The Financial-SCM Connection
By Stephen G. Timme and Christine Williams-Timme -- Supply Chain Management Review, 5/1/2000
One of the greatest business challenges today is providing a competitive return to investors. A company may not directly compete for customers against return-rich organizations like The Home Depot, General Electric, Cisco Systems, and the high-flying dot-coms (at least not yet).
But all companies compete against each other in the financial markets. Those companies offering a competitive return tend to prosper and grow. Those that don't are limited in their ability to grow and many times cease to exist.
Providing a superior return is becoming more complex because of increasingly demanding customers, heightened competition, and ever-changing technologies. "C-level" managers (CEOs, CFOs, and so forth) are seeking new solutions to meet this challenge. Supply chain management (SCM) has the potential to provide these solutions—and, in doing so, move SCM from the "backroom to the boardroom." At many companies, however, at least two factors inhibit SCM's boardroom debut.
- First, many C-level managers hold a traditional view of supply chain management and do not fully recognize its potential impact on all areas of financial performance (growth, profitability, and capital utilization). Unfortunately, the traditional view is narrowly defined in terms of SCM's effect on only one aspect of overall financial performance—operating costs.
- Second, many SCM professionals do not speak the "language of finance." Thus, they fail to articulate the real value of their solutions at the C-level.
This article examines the financial-SCM connection, illustrating how supply chain solutions can help improve a company's overall financial performance. The examination is conducted from a chief financial officer's perspective since the CFO is a key player in signing off on performance-improvement initiatives. The article first examines why a company must provide a competitive return to investors, describes the key factors that drive financial performance, and explains how a CFO thinks. Next, it presents an effective metric for showing a CFO how supply chain solutions affect overall financial performance.
Competitive Return and the CFO's PerspectiveA company must offer a competitive return in the financial markets to attract the funds it needs to maintain its existing business and provide for future growth. For a publicly traded company, a competitive return is measured by "total shareholder return" (dividends plus the change in stock price measured as a percentage of the price paid for the stock).
Providing a competitive return has become more challenging as the major stock indices in recent years have provided stratospheric returns relative to their long-term historical performance. The average annual total shareholder return on the S&P 500 (Standard & Poor's 500 Stock Price Index) over the last five years, for example, is an impressive 27 percent. This compares with a long-term average return of 10 to 12 percent. A company with the same risk as the average company in the S&P 500 needed at least a 27-percent return to have provided a competitive return. How is your company performing against this benchmark?
In the near term, it is not always clear what drives a company's stock price. Some speculate it is investors' emotions, while others claim it is animal spirits. However, over time, stock price tends to be driven by the financial performance of a company's operations, which is related to three key factors:
- Growth—How fast revenues are growing year-over-year.
- Profitability—How much is left over in profits per dollar of revenue after deducting operating expense (procurement, manufacturing, transportation, distribution, etc.). This is often also called operating profit margin.
- Capital Utilization—How many dollars of revenue are generated for each dollar invested in capital (e.g., inventories and accounts receivable, warehouses, fleets, plant and equipment). We like to refer to capital utilization as "SPEED"—with the competing companies recording the highest average speed winning the race.
It is the chief financial officer's job to make sure that a company's financial performance provides a competitive return to investors. He or she takes a holistic view of solutions to provide this return. The CFO constantly is searching for new answers to such questions as:
- How can the return on the existing business be improved?
- What new businesses should we enter and what are their returns?
- Where will the company get the funds to run the business and fund growth?
- How will the company meet investors' expectations?
Supply chain professionals must show how their solutions provide answers to these questions if they are to move SCM from the backroom to the boardroom. The good news is that many SCM solutions do provide answers to these questions because of their effect on the key performance drivers. The bad news is that they often are presented only from a "lower operating costs" perspective, which is a part of the profitability driver. The impact on the other components of profitability and on the growth and capital utilization drivers often is not quantified. The result: The CFO is left with an incomplete view of the solutions' potential impact on overall financial performance.
Exhibit 1 illustrates SCM's potential impact on the three drivers of financial performance and, in doing so, provides answers to the CFO's key questions. (Source for all exhibits in FinListics Solutions.) The analysis is for the average company on the S&P Industrials. It shows the impact on stock price of SCM solutions that grow revenue, reduce unit-operating expenses, increase inventory turns, reduce days' sales outstanding, and increase fixed-asset utilization. The exhibit shows the potential power of SCM solutions to increase stock price significantly—a message that supply chain professionals must send to the boardroom.
