Bridging the disconnect between finance and purchasing (Part 5): Cost of Capital and the advent of an elusive tie-in to purchasing

Posted on September 20, 2011

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In many instances, purchasing, perhaps more than any other business function, is wedded to routine.  Ignoring or accepting countless economic and political disruptions to their supply of materials, companies continue to negotiate annually with their established networks of suppliers or sources.  But many purchasing managers’ skills and outlooks were formed 20 years ago in an era of relative stability, and they haven’t changed.  Now, however, no company can allow purchasing to lag behind other departments in acknowledging and adjusting to worldwide environmental and economic changes.  Such an attitude is not only obsolete but also costly.

from the Harvard Business Review article titled Purchasing Must Become Supply Management by Peter Kraljic

Even though the above HBR article was originally published in 1983 reading it today, one could easily apply the the same commentary to the here and now.

This is especially true when it comes to bridging the gap of understanding (or misunderstanding) between finance and purchasing.

So far in our series we have discussed the link between ROIC, EVA and EPS in terms of aligning the purchasing department’s objectives with the goals of the finance department in an effort to drive greater and more tangible value through what has become on the global stage a highly strategic function within the modern enterprise.

In this the fifth part in the 6-Part series I will examine the importance of what the authors of the book Straight to the Bottom Line referred to as one of the five critical finance terms every purchasing professional should know . . . the cost of capital.

While we are undoubtedly all very familiar to varying degrees with the term cost of capital, it is in the practical application in our everyday acquisition practices that there is often times a failure to connect what is spent with the corresponding bottom line impact on our respective organizations.

In terms of a specific definition, cost of capital is defined as follows:

. . . is a term used in the field of financial investment to refer to the cost of a company’s funds (both debt and equity), or, from an investor’s point of view “the shareholder’s required return on a portfolio of all the company’s existing securities”.  It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.

There you go . . . the answer in less than a paragraph!

For most purchasing professionals, extracting the specific tie-in to our daily functions from the above definition is to a certain extent obfuscated by the fact that we are not dealing with an indigenous terminology.  In fact, most readers will, after a brief scan of the above paragraph, move on in an effort to find some nugget of relevant and relative wisdom.

Unfortunately, the much sought after explanation of the direct link between the cost of capital and purchasing is elusive even within the usually astute writings of the Straight to the Bottom Line crew from Greybeard Advisors.

Go ahead and do a search on the Internet using terms such as cost of capital and purchasing.

With Google, you get Wikipedia’s Capital Cost definition followed by a link to their Historical Cost overview in which a search using the term purchasing produces a corresponding link to Constant Item Purchasing Power Accounting.  Hmmm, sounds interesting but what does it mean . . .

“Constant Purchasing Power Accounting (CPPA) is a consistent method of indexing accounts by means of a general index which reflects changes in the purchasing power of money. It therefore attempts to deal with the inflation problem in the sense in which this is popularly understood, as a decline in the value of the currency. It attempts to deal with this problem by converting all of the currency unit measurement in accounts into units at a common date by means of the index.”

Okay, feel better now?  Did the clouds of misunderstanding suddenly part to reveal a clarity of connection?

Not yet?  Let’s try the next search return . . . from the NYU Stern School of Business.

Doing a search using the word purchasing here is what comes up:

Currency Effects on Investment Analysis
One of the debates that analysts often engage in when doing investment analysis is whether the analysis should be done in one currency or another. Intuitively, an analysis of whether a project is a good or bad one should not depend upon what currency the analysis is done in. The important fact to keep in mind is that cash flows and the discount rate have to be estimated consistently. To convert the analysis from one currency to another would have required the following steps:
Step 1: Estimate the expected exchange rate for each period of the analysis.
While forward rates might be available for some currencies for a few periods, there are very few cases where forward rates will be available for the entire project life. To estimate the expected exchange rate, draw on the purchasing power parity theorem that argues that changes in exchange rates between two countries will reflect differences in inflation in those countries.
Step 2: Convert the expected cashflows from one currency to the other in future periods, using these exchange rates.
Step 3: Discount the expected cashflows at a discount rate, based upon the same currency.

Ahhh, the old purchasing power parity theorem.

Do you see a pattern here?

The fact remains that the disconnected bridge between finance/purchasing originates on both sides of the fence in that there is an unnecessary complexity that forces purchasing people to excavate through mounds of financial mumbo jumbo in much the same way that a paleontologist has to painstakingly uncover a fossil to get an image that is even remotely tangible.

For most of us already heavily burdened with a demanding workload, going much beyond the effort that I have put forth so far in the writing of this post, would be unlikely if not outright impossible.

So why if, according to the Greybeard Group and in particular Rudzki, cost of capital is one of the key five terms purchasing professionals need to know, is it so darn difficult to get a straight answer?

Finance & Purchasing: Unnecessary Complexity

After all senior executives are usually the ones who advocate the belief that if you can’t explain the importance of the subject matter about which you are talking in 20 seconds or less, you either do not know what you are talking about or, the subject matter isn’t relevant.

So let’s do a little experiment . . .

How many out there in the social networking world can readily provide in 20 seconds (or the equivalent in words) or less, the all important link between cost of capital and purchasing?

I will be posting this question on my social networks and will share with you with the comments I receive.

In the meantime, I would encourage you to share your thoughts here directly in the comment box below.

Then we will compare notes to see if books such as Straight to the Bottom Line have really had the industry impact I believe they should.

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Posted in: Commentary, Finances