Category Archives: Finance

A Quick Introduction to Finance, Part III

A recent article over on CPO Agenda on “Skills for the Future” that summarized the findings from a recent workshop that debated the skills the future would require identified better finance skills as keys to future purchasing success. Since the article simply rambled off a list of terms with no definition, I decided I’d define the basics for you.

Asset Turnover: is the amount of sales generated for every dollar worth of assets. Simply put, it is revenue divided by assets. It measures an organizations efficiency at using assets to generate revenue. The higher, the better. It can also indicate pricing strategy. A company with a low profit margin tends to have high asset turnover, while those with high profit margins tend to have low asset turnover.

Return On Investment: (ROI) is a performance measure used to evaluate the efficiency of an investment. It is calculated as the return on investment divided by the cost of the investment. The higher the ROI, the better the investment.

Return on Invested Capital: (ROIC) is a performance measure used to assess the company’s efficiency at allocating the capital under its control to profitable investments. It is calculated as the Net Return for all Investments divided by the Total Capital available. (Where Net Return is Net Income minus Dividends).

Profit Margin: net margin, net profit margin, or net profit ratio is a measure of profitability that is equal to the net profit (after taxes) divided by revenue. Like Asset Turnover, ROI, and ROIC, bigger is better.

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A Quick Introduction to Finance, Part II

A recent article over on CPO Agenda on “Skills for the Future” that summarized the findings from a recent workshop that debated the skills the future would require identified better finance skills as keys to future purchasing success. Since the article simply rambled off a list of terms with no definition, I decided I’d define the basics for you.

Cost Breakdown: is the process of breaking a cost down into its components.

Cost breakdowns are the basis of Total Landed Cost and Total Cost of Ownership calculations. For example, the cost breakdown of a transformer would be steel, labor & overhead, copper, oil, transportation, miscellaneous components, and supplier profit margin. The total landed cost would be the unit cost, the taxes, the export tariffs, the import duties, and the transportation and in-transit storage costs. The total cost of ownership would also include inventory costs, utilization costs, and waste / defective unit return costs.

Life-Cycle Cost Analysis: (also known as Whole Life Cost) refers to the total cost of ownership over the life of on asset. It starts with the costs incurred in the planning and design phases, includes production related costs such as new machinery or equipment, raw material costs, labor and overhead costs during production, distribution, maintenance, and eventual disposal. From a life-cycle cost perspective, the cost per unit is just one cost among many.

Cost Engineering: is an area of engineering practice concerned with the application of scientific techniques to cost estimating and cost control. It will use advanced statistics and cost models to try and accurately estimate the total cost of a product before it is built and to identify methods to control costs that could increase beyond acceptable bounds.

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A Quick Introduction to Finance, Part I

A recent article over on CPO Agenda on “Skills for the Future” that summarized the findings from a recent workshop that debated the skills the future would require identified better finance skills as keys to future purchasing success. Since the article simply rambled off a list of terms with no definition, I decided I’d define the basics for you.

Working Capital: is a financial metric which represents the operating liquidity available to a business. It’s calculated as current assets minus current liabilities. Positive working capital is required to ensure that a firm is able to continue its operations. Furthermore, it must have enough cash on hand to satisfy operational expenses and maturing debt.

Current Assets: include inventory, holdings, and accounts receivable.

Current Liabilities: accounts payable, debts, and (due) operational expenses.

A key part of working capital management is:

Cash Management: which aims to ensure that the business always has enough cash-on-hand to meet day-to-day expenses.

For example, let’s say that monthly payroll is 200,000, monthly leases are 50,000, and 100,000 in payables are due within the next 30 days. This says that the business needs 350,000 to meet its expenses this month. This also says that, unless payables are received, if the business only has 400,000 in the bank, then it only has 50,000 available for new investments or initiative. As a result, even if you wanted to buy 100,000 in raw materials to negate the need for your supplier to get financing and reduce total supply chain costs, you couldn’t do so. On the other hand, if the business had 500,000 in the bank, you could, but you wouldn’t necessarily want to unless it was the best use of the business’ cash.

