Value Creation Emerges as Important Metric for Supply Chain Improvements

26 February 2001 00:00 Source:ICIS Chemical Business
By Pedro Portugues and Reginaldo Montague

Improving supply chain practices is an ongoing objective of most organizations, and a critical issue is deciding what methodology should be used to measure supply chain gains.

Although there are numerous measures of financial performance, such as return on investment (ROI), economic value added (EVA) and market value added (MVA), EVA will be used to illustrate how value creation can occur through supply chain improvements. A recent Deloitte Consulting survey found that EVA, a more dynamic measure of business value creation, was not being used to any great extent to plan and control supply chain activities. Standard cost was used most frequently.

Since supply chain improvements are likely to affect many of the drivers that influence financial performance, it is important to take them into account when measuring it. The financially linked metrics used to evaluate supply chain performance should incorporate the internal organization as well as external partners. In turn, the inherent value of supply chain improvements should be linked to an integrated company strategy. A recent Deloitte survey showed that 47 percent of respondents had no formal supply chain strategy and obviously no systematic way to measure supply chain improvements.

One approach to understanding value creation in the supply chain is to analyze possible areas of supply chain improvements to determine how they might impact the financial metric of interest, such as EVA. According to a supply chain benchmarking organization, the Performance Measurement Group LLC, the following are key supply chain practices:

- Delivery performance to request--The percentage of orders that are fulfilled on or before the customer's requested date.

- Order fulfillment lead times--The total lead time to satisfy demand for product. This includes times from customer signature/authorization, order receipt, completed order entry, order fullfillment, shipment, customer receipt of an order and last to completed installation (if appropriate).

- Order fill rates--The percentage of ship-from-stock orders shipped within 24 hours of order receipt.

- Total supply chain management cost--The total cost to manage order processing, which includes acquiring materials, managing inventory, and managing supply-chain finance, planning, and management of information systems (MIS) costs.

- Cash-to-cash cycle time--The number of days between paying for raw materials and getting paid for product, as calculated by inventory days of supply plus days of sales outstanding minus average payment period for material.

- Total inventory days of supply--The number of times inventory turns over divided into 365 days per year; as calculated by total inventory divided by cost of goods sold divided by 365.

- Value-added productivity per employee--The contribution made by employees to the final value of product as measured by total product revenue minus material purchases divided by total employment.

- Net asset turns--Total gross product revenue divided by total net assets.

Each of these metrics can be linked to value creation in an organization either directly or through empirical evidence. At a high level, EVA is the excess profit given the resources in a corporation. NOPAT (net operating profit after tax) could be viewed as the income generated from the capital used. It is essentially the earnings before interest and taxes (EBIT) less taxes; the Stern Stewart methodology requires a series of accounting adjustments to construct an adjusted EBIT. The capital cost could be considered the net resources provided to the organization to produce NOPAT.

To improve EVA, the task of the management team is to maximize NOPAT while minimizing the capital required to achieve this. If EVA from one year to the next declines or is zero, that firm failed to generate value.

However, the capital cost comes at a cost (k). Organizations typically have a standard cost of capital or, if that is unavailable, a weighted average cost of capital (WACC) can be used. In either case, it is an indication of return expectations given debt servicing requirements and returns demanded by investors.

To determine some key sources of potential benefits in EVA improvements, given supply chain improvements, the capital piece of EVA needs further deconstruction. It is composed of net working capital and other capital. New working capital is the difference of current assets and current liabilities. Other capital includes property, plant and equipment (PPE) and adjusted goodwill.

Current assets include cash, short-term securities, accounts receivable and inventory while current liabilities include accounts payable.

What is the impact of a change in inventory or change in accounts receivable on EVA? If one assumes a pure inventory reduction or a pure accounts receivable reduction and, assuming all other factors remain constant, one can demonstrate some interesting results. A reduction or negative change in inventory, while all other factors remain constant, should lead to an improvement in EVA.

A similar result is evident for a reduction in accounts receivable.

In part because of complex accounting based adjustments and varying perspectives on how to make such adjustments, measuring changes in EVA is more valuable than measuring actual EVA itself.

Just as reductions in accounts receivable and inventory would lead to improvements in value, similar changes would lead to improvements in cash-to-cash improvements.

Where DSO is the days of sales outstanding measured by: DI is the days of inventory measured by: where the cost of goods sold (COGS)/average inventory is the inventory turns; and DPO is the days of payables outstanding measured by:

It should be noted that although extending payables would provide an internal source of financing in addition to an apparent improvement in EVA and cash-to-cash cycle time, it usually tends to erode supplier relationships by increasing the difficulty in building a relationship across the supply chain. This illustrates the value of balancing rigorous quantitative metrics with qualitative metrics.

A generic example illustrates how this plays out using EVA. Company X has a NOPAT of $404 million in the base case. From the base case year to the following year, it makes significant reductions in inventory and accounts receivable through some extremely aggressive supply chain improvement projects. Company X reduced inventory by $68 million and accounts receivables by $570 million. If we assume NOPAT remains the same in each case, Company X saw improvements in EVA as Figure 1 shows. All things being equal, the improvement for accounts receivable would be $86 million or 15 percent of the $570 million improvement in EVA from its baseline position.

If the NOPAT side of the equation remains unchanged, then the remaining consideration is the capital cost. By driving the inventory and accounts receivable down, there is a direct improvement in EVA. Of course, most decisions are not that simple. They require investments and expenses affecting both sides of the EVA equation occurring in a dynamic competitive environment. However, by making these simplifying assumptions, this exercise illustrates the power of supply chain improvements in driving value.

This analysis can be extended to total supply chain management cost, net asset turns, and value-added productivity per employee. Total supply chain management cost is linked to COGS (cost of goods sold) and SG&A (selling, general and administrative) expenses and produces an improvement in EVA by a reduction in NOPAT. Productivity measures such as asset turns and revenue per employee would also yield improvements in EVA by increasing value generated per a constant or declining base.

The other metrics such as fill rate, delivery performance to request and order fulfillment lead time, must be linked empirically based on data specific to the company and industry. These four metrics address service levels the organization can provide its customers affecting revenue.

To be sure, supply chain improvements would not be achieved by the mere introduction of financially linked metrics. In fact, it requires the alignment of a company's business strategy, business processes, organizational structure and technology application as well as effective partnering. Financially linked metrics are an attempt to link the business strategy to its execution. Pedro Portugues is a senior manager in Deloitte Consulting's New York office. He has 15 years of business experience and specializes in analyzing supply chain issues. Reginaldo Montague is a senior consultant with Deloitte Consulting's Chicago office. He specializes in supply chain management. and has 17 years of industry experience.