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The opportunity to increase shareholder value in the future will be to take care of both the income statement and balance sheet through supply chain excellence. What Do You Say? Click Here to Send Us Your Comments Click Here to See Reader Feedback

Last week, SCDigest editor Dan Gilmore offered his review and comment on The New Supply Chain Agenda, a new book from three of the supply chain’s most well known names: Reuben Slone, Paul Dittmann and the late John Mentzer. (See The New Supply Chain Agenda?). Below, we provide a brief excerpt from that book that discusses the foundational concept of how the supply chain can contribute to the economic profit and therefore shareholder value of the corporation.

Given the hype of the last ten years surrounding the supply chain excellence of companies such as Walmart, Toyota, and Amazon, why do so many firms still not get it?  The success of the firms ranked in an AMR Research's Supply Chain Top 25, such as Apple, IBM, and Proctor & Gamble, should have made everyone focus on supply chain as the driver of shareholder value.

The most neglected pathway to increasing shareholder value runs through the supply chain. This isn’t a cost-cutting argument, though supply chain excellence often dramatically reduces costs over the long term. In fact, reaching excellence is expensive, both in terms of executive attention and actual cash outlays. Supply chain excellence drives shareholder value because it controls the heartbeat of the firm – the fundamental flow of materials and information from suppliers through the firm to its customers. Unfortunately, too many companies have a supply chain in which this flow is crippled by the lack of a strategy, the absence of talent, a misapplication of technology, internal and external silos, and a basic lack of discipline in managing change, all issues we address in later chapters.

The supply chain isn’t just trucks, pallets, and warehouses. But being trapped in a traditional view is one of the primary reasons that few companies are taking advantage of the shareholder value opportunity presented by supply chain excellence. You, like many executives we talk to, may be skeptical that investing in this new, expansive vision of a supply chain is worth it. So we’ll begin by looking at the unequivocal link between supply chain excellence and shareholder value by focusing first on economic profit, which is the linchpin between the two.

Driving Shareholder Value by Creating Economic Profit

Economic profit very simply is profit less the cost of capital needed to generate that profit. That profit is a big deal because it means the company is delivering returns above the cost of the capital invested. Generating economic profit should be the prime goal of all firms.  Most CEOs intuitively know that economic profit drives shareholder value. But many don’t clearly comprehend the linkage that begins at supply chain excellence and continues to shareholder value via economic profit. Supply chain excellence very often can deliver the most upside to economic profit and shareholder value because its full potential has been so underutilized in the past compared to other corporate initiatives. 

(Supply Chain Trends and Issues Article - Continued Below)

Economic Profit Increases Shareholder Value

When economic profit increases over time, shareholder value increases. Stern Stewart & Co. has done extensive research on this concept which it calls economic value added (EVA). It has shown through analysis in many companies that the relationship is very strong, especially over time, when the data is normalized. To understand the impact of economic profit, consider the following example: suppose a newly formed company earned $10 million in net income on a capital base of $100 million. This capital base includes both physical capital, like factories and warehouses, and working capital, like inventory and receivables. In this simple example, the company has a return on capital of 10 percent. However, suppose the required return that investors demand for having their money locked into this new venture adds up to an investment expectation of 13 percent on the invested capital. That means that, although this firm is enjoying accounting profits, it actually lost 3 percent last year for its shareholders compared to their expectations. Economic profit charges the company a penalty for tying up investors’ cash to support operations. The capital on the balance sheet becomes just as important as the net income on the income statement.

The Supply Chain Drives Economic Profit

In an increasing but still small number of firms, the CEO and the board understand the value of the supply chain to their firm. But many other CEOs, battered by an immense range of items competing for their attention, do not see this link clearly. Yet the link is there.  Using the expansive view of the supply chain described earlier, in many firms, the supply chain controls most of the inventory, manages 60 percent to 70 percent of the cost, is the foundation to generate revenue by providing outstanding product availability, and manages most of the physical assets of the firm.

We believe the Great Recession of 2008-2010 will increase the focus on economic profit. In an era of tighter credit, supply chain levers can be used to free cash reserves from balance sheets rather than depending on restricted credit markets.  The opportunity to increase shareholder value in the future will be to take care of both the income statement and balance sheet through supply chain excellence.

Any reaction to this brief description of "economic profit" and the opportunity to use supply chain to drive it? Do you think thse concepts and linkages are well enough understood today in the supply chain and the boardroom? Let us know your thoughts at the feedback button below.

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