Logistics and Supply Chain Management (SCM) Key Performance Indicators (KPI) Analysis

Logistics and Supply Chain Management (SCM) Key Performance Indicators (KPI) Analysis A Canada/United States Aerospace Sector Supply Chain Perspective October 2006

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Executive summary The Aerospace global supply chain (GSC) is driven by a customer-centric reality, smart border requirements, logistics mandates (such as Radio frequency identification (RFID)) from large corporations, and mass customisation in a Just-In-Time (JIT) manner. Logistics and supply chain management (SCM) are thus expected to play a key role in GSC and contribute dramatically to productivity growth of Canadian Aerospace firms within the next few years. The particular supply chain characteristics of the Aerospace sector is its high level of GSC integration, the application of SixSigma processes and a shifts towards manufacturers that provide both goods and services. Measurement of logistics and supply chain management (SCM) key performance indicators (KPI) is an essential part of the agile supply chain concept. It is estimated that 37 percent of North American (NA) firms that have put in place logistics and SCM KPI corporate wide measurement applications have achieved a decrease of 15 percent or more in shipment delays compared to only 7 percent of firms that did not measure those KPI consistently 1. The Aerospace sector has traditionally incorporated SixSigma measurement processes, which are concentrated on product quality and not on JIT lean manufacturing. On-time delivery, a logistics and SCM JIT measure, is the most used KPI in the North American (NA) Aerospace and defence sector. This enables the Aerospace industry to increase its level of mass customization and decrease delivery times, while maintaining a high level of quality. While inventory turns is the main KPI for evaluating supply chain agility, logistics cost KPI allow firms to evaluate the efficiency of their logistics and SCM operations. The combination of supply chain agility and efficient SCM practices is key to long term competitiveness and prosperity of Canadian firms in a global supply chain (GSC) context. Inventory turns With respect to supply chain agility, Canada s Aerospace manufacturing raw materials inventory turns in 2005 were below that of the average for the Manufacturing sector by 31 percent and in 1992 by 101 percent. This reflects a continuous trend of improvement in the Aerospace sector in terms of their raw materials inventory turns, with a growth of 77 percent between 1992 and 2005 2. On the finished goods side, the Aerospace sector had inventory turns that were below the average for the Manufacturing sector by 48 percent in 2005, a definite improvement from 1992 when their inventory turns were 89 percent below those of the Manufacturing sector on average. This is explained by a stronger growth for the Aerospace sector than for the 3

Manufacturing industry in finished goods inventory turns during this period (57 percent compared to 23 percent respectively) 2. In terms of total inventory turns comparison with the U.S., there is a very small gap, the U.S. having total inventory turns that were somewhat higher than that of Canada in 2005. However, this gap is not significant because both countries have very small total inventory turns that are similar and have been overlapping constantly for the past decade, both of them keeping to variations of no more than +20 percent,-20 percent over this period (with a unique exception for Canada in 2002, when a growth rate of 40 percent occurred) 3. Logistics Costs The Aerospace sector has a logistics cost distribution that is particular, in that it is quite different from, not only the average distribution, but also from the distribution of sectors that were selected for comparison in this study. The initial difference is that there are lot less logistics outsourcing costs in the Aerospace sector, relatively speaking, than in the Manufacturing average and in various sub-sector of Manufacturing. For instance, the Motor vehicle manufacturing sector has outsourcing logistics costs that are 4 times higher than those of Aerospace 4. A second difference appears when looking at inventory carrying costs, in term of percentages of total logistics costs. The Aerospace manufacturing sector has inventory carrying costs that are larger than the average for the Manufacturing industry and larger than those of various sub-sectors taken for comparison purposes. As an example, the Aerospace manufacturing sector has inventory carrying costs that are 46 percent higher than those of the Chemical manufacturing sector. Finally, internal costs, expressed in terms of percentage of sales, are relatively similar for the Aerospace sector and the Manufacturing average. However, compared to some of the sectors taken for comparison, the Aerospace manufacturing sector has larger internal logistics costs, as percentage of sales (the difference being of 26 percent with the Motor vehicle manufacturing sector) 4. Technology The focus used to be on SixSigma processes rather than on improving their supply chain agility and flexibility, but this is starting to change. Improving operational performance and shorter cycle times were identified as the top two drivers whereas increase in product quality came only as third. Generally speaking, twice as many SCM high technology adopting firms enjoy a reduction in inventory carrying cost compared to low technology adopting ones. Furthermore, in terms of success to implement JIT Lean manufacturing, 71 percent of 4

NA Aerospace and Defence firms experienced a reduction in supply chain costs as expected, compared to only 51 percent in average for the whole Industry 5. 5

