green eyeshades and balance sheets

We've spoken elsewhere of the need to couch what we do—and what we hope to do—in supply chain management in the language of the executive suite, paying particular attention to the chief financial officer. But what are the financial ramifications of supply chain performance? Which levers of corporate achievement can we pull? What needles of company performance can we move on the dials?

Two leading thinkers on these topics are Dr. Stephen Timme of FinListics Solutions and Dr. Terrance Pohlen of the University of North Texas. Timme writes, teaches, and trains extensively in the arena of increasing shareholder value through supply chain management. Pohlen researches, publishes, and speaks on cost and cost accounting issues in supply chain management. Their guidance has helped our understanding of the EVA and ABC material presented below.

There are numerous techniques available to measure financial performance and the contributors to it. The least useful are the traditional ones—cost accounting, performance to budget, and so forth. It's not about balance sheets or profit-and-loss statements or outside auditors. It's about management accounting, its links to organizational financial performance, and converting quantitative financial data into information, and information into intelligence—intelligence that can be acted upon for the corporate good.

Among contemporary alternatives, activity-based costing (ABC), the balanced scorecard (BSC), and economic value added (EVA) all provide different perspectives on financial performance. Integrating them provides a powerful view of overall performance. And research continually shows that EVA leaders are shareholder value leaders.

Activity-Based Costing (ABC)
ABC can transform the quality of data and information underlying key operational and strategic decision-making by transforming how costs are calculated and presented. It is detailed and takes a fair amount of work to implement. But done well, ABC can make for what Dr. Phil calls "a life-changing day." Among other things, activity-based costing can accurately show how changes in service affect cost— and profitability. It can link indirect costs/resources with specific customers and supply flows, and bring focus to high-cost activities and processes. It provides more complete and more accurate visibility to costs and trade-offs.

The objectives of the exercise are to understand the profitability of specific customers and products, to understand cost drivers and to shine a light on where cost reduction and value creation are needed, to know why costs go up or down, and to communicate that information throughout the organization. In summary, activity-based costing is a technique to accurately associate both direct and indirect costs with those elements that consume an organization's resources—activities, customers, products, and/or individual supply chain flows. It translates and transforms traditional reactive cost reporting into proactive actionable information.

The process begins with a two-stage approach to assigning costs: resource costs assigned to activities, and activity costs assigned to products and customers. Resource costs are assigned to activities based on "drivers," and activity costs are the total of all resources necessary to accomplish the activity. Not only does the activity cost show all the resources, but it also identifies resources needed—or not needed— when activity volumes change.

Typically, the level of costing detail must be carefully considered—generally, it falls into the range of plus or minus 30 items. In all cases, costs are assigned on a per-activity basis—per shipment, per unit, etc.

Finally, cost objects are defined—customers, channels, products, and so forth—and a bill of activities, resembling a manufacturing bill of materials, is constructed to incorporate all relevant activities and their costs.

Economic Value Added (EVA)
EVA is a proprietary term popularized by the investment firm Stern Stewart. It is a powerful tool in corporate performance analysis, positing that nothing we do is important unless it helps create value. That value—the economic value added—is defined as NOPAT (net operating profit after taxes) minus the cost of capital times total asset value.

NOPAT is simply net profit minus taxes, and net profit is merely gross margin less total expenses. Gross margin is sales minus cost of goods sold. Total assets are the sum of current assets plus fixed assets. Current assets are inventory, cash, and the like; fixed assets consist of plant, equipment, and similar items. Simple, so far.

Supply chain management can profoundly affect several elements of the EVA calculation, beginning with asset productivity—getting more out of existing plant and equipment assets, building or acquiring right-sized additional assets, or reducing space and equipment. It includes managing inventories to the right levels of investment and the right levels of performance, indicated by such measures as turns, service levels, and customer satisfaction.

We can drive out costs—waste—and manage costs to the optimum when reduction is not in the cards. We can affect sales and market share through superb operational execution in fulfillment and customer service.

Our work in reducing cycle times, improving flexibility, and reducing all forms of waste affects many elements of the EVA equation. And we can show these impacts in an EVA tree that builds to a picture of EVA results.

In short, supply chain management—in manufacturing, in procurement, in physical distribution, in planning, in information systems—can move the EVA needle like nobody else can. And increasingly, the EVA needle is the most important one of all.

Balanced Scorecard (BSC)
Some good early work in defining and describing the balanced scorecard was produced by David Norton and Robert Kaplan in the early '90s. They outlined four interlinked BSC perspectives:

• The internal business perspective—what must we excel at?
• The customer perspective—how do customers see us?
• The financial perspective—how do we look to shareholders?
• The innovation and learning perspective—can we continue to improve and create value?

The balanced scorecard approach links the cause-andeffect elements of the four perspectives, with innovation and learning driving improved operational performance. Elevated performance, in turn, supports improved positioning with customers, which ultimately translates to increased shareholder value based on a stronger top line, well-managed costs, and net results of a better bottom line and increased asset utilization.

There are variations on the balanced scorecard theme, in which diverse performance metrics—output, quality, human resources—are displayed. That's a good thing in general, but is not so useful as the more rigorous linkage from perspective to perspective. When you can demonstrate how training drives pick accuracy, which supports greater customer satisfaction, which, in turn, leads to higher sales, margins, and share value, the story becomes not just interesting, but compelling. And it's a story that C-level executives want and need to hear.

A word of caution: It is possible, and too easy, to create a diverse scorecard that may be called "balanced," but which is not relevant to real drivers and how they affect the dependent perspectives that make up how a supply chain succeeds or fails.

All together, now
How powerful is this notion of tying ABC, EVA, and BSC together? Nearly unbelievably so. Imagine managing from reported BSC results, and managing toward BSC objectives. And what if the financial perspective focused on economic value added—real, after-tax growth in the company's underlying economic value—and its positive impact on share value? Consider adding to that the ability to know— really know—the costs and profits associated with major activities, core products, and key customers.

Does this combination and integration define Utopia? Of course not. Is it practical and real? You bet. Is it easy? Not at all. Is it worth the effort? Contemplate which companies might be making it work. Look for them among the leaders. They're the leaders in cash-to-cash cycle performance; they're the leaders in shareholder value gains. They are outperforming their industries, and they are in the top tier of supply chains, irrespective of industry. Think Dell and Apple. Think Best Buy and Wal-Mart. Think Toyota, Procter & Gamble, and Johnson & Johnson. Think Tesco.

Are they all doing everything perfectly in terms of ABC/BSC/EVA integration and execution? Probably not, but they're clearly focused on knowing costs, building value, and general supply chain excellence.