Charting your Financial Impact

Posted 10/04/2015

How can procurement become more aligned with, and demonstrate its impact on, the main measures of business success? This is a question that all CPOs face but few have fully answered. This aim of this article is to explore the impact that procurement can make on a company’s sustainable shareholder value – the core measure of any company’s success – and to suggest how the image of procurement can be considerably improved in this area.

Financial markets have been globalising for several years now, transferring billions of dollars around the world every day. This financial globalisation has induced investment promiscuity and accentuated the importance of how companies are perceived by fund managers, institutional and private investors alike.

Perhaps more importantly, financial market globalisation has led to tremendous short-term pressure on senior management teams to deliver, irrespective of their business sector. This, in turn, has influenced how companies are managed.
The success of management teams in adapting their business strategies and performance to these constant short-term financial pressures may be measured in terms of sustainable shareholder value (SSV). This reflects the capacity of a publicly quoted company to regularly increase its stock-market value, frequently outperforming major market indices over the long term. Such companies are often market leaders, innovative, have strong and stable management and inspire confidence from investors by meeting or surpassing forecasts and rewarding investors. Moreover, their business models generate above-average growth and free cash flow – both essential elements in the quest for competitive advantage.

Eiffage, the sixth largest construction company in Europe, is a good example of SSV creation. Over the past 10 years, the company has increased its stock market capitalisation by 1,500 per cent to €6.4 billion, excluding dividend payments. Eiffage is responsible for building projects such as the Viaduc de Millau in France, nuclear power stations in China for Electricité de France (EDF), and the airport of Bale/Mulhouse, which is partly situated in France and partly in Switzerland. More than 90 per cent of its 50,400 employees are shareholders and their faith in SSV creation is very much intact.

Warren Buffett, a major SSV advocate, has repeatedly advised any would-be investor to “know the business” he or she is investing in before referring to graphs, analyst reports, or indeed the financial advice column in their local newspaper. The more than 16 per cent annual returns he has delivered for Berkshire Hathaway investors since the early 1960s suggests that his advice should be heeded.

The procurement paradox

However, despite the growth of global markets, massive outsourcing of business functions to third-party suppliers, consolidated supply bases and a growing number of articles and media attention, relatively little is known about the real business impact that procurement can make on SSV creation. “Knowing the business” should also encompass procurement, as in many companies third-party spend accounts for more than half of total revenues. And yet procurement’s “corporate attractiveness” leaves a lot to be desired when compared with marketing, finance or even research and development functions. Why? There are several reasons that come to mind:

  • The perception that procurement is only synonymous with cost cutting, controlling, avoidance or policing all forms of excess in indirect spend.
  • Short-term financial pressures mean that senior management and fund manager bonuses nearly always depend on this year’s results, which force CPOs to deliver immediate cash to the business.
  • It is much easier to value the short-term savings made during an e-auction or by negotiating a pan-European supply agreement than it is to develop trust and confidence in a long-term relationship with a key supplier. The latter initially can only be measured in terms of improvement projects and innovation – things that, in the short term, can cost more money than they generate.
  • It is very difficult for a CPO to measure their team’s impact on the business, either because the organisational structure is complex and they can’t capture all the benefits that are being delivered, or simply because they don’t always know where savings are being reinvested.

Although all of these reasons are important, they ignore the key role that is being played by procurement organisations in terms of value creation.

Key shareholder value drivers

Over 20 years ago, the US professor and author Alfred Rappaport defi ned four key shareholder value drivers:

1. Accelerating free cash flow
2. Reducing costs
3. Reducing risk and the cost of capital
4. Increasing long-term business value

Creating shareholder value requires all of them, and purchasing’s impact is as follows:

1. Free cash flows are what are left to pay dividends, buy back shares, make ac-
quisitions after new investments, stocks, financing costs and net working capital have been taken into account. All savings in a procurement organisation should theoretically be added to free cash flow. This doesn’t happen in reality, as companies consider that the money could be better spent elsewhere.
2. Reducing costs is the easiest link between procurement performance and SSV. All procurement organisations cut costs with tangible and intangible results, whether or not costs are reduced or avoided.
3. Reducing risk by hedging raw materials and currencies, optimising the supplier selection process and improving relationships with key suppliers are steps procurement can take. The cost of the equity will depend on investor expectations and sector fundamentals, while the cost of the debt will depend on the nature and length of the contractual agreement.
4. Increasing long-term business value through greater transparency and vastly improved relationships with key global suppliers is procurement’s part. This will enable it to optimise free cash flow generation and minimise the cost of capital, thereby increasing company valuation.

However, these drivers are not enough to satisfy analysts. There is also a need for:

5. Excellent financial communication from the CEO, the CFO and the CPO, both internally and externally.

6. Building trust and confidence by delivering on forecasted results over several years. This will depend on the volume of business and, more especially, the quality of the relationship that the procurement organisation has with key suppliers.

This last point underlines the potential procurement impact on value creation or sales growth. The quality of a relationship with a key supplier is fundamental in terms of obtaining innovation, increased market share, higher prices and speed to market.

Figure 1 (above) proposes an initial framework that can help to clarify these linkages based on identifying, unlocking, capturing and focusing all strategies on value creation. SSV is measured by the capacity of a company to provide a return on invested capital (ROIC) that is superior to the weighted average cost of capital (WACC).