SCM's Impact on Overall Financial Performance
Economic profit is a useful metric for measuring the impact of SCM solutions on overall financial performance. Economic profit goes by many different names. One of the most popular is economic value added (EVA) developed by Stern Stewart and Co. The benefit of using economic profit is that it readily shows the dollar impact of SCM solutions on the key drivers of growth, profitability, and capital utilization.
Economic profit measures the true profits a company generates after subtracting from revenues the total costs of doing business—operating costs, taxes, and a fair return to investors. An easy way to think about economic profit is to calculate the change in your personal net worth for a given level of salary and bonuses, as illustrated in Exhibit 2.
Salary and bonuses are like revenues. Nonfinancial living expenses such as food, clothing, and utilities are like operating expenses, and unfortunately, taxes are like taxes. Subtracting nonfinancial living expenses and taxes from salaries and bonuses is like "net operating profit after taxes" (NOPAT). However, one of the most important personal finance expenses—the mortgage payment (or, technically only the interest component) or rent payment and other financing charges—must be subtracted to know the change in your net worth. If the long-term trend in the change is positive, you are getting ahead. If it is negative, you are falling behind and changes must be made in your personal finances to avoid bankruptcy.
Economic profit in the language of finance is net operating profit after taxes less a "capital charge." The capital charge is capital times the cost of capital. Capital is the net book value of how much is invested in assets such as accounts receivable, inventory, machinery, plants, and buildings. The cost of capital is a blend of borrowing costs and shareholders' expectations for dividends and stock appreciation.
Economic profit measures the change in shareholder value for a given level of revenues. This is similar to the calculation of the change in your net worth. If the long-term trend in economic profit is positive, shareholder value is being created. This means that a company is earning a return in excess of its cost of capital. If it is negative, shareholder value is being destroyed because the company is earning less than its cost of capital. Shareholders would be better off placing their money elsewhere. If economic profit is consistently negative, then (as with your personal finances) changes must be made to make it positive.
Exhibit 3 gives the economic profit for the average company in the S&P Industrials.
At the CFO level, supply chain solutions are of interest only to the extent that they influence growth, profitability, and capital utilization—the financial drivers. The following discussion provides examples of how SCM affects these drivers and shows the resultant impact on economic profit. In these examples, the results for the average company in the S&P Industrials is used as the base case.
Growth
The average company in the S&P Industrials grew revenues at 7 percent over the previous year's level. The impacts of SCM on revenue growth are varied and can be thought of both in terms of existing business and new business, as described below:
SCM also provides solutions that help a company enter into new businesses through improved speed-to-market, SPEED, and cost management. Examples of how SCM can provide a competitive advantage for entering a new market are explored later in this article.
Profitability
Profitability is what's left over per $1 of revenue after paying all operating expenses. Earlier, Exhibit 3 showed that the average company in the S&P Industrials had $0.11 in profitability before taxes and $0.07 after taxes. Typically, the benefits of SCM solutions have been thought of in terms of their impact on profitability through reduction in related supply chain operating costs. Logistics-related operating costs (such as transportation, warehousing, inventory carrying, and administrative) are estimated to be approximately 8 percent of the average company's revenue. (This is the figure developed by Herbert W. Davis and Co. and presented at the Council of Logistics Management's annual conference in 1999.)
Many benchmarking studies have examined the numerous key performance indicators that drive SCM operating costs. These studies provide insight into the impact of supply chain solutions on operating costs. The CFO perspective, however, is the impact on the bottom line, which is economic profit. Exhibit 5 shows the impact on economic profit from a 5-percent reduction in SCM operating costs. These costs are put at 8 percent of revenues.
The results show that for the average company in the S&P Industrials, the 5-percent reduction nearly doubles economic profit. The increase in market value is in excess of $450 million, which is a 6.5-percent increase in overall market value. Another way to view the $450 million is that it provides the CFO with funds to buy another company—or makes it more costly for someone else to purchase the CFO's company. Either way, the initial cost-reduction perspective should be broadened to encompass the overall financial performance.
Capital Utilization—The Need for SPEED
Capital utilization, or SPEED, is a key driver of providing a competitive return to investors. SPEED is how efficiently a company utilizes its capital. It measures the dollars of revenues generated for each dollar invested in capital. For example, Dell's SPEED is $7.45. This means that $7.45 in revenues is generated for every dollar invested in capital. A company's SPEED reflects what it does. For example, a grocery store like Kroger has a SPEED of $8.00 because it does not require much investment in capital to generate revenues. Whirlpool has a SPEED of $1.80 because it is a manufacturer and is more capital intensive than a grocery store. A highly capital-intensive telecommunications company like BellSouth has a SPEED of $0.70.
