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Increasing the Value of Your Enterprise Through Improved Supply Chain Decisions Part 2: Financial Metrics

Written By: Mark Wells
Published On: November 12 2002

Financial Metrics that Equate to Corporate Performance

Corporate performance has been defined in numerous ways. Economic Value Added (EVA®), Economic Profit, Owners Earnings, Residual Income, and Economic Value Management are .are intended as comprehensive evaluations of corporate performance. Other measures such as return on investment (ROI) and earnings per share (EPS) can leave out the cost of the capital required to achieve the return or earnings. Economic Value Added illustrates a measure of comprehensive corporate performance that is determined by the combination of financial metrics shown in red in Figure 3. (For an alternative example, see the Appendix.)

Figure 3.


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In its simplest form, the formula for EVA® can be reduced as follows1:

EVA = Return on Net Assets (RONA) less Weighted Average Cost of Capital (WACC)

where

RONA =
Net Operating Profit after Tax (NOPAT)

Net Assets
 
NOPAT =
Net Sales less Operating Expenses and Taxes
 
Net Assets =
Cash, Working Capital and Fixed Assets
or
Total Assets less Current Liabilities and Financial Assets

and

WACC = E/V x Re + D/V x Rd x (1-Tc)2

Where:

Re = cost of equity
Rd = cost of debt
E = the market value of the firm's equity
D = the market value of the firm's debt
V = E + D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = the corporate tax rate

The numerator for RONA is profit, so RONA is heavily influenced by revenue and costs. Therefore, managing both revenue and costs is critical to overall performance. Taking a very simplistic point of view, total costs include both Cost of Goods Sold (COGS = the costs of inputs, adding value through the transformation process, and delivering the product/service bundle) and Sales, General and Administrative (SG&A) costs.

The Weighted Average Cost of Capital reduces to summing the product of the cost3 of each capital component and the proportion of total capital that each component comprises. WACC has two impacts. The first is to the income statement and cash flow. For example, interest on loans that provide money to purchase inventory has to be paid. The second impact relates to the balance sheet. Since invested capital comes from banks, bonds, and the equity market, having too much capital tied up in inventory may mean that a company must raise additional capital and pay a higher price for that capital or forego new investments or enhancements to operations.

This is Part Two of a three-part article.

Part One discussed the Supply Chain in terms of corporate objectives.

Part Three will cover how Supply Chain Decisions Create Supply Chain Capabilities.

1 O'Byrne, Stephen F. and Young, S. David, EVA And Value Based Management (McGraw-Hill, 2001) pp. 34 46.

2 http://www.investopedia.com/terms/w/wacc.asp

3 Costs for debt are relatively easy to identify. The cost of equity is more challenging and can only be estimated based on the return demanded by investors.

Supply Chain Capabilities Drive Financial Metrics

If the key financial metrics for creating corporate value relate to costs, capital charges and consumption, and profitability, then the corporate capabilities or competencies required to drive those metrics must include controlling supply chain costs, managing supply chain cycle time, and optimizing responsiveness to the marketplace (Red boxes in Figure 4). These capabilities are developed through decision processes that are competent in the areas of inventory and supply chain flexibility. In addition (and in contrast) to the linkages from supply chain capabilities to financial metrics, decisions that optimize inventory are directly linked to the effect of financial leverage on EVA®.

Figure 4.


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Supply Chain Capability #1 - Reduce Supply Chain Costs

Companies incur supply chain costs in the course of conducting the three main operating activities—procurement, transformation and delivery. As previously noted, these activities may involve not only materials, but also services and data or information. As information technology has advanced, the transformation and, in particular, the delivery of information have blurred the traditional demarcation between the acquisition of orders and the fulfillment of orders. For example, committing to orders might once have been clearly a marketing or sales activity. However, information technology now empowers the ability to commit to a customer order in real time, at any time during the day, considering not only on-hand inventory, but also real production capability so that the activity of acquiring the order and the activity of fulfilling the order are becoming more closely coupled.

Many supply chain costs are not obvious. In spite of their subtlety, these costs can have a dramatic effect on the bottom line. In addition, standard accounting practices often do not capture these costs in a manner that would allow them to be classified with respect to the value that they add. This has given rise in recent years to an interest in "activity-based costing".

Some of these costs include expediting costs such as premium freight or charges levied by your suppliers when they have to perform an emergency schedule change and incur an additional setup, all because your requirements have changed. Costs of poor quality have been well documented by Juran, Deming, Crosby, and others4. The costs of a poor schedule that incurs too many setups may not be so obvious. Another subtle set of costs includes the costs to carry inventory. While the theory is sound and widely acknowledged, it is a class of costs that are typically captured under other categories. All of the incremental charges you pay to store, move, insure and pay taxes on inventory that isn't selling are part of your supply chain costs. The financing charges are part of the weighted average cost of capital that is affected directly by inventory decisions.