Part of Working Capital Management is making the right decisions when it comes to managing cash. This includes making the right borrowing decisions as well as the right investing decisions. If financing your supplier reduced your total cost of ownership of 300,000 worth of goods by 1%, but a short term loan could generate 6% interest, the short term loan would be the better decision. This is because it would generate 0.06 * 100K or 6K worth of interest as opposed to the 0.01 * 300K or 3K worth of savings. On the other hand, if the financing reduced the total cost of ownership of the goods by 3% and the best interest rate was only 4%, financing the supplier’s raw material buy would be the right choice because 9K worth of savings beats 4K worth of interest any day. This is the type of financial planning that Supply Management professionals need to understand to make the right recommendations, and decisions, for the business as a whole.

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The Tiger is Only Beginning to Roar

Earlier this year I told that that this is the year of the tiger … and China is going to roar as it is on track to overtake Japan as the 2nd largest global producer of GDP. But this is just the beginning. China is expected to become the global leader in scientific research in a mere 10 years (Financial Times [FT]) and the global leader in GDP within 25 years (The Economics Journal).

According to the FT article, Thomson Reuters, which indexes scientific papers from over 10.5K journals, analyzed the performance of the BRIC over the past 30 years and found that China outperformed every other nation with a 64-fold increase in peer-reviewed scientific papers, with a particular strength in chemistry and materials science. And although quality varies, China has also become more collaborative, with almost 10% of papers originating in China having at least one US-based co-author.

And the research pace isn’t expected to slow down. When you combine the government’s enormous investment in research (with funding increases consistently far above the inflation rate), an organized flow of knowledge from basic science to commercial applications, and the efficient, but flexible, way in which China taps the expertise of its extensive scientific diaspora in North America and Europe, drawing mid-career scientists back home with deals that allow them to spend part of the year working in the West, the productivity should only increase. And this, in turn, is going to continue to drive their economy upward and onward.

Now if only we’d take a lesson from China and investment the same amount of money into research and infrastructure. Maybe we could hold on just a little bit longer …

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Does a Quick Start Imply a Quick Finish?

It seems that the fashionable thing to do these days if you’re a Supply Management technology provider is to build a “Quick Start” platform and promote a rapid initial implementation, and the “obvious” rapid ROI that will result. Coupa, Rosslyn Analytics, and Aravo, among others, have all been making noise about their new SaaS platforms that allow for rapid results. And while each platform will give you rapid results if you listen to their advice and apply it properly, I’m starting to worry if this is the right thing to do.

Just like a narrow focus on “cost savings” can actually result in overspending and financial devastation if taken to the extremes, a narrow focus on quick wins can also cause you to miss the big picture, and the incredible savings opportunities that can result from good long term planning and cost control policies. A focus on short-term wins usually focusses on overspending recovery (which is good, but doesn’t solve the fundamental problems that led to the overspending), re-sourcing or re-negotiating high-spend categories (which may or may not have high savings opportunities), auctioning commodities (with little oversight), and “automating” processes (which is good if you take the time to redesign the processes first, which most companies don’t). And while all of these activities are good, because they always result in some cost reductions, there’s only so much low-hanging fruit on the spending tree and once it’s gone, if you don’t have a plan for reaching the bigger fruit in the higher branches, your new cost reduction program will finish as soon as it starts.

This is not to say that the companies I mentioned don’t have the tools and techniques to help you reach the fruit in the higher branches (after all, I’ve reviewed them all in the past and noted many positive aspects of each platform), but that you will have to take the time to build the ladder to get there. You’ll have to carefully research high-spend categories and build should-cost models to see which ones offer opportunities for immediate cost reductions, and which ones you’ll need to spend time working with engineering to come up with new product designs or delivery models to enable real cost reductions. You’ll have to move beyond auctions to decision optimization to tackle custom manufacturing categories where you have to consider dozens of costs which could include unit, shipping, storage, production, tariffs, taxes, currency exchange, hedge, utilization, and other costs. You’ll have to move beyond pure spend data to understand why production costs are higher than you expect — are your production times lagging industry average?, is your equipment out of date?, is your plant too big or too small?, etc. And you’ll have to implement end-to-end sourcing and procurement technologies to do true m-way matches that match contracts to purchase orders to invoices to goods receipts to payments to make sure you’re only buying on contract at the contracted price and only paying for what is actually delivered. True, long-term cost and risk reduction is a marathon, not a one hundred meter dash. And just like a quick start can wear out a marathon runner and prevent him from finishing the race, an uncontrolled quick start can set unreasonably high expectations or deliver less than optimal results, which can kill support for your project before you reach the end of your journey, where the real cost reductions await.

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