Think of SPEED as the average mileage per hour a racecar records in completing one lap around a racecourse. The cars with the higher SPEED start at the front of the field. The car with the highest average SPEED wins the race. The business of all businesses is the efficient movement of cash. A company may manufacture, distribute, or create new products, but its real business is the generation and reinvestment of cash. The quicker the cash is generated, the quicker a business can grow, the higher its financial performance and ultimately its return to shareholders.
Capital utilization is the area with the greatest potential for SCM solutions to improve overall financial performance. Companies generally insist that their managers focus on results related to the profitability drivers (transportation and warehousing budgets, for example) but not on capital. Profitability-related measures are important but incomplete.
Many supply chain decisions involve trade-offs between capital and operating expense. For example, inventory levels generally can be lowered by upgrading modes of transportation. However, this upgrade typically results in increased transportation expense. A manager whose performance is measured on transportation expense is loath to spend more on transportation to lower inventories.
Focusing managers' attention on profitability measures alone tends to create a mindset that the responsibility for capital utilization lies with some corporate group. It is a safe bet that capital is underutilized in these companies.
At FinListics Solutions, we like to conduct the following test to see how focused a company is on SCM capital. Apply this to your own organization:
- What percentage of managers know the size of the budget they manage? _________%
- What percentage of managers know the book value of the assets (inventory, warehouse, fleets, technology investment) they manage? _________%
Typically a large percentage (90 percent or higher) know the size of their budget—likely because bonuses are linked to budgets. Less than 10 percent of managers, by contrast, know what is invested in the assets they manage. Can you imagine not knowing how much your house or car is worth? Or going to a bank and asking for a new loan but not being able to tell the banker what you are worth? To address this issue, a number of companies have implemented SCM systems based on economic profit or some return measure such as return on capital. These approaches help focus managers on both profitability and capital utilization.
The CFO has both a tactical and strategic perspective on SCM's impact on SPEED and, in turn, stock price.
Tactical Perspective
Examining the bottom-line impact of reducing days in inventory provides a good example of the tactical perspective. The average company in the S&P Industrials has $500 million in inventory, which represents 60 days in inventory. Also, the average company incurs "noncapital inventory-carrying costs" of 10 percent of the value of inventories. Noncapital inventory-carrying costs include operating expenses such as obsolescence, warehousing, damage, pilferage, insurance, and taxes. Suppose that an SCM solution that upgrades modes of transportation reduces days in inventory by 20 percent or 12 days. But it also increases transportation costs by $5 million.
If you are a transportation manager with a bonus tied to transportation expense, this type of initiative has little appeal. But let's look at it from the CFO's perspective. Exhibit 6 shows the initiative's impact on economic profit and market value for the average company in the S&P Industrials.
The results in the exhibit show that the solution lowers initial inventory by $100 million. In addition, noncapital inventory-carrying costs are lowered by $10 million. If the business was not expected to grow, the $100 million inventory investment is a one-time benefit and the $10 million is re-occurring. For a growing business, the incremental investment inventory and the noncapital carrying costs typically grow at the same rate as growth in revenues. For example, for a business growing at 10 percent, the inventory investment benefit is $100 million the first year, $10 million in the second year, $11 million in the third year, and so on. The noncapital carrying costs benefit is $10 million in the first year, $11 million in year two, $12 million in year three, and so on. Exhibit 6 shows that the inventory-reduction initiative almost doubles the average company's economic profit (a $13 million improvement vs. a $14 million base).
Strategic Perspective
The CFO's strategic perspective of SPEED focuses on the new opportunities created by SCM solutions. One strategic view of the inventory-reduction initiative, for example, is that in the near term it provides $100 million to invest elsewhere. Another view follows the thinking that a company's stock price or market value is its currency. Exhibit 6 shows the potential impact of the inventory-reduction initiative on market value is $433 million or a 6-percent increase. This would provide the CFO with an additional $433 million in market value to buy another business. Alternatively, it would make the CFO's company that much more expensive for another company to buy.