Table of contents Executive summary... 2 Introduction... 7 I - Industry Productivity and Competitiveness via Logistics and SCM... 8 II - Inventory Management and Just-in-Time Key Performance Indicators... 12 A. Raw materials inventory turns... 12 B. Finished goods inventory turns... 14 C. Canada/U.S. comparison... 15 D. Benefits of indicators to productivity and competitiveness... 16 III - Logistics and SCM cost KPI analysis... 17 E. Logistics Internal costs... 17 F. Logistics Outsourcing costs... 18 G. Inventory carrying costs... 19 H. Logistics costs aggregates... 20 IV - Final remarks... 22 Annex I: Methodology... 23 Annex II - Definitions... 27 Annex III Inventory Management Data... 30 Annex IV Logistics Cost Data... 32 References 36 6

Introduction The Aerospace global supply chain (GSC) is driven by a customer-centric reality, smart border requirements, logistics mandates (such as Radio frequency identification (RFID)) from large corporations, and mass customisation in a Just-In-Time (JIT) manner. Logistics and supply chain management (SCM) are thus expected to play a key role in GSC and contribute dramatically to productivity growth of Canadian Aerospace firms within the next few years. Although Canadian Aerospace firms have used logistics and SCM performance indicators internally for decades, they have never had any tool for benchmarking themselves to their supply chain partners, competitors, sectors and U.S. counterparts. Industry Canada has partnered with the Supply Chain and Logistics Association of Canada (SCL) Research Committee to launch a national logistics and SCM performance indicators initiative. The objective of this study is to propose a Logistics and SCM key performance indicators (KPI) analysis that can be used as a benchmarking tool for firms and policy makers. This analysis will help firms understand where they are located with respect to leading enterprises, as well as firms within their own sector and the U.S and what steps they must undertake in order to become more competitive. Logistics and SCM functions can either be performed from internal activities or outsourced to a third party logistics (3PL) service provider, via wholesale distribution, or in a combination. The following report will guide supply chain managers through these different key components in order to provide them with a global view of their supply chain KPI. The Aerospace sector is particularly characterized by manufacturers that not only construct aircrafts, integrated systems, engines, space vehicles and military vehicles, but who also provide maintenance and repair services. There has been a shift in this industry in the past years from a goods providing sector, to one that provides a complete package, including both services and goods. Companies in this sector are usually grouped in four tiers: Tier I primes (original equipment manufacturers, assemblers), Tier II system integrators, Tier III component suppliers and Tier IV parts suppliers; all part of the Aerospace Component and Parts manufacturing sub-sector. There is high concentration at Tier I and II levels (top five firms represent 70 percent 6 of production in Canada). Their main customers are aircraft assemblers, airlines (commercial) and government defence procurements (military). Key drivers are airline profitability, aircraft low operating costs, fleet commonality, long-term growth rate of passenger air traffic, fleet retirement cycles and economic growth. 7

Analysis is initiated by a general section on industry productivity and competitiveness indicators via logistics and SCM. This will be followed by specific sections on inventory management and Just-in-Time KPI, and a logistics and SCM cost KPI analysis that includes three types of logistics costs: internal, outsourced and inventory carrying costs. Finally, sector specific KPI, complete with methodology, calculations and definitions will be tabled in Annexes in order to provide details to help individual firms policy makers develop applicable benchmarking tools. I - Industry Productivity and Competitiveness via Logistics and SCM As competition becomes more global, innovation is moving from a firm-to-firm level to a supply chain versus supply chain perspective. In order to better respond to increased customer needs, Canadian Aerospace firms must develop supply chain agility in a JIT and mass customisation mode. Supply chain agility is an operational strategy focused on inducing velocity and flexibility in the supply chain. A supply chain is the process of moving goods from the customer order through the raw materials stage, supply, production, and distribution of products to the customer. The Aerospace sector has traditionally incorporated SixSigma measurement processes which are concentrated on product quality and not JIT lean manufacturing. SixSigma is a term used generally to indicate that a process is well controlled, i.e. tolerance limits are ±6 sigma (3.4 defects per million events) from the centerline in a control chart. However, although SixSigma continues to be a major driver, JIT lean manufacturing has lately integrated the set of key drivers for the industry as well. This enables Aerospace industries to increase their level of mass customization and decrease delivery times, while maintaining a high level of quality. The next figure shows KPI identified by Aerospace firms, as well as the average for the manufacturing sector. 8

80% 1-Identified Key Performance Indicators (KPIs) 5 Industry average Aerospace/defense 60% 40% 20% 0% On-time Delivery Inventory Turns Manufacturing Cycle Time Cost Per Unit Quality On-time delivery, a logistics and SCM JIT measure, is the most used KPI in the North American (NA) Aerospace and defence sector. The other two most important KPIs for the Aerospace/Defence sector are manufacturing cycle time and inventory turns. The largest difference between this sector and the Industry average is for manufacturing cycle times, where 56 percent of firms in the Aerospace/Defence sector identified this indicator as being in their top three (compared to only 37 percent in average for the whole industry) 5. Measurement of logistics and SCM KPI is an essential part of the agile supply chain concept. It is estimated that 37 percent of North American firms that have put in place logistics and SCM KPI corporate wide measurement achieved a decrease of at least 15 percent in shipment delays compared to only 7 percent of firms that did not measure those KPI consistently. NA firms that measured logistics and SCM KPI also outperformed their industry counterparts on document issues, a key component of Smart Border solutions in JIT, by a ratio of 3.5 times 1. 2-Performance Advantage from Logistics and SCM KPI Measurement 1 percent NA Firms Achieving > 15 percent improvement 40% 35% 30% 25% 20% 15% 10% 5% 0% Total landed cost Shipment Delays Documentation Issues Corporate wide measurement Measured locally Not measured consistently 9

