"Need for Speed: Driving Improvements with Supply Chain Management"

By Dr. Stephen G. Timme, President FinListics® Solutions and CFOEd™

Copyrighted © 2001 by FinListics Solutions

Profit margins for many companies are being squeezed by:

• Increased Competition
• Changing Customers? Demands
• Higher Costs, and
• Disruptive Technologies

For example, the profitability for an index of consumer goods companies has dropped to 5.2% from 7.0% just a few years earlier. Whereas, the profitability of an index of automotive parts suppliers has dropped to 7.8% from 8.6% over the same period.

With shrinking margins, companies must increase the utilization of capital, or what we like to call "SPEED", to continue to provide a good return to investors.

• SPEED is the dollars of revenues generated per dollar invested in capital (e.g. inventory, fleets, warehouses, manufacturing facilities, accounts receivable, etc.).
• A company with $1,000 in revenue and $500 in capital has SPEED of $2.00.
• This means that on average $1.00 invested in capital generates $2.00 in revenue.

Supply chain management is a key driver of SPEED. Better management of inventories, warehouses, fleets, distribution network, etc. increase SPEED and, in turn, financial performance.

Exhibit 1: Examples of SPEED
Source: FinListics Solutions

SPEED is driven by:

• What a Company Does - Dell's SPEED is higher than Dow Chemical's in part because the assembly of computers is much less capital intensive than the production of performance plastics and chemicals.
• How a Company Does it - Dell's world-class supply chain management results in lower days in inventory and higher fixed assets utilization. And, therefore, higher SPEED than less efficient competitors and many other companies.

How SPEED Drives Total Returns to Investors
Return On Capital (ROC) is a key bottom-line measure of a company's financial performance. For example, a company has $100 in profits and $1,000 in capital. Its ROC is measured as:

Return On Capital	=	Profit / Capital
	=	$100 / $1,000
	=	10%

Also, suppose that the company has $2,000 in revenue. Return On Capital is now reformulated to highlight SPEED.

Return On Capital	=	Profits Revenue	x	Revenue Capital
	=	Profitability	x	SPEED
	=	$100 $2,000	x	$2,000 $1,000
	=	5%	x	$2.00
	=	10%

The company keeps $0.05 in profits per $1.00 of revenue. And $2.00 is generated per $1.00 invested in capital.

Exhibit 2 shows the impact on the company's Return On Capital if competition and other factors drive down profitability to 4% and the SPEED needed to maintain a 10% ROC.

	Base Case	Profitability Drops to 4% and No Change in SPEED	Profitability Drops to 4% and SPEED Changes to $2.50
Profitability	5%	4%	4%
X SPEED	$2.00	$2.00	$2.50
= Return On Capital	10%	8%	10%

If profitability drops to 4%, with no change in "How" the company does business, SPEED remains at $2.00 and Return On Capital drops to 8%. Some of the consequences of a lower Return In Capital are:

• Lower internal cash generation
• Difficulty in raising outside cash
• Slower growth due to lack of cash
• Increased indebtedness

This highlights the need to change "How" the company does business if there is a change in profitability.

• Suppose better supply chain management increases SPEED to $2.50.
• Return On Capital remains at 10% even with lower profitability.

Exhibit 3 shows profitability, SPEED and Return On Capital for the sample of companies
in Exhibit 1.

	Dow Chemical	Kellogg	Delphi Auto	Wal-Mart	Dell
Profitability	9.8%	9.6%	4.1%	4.0%	7.2%
X SPEED	$1.00	$1.94	$2.87	$3.43	$11.77
= Return On Capital	9.8%	18.6%	11.7%	13.7%	84.7%

Exhibit 3 highlights the importance of SPEED.

• Dell's 7.2% profitability is about average for the 5 companies. However, its SPEED of $11.77 results in an off-the chart 85% Return On Capital.
• Wal-Mart and Delphi Automotive have similar profitability of 4%. However, Wal-Mart's higher SPEED of $3.43 delivers a 200 basis point higher Return On Capital (13.7$ vs. 11.7%).
• Kellogg and Dow also have similar profitability. But Kellogg's SPEED is nearly double Dow's resulting in significantly higher Return On Capital.

The point of this comparison is not to suggest that all companies should have Dell's SPEED or that Dow Chemical can double its SPEED. The point is to highlight the importance of finding new ways to improve SPEED to deliver a Return On Capital that is attractive to investors.

Key Components of SPEED
Two key operational components of SPEED are:

• Cash Operating Cycle
  • Days In Inventory plus
  • Days Sales Outstanding less
  • Days Purchases Outstanding
• Fixed Asset Utilization
  • Revenue / Property, Plant & Equipment (PP&E)

Exhibit 4 shows the cash operating cycle and fixed asset utilization for the companies
shown in Exhibit 1.

