Bridging the disconnect between finance and purchasing (Part 2): Leveraging purchasing to improve ROIC

Posted on September 13, 2011

2


What’s really cool is that software leviathans are awakening to the promise of these treasures and developing increasingly powerful IT solutions that leverage the Internet to multiply the savings potential and add speed.  And the reason extremely few companies are doing well?  Poor executive leadership.

from the book Straight to the Bottom Line: An Executive’s Roadmap to World Class Supply Management by Robert Rudzki, Douglas A. Smock, Michael Katzorke, Shelley Stewart Jr.

What I found interesting about the collaboration that is Straight to the Bottom Line is that besides removing the barriers to understanding the diverse and important role that procurement and supply management plays in the financial health of an organization, the authors squarely place the blame for the disconnect between finance and purchasing on the shoulders of executive leadership . . . or the lack thereof.

While I will leave the discussion concerning 21st Century leadership challenges to another series (although you might want to tune in to the on-demand broadcast of a panel discussion on the subject which aired on the PI Window on Business titled 21st Century Leadership: An Evolutionary Profile), it is nonetheless an important acknowledgement for senior management to make if the situation is ever going to improve.

That said Straight to the Bottom Line, about which I had also written back in early 2008, and in particular Rudzki, emphasized the fact that there are five critical finance terms every purchasing professional should know (and obviously understand).

They are as follows:

1. ROIC (Return on Invested Capital): earnings divided by the total capital invested in the business (long term debt plus stockholder equity)

2. Cost of Capital: the weighted average “cost” of debt and equity. It represents what you must earn to, minimally, cover the expectations of your debt holders and stock holders

3. EVA (Economic Value Add): if ROIC is greater than Cost of Capital, then EVA is positive (you are adding value to the organization). If ROIC is less than Cost of Capital, then value is being destroyed and – absent substantial corrective action – the demise of the enterprise is just a matter of time

4. EPS (Earnings per Share): the net income divided by the # of common shares outstanding. Typically calculated on a quarterly and annual basis.

5. P/E Ratio: The ratio of the common stock price to the annual earnings per share. Companies/industries typically “enjoy” certain P/E ratios, therefore, increasing the E (earnings) often directly equates to a higher stock price.

Of the five, Rudzki highlighted both ROIC and EPS as being the two biggies, as they are what Wall Street and bankers are most interested in. In essence, ROIC and EPS are the ultimate “report card” of senior management.

As such, we will focus on the specific link between purchasing and improving ROIC today and then examine the EPS tie-in tomorrow.  From there I will review the remaining three points as they are obviously important to the extent that they warranted inclusion in the list.

Divided into two distinct categories, Actions to Improve Margins and Actions to Improve Asset Utilization, the book is adept at identifying the critical points or areas towards which purchasing professionals should focus their attention.

Actions to Improve Margins (Revenue related):

  • Faster new product design & development
  • Optimum and reliable parts and raw materials suppliers
  • Excellent transportation service providers

Actions to Improve Margins (Cost Related):

  • Reduce freight costs and claims
  • Reduce raw materials costs
  • Reduce indirect materials/services costs
  • Reduce manufacturing variability

Actions to Improve Asset Utilization (Working Capital related):

  • Improve payment terms with suppliers
  • Utilize inventory programs with suppliers

Actions to Improve Asset Utilization (Capital Expenditure related):

  • Improve redeployment of used assets (“asset recovery” programs)
  • Reduce total costs associated with capital spending

As you review the above list many of the key points such as Optimum and reliable parts and raw materials suppliers, Excellent transportation service providers, Reduce indirect materials/services costs and, Improve payment terms with suppliers makes one wonder why there was and still is a disconnect between finance and purchasing in the first place.  Each of these are the logical elements of a sound supply management strategy that require little if any further explanation.

And while there are to be certain exciting innovations in many areas upon which purchasing professionals must keep a watchful eye such as Made in Transit shipping, the reality is that ultimately the inability for organizations to connect the dots between purchasing and their balance sheet has more to do with a breakdown in communication.

In this regard, Rudski and company doesn’t hold back any punches citing critical breakdowns such as a lack of understanding of the opportunity presented by improved supply-side performance; lack of active support for purchasing; poor choice of leader for the purchasing function; incorrect reporting relationship between the Chief Procurement Officer and the executive suite; a lack of alignment between corporate, financial, and purchasing objectives; and most importantly, a weak or totally lacking mandate.

Over the years I have addressed each one of these shortfalls at length often referring to the purchasing department as being the Rodney Dangerfield of the corporate hierarchy in that it “get’s no respect.”

The most telling example of this was one of the many observations that were made during a 2007 CPO Agenda Roundtable discussion in which the majority of senior executives expressed the belief that the best person to run a purchasing department, is someone who does not have a purchasing background.  You can read my February 8th, 2011 post According to study conducted over three decades buyers warrant little consideration in terms of value to the organization, to gain an in-depth understanding from where the challenges referenced in the book likely have their origins.

All this tells me is that even though there is a need for supply chain professionals to take the initiative to look beyond the confines of being pigeon-holed in terms of how executives have traditionally viewed purchasing’s role, including making the effort to understand the strategic relevance of what they do and how it impacts the bottom line, the real focus should not be on terminology but instead on establishing better communications with all key stakeholders both within and external to the enterprise.

Tomorrow in Part 3 of the series I will delve into the link between purchasing and Earnings Per Share “EPS” calculations.

30

Posted in: Commentary, Finances