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In Part 1 of this article presented last month, we reviewed some basic Supply Chain Management (SCM) concepts, strategies and tactics that are directly applicable to C-level executives for implementation and sustained support. The primary purpose of Part 2 is to present an overview of research findings showing the relationship between SCM and corporate financial statements, earnings per share, and business valuations. Perhaps when CEOs begin to receive performance numbers in their language, they can then justify the investments in time, money, people and other resources necessary to bring supply excellence into the companies they lead. As you go through this section, readers are urged to keep in mind the paramount importance of CEO’s understanding of the long-term value of SCM to corporate performance, while providing the leadership, guidance and resources to overcome the obstacles along the way.
By focusing on supply chain initiatives to cut costs, and thereby improve revenues, companies can add as much as 8 points of new profit to their financial statement. The opportunity here is huge. Assuming that a firm does have 40 percent of its costs connected to the supply chain, then a 20 percent improvement would add 8 points (.40 X .20) of new profit to the financial statement. Even a more modest cost-reduction improvement of 15 percent would add 6 points of new profit to the bottom line—still a very significant improvement(1).
Effective management of the supply chain can create cost reduction and sales expansion opportunities, and both of these results should translate to higher profits and greater shareholder value. The problem is linking supply chain activities to increased company value. It would stand to reason that as firms become more sophisticated and adept in managing supply chain activities, then the results should be reflected in the value that investors place on the company’s stock. Several specific cases are mentioned in this article:
PETsMART revenues have reportedly grown at a rate of 22% annually after having linked its supply chain of global vendors via collaborative groupware over an extranet
Fujitsu, a Japanese chipmaker, speculates that the adoption of supply chain management practices in 2002 will result in increasing the firm’s return on equity to 10%.
Seven-Eleven Japan (SEJ). is Japan’s largest convenience store retailer, operating more than 8,200 stores. Many experts attribute much of SEJ’s success to effective supply chain management. The company has an extremely agile logistics system and state-of-the-art systems for determining market demand and communicating with suppliers. On average, each of their stores turns inventories about once per week. For seven consecutive years the company has posted the highest level of operating income in the Japanese retail industry.(2)
Research, conducted by The Performance Measurement Group, a PRTM Company, finds that discrete manufacturers with mature supply chain practices are 40% more profitable than discrete manufacturers with less mature practices. Although other factors such as product innovation and channel management certainly contribute to this profit edge, supply chain management is a key driver.
Study results show that companies with mature practices outperform their peers in delivery, flexibility, responsiveness, and cost.
The organizations with more advanced practices are better at predicting market demand and meeting customer expectations, achieving a 10% advantage in both unit forecast accuracy and delivery performance. In addition, mature-stage companies have a 10-25% advantage in three components of overall supply chain management costs--order management, materials acquisition, and inventory carrying. As a result, total supply chain costs for these later-stage companies are only 9% of revenue on average, versus 10.7% for lesser-stage companies. For a $1 billion company, that translates into savings of almost $20 million.
Mature-stage consumer goods companies echo these results. They can deliver products six days faster, meet customer requirements almost 100% of the time, and have total supply chain management costs that are 20% lower. Given this segment's focus on cost management and control, these benefits translate into a tremendous competitive advantage. At the other end of the spectrum, life sciences companies remain functionally focused. In this industry segment, overall supply chain performance often takes a back seat to product development, manufacturing ramp-up, and product quality--all of which can make or break a company's financial performance.
Best-in-class companies have a planning process that regularly involves operations, marketing, sales, and finance in deciding strategic supply chain changes. Although 92% of companies with mature practices have adopted this practice, only about 55% of lesser-stage companies have. Since mature-stage companies are already better at supply chain planning, the shift of focus away from Plan will only increase their performance advantage.(3)
Companies with superior supply chain performance outperform their peers in earnings per share, return on assets, and profit margins.