In order to take advantage of logistics and SCM KPI measurement, supply chain managers must also take into factor their sector specific focus into their strategy. As an example, the Automotive sector focuses on JIT and continuous flow of product and information under the Lean principles. Retail and Consumer product goods (CPG) sectors concentrate on total delivered cost and in-store stock-outs ratios. The Pharmaceutical sector is pushing for item level traceability and supply chain visibility for governmental requirements and product recall issues, while the Aerospace sector emphasises total supply chain quality ratios such as Six Sigma processes and standards. The following figure shows the top factors driving a company to implement a Lean Strategy. The two key factors driving NA Aerospace/Defence firms to implement a Lean Strategy are related to logistics processes. A first difference between the NA Manufacturing industry average and the Aerospace/defence sector appears here. 80% 60% 40% 20% 0% 3-Key Factors Driving a Company to Implement a Lean Strategy 5 Pressure to improve operat ional performance Customers demanding shorter order cycle time Increase product quality (non logistics) Industry Average Aerospace/defense Although pressure to improve operational performance and shorter order cycle times were the top two drivers for the Aerospace sector, the largest difference between it and the Manufacturing industry in general was for the increase product quality driver, which a lot more firms in the Aerospace sector reported as being a top driver. This reflects the idea that the Aerospace sector is a lot more based on SixSigma processes than the industry as an average. However, although this is the case, the Aerospace sector also gives a lot of importance to JIT lean manufacturing, as is demonstrated by its top two drivers. 4-Top Strategic Actions Undertaken to Implement a Lean Strategy 5 100% 75% 50% 25% 0% Reduce non value added manufacturing and supply chain costs Reduce inventory and assets Improve manufacturing and supply chain flexibility Customer demand driven manufacturing Industry average Aerospace/defense Synchronize manufacturing and logistics processes to deliver on time and complete orders Looking now at the top three strategic actions undertaken to implement a JIT Lean strategy, the top three strategic actions identified by the NA Aerospace/Defence sector were reducing non value added manufacturing and supply chain costs, improving manufacturing and supply chain flexibility and reducing inventory and assets. Of particular interest here is the fact that 88 percent of firms in the Aerospace/defence sector identified reducing 10

non value added manufacturing and supply chain costs (compared to an average of only 64 percent for the whole industry) 5. The focus on reducing logistics and SCM costs is thus more important in Aerospace than in other sectors. The next figure shows the extent to which JIT Lean manufacturing techniques are used in the Aerospace/Defence sector. 80% 60% 40% 20% 0% 5-Company's Incorporation of Lean Manufacturing Techniques 5 Learning about Lean Lean production in manufacturing either planned or limited Industry average Aerospace/defense Fully engaged in Lean manufacturing and extending processes into supply chain Although 94 percent of firms in the NA Aerospace/Defence sector have either planned or engaged in JIT Lean in manufacturing (compared to only 70 percent on average for the whole Manufacturing industry), only 35 percent have developed extensive SCM and logistics processes with their supply chain partners 5. The following figure shows, for Canada, the percentage of firms that applied innovative processes, and of those innovative processes, what percentage was logistics related 7. 60% 6-Logistics and SCM Innovation in Canada for the Aerospace Sector 7 50% 40% 30% 20% 10% 0% Manufacturing Aerospace product and parts Transportation equipment (less Aerospace) Machinery manufacturing Manufacturing methods Logistics innovation Logistics innovation in innovative plants As this figure shows, the Aerospace sector has the largest percentage, amongst the selected sectors and the average of the industry, of innovative plants in manufacturing methods. However, in terms of logistics innovation they are average and in terms of logistics innovation in innovative plants they are below average. This indicates that logistics innovation has not yet taken full flight in this sector and that innovation in manufacturing methods is still very important. This may be explained by the focus on Six 11