	Dow Chemical	Kellogg	Delphi Auto	Wal-Mart	Dell
Days in Inventory	77	57	26	53	6
Days Sales Outstanding	88	36	54	3	37
Days Purchases Outstanding	48	42	40	33	54
Cash Operating Cycle	117	51	40	23	-11
Fixed Asset Utilization	$2.24	$2.65	$5.72	$4.59	$33.03

Again, the cash operating cycle and fixed asset utilization is driven by what a company does and how it does it.

• What It Does - Wal-Mart's and other retailers' cash operating cycle is lower than many other companies because of lower days sales outstanding resulting from a high percentage of cash sales.
• How It Does It - Dell's cash operating cycle of -11 days (yes, it really is negative) is driven in large part by its superior management of inventories.

Driving SPEED with Supply Change Management
Supply Chain Management is one of the areas with the greatest potential to improved "SPEED." Exhibit 5 shows a high-level breakdown of some supply chain enablers' impact on Key Performance Indicators

Exhibit 5: Supply Chain Management Enablers of SPEED

Key supply chain management enablers of capital utilization are:

• Visibility - more accurate and timely information on the flow of goods and capacity.
• Forecasting - better balancing of demand, procurement, production and distribution.
• eBusiness - use of technologies such as trading exchanges, B2B and B2C lower costs, increase revenues and increase capital utilization.
• Network Optimization - designed to maximize Return On Capital not solely minimize operating costs.
• Strategic Outsourcing - focusing on core competencies by converting the fixed costs of assets such as warehouses, fleets, distribution, etc., into variable costs through use of third-party providers.

The combination of these enablers has the power to drive improvements in the Key Performance Indicators shown in Exhibit 5. And ultimately capital utilization.

A Framework for Analyzing the Impact of Supply Chain Initiatives on SPEED Exhibit 6 provides a strategic framework for analyzing the impact of supply chain initiatives.

• In the analysis, a company has a 10% cost of capital (COC) - the minimum return it must provide investors is 10%. This means that its long-term Return On Capital must be at least 10%.
• The ROC/COC break-even curve shows various combinations of profitability and SPEED that result in a 10% ROC (e.g., 10% Profitability x $1.00 SPEED; 5% Profitability x $2.00 SPEED; and 2.5% Profitability x $4.00 SPEED).
• Of course the company's goal is to earn a ROC in excess of its 10% cost of capital.
  • A company with a long-term ROC above the ROC/COC creates value for investors.
  • A company with a long-term ROC below the curve destroys value and must find ways to improve performance.

Exhibit 6: Framework for Analyzing Impact of Supply Chain Management Initiatives on SPEED and Return On Capital

• For example, at the coordinates in (1), the company has a 12% ROC which is comprised of 6% Profitability and $2.00 SPEED.
• In (2), supply chain solutions increase capital utilization. SPEED increases to $2.50 leaving profitability unchanged.
  • The expected ROC increases to 15% (6% Profitability x $2.50 SPEED).
• In (3), competition lowers profitability to 4% from 6%.
  • Supply chain initiatives increasing inventory turns and fixed asset utilization increase SPEED to $3.00.
  • ROC remains at 12% (4% Profitability x $3.00 SPEED) even with lower profitability.
  • If SPEED is not increased, ROC drops, as will returns to investors.

Organizational Considerations

Many supply chain management initiatives involve trade-offs between capital and operating expense.

• For example, a network optimized to maximize Return On Capital inventory levels and fixed assets generally involves up-grading modes of transportation and more frequent shipment.
• This typically results in increased transportation expense.
• A manager who is measured on transportation expense is loathed to spend more on transportation to lower inventories.

This raises one of the most important issues related to making supply chain management a successful enabler of SPEED. Most companies don't focus managers on supply chain capital,

• Companies generally focus managers on Key Performance Indicators (KPI's) related to operating expenses (transportation, warehousing and procurement budgets, $/CWT, etc.) but not supply chain capital.
• These KPI's motivate managers to make the best decision based on solely on operating costs.
• Decisions based solely on operating costs are many times sub-optimal when compared to KPI's focusing on costs and supply chain capital.

Focusing managers only on cost-related KPI's tends to create an environment that believes the responsibility of capital utilization lies with some corporate group. It is a safe bet that capital is under-utilized at these companies.
Therefore, it is essential that new supply chain scorecards be developed that include both cost Key Performance Indicators as well as those that drive capital utilization. Doing so increases the likelihood of using supply chain management to drive increased SPEED and returns to investors.