AMR Research validated this through some very detailed benchmarking, working with manufacturers looking for the drivers of overall supply chain superiority. What they found was that companies that had higher levels of demand visibility and forecast accuracy reduced supply chain costs and increased perfect-order percentages. Across the industry, companies with better demand-forecast accuracy also have 15 percent less inventory, 17 percent better perfect-order ratings, and 35 percent shorter cash-to-cash cycle times than their peers. The study notes the correlations between superior perfect-order performance and some key financial and market indicators, including the following:
· Earnings Per Share (EPS)--Higher perfect-order performance correlates with higher EPS. Specifically, this study reveals that a 10 percentage-point better perfect-order rating correlates with 50 cents better EPS. On one million shares, 50 cents per share translates to $500,000.
· Return on Assets (ROA)--Companies with better perfect-order ratings also tend to have better ROA; five percentage points in the perfect-order rating correlates with 2.5 percent better ROA. On $1 billion in assets, that translates to $25 million.
· Profit Margins--Better perfect-order performance also correlates with higher profit margins. A three percentage-point better perfect-order rating correlates with 1 percent additional profit margin. Take the case of a $1-billion company with a 10-percent profit margin: increase to 11 percent, and you've added $10 million to the bottom line.(4)
And finally, a study by the Institute of Supply Management of U.S. manufacturers, for example, found that purchasing and supply chain management (PSM) can influence every major element of the income statement, with the greatest impact on cost of goods sold. Covering a period from 1999-2001, the study concluded that companies are more aware of PSM's impact on high-level financial measurements, such as earnings per share (EPS), economic value added (EVA), stock value, profitability, and asset/capital utilization. This change suggests that top management no longer views supply chain management activities in isolation but rather within the context of their influence on overall company success. This conclusion is confirmed by a recent A.T. Kearney study. In an appendix, the study lays out the key financial areas of SCM impact and influence:(5)
Charting PSM's Financial Responsibilities
Asset/Capital Utilization - Profitability & Growth
Return on Assets - EPS/EVA
Return on investment - Stock Value
Return on Net Assets - Profit Margin
Return on Capital - Cost Reduction/Savings
Return on Equity
Purchasing Efficiency - Cash Flow Efficiency
Operating Expense Savings - Cash Generation
Cost Savings of Purchased Goods - Cash Cyc Reduction
Administration Expense Savings
Now we’ll look at a couple of studies that relate the negative impacts and costs of SCM failures to corporate financial results.
Not only do these serve as excellent examples of the costs of doing things wrong, they may serve as excellent ammunition to convince your CEO of the vital need for having a long-term strategy in place for developing and maintaining SCM competence within your organization.
Although there has been very little formal research to link the adoption of SCM strategies to stock value, there is some anecdotal evidence that such a linkage exists. For example, the lack of supply chain efficiencies has been cited as one of the major factors leading to the downfall and bankruptcy declaration by Kmart Corporation.(6)
Supply chain management can significantly affect a company's financial performance--both positively and negatively. Motorola provides a specific example of how a misaligned supply chain can cause stock price to fluctuate. After the 1994-95 Christmas season, Motorola's mobile phone sales dropped dramatically as the distributors sold off the excess inventory built up during the holiday season. As a result, Motorola's share price sagged, and it took the company a long time to recover.(7)
A study conducted at the Georgia Institute of Technology found that a company announcing a supply chain disruption, such as a production or shipment delay, will experience a stock price fall that averages 8.62% on the day of the announcement and can drop as much as 20% over the next six months. This is a most interesting study on the negative effects of poor supply chain performance on financial results. Intuitively, most people recognize the linkage between a company’s supply chain performance and its shareholder value. Now there’s hard statistical evidence to support that intuition. This research shows that “glitches” in supply chain performance—defined as a disruption in the matching of supply and demand—can have a devastating effect on stock price. The total damage, in fact, can be as high as 18 percent. Based on a sample of more than 1,100 supply chain glitches subjected to this methodology, this study’s authors estimate that companies will suffer an average drop of 7.5 percent in stock price when they announce a glitch. Furthermore, they found an average drop of 18.5 percent when stock price performance was measured starting two quarters before and ending two quarters after the glitch announcement. By showing how much shareholder value can be lost through poor SCM, these results also indicate how much can be gained through effective SCM.