Sigma quality control versus JIT lean mass customisation focus for other Manufacturing sectors in Canada. This trend may change in the near future. Large customers, such as the U.S. Department of Defence and final assemblers, are initiating logistics and SCM traceability mandates, such as Radio Frequency Identification (RFID) through their respective supply chain. This could impact dramatically the level of investment in logistics innovation and in productivity opportunity for the Canadian Aerospace sector. II - Inventory Management and Just-in-Time Key Performance Indicators Key to the success of an agile supply chain is the speed and flexibility with which these activities can be accomplished and the realization that customer needs and customer satisfaction are the very reasons for the network itself to exist. Achieving agility starts with the physical flow of parts, from the point of supply, through the factory, and shipment through agile distribution channels. The main logistics and SCM KPI to measure supply chain agility is inventory turns. Inventory turns can be defined as how many times a year the average inventory for a firm changes, or is sold. This ratio is a common industry standard KPI in inventory management performance analysis. This section will compare inventory turns for the Aerospace sector with the average for the Manufacturing industry, for both raw materials (the inventory of products coming from suppliers) and finished goods (the inventory of products ready to be expedited). Finally, a comparison between Canada and the U.S. will be done for the Aerospace sector. A. Raw materials inventory turns 25 7-Raw Materials Inventory Turns for Canada 8 Manufacturing Aerospace manufacturing Inventory turns per year 20 15 10 5 0 1992 1996 2000 2001 2005 On the raw materials side, the Aerospace sector has had an Inventory Turns per year ratio that is below that of the Manufacturing average since the early nineties. In 2004, the Inventory turns ratio for the Aerospace manufacturing sector was 38 percent lower than the average for the Manufacturing sector. However, in the past five years, the largest 12

difference was attained in 2001 (39 percent). The following figure shows growth for specific selected timeframes (selected in order to take into account the economic shock following 9/11) 8. The Aerospace sector, 8-Raw Materials Inventory Turns AAGR for Canada 8 as well as the Motor Vehicle manufacturing Motor vehicle AAGR 01'-05 and Manufacturing AAGR 00'-01' sector as a whole, had AAGR 96'-00' consistently had AAGR 92'-96' increasing raw materials inventory turns per year before Aerospace 2001. Before this year, the Aerospace had an average annual growth rate (AAGR) that was Manufacturing superior to both that of the Motor Vehicle manufacturing sector -10% -5% 0% 5% 10% 15% 20% and that of the manufacturing sector as an average. In 2001 raw materials inventory turns decreased for this sector and sub-sectors. The decrease was more pronounced in the Aerospace sector, where raw materials inventory turns decreased by 44 percent and 25 percent more than in the Motor vehicle sub-sector and the manufacturing sector respectively. However, after 2001, the Aerospace manufacturing sub-sector recovered with an increase of 4.12 percent in its raw materials inventory turns, following the average trend in the Manufacturing sector. The final figure on the raw materials side shows the overall growth for raw materials inventory turns for Canada between 1992 and 2005. Inventory turns 25 20 15 10 5 0 9-Overall Growth for Raw Materials Inventory Turns in Canada Between 1992 and 2005 8 Manufacturing Aerospace manufacturing 1992 2005 Total growth 100% 50% 0% Growth As this figure shows, the Aerospace sector had lower than average raw materials inventory turns, for both 1992 and 2005. However, this sector grew by 77 percent which translate into a growth that was almost 4 times lager than the average growth for manufacturing. 13

B. Finished goods inventory turns The following figure shows the evolution of inventory turns on the finished goods side. 35 10-Finished Goods Inventory Turns for Canada 8 Manufacturing Aerospace manufacturing Inventory turns per year 30 25 20 15 10 5 0 1992 1996 2000 2001 2005 During the last decade, finished goods inventory turns per year for the Aerospace manufacturing sector have consistently been below the manufacturing average. In 2005 the Aerospace sector had finished goods inventory turns per year that were 48 percent below the average for manufacturing. The following figure shows growth for specific selected timeframes (selected in order to take into account the economic shock following 9/11) 8. Previous to 2001, both the 11-Finished Goods Inventory Turns AAGR for Canada 8 Aerospace and Motor vehicle manufacturing subsectors, Motor vehicle as well as the Manufacturing sector, had an increasing finished goods inventory turns per Aerospace year ratio. However, in 2001 the Aerospace sector had a sharp decrease in its AAGR 01'-05 AAGR 00'-01' finished goods inventory Manufacturing AAGR 96'-00' turns ratio, falling from an AAGR 92'-96' average increase of 19.8-30% -20% -10% 0% 10% 20% 30% 40% 50% 60% percent between 1996 and 2000, to a decrease of 20.6 percent in 2001. In this case, the decrease was more pronounced in the Aerospace sub-sector than in the 14

manufacturing sector. However, after 2001 the increasing trend seems to be reestablished as the finished goods inventory turns per year ratio re-started to increase in the Aerospace sub-sector and in the average for the manufacturing sector. The final figure in this section shows the overall growth for finished goods inventory turns for Canada between 1992 and 2005. As this figure shows, the 12-Overall Growth for Finished Goods Inventory Turns in Canada Between 1992 and 2005 situation on the finished 8 30 60% goods side is similar to that on the raw materials one. 40% 15 The Aerospace sector had 20% finished goods inventory turns that were below those 0 0% of the manufacturing Manufacturing Aerospace manufacturing average for both 1992 and 1992 2005 Total growth 2005. However, the overall growth in the Aerospace sector was 58 percent, translating into a growth that was 2.4 times larger than that of the manufacturing average. Inventory turns C. Canada/U.S. comparison Finally, it is interesting to compare the situation in Canada to that in the U.S. However, in order to do so, total inventory over sales must be taken instead of either raw or finished goods inventory turns ratios. This is because the data for finished and raw materials in not published in the U.S. at the needed level. Total inventory includes work in process inventory in the Manufacturing plant, which is not a common item used in logistics and SCM KPI. The following figure shows the time trend for total inventory over sales for both Canada and the U.S. in the Aerospace sector. Growth 4 13-Total Inventory Over Sales for Canada and the U.S. in the Aerospace Sector 3 Total inventory/sales 3 2 1 0 Canada 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 U.S. 15