More and more CFOs are looking to SPEED as a means of creating more competitive business models to improve or maintain the performance of the existing business and to expand into new businesses. This perspective is reflected in the following example. A company has $100 million in revenue, profitability of 12 percent (88 percent operating expenses), and capital utilization of $1.50. With a SPEED of $1.50, $67 million is invested in capital ($100m / $1.50). Exhibit 7 shows the company's existing business has a positive economic profit of $0.5 million.
The column titled "Existing SPEED" shows that the economic profit is -$0.7 million for entering the new business if SPEED remains unchanged at $1.50. Or if the profitability on the existing business drops to 10 percent, the economic profit falls to -$0.7 million from $0.5 million. Neither scenario is a good one.
In the context of the new business opportunity, the company may decide not to enter the business. This decision results in lost revenue opportunities and lost revenues from existing customers if they expect the company to offer the new service as part of an overall product offering. Or if the company does enter the new business, it will do so at an economic profit loss. In the context of the existing business, the lower profitability without a change in SPEED would likely result in a much lower stock price.
Suppose an SCM solution involving better forecasting and network optimization lowers inventory and warehouse investment and improves scheduling and manufacturing plant throughput. And that these result in a SPEED of $2.00. More than likely there also would be a reduction in costs and on improvement in profitability, but this is left out of this example. Exhibit 7 shows that in this case, the new business improves economic profit by $1.0 million even though it has lower profitability than the existing business. For the existing business, economic profit actually increases to $1.0 million from $0.5 million even on lower profitability. In either case, the SCM solution's improvement in capital utilization provides the company with a competitive advantage.
The results in Exhibit 7 show why more companies are focusing on SCM solutions to increase SPEED as a means of offsetting profitability pressures from increased competition and customer demands. Increased competition and customer demands typically lower profitability. New competitors tend to offer lower prices, grabbing market share from incumbents. Furthermore, in many markets, customers typically aren't willing to pay more for product enhancements and better service.
The FinListics Economic Profit Break-Even Model in Exhibit 8 highlights the importance of SCM's impact on SPEED by showing the many different ways to earn a positive economic profit. In the analysis, a company has a 10-percent cost of capital. The break-even curve shows the combinations of profitability and SPEED that result in a zero economic profit. Pre-tax profitability (operating profit / revenue) is used because managers and investors often refer to a company's consolidated or segment operating profit margin.
The model shows that a company with a SPEED of $2.00 has an 8.3-percent break-even profitability. A company with $100 million in revenue has $8.3 million in operating profit ($100 million × 8.3%), which after taxes is $5.0 million in NOPAT ($8.3 million — $8.3 million × 40% tax rate). With a SPEED of $2.00, it has $50 million in capital ($100 million revenue / $2.00 SPEED). The capital charge on the $50 million in capital is $5.0 million ($50 million capital × 10% cost of capital), which results in a zero economic profit ($5.0 million NOPAT — $5.0 million capital charge).
Given a company's actual SPEED, the vertical distance from the break-even profitability and actual profitability is the pre-tax economic profit per dollar of revenue. For example, a company has revenue of $100 million, 10-percent profitability, and SPEED of $2.00. Its pre-tax economic profit is $1.7 million [$100m × (10% actual profitability — 8.3% break-even profitability)].
The tool shows how increased SPEED resulting from improved SCM increases competitive advantage and economic profit. For the same profitability, any SCM initiative that increases SPEED increases economic profit. An increase in SPEED also creates a product market competitive advantage by letting a company generate the same or higher economic profit with the same profitability.
Growing Market Application
Suppose a company and all of its competitors operating in an ultra-competitive product market have a profitability of 8.3 percent and a SPEED of $2.00. This combination of profitability and SPEED results in a break-even economic profit—the business returns just enough to pay the cost of capital. An SCM initiative is expected to increase SPEED to $3.00. At a SPEED of $3.00, 5.6 percent is the break-even profitability. If profitability remains at 8.3 percent, the model shows that the company earns a positive economic profit. The pre-tax economic profit is the 2.7 percent (8.3 percent to 5.6 percent) per dollar of revenue.
However, the increased SPEED provides a competitive advantage since the break-even profitability is now 5.6 percent. This advantage gives the company a variety of ways in which to capture market share. For example, it could lower prices, offer higher service levels, and spend more on advertising and promotions. Suppose that the combination of these factors results in profitability of 7.0 percent. This seems to run counter to conventional wisdom that the goal is to increase profitability. The key element in this example is that the SCM initiative provides an infrastructure that lets the company operate in a lower profitability environment while earning more economic profit and providing higher returns to shareholders.