After adjusting for the average industry and market movements for the same period, this research shows that glitch announcements are associated with a stock price decrease of nearly 7.5 percent. The reaction was negative for 75 percent of the announcements, providing additional support for the proposition that glitches are bad news for shareholder value. Depending on the model used, this study shows that the average destruction in shareholder value ranges from $134 million to $152 million per glitch in 1999 dollars. Therefore, the overall destruction in shareholder value for the 1,131 glitches is estimated to be between $151 billion and $172 billion. By any standard, this represents a significant negative impact on shareholder health.
Although both small and large companies experience a drop in share price from glitches, the impact is more devastating for smaller companies than for larger companies: -8.35 percent vs. -5.85 percent. This could be due to a number of reasons. The economic impact could be more severe for smaller companies because
· They are more likely to be highly focused.
· Their profitability is critically dependent on flawless supply chain management for a limited set of products.
· Recovery may take longer to recover because they may not have the capital to invest in technologies and solutions that could accelerate solutions.
· Their small size reduces their power to influence and change the behavior of other supply chain partners in a way that could help them recover from glitches.
· Finally, there’s a higher probability the investment community might be more surprised by a glitch announcement from a smaller company.
All Glitches Are Penalized. The stock market severely penalizes companies that experience glitches irrespective of which link in the supply chain is responsible for the glitch. The study shows that when glitches are attributed to internal problems, the average loss is 7.14 percent. Glitches caused by customers resulted in a loss of 10.92 percent, whereas glitches attributed to suppliers are associated with a loss of 8.26 percent. The results show the heavy price that one link in the supply chain pays for the poor performance of another. Such significant losses in shareholder value should provide an incentive for all of the links to work collaboratively to minimize disruptions.(8)
Conclusion:
As the results show, there is certainly some level of connection between the recognition that a firm is adopting supply chain-enhancing approaches and the value that investors place on the company. And the findings from the Georgia Tech study make a strong case about the negative effects on financial performance stemming from poor supply chain planning or execution. I think the most important point to be taken from all of this is that a growing volume of recent research is now available to support the position that supply chain management really matters! And it’s not just for the Big Boys either. To ensure this message is received by C-level executives in a manner they can relate to easily, SCM professionals need to develop reporting tools that will convert specific operational proposals or results into financial statement, cash flow and even EPS /business valuation terms.
To be specific, it’s not good enough to report that new SCM initiatives have resulted in X% reductions in transportation expenses, or X% reductions in inventory, or X% increase in perfect order fulfillment and so forth. These KPIs standing alone are just not in the financial language spoken at the C-levels. Now contrast the above performance metrics with reporting that directly links increases or reductions in SCM performance attributes to EBITA, NOPAT, annual or future discounted cash flow, EPS, ROA and business valuations. I would also suggest inclusion of simple Benefit-Cost Ratio analysis in order to present the net effects of SCM performance enhancements in the most accurate way possible. CEOs and CFOs would now be able to see exactly how SCM impacts the financial fortunes of the business, and this common and shared visibility can lead to coordinated and sustained efforts to achieve and maintain SCM excellence. And that, without a doubt, is in the interests of all. In Part 3 in this series on Financial Supply Chain Management, I will present a series of reporting tools that achieve the operational-to-financial results translations referred to above.
(1) Excerpts from SCMR Article – Annual Survey of Supply Chain Progress – Nov/Dec 2004
(2) JOURNALOF BUSINESS LOGISTICS, Vol. 26, No. 1, 2005
THE STOCK PRICE REACTION TO SUPPLY CHAIN MANAGEMENT ADVERTISEMENTS AND COMPANY VALUE
(3) From: Business Wire - June 4, 2003 PRTM Research Shows Leaders Boost Financial Performance with Supply Chain Best Practices.
(4) MSI September 1, 2004 Author: Caruso, Dave “Supply chain excellence means superior financial performance.”
(5) From: Supply Chain Management Review, November 1, 2002 Author: Liu, Baohong
(6) JOURNALOF BUSINESS LOGISTICS, Vol. 26, No. 1, 2005
THE STOCK PRICE REACTION TO SUPPLY CHAIN MANAGEMENT ADVERTISEMENTS AND COMPANY VALUE
(7) From: Supply Chain Management Review, November 1, 2002 Author: Liu, Baohong
(8) How Supply Chain Glitches Torpedo Shareholder Value - Vinod R. Singhal & Kevin B. Hendricks -- 1/1/2002
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Introduction