Although at first glance the total inventory over sales ratio may seem to be countercyclical between the U.S. and Canada, a closer look at the scale shows that in fact this ratio seems to be quite stable for both countries since the early nineties. Looking at the following figure shows that variation in the total inventory over sales ratio was not very pronounced over the specified timeframe, keeping to the +20, -20 percent band. 60% 14-Total Inventory Over Sales Yearly Growth for Canada and the U.S. in the Aerospace Sector 3 Canada U.S. Yearly growth 40% 20% 0% -20% 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004-40% However, there was one exception for Canada in 2002 when the growth in total inventory over sales ratio was more than 40 percent. D. Benefits of indicators to productivity and competitiveness Technology and best practices are important factors in inventory management. It is clear that logistics and SCM technology-enabled companies in North America achieved higher improvement rates than other firms, as displayed in Figure 15. The concept of high technology/process adopters vs. low technology/process adopters is used to explain the difference between NA companies having better than average technologies and bestpractices, and their opposites. Figure 15 displays the percentage of NA respondents that achieved a greater than ten percent improvement in three logistics and SCM KPIs, namely: increase in the perfect order percentage to the customers; reduction in inventory carrying cost; and reduction in lead times to the customers. This figure shows that companies that use best practices in inventory management technology and processes in their industry achieved significantly better JIT KPI results than their peers 9. 16

15- High Technology Adopters Achieve Better Results in Inventory Management 9 60% % of Respondents 40% 20% 0% Increased Perfect Order % to Customers Reduced Inventory Carrying Cost Reduced Lead Times to Customers High Technology Adopters Industry Norm Low Technology Adopters In terms of success to implement JIT Lean manufacturing, 71 percent of NA Aerospace and Defence firms experienced a reduction in supply chain costs as expected, compared to only 51 percent in average for the whole Industry 5. III - Logistics and SCM cost KPI analysis While inventory turns is the main KPI for evaluating supply chain agility, logistics cost KPI allow firms to evaluate the efficiency of their logistics and SCM operations. The combination of supply chain agility and efficient SCM practices is key to the long term competitiveness and prosperity of Canadian firms in the emerging GSC context. Logistics costs occur internally within firms, are outsourced to logistics service providers and occur via inventory carrying costs. The sum of these three components will enable firms to evaluate their sector total costs and benchmark themselves against their own industry, their U.S. counterparts and other key sectors that share similar logistics and SCM processes. The mix of internal, outsourced and inventory carrying costs will also allow firms to evaluate their own logistics and SCM cost structure while enabling them to rethink their business model, if deemed necessary. This section presents logistic costs in the Aerospace Products and Parts manufacturing sub-sector for Canada, compared to Motor vehicle manufacturing and industry averages. E. Logistics Internal costs Internal SCM and logistics costs encompass all logistics activities that occur within a firm. It excludes all outsourced logistics activities and all production processes. Comparisons between Canada and the U.S. were done in constant Canadian based factor: by bringing the U.S. economy to a comparable level with Canada, which meant 17

downsizing the U.S. economy so that when comparing both countries, it is done for two economies of similar size. The following figure shows internal logistics costs. 8% 6% 4% 2% 0% 16-Internal Logistics Costs for the Aerospace Products and Parts Manufacturing in Canada 10 % of Gross output % of GDP Manufacturing Motor vehicle manufacturing Aerospace products and parts manufacturing As percentage of GDP, internal logistics costs for the Aerospace Products and Parts manufacturing sub-sector are lower than for the Manufacturing Sector as a whole (with a difference of 45 percent). However, the Aerospace products and parts manufacturing sector had logistics internal costs, as percentage of GDP, that are higher than those for the Motor Vehicle manufacturing sector (59 percent difference) 10. As percentage of gross output, internal logistics costs for the Aerospace Products and Parts manufacturing sub-sector are lower than both, the average for the Manufacturing industry and for the Motor Vehicle manufacturing sector (with a difference of 30 percent and 2.5 percent respectively) 10. F. Logistics Outsourcing costs Logistics outsourcing costs encompass activities assigned to a logistics service provider. Using the purchases that originate from the users (such as Manufacturing) as part of logistics activities is appropriate, instead of using the sales, because it avoids multiple counting. The next figure will show logistic outsourcing costs for the Aerospace Products and Parts manufacturing sub-sector, comparing it to sector and industry averages and showing the percentage of outsourcing logistics costs that are specifically related to storage and warehousing. 18

