Linking Financial Decisions to Supply Chain Performance

When scrolling documents on the web or participating in supply chain management events and conferences, it’s not unusual to find white papers and presentation material asserting the relevance of supply chain management as a strategic corporate asset. The ability to optimize the network of suppliers, distributors, warehouses, manufacturing and distribution centers, as well as transportation modes, is key to achieving corporate success.

However, when interacting directly with operations executives there is no unanimous agreement on what supply chain management really is. Some affirm it’s an evolved form of logistics – mainly transportation, warehousing and distribution. Others, especially from the public sector, identify supply chain management with procurement. In the fast-moving consumer goods sector, the key supply chain activities are mainly linked to distribution and warehouse management. While there is no right or wrong answer regarding the exact definition of supply chain management, the underlying effect of such a diversity of opinions is that the supply chain becomes a set of functionally dispersed ‘islands of power’.

Our continuous research and daily interactions with end-user companies show that there is a need for a commonly accepted framework that defines the typical processes of a supply chain. Recent research conducted among supply chain and finance managers by the Supply Chain Council found that there is also disagreement on the issue of alignment between the supply chain and other corporate functions – a perfect 50-50 split between respondents who consider the alignment as being poor/very poor versus good/very good.

A deeper analysis of the ‘positive’ responses suggests that financial officers are beginning to understand that an effective management of the supply chain plays an integral role in financial success. But, to the eyes of the CFO, supply chain management is unsatisfactory because supply chain managers lack financial rigor; they lag in management efficiency; and do not provide clear visibility into supply chain financials.

The consequence of this is that CFOs are taking more of a leadership role in supply chain management. Research from UPS Consulting confirms anecdotal data collected across Supply Chain Council members: 34 percent of CFOs are directly responsible for the performance results of their company’s supply chain, and 49 percent think they will be in the next two years. While this appears to be an acknowledgement of the increased strategic relevance and importance of supply chain management to the company’s success, the reality is that the supply chain manager and the CFO too often speak on different wavelengths. Supply chain managers must speak the same ‘language’ of the CFO if they want to prove the value of their corporate role and count more.

The language of the CFO

There are typically two indicators used by financial directors to gauge overall corporate performance: cash-to-cash cycle and economic profit. To the ears of the supply chain manager, however, these terms might not be too familiar – and unfortunately, the common definitions do not help much either.

As a matter of fact, confusion increases among supply chain operators even when the definitions come from a very basic and popular source of information such as Wikipedia. It does not help to grasp the real meaning of these indicators (and, moreover, to evaluate what actions to perform to improve their result) by reading that cash-to-cash cycle represents “the number of days expired between canceling a payable and generating cash”, and that economic profit is “the amount by which earnings exceed or fall short of the required minimum rate of return that shareholders and lenders could get by investing in other securities of comparable risk”.

Since supply chain managers often speak in acronyms, the CFO might come to the rescue of the SC manager by also speaking in acronyms. So cash-to-cash cycle becomes C2C = DII + DSO – DPO, while economic profit is translated into EP = NOPAT – (WACC*Capital). In an extreme effort to rescue the now totally confused colleague, the CFO might try to introduce another indicator, tightly linked to cash-to-cash cycle yet usually easier to measure once the reading of a balance sheet becomes as familiar as reading a bill of materials. That is, working capital.

Working capital is a valuation metric calculated as current assets minus current liabilities. Also known as operating capital, it represents the amount of day-by-day operating liquidity available to a business. In mathematical terms, working capital is calculated as WC = AR + Inv – AP, where AR stands for accounts receivable (the amount that customers owe a business); Inv is the inventory value; and AP is accounts payable (payments to suppliers for goods and services purchased).

From Wikipedia, we also learn that “any change in the working capital will have an effect on a business' cash flows. A positive change in working capital indicates that the business has paid out cash, for example in purchasing or converting inventory, paying creditors, etc. Hence, an increase in working capital will have a negative effect on the business' cash holding. However, a negative change in working capital indicates lower funds to pay off short-term liabilities (current liabilities), which may have bad repercussions on the future of the company”.

Sustainable ways to affect working capital

The levers to achieve a positive result of working capital lie in both reducing AR and inventory value, and increasing AP. The most common belief among supply chain operators is that AR is almost untouchable since it is tightly linked to sales and, therefore, it is in the sales managers’ turf. Inv is certainly an item under the direct control of SCM. Many techniques and practices exist to size it, optimize it and reduce it. AP is a purchasing manager’s job, which is immediately accomplishable by ‘seizing’ the supplier with a take-or-leave proposal aimed at extending payment terms by contract. What was previously paid after 30 days is now paid in 45.

If collaboration is a practice that goes beyond pure academic exercise to be practically implemented and executed across all supply chain constituents, then the SC manager cannot accept the perspective of getting involved in practices that reduce the level of trust and credibility of his/her function in favor of short-term, short-sighted and potentially counterproductive results.

This means that the supply chain manager that speaks on the same ‘wavelength’ as the CFO has the responsibility to understand what it takes to achieve the desired result in a sustainable and responsible way, and translate that into action. That is, instructions and practices that the operators in the shop floor, in the warehouses, in the distribution centers, in the purchasing departments and in the planning offices, can properly execute and measure with a more familiar set of metrics.

AR is certainly not an ‘out of bounds’ zone, and can be positively affected through supply chain activities such as providing more reliable transit times and shorter lead times. In order to positively impact AR, the SC plays a role by delivering products in the right quantity and with the right specs. Improving an otherwise bad invoicing process due to incorrect information on delivery documents can also have a positive effect on the reduction of the AR value.

Better forecast accuracy and demand reliability (a study by EyeOn cites a two percent potential reduction of purchase prices as a direct consequence of improved demand reliability) represent a practical way through which supply chain practices impact AP.

Reliable production planning and scheduling together with agreed quality assurance protocols can surely improve the quality of the relationship with suppliers. That enables the purchasing department to close better deals once a win-win and trustworthy collaborative environment has been established.

The bottom line

The company case study in the sidebar (opposite) will prove that these are not pure academic recommendations but actual real practices. Some conclusions can be derived from the analysis of the trends and practices observed. The most practical way to leverage and exploit the results of the investigation is to describe them as role-based action items for the different participants to this important business domain that goes under the name of the financial value chain.

• The role of the finance department: financial officers should draw the line to connect the investor mandate with operations. They are in the best position to translate into operational terms the financial targets that meet the expectations of the investor community.
• The role of supply chain officers: handle the trade-offs implicit in every supply chain decision and incorporated in every operational metric. It is up to the SC manager to break down the financially correlated operational targets into more specific and detailed instructions that will be transferred to operations people.

There is no magic ‘silver bullet’ or perfect mathematical algorithms and models that will predict the exact outcome of endeavor. It is absolutely certain, however, that any model and interpretation based on consensus will trigger positive and virtuous reactions.