Learning the language of finance

Shareholders invest their hard-earned money in corporations with the expectation that the enterprises will make smart investments in operational assets that grow the company and deliver dividends. Most of these assets reside in the supply chain, which is why supply chain professionals need to be able to speak like financial analysts. Executives have a much better chance of making decisions that keep shareholders happy if the supply chain function can explain how asset investments affect margins, turnover, and, ultimately, cash flow.

For the past few years, we have been teaching a graduate-level course focused on supply chain finance at the Massachusetts Institute of Technology (MIT) Center for Transportation & Logistics. Our aim is to seed the supply chain profession with graduates who have basic fluency in the language of finance. This knowledge quickly proves valuable; students report that they have more engaging discussions during their job interviews, even after just a few sessions in the course. But financial fluency is useful long after the job interview is over. It provides long-term benefits by allowing operations professionals to better assess and communicate the value of the supply chain initiatives they seek to implement.

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For those of you who cannot take nine months off from work to pursue a graduate degree, here are seven takeaways from our course that we believe will help you to be both financially savvy and articulate.

1. Understand the financial impact of supply chain activities. Supply chain managers need to understand the correlation between supply chain management activities and key financial statements such as the corporate balance sheet and income statement.

The balance sheet is a single-point-in-time "snapshot" of a company's assets, liabilities, and shareholders' equity, and includes inventory, accounts receivable, and accounts payable. The income statement provides a summary of the company's revenues and costs over a defined period of time, and includes a listing of the direct and indirect costs at a high level. These are not the only important financial statements, but they are two of the more important ones for the business as a whole and for the chief financial officer (CFO).

Recognizing those connections is critical because the supply chain manager has to "speak the language" of the CFO in order to get senior executive support. Senior executives do not want to hear about cost structures and inventory turns; they want to understand the supply chain's impact on gross profits and working capital. To make your case, you need to be able to quickly and clearly communicate that information.

2. DuPont analysis distinguishes the role of profitability and turnover in creating returns. DuPont analysis is a fundamental approach to financial management that is couched in a simple formula:

Return on Assets (ROA) = Profit Margin * Asset Turnover¹

Used by the chemical manufacturer DuPont since the 1920s, this formula helps a company find the right "chemistry" between the financial statement (focused on profits) and the balance sheet (focused on asset turns).

Focusing on these measures can help broaden supply chain initiatives beyond cost and inventory reductions, since those measures can demonstrate that higher prices (perhaps achieved through better service delivery) also improve margins and better asset utilization (perhaps by loading trucks with more freight) also improves asset turns. In addition, although we always seek the win-win of improving both margins and turnover, often there is a trade-off between the two. For example, refusing to discount slow-selling items results in higher margins but lower turnover, because inventories remain on the books longer.

Supply chain professionals can assess decisions at a high level if they can map them to the DuPont ratios and (continuing the example above) determine when discounting might actually improve the ROA. Recently some companies have turned to economic value added (EVA) as an alternate way to evaluate trade-offs between profitability and assets. This concept is also dated, as General Electric (GE) used it in the 1950s under the term "residual income."

3. Be aware that accounting is a practice, not a science. We often think of accounting as an exact science because it involves numbers that are clear and documented. But since accounting is the practice and method for recording and classifying the sources and uses of funds, it involves both an objective and a subjective element.

The recording process is rigorous and highly structured, almost always involving tangible items with discrete values associated with them. The classifying process, however, is less exacting, with industry guidelines such as Generally Accepted Accounting Principles (GAAP) giving the accountant some discretion as to how to classify transactions. A business therefore has several options to consider for recording various transactions. Should we record this purchase as a period expense, or as a capital asset purchase? When should we record the official date of sale? How long will this capital asset last, and how fast should we depreciate the asset? Should we record assets on a last-in-first-out (LIFO) or first-in-first-out (FIFO) basis? What internal costing method should we use, and how should we allocate overhead costs?

Giving the accountant options for classifying various transactions makes sense because the same period expenditure may represent different things to different companies. A computer that serves as a standard office-support device in one company, for instance, could be classified as a critical corporate asset in another. However, this level of discretion can also get some executives and companies into costly scandals, many of which involve supply chain managers as unwitting partners. Consider, for example, the 2004 case of the pharmaceutical company Bristol-Meyers Squibb, which had to pay a US $150 million settlement fee for inflating its financial results by "stuffing its distribution channels with excess inventory near the end of every quarter," according to the U.S. Securities and Exchange Commission.² Who made those shipments? Supply chain managers, of course.

Supply chain managers need to be aware of these potential pitfalls, and should be prepared to probe cost "data" supplied by the accounting department. For instance, does the company use LIFO or FIFO methods of recording inventory assets? That matters a lot if you are responsible for inventory because, depending on which method is used, a specified dollar amount of inventory may represent very different unit volumes. This is because the LIFO method records inventory-asset costs using the most recently purchased materials, and FIFO records inventory assets using the oldest inventory on the books. In most cases the purchase cost for additional inventory assets increases over time, which means that for the same number of units in inventory, the dollar value of that inventory on the books tends to be lower using LIFO than if the company used FIFO. For example, if you bought five units last week for $10 each, and five units this week for $20 each, you would have 10 units on hand at a total cost of $150. If you then sold five units, the remaining inventory of five units on hand would be recorded as $50 using LIFO, and $100 using FIFO.