Outsourcing share 17-Logistics Outsourcing and Storage and Warehousing Shares for Aerospace Product and Parts Manufacturing in Canada 11 2.0% 6% 1.5% 5% 4% 1.0% 3% 0.5% 2% 1% 0.0% 0% Manufacturing Motor vehicle manufacturing Aerospace product manufacturing Outsourcing as % of total commodities Storage and warehousing as % of Logistics outsourcing Storage and warehousing share With respect to logistics outsourcing, the Aerospace Product and Parts manufacturing sub-sector has lower costs than both the Manufacturing industry and the Motor Vehicle Manufacturing sector (68 and 56 percent lower, respectively). However, when looking at storage and warehousing costs as a share of logistics outsourcing costs, the Aerospace sub-sector is below the Manufacturing average (71 percent difference), but has larger storage and warehousing costs than the Motor vehicle manufacturing sector (92 percent difference) 11. G. Inventory carrying costs Inventory carrying costs are defined as a series of costs that compose a company s supply chain management costs. They include opportunity costs, shrinkage, insurance and taxes, total obsolescence (for raw materials, work in process (WIP), and finished good inventory), channel obsolescence and field service parts obsolescence. It excludes all distribution cost related to warehousing, which are captured in the internal and outsourced logistics costs. However, it is important to keep in mind that inventory carrying costs cannot be used to compare the size of the economic activity of a sector since it mainly represents accounting based costs, therefore it should not be calculated in percentage of sector GDP. 19

The next figure looks at the last component of costs, the inventory carrying cost. 18-Inventory Carrying Cost as % of Sales for Canada in 2002 10 4% % of sales % of sales 3% 2% 1% 0% Manufacturing Aerospace products and parts Motor vehicle manufacturing. As the previous figure shows, the Aerospace sector has inventory carrying costs as percentage of sales that are higher than the industry average and the Motor vehicle manufacturing sub-sector. In terms of percentages, the Aerospace sector has inventory carrying costs that are 2 and 5 times higher than in the manufacturing industry and the Motor vehicle Manufacturing sector respectively. When compared with data for inventory turns, this shows that sectors that are adopting JIT processes with high inventory turns, such as the Motor vehicle manufacturing sector, have significantly lower inventory carrying cost compared to total Manufacturing and Aerospace. H. Logistics costs aggregates The following figure looks at the overall composition of logistics costs for the Aerospace manufacturing sector in Canada, and compares it to other selected sectors. 100% 19-Total Logistics Costs for Canada in the Aerospace and Selected Sectors in 2002 10 75% 50% 25% 0% Manufacturing Aerospace products and parts Motor vehicle Internal costs Outsourcing Inventory carrying cost Beverage manufacturing 20

As can be seen in the previous figure, the Aerospace sector has a logistics costs distribution that is particular, in the sense that it is different, not only from the average logistics costs distribution for Manufacturing, but also from various selected sub-sectors. The first difference is that there is a lot less logistics outsourcing in the Aerospace sector. For instance, the Motor Vehicle, and the Beverage Product manufacturing sectors outsource, respectively, 5 times more than the Aerospace sector in terms of internal logistics costs expressed as percentages of total logistics costs. This may be due the nature of the Aerospace sector, where higher quality requirements and intellectual property rights may render the outsourcing of various processes more difficult than in other sectors. The second difference is that the Aerospace sector has larger inventory carrying costs than the manufacturing average and that all of the sectors that were chosen for comparison. As an example, the Aerospace sector has inventory carrying costs that are 2 and 3 times higher than that of the Motor Vehicle, and Beverage manufacturing sectors respectively, in terms of logistics outsourcing costs as percentage of total logistics cots. This can be explained by the differences in the core characteristics of the production process in these sub-sectors. First, the Aerospace production process is much longer than that of the other two sectors chosen here for comparison. This, added to the fact that it is a highly integrated sector, explains in part the high inventory carrying cost. Another part of the explanation is that Aerospace manufacturing deals with very high tech components, which may need special condition when left in inventory. Finally, the next figure shows the composition of total logistics costs as percentage of sales. 8% 20-Total Logistics Costs as % of sales for Canada in Aerospace Manufacturing Inventory carrying cost and Selected Sectors 11 Outsourcing Internal costs 6% % of sales 4% 2% 0% Manufacturing Aerospace products and parts Motor vehicle In terms of costs as percentages of sales, the Aerospace sector had logistics internal costs that were similar to that of the manufacturing average, but much larger than that of the motor vehicle manufacturing sector. 21