Supply Chain Capability #2 -Optimizing Operational Cycle Time

For this discussion, the term cycle time denotes the total time elapsed from the time an order is received until the customer can be invoiced or charged. In the case of post-sale service, cycle time refers to the time from the identification of a need for the service until the completion of the service. Cycle time can be decomposed into its components, including procurement, manufacturing, packaging, distribution, and service.

Optimizing cycle time is the right way to think about this subject, rather than minimizing cycle time. You optimize cycle time by gaining insight into the tradeoffs between economy of scale and rapid schedule changes. This tradeoff is often most dramatic in manufacturing, but it is also relevant to procurement, warehousing, and transportation. Some actions reduce cycle time, but decrease economy of scale. More frequent machine setups can yield this result. But if the cost and time required for a setup are reduced, then the negative impact on economy of scale can be negligible.

Consider another example. Developing the ability to plan multiple less-than-truckload (LTL) shipments together into an integrated TL with a smart route and reverse loading creates some economies of scale, but also has the potential to increase delivery cycle time.

Visibility into your customers' requirements, and providing visibility into your requirements for your suppliers will help to reduce cycle time. For example, if your customer changes an order at the last minute, there is a high probability that some days, perhaps even a week or more, passes before you know that such a change is happening. During this time, you could be planning the best way to accommodate this change (or even a potential change) while meeting all of your other requirements and managing cost. However, as time continues to pass, the cumulative effect of the decisions you make based on the fallacious assumption that your customer's requirements are not changing increases the risk to your operational effectiveness and efficiency, should you have to adjust suddenly to a change in requirements. This latency in awareness equates to a risk to operations and exists in direct inverse proportion to the visibility that you have into your customer's requirements. Opaque barriers to such visibility may mean that you need to stop production on one product, store the converted and unconverted inventory as work-in-process (WIP), possibly in outside storage, and complete a setup for another product. Shipping schedules may have to change. Slotting and staging activities in the warehouse may be disrupted. You may even have to negotiate with your suppliers to do the same, particularly, if they don't have visibility into your plans.

Information is a partial surrogate for time. The sooner that information regarding changing requirements can be known, and the more complete that information is, the more likely it is that members of supply chains in a value network will be able to plan around these changes with the least impact to cost.

Supply Chain Capability #3 - Responding to the Marketplace

Responding to the marketplace means several things. First, preparing to respond is something that all companies do. Every organization must plan in an attempt to anticipate market requirements before they happen. Capital has to be allocated. Staff must be in place. Suppliers should be identified. Planning for demand is a fact of business.

Second, the company must develop a product and service bundle that will find paying customers in sufficient number at a price that yields a proper margin.

Third, responding to the marketplace means being able to have the right product, in the right place, at the right time, at the right quality, for the right price so that the service level achieves an economic optimum. In other words, the service level should be such that the combined risk of the economic fallout from missed, reduced, or cancelled orders, and of having too much capital tied up in inventory or excess capacity is minimized.

Finally, in the circumstance where demand outstrips the ability of a company to meet every order on time, the product mix should be such that it meets the corporate objectives, which may include maximizing margin, satisfying the most important customers, shipping the most product on time, or satisfying the most customer orders on time.

Figure 5. - Causal Metrics Matrix5


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This concludes Part Two of a three-part article.

Part One discussed the Supply Chain in terms of corporate objectives.

Part Three will cover how Supply Chain Decisions Create Supply Chain Capabilities.

4 Crosby, Philip B., Quality is Free: The Art of Making Quality Certain, (McGraw-Hill, 1979)
Juran, Joseph, M., Juran on Leadership for Quality, (Free Press, 1988)
Deming, W. Edwards, Out of the Crisis, (Massachusetts Institute of Technology, Center for Advanced Engineering Study, 1986)

5 "Identifying the ROI of an Application for Supply Chain Management", Mark Wells, TechnologyEvaluation.com, July 2001.

Appendix

An alternate financial accounting metric for overall corporate performance Return on Common Equity (ROCE)6 , where,

ROCE = Return on Net Operating Assets (RNOA) + Effect of Financial Leverage (FLEV * SPREAD)

RONA =
Operating Income (after tax)

Net Operating Assets
 
FLEV =  
Net Financial Obligations

Common Shareholders' Equity
   
SPREAD =
RNOA - Net Borrowing Cost

About the Author

MARK WELLS has worked for the past 20 years on many of aspects supply chain management from within industry, as a supply chain consultant, and as part of a software development organization. He has held his CPIM certification from APICS since 1989. He holds an MBA from Drexel University where he has also taught operations management and operations research. He currently works for Oracle Corporation, focusing on tools for the supply chain decision maker.

Mr. Wells can be reached at mark.wells@oracle.com.

6 Penman, Stephen H., Financial Statement Analysis and Security Valuation, (McGraw-Hill Irwin, 2001), pp. 338 - 339.

 
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