Axing the Hockey Stick

John La Bouff, Senior Manager, Deloitte Consulting LLP

Consider the revenue "hockey stick." Unfortunately, it has been widely accepted as a way of doing business, and many businesspeople go to ridiculous lengths as the end of each quarter approaches to find a way—any way—to ship promised revenue. It's not unheard of to ship a third or more of a quarter's total revenue in the last two or three weeks. Sadly, although executives typically understand the grim realities of demand uncertainty, many still insist on driving to short-term financial results that are disconnected from the realities of their markets and their customers. The hockey stick may be a part of the conventional wisdom, but it's time executives come to recognize its negative impact on internal operations and their organization's long-term performance. It's time for a new wisdom.

The Laws of Linearity

When it comes to the customer-supplier relationship, some accepted views of "linearity" have become ingrained. These hold that: linearity is a measure of how steady-state your internal operations run; such a steady operating rate is good, regardless of customer product consumption; and your customers are on the hook to help you achieve this kind of linearity. These views would be fine except: it's not; it's not; and they're not.

Instead, here are some—perhaps heretical—revised "laws of linearity" that you should consider when planning your performance strategy.

• The First Law of Linearity: Your linearity is the degree to which product delivery exactly matches customer product consumption. As in analog electronics, linear means a proportional response, not a flat line. Your customers' product usage can be steady from day to day, or it can be a wild wiggle—it doesn't matter.
• The Second Law of Linearity: If you want to improve linearity, operations need to be aligned with customer product consumption as precisely as possible.
• The Third Law of Linearity: Stability, which reflects how steadily you can run operations, depends on your customers' linearities, their customers' linearities and so on.

Meeting the Numbers at Any Price

Following the hockey stick approach—essentially anything you do to "meet your numbers" when linearity says the natural outcome is otherwise—tends to make things worse in the long haul.

For example, say you planned and publicly announced to sell $13 million in product this quarter, and now stockholders and analysts are waiting in ambush. Meanwhile, the people you sell to aren't helping you meet your numbers. With two weeks to go in the quarter, you're only at $9 million. At this late stage, if you're to nail it, you have to figure out how to take what was to have been a $1 million a week run rate and double it.

At this point, you possibly don't care why you are not tracking to projections in the first place. The sole remaining objective—in this example—is to hit your numbers. Essentially, your position is that as long as you can nail your announced target by pushing your goods across the financial line between you and your customers, it doesn't matter what happens with these goods on the other side.

Figure 1. The Hockey Stick: Costs of Institutionalized Nonlinearity

Shipments ahead of consumption force customers to incur costs of holding inventory. Compensating monetary considerations (in reduced ASP) are required to make this an attractive proposition to the customer, which in turn amplifies the supply chain effort required—target revenue now requires even more units in a short span of time.

But, it does matter. In the long run, what happens to your products when they leave your warehouse matters more than almost anything else. As we examine why, let's agree on some working assumptions:

• Your customers can do basic math.
• Your customers try to operate their concerns in response to their customers' demands.
• Whatever your customers are doing to position you against your competitors, the competitors feel the effects just as much.
• If your customers have inventory, then they have more choices than when they actually need your product to keep their lines going.

Whatever you sell or ship beyond your customers' actual product usage accumulates over time. When facing their own customers, your customers' realities do not change as a result of the excess stock you manage to push to them. If they bought something from you that they didn't need right away, then you must assume they won't sell it to their customers any faster than they were prior to the sell.

So, let's say you were successful in grabbing those last-minute sales to meet your quarterly numbers. Congratulations on an illusory victory; you may feel you have won a battle, but perhaps you have lost ground in the war. If you've pushed more inventory over to your customers than they actually need, then your problems have only started.

For one thing, your customers have moved cash, which earns interest, into inventory, which doesn't (and, of course, costs money to own). It's also a zero-sum game; your asset picture improved in the opposite direction. And everybody knows what happened; both you and your customers can calculate how much interest and holding cost benefit was transferred to your side.

So what did you give up to get what you needed? Your math-savvy customers would not have agreed to a last-minute buy without some compensating financial concession. You probably capitulated on pricing. Most likely, you accelerated your forward-pricing roadmap to give them next quarter's pricing early.

What kind of dollars are we talking about here? Well, when only looking at weighted average cost of capital (WACC)—usually around 12–15 percent—and ignoring other holding costs, let's say you moved an extra $1 million into your customers' warehouses that they will let sit for an extra three weeks. At 15 percent WACC, they incurred a cash expense of almost $9,000; and your premature access to revenue earned you similar interest income. Your quid pro quo was probably to knock down your prices by nearly 2 percent. In fact, considering that holding costs are substantially higher than WACC, it's probably a fair bit worse than that. Your margins took a whack they probably didn't need. Worse, you also accelerated the forward erosion for coming quarters.

And now, because it took more units to meet the revenue number at the reduced price, you further amplified the quarter-end fire drill in your factories and warehouses. Additionally, you blinded yourself as the next quarter begins. Your customers' demands may be keeping pace, slowing or accelerating, but you'll have no idea what's happening until they burn through the inventory you essentially paid them to take.