On the logistics outsourcing side, the Aerospace sector has logistics outsourcing costs that are below both the manufacturing average and the percentage for the motor vehicle manufacturing sector. Finally, the Aerospace manufacturing sector has inventory carrying costs that are larger than both the average for manufacturing and the percentage for the motor vehicle manufacturing sector. IV - Final remarks In order to benefit from the productivity of logistics and SCM, individual firms must develop their own personal action plan. The final step in a business case is to make recommendations and develop a roadmap for implementing the proposed action plan. The roadmap exercise consists of documenting the long-term perspective into specific action items linked to deliverables, performance indicators objectives, return on investment and a project time frame. For some firms, the first roadmap action item could be an internal evaluation of their logistics KPI with some participation in associations and networking activities. For others, it could be implementing a pilot project with a customer and a supplier. In all cases, a well-documented roadmap allows firms to gain the support of all their stakeholders for their logistics and SCM competitiveness strategy and to solicit their involvement in the implementation phases of the firm s logistics and SCM action plan. Proposed Action Plan: 1- Evaluate internal firm logistics and SCM KPI based on the indicators listed in this document. 2- Map out business processes, global supply chain and technology adoption. 3- Benchmark your firm s KPI to your industry KPI in Canada and in the U.S.. 4- Assess firm s performance KPI to industry taking into consideration supply chain processes. 5- Benchmark firm s KPI to other industries KPI in Canada and in the U.S. that share the same logistics and SCM processes and drivers. 6- Create a multi-function project team. Senior management buy-in could determine the success rate of this initiative, as will a champion at the initial stage. 7- Develop a logistics and SCM competitiveness roadmap. 8- Develop performance measurements of the roadmap initiatives. 9- Educate your company executives across departments, supply chain partners and service providers on the value of the roadmap for each specific stakeholder. 10- Increase supply chain collaboration initiatives that drive value in your specific sector. 11- Partner with supply chain partners to develop with you the technology, processes and information solutions needed to manage the process. 12- Implement KPI program with frequent use of measures focused on cost-effective customer-driven satisfaction issues with supply chain partners. 22

Annex I: Methodology SCM & Logistics Costs Methodology Every company measures its costs related to marketing, human resources, research and development, etc. Interestingly, very few know how much their logistics costs really are. The last decade saw a growth in interest for concepts such as JIT, Lean manufacturing and Efficient Consumer Response, all of which, in addition with the globalization of the supply chains, brought the importance of Logistics and Supply Chain Management (SCM) from an operational status, often to a strategic status for the company and its partners. It is for this reason that Supply Chain & Logistics Canada s (SCL) Research Committee and Industry Canada have partnered with Jacobson Consulting to launch a logistics cost methodology research initiative. By combining the industry know-how of SCL with the supply chain research experience of Industry Canada and the economical modeling specific expertise of Paul Jacobson, a former director at Infometrica, the partners have developed an optimal research team for this initiative. One of the main sources of logistics costs data available until now is the Annual State of Logistics Report, published in the U.S., which is sponsored by the Council of Supply Chain Management Professionals (CSCMP). This report provides annual data on the cost of the U.S. business logistics system in relation to their Gross Domestic Product (GDP). The data provided goes back to 1984 and is mainly available on a macro level, with categories available such as Inventory Carrying Costs, Transportation Costs and Administrative Costs, but does not look at the sector-level data. It is important for a company to understand the nature and the costs of its logistics and SCM operations. Furthermore, companies should be able to access that type of information on each industrial sector for comparison purposes. Comparing the information to GDP is essential to understanding the importance of logistics on a given sector, while comparing the information to the Gross margin allows companies to benchmark their logistics and SCM costs to their sector, their partners and their competitors. Gross margin = total operating revenue - cost of goods sold Total operating revenue = sales of goods purchased for resale + commission revenue + sales of goods produced + repair and maintenance revenue + revenue from rental and leasing + other operating revenue. Cost of goods sold = Opening inventory + Purchases - Closing inventory. Here, the research initiative will focus on providing sector level information of logistics and SCM costs that occur internally through firms (such as in the manufacturing, wholesale and retail sectors), as well as evaluating supply chain s functions that are outsourced by sectors, and their relative inventory carrying costs. By combining these three categories, individual firms will have the opportunity to have a global view of supply chain management costs by sectors and of the outsourcing trends, thus allowing them to benchmark themselves to their competitors, partners and other sectors in Canada and in the U.S.. 23

SCM and logistics costs can be broken down in three separate, but complementary pieces: internal costs, outsourcing costs and inventory carrying costs. Each one is described below, with its methodology and an example when appropriate. Internal SCM and logistics costs: Internal SCM and logistics cost encompass all logistics activities that occur within a firm, such as a manufacturer, wholesaler or retailer. It excludes all outsourced logistics activities and all production process. Individual firms can evaluate their internal logistics cost by adding their respective logistics cost activities and their components as stated in the table below. Internal logistics cost activities Inbound and outbound transportation Transportation management Warehousing Materials handling Order fulfillment Logistics network design Inventory management Supply/demand planning Management of third party logistics services providers Custom brokerage Logistics and SCM technology management Sourcing and procurement processes (excluding purchase of goods cost) Internal logistics cost components of activities Logistics wages cost Logistics infrastructure depreciation Logistics technology investment depreciation Transport equipment depreciation Training cost related to logistics position Logistics management cost Internal SCM and logistics costs are the most complex to calculate since no organization accounts for these. The estimates of internal logistics costs in this report were compiled via the following methodology: 1- Determine the occupational types related to logistics, and link those to logistical activities. In total, twenty-one occupations were found and assigned to one of the four logistics activities namely: Distribution Centers (DC), Office work, Truck transportation and Other transportation (rail, etc.). For example, material handlers are linked to DC activities, while customs & ships brokers and industrial engineering and manufacturing are part of office related activities. 2- Find for each industrial sub sector the number or persons in each occupational sub category. There are sixty sub sectors in manufacturing, thirty in wholesale and thirty in retail. 3- Find the logistics suppliers equivalent to the four logistics activities from above. For example, under Office work were included the consulting services and support to transportation and warehousing personnel. 4- Calculate the wage bill of the four logistics activities after occupations were linked to them. The ratio of the total costs divided by the wage bill is then charged to the sixty sub sectors in manufacturing, to the thirty sub sectors in wholesale and to the thirty sub sectors in retail. For example, for each dollar spent in salaries, it is known that in average 2$ are spent on infrastructures, technologies and management costs. All this allows the estimation of the logistics and SCM costs for each industrial sub sector. Outsourcing costs: Outsourcing costs encompass activities assigned to a third-party. Outsourcing costs come from input-output tables from Statistics Canada that indicate how much each industry requires of the production of each other industry in order to produce each dollar of its own output by compiling the purchases of logistics services by users. 24

