21 Apr 2013 How misaligned business metrics can cost millions
Isn’t it interesting how opposites attract. When the circumstances are just right, people, businesses, natural elements and chemical compounds bind together in synergistic relationships of mutual self interest. Successful supply chain partnerships are just like that and collaborations between very different businesses can create profitable partnerships in which the whole is much greater than the sum of the parts.
And isn’t it disappointing when different parts of the same organization repel each other like the poles of a magnet. You would think that procurement and finance divisions of the same business would have a similar agenda but when it comes to some matters of finance, buyers have more in common with their suppliers than they have with their own finance people.
I’m from a purchasing background – not finance. I used to get nervous when discussing supply chain finance with finance specialists. I still do. They can use jargon to confuse me – it’s what jargon is for – and sometimes I feign ignorance in order for them to patronize me with simple explanations of the world of accountancy. And this is really useful because it’s only when you get down to the lowest common denominators, the raw, basic principles that we all have in common that we see the fundamentally opposed agendas of procurement and finance.
Call me simplistic but I see profit as the essential financial objective of a business. When I think of the reasons why it would be good to get a lower price for the best products for my business, I see that because a lower price means lower costs which means bigger profit. When I see cash in the bank I see interest. The interest I can earn on that cash (or the return I can get by investing it in some other way) is the contribution that cash can make to profit.
But the world is more complicated than this in reality. Procurement is by no means just about securing the best deal or the lowest price but costs of goods and services and the cost of securing those goods and services, the contribution to profit is a fundamental KPI. A discount, secured in return for early payment, contributes directly to profit. It is therefore a good thing. If it further contributes to the stability of the supply chain by helping to lower the cost of working capital of the supplier then that’s a good thing too. So supply chain finance* initiatives like dynamic discounting are a good thing. But this is where there is an objection from finance.
For a $1billion business – a business that spends a $1billion a year on buying goods and services – holding on to cash for an extra day delivers about $3million of extra cash flow. Paying a day early costs about $3million. To get a 1% discount on goods valued at $1million in return for payment 30 days early would gain $10,000 in discount. That’s $10,000 extra profit. Good thing right? Accountants see this differently. They see a cost of $82,000 terms of cash flow. ($1million divided by 365 multiplied by 30) But cash flow isn’t the same as profit. You’d have to be getting a return in excess of about 12% to to make $82,000 of extra cash flow generate $10,000 of profit but accountants don’t always do that calculation because cash flow is their fundamental KPI, not profit.
I understand that profit is not always the fundamental KPI for procurement. Quality can outweigh cost. So can ethics. The mitigating the risk of supply can be more important than the money. Wider business objectives depend on circumstances. Aggressive growth at any cost in order to secure market share can lead a business, wisely, to throw the rule book out of the window. Profit isn’t always paramount – but I do despair when I see different parts of the same business using different KPIs to manage the same organization. While procurement struggles to maintain safe supply of goods, their finance colleagues are seeking to extend payment terms. And while suppliers are going under because they can’t secure working capital for less than 20% APR, their customer’s treasury teams are sitting on a pile of cash earning a paltry percent.
Misaligned KPIs blind business. Trying to develop consensus amongst a group of people who want fundamentally different things is futile but failure to rise above the discrepancies in the detail can be a very costly mistake.
* Supply Cain Finance can mean a million different things. Some would define it in very specific terms to describe a way in which buyers and suppliers collaborate to manage their financial supply chain. Other terms like payables financing, receivables financing, trade finance, dynamic discounting and reverse factoring are all in some ways synonymous with each other but its a matter of semantics and the term supply chain finance is evolving to be recognized as that general term. I use dynamic discounting as an example of supply chain finance because it is easy to explain and the arithmetic easy to understand but it is by no means the only way to generate financial synergies in the supply chain.
Pete Loughlin can be found on twitter @peteloughlin