Bridging the disconnect between finance and purchasing (Part 3): EPS and the Swinging Pendulum of Responsibility

Posted on September 14, 2011

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Now comes the fun part.  The changes which are possible – based on what I’ve described so far, are identified in blue in the next figure.  Revenues are shown to increase 3%, purchased goods and services costs (as a % of revenues) are reduced from 60% to 55%, and SG&A expenses as a % of revenues are reduced by 1%.  Those three improvements – which, by the way, are very achievable based on what we’ve covered so far – have a large cumulative impact on net income and EPS.

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.

In yesterday’s post I had indicated that the authors of the Straight to the Bottom Line book did not hold back any punches in terms of placing responsibility for the disconnect between purchasing and finance on the shoulders of executive leadership.

This limited or limiting vision on the part of senior management relative to the power of purchasing was reiterated in another book from the same authors titled On-demand supply management: world class strategies, practices, and technology.  In this text they had made the observation that “The same supply management leader who received corporate accolades for leveraging savings from spend analysis . . . quickly begins to hear the CEO’s and CFO’s relentless question, what have the suppliers (read: and you) done for me lately?”  The authors then go on to say that the previous “glory” has been replaced by even greater challenges.

The challenges to which they are referring is a common lament by purchasing professionals in that having harvested the low hanging savings fruit, there is an even greater expectation for duplicating the effort in subsequent years.  As indicated by a CAPS 2003 study in which the utilization of Reverse Auctions did not produce sustained levels of savings (in fact savings actually decreased before flat lining once the buying price was corrected to reflect actual market conditions), this is not an easy task.  As a result, purchasing departments are still confronted with management’s query demanding an answer to the question “how come you did so much better last year.”

Even though this reflects a one-dimensional understanding of the purchasing department’s power to significantly impact an organization’s bottom line, the author’s suggestion that “Seasoned supply professionals who read this book will certainly recognize this attitude shift,” which they contend is “driven by the dynamic nature of the competitive market game,” means that the onus or pendulum can also swing to the buyer side of the collaborative equation in terms of the need to make a responsible contribution.  In essence we can no longer claim ignorance in line with the you can’t manage what you don’t measure axiom.

Being aware of senior management’s limited understanding of purchasing beyond the traditional adjunct of finance view, coupled with the identification of key performance indicators such as ROIC and Earnings Per Share “EPS”, it is incumbent for each and every purchasing professional to demonstrate a broader, more enterprise holistic reach of their activities to demonstrate true value and finally silence the what have you done for me lately executive refrain.

While I had previously identified how a purchasing department’s proficiency (and efficiency) can have a positive impact on ROIC, today we will examine the extent to which the purchasing process and performance can and will have an impact on EPS.

What is Earnings Per Share?

According to the Stock Research Pro website, EPS is defined as follows; A company’s Earnings per Share (EPS) represents the portion of the company’s earnings (after deducting taxes and preferred share dividends) that is distributed to each share of the company’s common stock. The EPS measure gives investors a way to compare stocks in an “apples to apples” way.

For newer companies the EPS is based upon future or projected earnings, while the EPS for larger, more established companies is based upon actual earnings.  In the latter case, if earnings drop, the company’s share price will likely be impacted negatively.

Regardless of whether you are employed by a newer company or an established organization, the ultimate bottom line is just that . . . how can purchasing positively influence earnings re the bottom line numbers?

According to InvestopediaMost companies aim to improve their bottom lines through two simultaneous methods: growing revenues (i.e., generate top-line growth) and increasing efficiency (or cutting costs).  It is obviously in the reduction of costs where purchasing can have the greatest and most direct impact on a company’s EPS.

However, not all roads lead to the promised land of reduced spend and increased net earnings.  In reality, most organizations employ outdated and ineffective strategies such as vendor rationalization or centralized contract compliance as the levers to achieve the desired outcome.

As a regular subscriber to this blog you will undoubtedly think of the countless posts I have written about these purported best practice initiatives that when broadly applied across all areas of spend actually serve to undermine efforts to realize increased savings and earnings.  The key phrase here is the broad application of a specific strategy across all areas of spend.  This is important to keep in mind as your read the following paragraphs.  For those first time readers, here is the link to the post Kraft Buys Into the Mirage of Vendor Rationalization, that I am sure you will find interesting as it will serve as a primer in terms of explaining the logic behind my thought process.

Relative to today’s article, and in an effort to maintain a consistency of information source, I will once again refer to the On-demand supply management book and the Kennametal case reference in particular.

According to the book’s authors, Kennametal achieved cost reductions of about $16 million per year after taking their first steps towards spend analysis and the resulting move to establish “corporate contracts” in combination with a deliberate effort to “focus on key suppliers.”  Prior to this shift in strategy, cost reductions hovered between the $5 to $6 million range.

A key component of the initiative was to funnel 85% of spend within a given category through their top five suppliers.  The authors noted that other organizations strive to direct 95% of their spend through only two suppliers with one being designated as being in a dominant position, while the other being viewed as being in an opportunity position.

What is worth noting is that even though the company stresses compliance, at Kennamore it is not mandatory.

Referencing what management called malicious compliance, the company’s executive leadership recognized the fact that a blindly and broadly applied edict is tantamount to shooting oneself in the foot as it removes the leeway for a buyer to acquire something at a better price such as a loss leader.

Though forward thinking examples like the one provided by the Kennametal case reference is exciting, as it represents a long overdue move away from the aforementioned and lingering one dimensional view of the purchasing function, it is nonetheless an epiphany that continues to elude the majority of executives.

Hopefully, as more purchasing professionals take the initiative to understand the connection between procurement and EPS, we will see a Kennametal-type transformation occur more frequently and with greater urgency.

Tomorrow in Part 4 of the series I will examine the link between purchasing and Economic Value Add “EVA.”

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Posted in: Commentary, Finances