Using the purchases that originate as part of logistics activities is appropriate, instead of using the sales, because it avoids multiple counting. Example A manufacturing firm writes a check for $10 million to a 3PL to assume all its distribution activities for the current year. That 3PL does not actually own trucks, and hire a transportation broker to actually contract the required vehicles as necessary, for that same amount. The transportation broker will sign multiple deals during that year with transportation companies, again totaling $10 million. By looking at the sales figures in the input-output tables, the logistics activity in that scenario would now total $30 million. Utilizing instead the purchases of logistics services allows isolating the real logistics activity, which is indeed $10 million. An example of the activities that are outsourced and/or done inside a company is displayed in the chart below. In-House and Outsourced Supply Chain Activities in Canada 12 Customs Clearance 4PL Services Customs Brokerage Freight Forwarding Factoring Inbound Transportation Fleet Management Cross Checking Outbound Transportation Freight Bill Reverse Logistics Shipment Consolidation Supply Chain Management Distribution Control Procurement of Logistics Services Inventory Ownership Carrier Selection Warehousing Rate Negotiation Information Technology Order Fulfillment Order Entry Processing Customer Service Inventory Management Outsourced In-House 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% As can be seen, outsourcing differs largely according to the type of activity. Certain activities are largely outsourced, such as Customs Clearance or Customs Brokerage, and others are mainly done in-house, such as Inventory Management and Customer Service. 25

Inventory Carrying Cost: Lexi-Com s Glossary of Logistics Terms defines inventory carrying cost as follows. One of the elements comprising a company s total supply chain-management costs. These costs consist of the following : 1) Opportunity Cost : The opportunity costs of holding inventory. This should be based on your company`s own cost of capital standards using the following formula. Calculation : Cost of Capital x Average Net Value of Inventory 2) Shrinkage : The costs associated with breakage, pilferage, and deterioration of inventories. Usually pertains to the loss of material through handling damage, theft, or neglect. 3) Insurance and Taxes : The cost of insuring inventories and taxes associated with the holding of inventory. 4) Total Obsolescence for Raw Material, WIP, and Finished Goods Inventory : Inventory reserves taken due to obsolescence and scrap and includes products exceeding the shelf life, i.e. spoils and is no good for use in its original purpose (do not include reserves taken for Field Service Parts). 5) Channel Obsolescence: Aging allowances paid to channel partners, provisions for buy-back agreements, etc. Includes all material that goes obsolete while in a distribution channel. Usually, a distributor will demand a refund on material that goes bad (shelf life) or is no longer needed because of changing needs. 6) Field Service Parts Obsolescence : Reserves taken due to obsolescence and scrap. Field Service Parts are those inventory kept at location outside the four walls of the manufacturing plant i.e., distribution center or warehouse. What inventory carrying costs do not consist of : - all the necessary handling of the goods and/or materials, - the depreciation of the goods and/or materials. Those are actually already included in the internal logistics costs above. Inventory Carrying Cost Rate: The inventory carrying cost rate is applied on the average annual inventory in order to estimate the cost of having inventory into a specific firm or industry. The average industry accepted and used rate is estimated at 20 percent 13. TOTAL SCM & LOGISTICS COSTS = INTERNAL COSTS + OUTSOURCING COSTS + INVENTORY CARRYING COSTS Inventory carrying costs and outsourcing costs cannot be put in terms of GDP, since they are accounting-based, and not a real economic activity. Both are compared to gross margins. On the other hand, internal costs can be compared both to GDP and to gross margin. Logistics and SCM costs vary widely by sector. The proportion of internal costs, outsourcing costs and inventory carrying costs is also different between sectors. For example, in a JIT mode, internal costs tend to increase, but this is balanced by a reduction in the inventory carrying costs; this happens in volatile sectors, such as upscale clothing, computers and perishable goods. 26