Bridging the disconnect between finance and purchasing (Part 4): Determining true economic performance through real-time production logistics

Posted on September 16, 2011


“It is equally important to measure the allocation of financial resources that look beyond standard capital investment analysis tools such as time value of money, rate of return, salvage value, and so on, and take into account the ongoing value to the equity stakeholders in securing this investment.  Economic Value Add (EVA), a financial analysis tool developed by Stern-Stewart in 1989, has gained traction as a means of measuring the true financial performance of an organization by determining what is known as the economic profit of the company.  Economic profit is defined as the “profit that remains after deducting the cost of capital invested to generate that profit.”

from the technical brief The Economic Value Add Of A Production Logistics System

As I looked to define the connection between EVA and the procurement world on a basis that reflected the everyday realities associated with a global supply chain, the above referenced white paper caught my attention for several reasons.

To start, my interest was immediately piqued by the brief’s reference to the fact that while logistics applications such as warehouse management systems (WMS) and transportation management systems (TMS) have been developed and deployed to manage the outbound distribution of finished goods, it was the paucity of similar tools to manage and measure the effectiveness of the inbound flow of raw materials through the production process that was noteworthy.

In other words, and similar to my work with the Department of National Defence, in which factors such as the time of day that an order for an MRO product was placed and it’s influence on the logistical chain of execution including time zone cut-offs and customs clearance, that along with the cost and quality of goods provided a comprehensive understanding of SLA delivery capability and performance, taking into account how both the inbound and outbound flow associated with production logistics directly impacts EVA is critical.

Production logistics for the uninitiated is, according to the paper, the management of the progressive stages that begin with the inbound transportation of raw materials from suppliers to a processing facility through to the  delivery and consumption of that material as it is transformed into finished goods.

The fact that the emphasis for most organizations has traditionally been focused primarily on the outbound side of the equation provides yet another example of the disconnect between senior management including finance, and the purchasing department, in that top line activity (and the technology to facilitate improved performance) almost exclusive occupied center stage.

Within this context, EVA is an important metrics in that it encapsulates the true costs and benefits of the inbound and outbound aspects of a sound production logistics process, which as stated in the paper enables a logistics department or organization to make an impact by increasing net sales and reducing operating costs and assets.

More specifically, and cited as an example in the brief as being key financial metrics in calculating EVA, net sales is comprised of sales less the cost of goods sold and current assets that are divided to inventory, cash, and accounts receivableThe cost of capital, or required rate of return according to the authors, reflects the rate that investors are compensated for their investment risk.

Through the above calculations, it has been suggested that the analysis of the data provides the basis for measuring how alternative logistics strategies and investments affect the value of the company.  If this conclusion is to be accepted, then the extended question that needs to be asked is what role does purchasing play in relation to having a positive effect on the inbound and outbound processes of the company?

Right off the bat, an obvious area of influence is a decrease in the Cost of Goods.

However, a myopically focused effort on reducing costs of goods has its own perils as pointed out in the book The EVA Challenge: Implementing Value-Added Change in an Organization.

The following excerpt from page 79 tells an interesting story that is worth noting:

At the other end of the money sprout, purchasing agents have transformed their approach.  In the past, says Dave Guy, General Manager, Zeeland Operations, “Our purchasing agents kind of ignored payment terms.  They were interested in getting cash discounts, because that would lower material prices.”  Their performance was measured by the prices they paid, with no consideration of the capital cost of speedy payments.  No longer.  As an example, Guy offers an analysis that came from extending payments ti three aluminum suppliers.  In one case, by taking 30-day terms rather than 15, there was an EVA improvement of $14,174 on a purchase of $3.1 million.  In these examples, involving $6,658,238 in aluminum buys, EVA was boosted by $27,746.  Every little bit counts.

As was the case with both Parts 2 (ROIC) and 3 (EPS) in this series, EVA is also one of those areas of finance in which there is an enterprise-wide convergence of complimentary functional elements that come together to ultimately impact a company’s bottom line.  It is through this collaborative lens of understanding that purchasing and purchasing professionals will identify their increasingly important roles within a global entity, and in the process establish a true value presence that on a go forward basis will be recognized by upper management and finance.


Posted in: Commentary, Finances