Integral Logistics Management — Operations Management and Supply Chain Management Within and Across Companies

1.7.3 Scenario: Assessing the Economic Value Added (EVA) of Supply Chain Initiatives

Intended learning outcomes: Describe selected supply chain events and their relationship to current assets. Explain an example representation of the value of a supply chain initiative (SCI) in the form of the Economic value added (EVA).

Supply chain managers often have problems in communicating quantitative benefits of their management decisions, which go further than reporting service level improvements and cost reductions, to the boardroom. On the other hand, financial managers have problems assess­ing the real contribution to enterprise value of supply chain initiatives (SCIs). Many assump­tions have to be made when, for instance, calculating the economic value added (EVA) of such projects. As a result, investment decisions about SCIs carry a certain level of risk.

Economic value added (EVA) is a metric for representing enterprise value. EVA is positive, i.e., value is generated, when an investment activity leads to higher NOPAT than the weighted average costs of capital (WACC) invested in the assets required for generating that income.

In other words, value is only generated when the investment is expected to provide more profit than the stockholders would get by alternative investments on the market. The equation is therefore:

EVA = NOPAT – WACC × value of fixed and current assets

Hence, the challenge is to provide transparency on the benefits and risks of the various supply chain structures and SCIs used for improving the performance of the supply chain — generally the reduction of inventory and reduction of lead time — in terms of the financial variables like EVA.

The supply chain value contribution (SCVC) method as described by [Schn10] is a tool for providing transparency about the cause and effect of SCIs on supply chain performance and the utilization of assets, with a focus on the working capital.

The integrated view of the SCVC method links logistics’ and financial managers’ perspectives on the supply chain. This provides the required common language for assessing the contribution of SCIs to enterprise value. Hence, investment decisions can be made on a more profound basis and related risks mitigated. The key element of the SCVC method is the use of the SCOR model and identified relationships between specific supply chain events and the different elements of net working capital. Figure shows an example visualization of these relationships in a make-to-stock production environment.

Fig.         Selected supply chain events and their relationship to current assets.

The upper part of the figure lists identified supply chain events with a direct relationship to the elements of working capital, displayed in the middle part, and relevant metrics used by logistics and financial management shown in the lower part. The horizontal axis represents the flow of time, which is followed by the flow of material, information, and cash. The vertical axis is relevant for the middle part and represents the valuation of material and the amount of the unpaid received or sent invoices and of the cash in- and outflows.

All material that is inventory, either in transit, raw material, in process, or finished goods, appears on the balance sheet, valued at actual total costs. This has two important consequences. First, where costs are reduced, the valuation is decreased by the same amount. Second, considering that the balance sheet is a snapshot of the company’s asset and capital situation at a given point in time, there is material in the whole supply chain, which appears as inventory in the corresponding stage. The shorter the supply chain, the less material adds up in the inventory account. In Figure, the heights of the inventory rectangles represent the actual total costs of the material until the particular stage. The widths represent the duration of time (i.e., cycle time) the material remains (on average) within the particular stage of the supply chain at a given point in time. The area of the rectangles is the value of the particular element of inventory appearing on the balance sheet. By reducing costs, the height of the rectangles is decreased. By reducing cycle times, the width of the rectangles is reduced, resulting in a smaller area and therefore a lower valuation of the particular element of inventory. So both cost and cycle time reductions reduce the amount of capital lockup within a company.

A similar logic can be applied to the accounts payable and receivable, respectively. The widths of these boxes represent payment terms, or, as a performance measure, the days payable/receivable outstanding. The heights represent the amount appearing on the corresponding inbound or outbound invoices. Cash inflows and outflows do not have a “cycle time,” but they have a value, and influence the amount of cash the company holds in the balance sheet. Figure does not show the cash pool. Because production processes are here considered a “black box,” the figure shows this element not as a rectangle but as a trapezoid. This represents the value-adding activities taking place in this phase, with costs incurred appearing in accounts payable. However, in a more detailed analysis, these aspects could be included.

Any supply chain can be displayed accordingly, providing an integrated view of operational supply chain performance and the resulting utilization of working capital. Using this visuali­zation to display a change in supply chain performance, resulting from the implementation of an SCI, makes it possible to calculate the contribution of the initiative to enterprise value, based on EVA. This is done by entering the data of the corresponding analysis into the structure as shown in Figure

The data in the figure are based on an example scenario fully described in [Schn10]. In short, the scenario describes an SCI in which a logistics service provider takes over supply and inventory-related management activities. From a logistics perspective, this increased the reliability of shipping and storing processes, with shorter lead times at lower costs per product. Because of lower return rates and higher product availability, the number of sold products and therefore turnover increased by $22,980. The higher volume results in higher total SC cost of $4,589 and higher taxes of $5,517. From a financial perspective, the NOPAT is disproportionately higher ($12,874).

Fig.         Example representation of an SCI value in the form of the EVA.

In addition to the perspective of the profit and loss statement, EVA integrates the changes on the balance sheet. The logistics performance improvements described above affect working capital in two dimensions. Shorter lead times reduce the cash-to-cash cycle time, representing the time capital is locked up as material in the supply chain. In addition, because costs per product could be reduced at several stages of the supply chain, the valuation of the material in the different inventory accounts is reduced, too. These relations are visible in Figure Both effects result in reduced capital lockup of $54,713. After being multiplied with the WACC of the company of 15%, this value and the NOPAT effect make up the total EVA contribution of the SCI of $21,081.

Consider the following scenario: A central distribution center (CDC) located in Switzerland wants to evaluate whether it would be beneficial to change the mode of transport to the regional distribution center (DC) located in the south of Norway. Currently, transportation is by truck in order to achieve short transportation cycle times (3 days). Transportation by ship would take 7 days but is cheaper. The title of inventory is transferred as soon as the products arrive at the DC. The relevant average inventory value at the CDC is $300,000 in the finished goods warehouse, plus average $25,000 in-transit inventory with transpor­ta­tion by truck. The average in-transit inventory would double when chang­ing the transportation to ships. At the same time, the annual trans­portation cost would decrease from $20,000 to $15,000, with pay­ment terms toward any carrier of 60 days. The WACC of the firm is 8%.

What is the effect of the change of the mode of transport on NOPAT and EVA after one year? Would you advise changing the transportation mode? Include a sensitivity analysis in your reasoning, as the values of the initial variables can vary in practice. Hint: As the SCVC method only calculates the change of the EVA contribution from a baseline to a changed scenario, you need to consider only values that differ between the scenarios. Solution:

  • NOPAT: +$5,000 (same sales – $5,000 less transportation cost)
  • Average value of accounts payable: from $3,333 ($20,000 / 12 months * 2 months payment terms) to $2,500
  • Capital lockup: +$25,833 ($25,000 higher average in-transit inventory plus $833 lower accounts payable)
  • EVA change: $5,000 - $25,833 * 8% (WACC) = +$2,933

Approaches for sensitivity analysis:

  • Sales could drop because of longer order fulfillment cycle time
  • Higher/lower WACC

Course section 1.7: Subsections and their intended learning outcomes

  • 1.7 Scenarios and Exercises

    Intended learning outcomes: Describe improvements in meeting entrepreneurial objectives. Differentiate between entrepreneurial objectives and the ROI. Assessing the Economic Value Added (EVA) of Supply Chain Initiatives. Derive rough-cut business objects from detailed business objects.