Another thing to keep in mind is that the cost-accounting system that the company uses to allocate direct and indirect costs to products and customers provides critical operating information that can sway supply chain decisions. Different cost systems make different assumptions about how costs should be recorded (for example, how overhead costs such as utilities should be allocated to products or the processes used by products), and they use different granularity of data. As a result, one product may have much more overhead allocated to it than another. In that case, the manager may choose to focus attention on that product because it is a higher-cost unit. Under a different cost system, however, that same product may have a lower total cost, and the manager may choose to address a concern about another product instead. Deciding where to focus improvement efforts, then, depends in large part on the nature and the quality of the information provided by the costing system.

4. Activity-based costing requires a big investment but may also offer big benefits. Choosing the right cost-accounting method to support internal management decision making involves a trade-off: the amount of time and effort it takes to capture and record cost data versus the benefit that can be derived from that data. This is a consideration for any company that uses activity-based costing (ABC), a structured method for associating costs with business activities that continues to grow in popularity. ABC can more accurately tie the costs of activities conducted in production or delivery of a product or service to the potential revenues from those activities.

The information obtained by applying ABC can be extremely powerful and can help to identify inequities arising from the use of traditional "average costing" methods. These traditional practices overstate some internally reported product costs and understate others, leading decision makers to invest in the wrong products and services.

Here is just one example of the kind of difference ABC can make. Transportation service providers can benefit by applying ABC to their operations because it allows them to properly associate the real drivers of cost with the delivery of their services. The decision by both UPS and FedEx to adopt dimensional-weight pricing on all parcels in part reflects their recognition that pricing small parcels solely on the weight of the box did not accurately reflect what it costs them to ship and handle those boxes.

The challenge in adopting ABC is finding the right level of detail so that the cost to acquire the information does not exceed the benefit of collecting it. If that balance is maintained, the extra effort involved in ABC should reward managers with better information and the ability to make better decisions across the supply chain.

5. Don't hold on to holding cost. Many supply chain professionals (and business students in general) are introduced to the concepts of inventory holding cost, also known as inventory carrying cost, when they are taught how to calculate economic order quantity (EOQ). This is an essential parameter for setting inventory policies by estimating the cost of maintaining stock, which is a combination of capital and storage costs. Often, this holding cost parameter, which can range from 10-40 percent of the product value annually, is also used to calculate the savings from an inventory reduction. However, this "grab bag" of financial components can lead one to miscalculate (and often underestimate) the value of an inventory reduction.

Lowering the inventory level required to run your business reduces working capital requirements in perpetuity, not just in the year that reduction is implemented. Also, changes in the non-capital components of holding cost, such as warehouse facilities, equipment, labor, and shrinkage, among others, can affect the financial statements in multiple places. For example, lower costs lead to higher profits and thus, higher taxes.

Calculating projected cash flows using pro forma financial statements better captures the impact of the non-capital costs; these future cash flows can then be transformed into a current value by discounting them to consider the "time value" of money. (The "time value" concept recognizes that money available now is worth more than the same amount in the future, because it has greater earning capacity.) This discounted cash-flow (DCF) analysis of projected cash flows can also incorporate the perpetuity of reduced working capital and is the right approach for calculating the value of an inventory reduction. DCF also happens to be a language that your finance colleagues are more comfortable speaking when discussing any capital request that enables your inventory initiative.

6. Cash flows are relevant. As mentioned above, DCF analysis is a common approach for making capital-allocation decisions. The challenge is determining which cash flows are relevant. Our class sessions on DCF are not focused on how to do the calculations (although we do encourage our students to create an Excel template with the sophisticated sensitivity analysis that everyone uses for making such decisions). Instead, we consider one supply chain situation after another—software purchases, transportation mode options, make-versus-buy decisions, and so forth—and ask students which cash flows should be included in their DCF spreadsheet.

There are two key tests to determine whether a cash flow is relevant: (1) ensuring that there is actually a cash transaction, and not just an accounting calculation such as depreciation, and (2) confirming that the cash really does make a difference if the capital project is implemented, and is not a cognitive concept like sunk cost (a cost that has already been incurred and can't be recovered).

7. Supply chain has a big influence on working capital. When financial managers are looking to reduce working capital—that is, the difference between current assets and current liabilities—they often ask supply chain managers to reduce inventory. But supply chain managers also impact the other components of working capital: receivables from customers and payables to suppliers.

By virtue of their close working relationships with both suppliers and customers, supply chain managers can exercise great influence on terms and performance in each of these areas, putting themselves at the heart of capital and cash management. For example, Dell Computers famously operated on negative working capital back in the 1990s. The company popularized make-to-order computer sales, which relied on prepayments from customers and also consignment inventory from suppliers, enabling Dell to essentially operate on other people's money. Supply chain strategy and management, of course, played an indispensable role in making that possible.

Optimize your portfolio
The supply chain is the driver of value creation for most companies. While supply chain professionals are not financial advisors picking stocks for shareholders, they do make the key decisions about where to invest much of the capital that investors provide. And although picking finished-goods stocks for inventory is not as glamorous as picking Wall Street stocks, optimizing the portfolio of finished goods can have a significant impact on investors' financial portfolios.

Our graduate course provides a foundation for future professionals to connect their actions in the supply chain with business performance. We hope that you will take a cue from our students and increase your fluency in finance. It can turn into cash ... for your company and for your own wallet.

Notes:
1. Traditional DuPont analysis does consider ROE (Return on Equity) = Profit Margin * Asset Turnover * Financial Leverage, but as supply chain professionals do not have much influence on financial leverage, we focus on the ROA terms.
2. U.S. Securities and Exchange Commission, "Bristol-Myers Squibb Company Agrees to Pay $150 Million to Settle Fraud Charges" (August 4, 2004).