Daily Archives: December 27, 2015

Economic Damnation 08: Outdated Financial Models

Or, more accurately, outdated financial assumptions. Finance lives and dies by metrics that go by three (and four) letter acronyms such as CAPM, CFC, COGS, DSO, EPS, etc. If these don’t “add up”, Procurement can forget about ever getting any additional funding (and might even get rewarded with a budget cut by a CFO who thought that Procurement simply wasted his time with their last request), even though having these metrics “add up” isn’t always the right thing for the business.

Most CFOs are intensely focussed on CAPEX, COGS, DSO, DPO, ROI, and EPS. These have to look good because CAPEX and COGS take up most of the operating cash flow not swallowed up by salaries, DSO and DPO define how much cash flow there is to work with, ROI defines the return on using limited cash flow on an endeavour, and at the end of the day, all of this better add up to an acceptable EPS or the CFO can find himself in the unemployment line with the CEO if the shareholders get angry.

Now, the CFO is right to sweat these metrics because the organizational health depends on it, and it’s pretty much impossible to keep Procurement healthy in a sick organization, but if the metrics are misinterpreted or misused, and Procurement denied the budget it needs for talent, platforms, and services that will enable Procurement to deliver (significantly) more value (and bang for the buck), then in an effort to keep the organization healthy, the CFO will actually be making it sick by starving Procurement of the resources it needs to stay healthy.

Why would it do this? Because of outdated models and invalid assumptions. You see, most Finance organizations believe:

  • Unless your business is leasing, CAPEX should be minimal because all assets should be as liquid as possible.
  • COGS should be as low as possible, because minimizing COGS maximizes profit.
  • DSO should be as short as possible because the more cash on hand, the better.
  • DPO should be as long as possible because the more cash on hand, the better.
  • Only the projects with the highest, short-term, ROI should be funded.
  • At the end of the day, EPS has to increase quarter over quarter, year over year, because that’s what keeps the shareholders happy.

But not all of this is true. Do you know where the fallacies are?
We’ll give you a minute to think about it. And remind you to

Have you figured out where the fallacies lie? We’ll make it easy for you. Every single assumption is wrong. Why?

It’s not liquidity of the asset, it’s liquidity of the business. Sometimes it’s better to buy a valuable asset, and if cash is tight, use it as collateral against a low interest business loan than to lease at a rate that essentially doubles the cost of ownership over a 5 year period.

It’s not COGS, it’s POGS (no, not those annoying circular discs that plagued us during the mid-90’s) Profit On Goods Sold. If a few changes to the distribution and marketing strategy doubles sales, then it doesn’t matter that the COGS is increased 3% from 82% to 85%. 15% profit on twice as many units is much better than 18% profit on a base amount of units any day of the week.

It’s not DSO, it’s TSM – Total Sales Made. If increasing DSO allows a customer to buy more, well, if the organization has the war chest, or the credit rating to survive on a very low interest line of credit (compared to a weaker supplier or customer that might borrow at 12% to the organization’s 4%), then DSO should be increased for the right group of customers.

It’s not DPO, it’s TCO. If extending payment forces a supplier to take unreasonable loans or factor invoices at ridiculous discounts, that’s increasing their overhead operating costs considerably and, guess what, at contract renewal time, your rates are going up, up, up. Your short term gain translates into a long term loss.

It’s not always ROI, and the direct and indirect savings generated, sometimes it’s about the brand (image), such as switching to renewable energy or renewable materials which incurs a short term penalty due to the need to build new energy plants or switch to new processes, or about the knowledge gained, which would result from training, new systems, and the implementation of new processes. Organizations that stand still fall behind. Sometimes an organization has to take calculated risks and try a few high-risk investments to help it identify the best investments.

And while EPS is still the gold standard in the Wall-street led financial world, EPS cannot increase perpetually without investment, otherwise, at some point, the entire company will come crashing down. Remember, to continually increase EPS, one has to continually increase profit. To continually increase profit, that requires either continuously increasing revenue or continually decreasing costs, or both. Costs have a baseline that cannot be passed. And increasing sales almost always requires additional investment in marketing, which, at some point, will hit a point of diminishing return due to market size and consumable disposable income. And the faster one tries to grow, the faster the ceiling is hit, and the faster the rug is torn from beneath one’s feat when the dream comes crashing down. Just like leading Procurement organizations realized it’s not TCO but TVM, it’s not EPS, but VPS.

However, as long as Finance works on antiquated metrics based on antiquated assumptions, Procurement will be denied of the technologies, processes, services, training, and talent it needs to get the job done better. It’s damnation at it’s finest.