Tag Archives: EVA

How CFOs, COOs Can Bury the Hatchet

Discovering the ways their metrics match up can help finance chiefs and supply-chain executives align their companies’ spending choices.

Alejandro Serrano – CFO.com | US

Supply chain and finance are usually seen as separate and conflicting disciplines.

In a retailing or manufacturing company, key performance indicators are typically set by the chief operating officer to maintain high customer-service levels by keeping inventories high. At the same time, the CFO pushes the company’s supply-chain management to reduce inventory as much as possible to avoid the financial burden imposed by high working capital requirements. As a result, supply-chain and financial incentives become misaligned, and efforts to arrive at a compromise can be extremely frustrating for both disciplines. However, it is possible to bridge this divide.

There are many examples of how the interests of supply chain and finance can diverge in companies. In turbulent times, for instance, finance may have stronger reasons and incentives to free up cash by reducing inventories. But in prosperous times, supply chain may advocate the need for on-time deliveries even though such a strategy elevates inventory volumes.

In recent years, many companies have tried to become more efficient by operating on a global rather than a local level and developing a more-holistic view of their operations. But even if a consensus is reached on what the efficiency goals should be, a crucial question often remains: What’s the best method for assessing the appropriateness of an investment?

That question brings supply chain and finance into conflict again. Finance, for instance, may firmly believe that supply chain’s evaluations of investments are incomplete because they miss a portion of the picture. Supply chain may feel equally that finance’s analysis is missing an essential piece of the puzzle.

Still, finance and supply chain can find common ground even here. During a recent consulting project at a multinational company, for example, I learned how the two sides can come together.

Three people from different departments in the company proposed distinct approaches to solving a manufacturing problem: defining the production batch size. The finance people offered the approach of choosing the batch size that maximized the discounted economic value added (EVA), as was customarily done in the company. (EVA is the economic profit earned by a company minus its cost of capital.)

For their part, the supply-chain folks proposed using the economic order quantity (EOQ) formula, commonly used in business to calculate order quantities at the best possible cost. (Companies use EOQ to find out the correct number of units to order to minimize the total cost of buying, delivering, and storing the product.) At the same time, project management wanted to calculate the batch size so as to maximize the net present value (NPV) of the resulting incremental cash flows.

These approaches led to three different solutions, and it was impossible for the three departments to reach a consensus on which batch size to choose. I was asked to find the right method to use and to outline what assumptions, if any, would invalidate the other approaches.

Our first assumption was that the EOQ formula could not give the right solution to maximize value, because it does not discount cash flows; instead, it merely minimizes a cost function. However, working through the calculations produced a surprising result: all three approaches yielded exactly the same solution.

How could this be possible, given the differences between minimizing cost and maximizing value in the different approaches? It stems from the fact that the EOQ formula does, indeed, discount cash flows. In broad terms, the formula contains the inventory holding cost, a part of which is a financial cost, which coincides with the discount rate in any NPV approach.

The result immediately removed the misalignment between supply chain and finance. Although this is just one example, it sheds light on how barriers between departments can be removed by delving into the reasons for these divisions. The project should encourage managers to take a holistic view of their firm when making decisions and encourage researchers to keep working on ways to align the interests of finance and supply chain.

Alejandro Serrano (aserrano@zlc.edu.es) is professor of supply chain management at the Zaragoza International Logistics Program of the Massachusetts Institute of Technology, Zaragoza, Spain.  www.zlc.edu.es


Leave a comment

Filed under Supply Chain & Finance