases included in this investigation and shown in the earlier chart, it is the frequency of references to supply chain that has the strongest correlation with operating profit margin. The gradient of the regression line was the highest. The R-squared value, which is a measure of goodness of fit of the linear regression line – was the highest (albeit low). And, for those who care, the p-value was negligible meaning there is almost no chance that such a distribution would be observed if there was no correlation at all between these two factors.*

Of course, one can find all sorts of spurious correlations if one looks hard enough and correlation does not necessarily equal causation. While I won’t over-interpret this, the consumption of margarine and divorce rate in Maine it is not. The fact that there is a defendable logic underpinning the relationship, which has long been expounded, which was looked for and which was found, gives weight to a message I and others have been pushing for quite some time. Supply chain matters.

*If you would like more details on the methodology, more insight from this research, or to discuss the findings or their implications for you then please don’t hesitate to get in touch.