You don't know what your customers' actual demands are, so your production is now even more based on speculation rather than triggered by actual pull signals from your customers. Since you don't have the surge capacity to wait, you have to keep your lines running to support next quarter's projection. You may build the right stuff, you may not. Welcome to next quarter's hockey stick—you created it.

The Fourth Law of Linearity: Linearity is Cumulative

When you take the long view of your customer relationships, it should become instantly clear that, over time, your customers will not cumulatively buy more than they use. Therefore, the short-term manipulation done to dress up your numbers only degrades long-term performance. The hockey stick will never be a true friend.

If you begin the quarter with inventories in equilibrium (pacing your customers' consumption in a way their natural operating models require for reasonable operation), then you're going to be in good shape. If you're either above or below that level, then you're exposed to misleading signals from your customers.

Pushing inventory is certainly bad for you, but what does it mean for your customers? Some make the argument that your customers benefit from sitting back and letting you do this, and are in fact encouraging it. Perhaps that's true, but the net effect of the hockey stick mentality is to exacerbate both oversupply and shortage events in the supply chain. The presence of “push” inventory in the supply chain amplifies the bullwhip effect, increases the tie up of overall working capital, and degrades the financial health and operating performance of all participants. Whether your customers exhibit this behavior or not, it remains true that it's in their long-term best interests to promote linearity throughout the supply chain.

It's traditional to bewail your customers' role in this relationship, as if they're gaming you rather than the other way around. It is, of course, true that they have played along—but only because you made it attractive. The dynamics of your relationship have been based on fiction that was introduced in previous quarters, and now that fiction is going to have to be excised. Turning this around is going to involve some discomfort on both sides, as does any change in the dynamics of an important relationship. You're going to have a tough quarter, and maybe more than one.

Axing the Hockey Stick

It is possible to kill your hockey stick, and companies have done it successfully. It can be grueling, but the benefits are plainly evident. You can:

• Free up large sums of working capital while writing down less inventory.
• Mitigate price erosion and put extra support under your margins.
• Operate your supply chain with more clarity and finally be able to implement pull methods that simplify the process.
• Improve performance to match your customers' needs and all the while provide more reliable information to your own suppliers.

The basic model for working your way out of the hockey stick quagmire is simple, but admittedly hard:

• Engage your customers. When you are trying to change the game, you have to articulate to your customers clearly and tenaciously how you propose to improve the value proposition from their perspective, not degrade it. If necessary, you have to help them do their own metrics on: the effect the status quo is having on their working capital and holding costs, impacts on warehouse and factory performance from unnecessary stock fluctuations, and the cost of non-value-added activities that transpire between you and them.
• Address the addiction within. Somewhere in the C-suite is the mindset that, once established, expectations must be met or beat. One of the most frequent byproducts of this is the “top down forecast”: when the normal demand planning process fails to roll up to a suitable number, the mandate comes from on high to find a place to put the subtract answer. This can occur at any time, but gets progressively more manic and unrealistic as quarter end looms. There is no getting around this—fixing the hockey stick means letting demand speak for itself.
• Save yourself from yourself. Implement consignment or vendor-managed inventory (VMI) programs with your customers so you know you're getting your demand signals from their factory floors. Implement internal processes around optimizing the supply chain to support the pull behavior, not the “build this now because we may need to build that later” mentality. Aggressively pursue cycle time reduction and product postponement/rationalization so you are better positioned to execute just-in-time. Get ruthless about inventory.
• Become the model of consistency. Present a stable face to your customers so their behavior towards you, over time, is based on firm expectations. If the best lead times your operating model can support are four weeks or longer, then don't send a mixed message by moving them in or out constantly. Make sure your external face matches your true capabilities, and hold the line.

Let's get back to the laws of linearity. It's possible that your customers have some of the same pernicious behaviors you had and still have their own hockey sticks to deal with. That is likely to cause you nothing but grief because their demand streams won't be any more accurate than your wayward hockey stick methodology was. Your suppliers, too, may be pressing you from the other side. In both cases, however, the new laws of linearity maintain that the best possible outcome is to operate in synch with actual product consumption at the very end—the point of use—of your supply chain. Anything else results in cumulative error that piles up, to the detriment of all, in the chain. The only long-term remedy is to socialize the new tenets of linearity up and down the supply chain, and share information and techniques with a win-win attitude approach among all partners.

About the Author

John La Bouff is a 30-year veteran of the semiconductor industry, and was among the first to develop supply chain practices and systems designed around the fabless model. John is now a senior manager in Deloitte Consulting LLP's Silicon Valley practice, where he focuses on operational performance and product development improvement for semiconductor companies. You can reach John La Bouff at jlabouff@deloitte.com or 650-450-6056.

This article contains general information only and is based on the experiences and research of Deloitte practitioners. Deloitte is not, by means of this article, rendering business, financial, investment, or other professional advice or services. This article is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte, its affiliates and related entities shall not be responsible for any loss sustained by any person who relies on this article.

As used in this article, "Deloitte" means Deloitte Consulting LLP, a subsidiary of Deloitte LLP. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries.

Back to Articles Home