SPEED is the key in this example. The company is passing along part of the benefits from increased capital utilization to its customers in the form of lower prices—the reduction in profitability from 8.3 percent to 7.0 percent. It captures the remaining benefits as increased economic profit and ultimately stock price. The increase in SPEED lets the company increase revenue to $120 million from $100 million. The increase in pre-tax economic profit from the increased SPEED is shown in Exhibit 9.
Other Applications
The break-even model also shows the required changes in SPEED to offset a decrease in profitability to maintain the same economic profit. Suppose a company currently has 8.3-percent profitability and SPEED of $2.00. Further suppose that profitability is expected to drop to 6.7 percent due to increased competition. Or assume that the profitability of a new market is 6.7 percent. The model shows that SPEED must be increased to $2.50 to offset the lower profitability.
This model often reveals interesting results when applied at the product level. Conventional wisdom says that a product with 8.3-percent profitability is preferable to one with 6.7-percent profitability. Conventional wisdom is likely to be right if both products exhibit both similar supply chain characteristics and similar SPEED. But suppose that the products with 8.3- and 6.7-percent profitability have SPEEDs of $1.50 and $3.00, respectively. The break-even model shows that the product with 8.3-percent profitability has a negative economic profit and is destroying value. The product with 6.7-percent profitability has a positive economic profit and is creating value.
A Three-Step Plan for SuccessBenchmarking your company's overall financial performance is a good starting place to examine the potential impact of SCM initiatives on stock price. Many benchmarking studies begin by looking at specific SCM operating-performance indicators. Although these operating-performance indicators provide valuable insights at the operational level, they don't reflect the CFO's perspective. That perspective is overall financial performance.
We recommend a three-step approach to making the financial-SCM connection.
- First, conduct a high-level financial performance gap analysis. The overall financial benchmarking should begin by examining (1) revenue growth, (2) operating profit margin, (3) cash operating cycle (days in inventory + days sales outstanding — days purchases outstanding), and (4) fixed-asset utilization (fixed assets/revenue). The cash operating cycle and fixed-asset utilization are two key components of SPEED. A more detailed gap analysis can be conducted later, but don't forget the CFO's perspective.
- Second, map SCM operating-performance indicators to financial performance gaps.
- Third, develop initiatives to close the gaps.
Exhibit 10 shows an example of a high-level financial performance gap analysis. The analysis is for a hypothetical company called the "Target Company" and three competitors. The competitors may be from inside or outside the Target Company's industry. The approach is to benchmark the Target Company's performance to the best performance of the four companies. The resulting gaps are then converted into an economic profit and stock-price gap. The size of these gaps help you identify those areas that need to be addressed first.
The second step maps SCM operating performance indicators to the gaps. Keep in mind that the gaps are often inter-related. And that SCM typically won't explain an entire gap. For example, SCM-performance indicators such as manufacturing, warehousing, and fleet utilization may explain part of the fixed-asset utilization gap for the Target Company. Poor order fulfillment and stock-out losses, excess inventories, and a nonoptimized distribution network may explain part of the gaps in revenue growth, profitability, and the cash operating cycle.
The third step involves mapping SCM initiatives to closing the financial performance gaps and even having the company define best practice. In this step, it is crucial that SCM professionals be able to clearly articulate "how" the initiatives affect overall financial performance and by "how much." These must be explained from the CFO's perspective, which is nontechnical and focused on improving stock price.
Making the financial-supply chain management connection—in terms that the "C-level" executives can appreciate—is a fundamental prerequisite to achieving the breakthrough results anticipated from SCM initiatives. It's also a critical force in moving supply chain management from the backroom to the boardroom.
| Performance Measure | Target Company | Benchmark | Benchmark Company | Annual Economic Profit Gap ($millions) | Value of Gap per Share |
| Revenue Growth | 3.5% | 10.0% | Comp 1 | $28 | $0.94 |
| Profitability | 16.3% | 17.8% | Comp 2 | $57 | $1.87 |
| Cash Oper. Cycle | 60 | 35 | Comp 3 | 43 | $1.41 |
| Fix Assets/Revenue | $0.40 | $0.25 | Comp 3 | $137 | $4.52 |
| Total Economic Profit and Value per Share Gap | $265 | $8.73 | |||
| Target Company Actual Economic Profit and Stock Price | $347 | $32.94 | |||
| % Increase | 77% | 27% | |||
| Author Information |
| Stephen G. Timme and Christine Williams-Timme are the co-founders of FinListics Solutions. |
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