In other words, the return on a company’s assets must exceed the cost of equity (shareholder’s expectations) and the cost of debt. In this model there are seven different levels to illustrate the operational, tactical and strategic levels within an organisation. The content of levels 5, 6 and 7 will differ according to the sector.

Key performance indicators for value

We believe that effective value creation key performance indicators (KPIs) must include upstream key supplier involvement that provides transparency concerning gains and opportunities for both sides. In an ideal world this will lead to increased sales, higher prices and more market share. Only then can the top line, or the revenue impact of innovation, efficiency and speed to market, be measured in a sustainable way. Moreover, key suppliers will always be willing to share cost-saving ideas on a continual basis if the relationship is good. However, the supplier must continually offer competitive prices and the company must have a clear process for capturing cost savings and value creation.

The process for measurement should include cost savings, cost avoidance, innovation, speed to market and market share. The revenue impact can then be added to savings from cost reduction and measured against gross margin, earnings before interest and taxes (Ebit), WACC and free cash flow.

Very few organisations consider the tangible and intangible value generated through business-wide initiatives with key suppliers. Potential procurement, sourcing and supplier contribution to quarterly earnings is hardly ever used as a business goal and performance measure. One starting point is to measure “procurement performance” against shareholder value drivers, and particularly free cash flow.

Free cash flow and market capitalisation

Table 1 calculates the value of company X using discounted future cash flow analysis, which gives a value of €12.5 billion. This figure is derived from the sum of future discounted cash flows and an estimation of the “terminal value” (the present value of the future growth rate divided by the weighted average cost of capital). Third-party spend represents 75 per cent of turnover and we simulate a constant 10 per cent annual decrease in procurement, whereby all savings go automatically to the bottom line (free cash flow).

The simulation assumes that:

  • the growth potential of sales is 12 per cent per year;
  • the weighted average cost of capital is 10 per cent;
  • investments for growth equal a 20 per cent increase in working capital requirements and 28 per cent for new materials, to ensure growth in sales;
  • the growth period is five years

The results in table 2 suggest that a 10 per cent annual saving in procurement spend over a five-year period will more than double the value of future cash flows, ceteris paribus. These figures don’t include the impact on innovation or speed to market, nor do they include the impact of procurement on capital expenditure or net working capital management. They do, however, offer a framework for optimising procurement communication internally and externally.

Why is the ‘corporate attractiveness’ of procurement still relatively low?

We have identified two reasons that may explain the difficulty in promoting procurement as a key component of sustainable shareholder value:

1. Lack of internal credibility. Most company cultures do not associate procurement in business with success. It is often perceived as a support function that produces cash to invest in marketing and/or R&D. Procurement objectives are rarely aligned with business objectives and measurement tends to focus on purchasing price variance rather than total cost reduction. Presentations show how the increases from suppliers are lower than those budgeted, whereas CFOs want to know how they are going to offset it and reduce total costs year on year.

2. Alignment with the business. The inability to sell effectively internally by employing the same language as finance, marketing or R&D is one problem. The inability to measure effectively the procurement impact across sites, categories and countries is another. The inability to measure value (the business impact is always associated with cost reduction, stock management, payment terms, etc) in turn leads to a lack of commitment from top management to invest time and resources into a procurement change programme – for example, sponsoring and participating in a change to the way that major supplier relationships are managed.

Although attitudes towards procurement have changed in the past decade, there is still considerable room for improvement, as these examples show:

  • CPOs have difficulty proving that savings have affected the P&L, because there is little or no traceability of the benefits hitting a budget or cost centre. Budget holders tend to thank procurement for their help, then spend the savings provided on other things (or to offset overspends in other areas).
  • Many executives and general managers conceal their real financial contribution. There is little visibility, transparency or accountability. It is difficult in this context to present the savings.
  • Some CPOs claim the same saving year after year, even though there was only an impact in the first year. CFOs want them to start from a new baseline each year.
  • CPOs are rarely involved in major projects or confidential ones. Procurement is often brought in at the last minute to finalise a contract, or totally ignored.

The way forward for procurement

Only clear financial measures will enable senior management to understand the true business impact of procurement on business development and business efficiency. Senior management then needs to create processes that capture the inherent value implications. The same message must be interpreted in the same way from the top down, so training needs to be considerably increased.

So what can CPOs do to improve procurement’s standing and contribution? First, procurement must be seen as a com-
mercial team with broad skills that can be applied to a range of business projects. When procurement hears of a major busi-
ness project, it should volunteer for it rather than wait to be asked. Procurement should be involved in helping sales, marketing and R&D teams to close major deals.

Second, CPOs must sell themselves to CEOs, CFOs and be able to speak their language – their words, their themes and their timescales. The benefi ts delivered by procurement should be included in annual reports and investor briefi ngs.

Third, it is imperative for CPOs and procurement organisations to sell financially their tangible and intangible gains. CPOs should be able to illustrate the financial impact of the procurement organisation on Ebit and free cash fl ow. Lastly, bonus systems must create incentives to measure the value created by procurement staff.
Figure 2 suggests a measurement process to value procurement. The first stage (identify and create) is to measure value creation from procurement. This covers all forms of cost savings, cost avoidance, price and volume variations, and estimates the fi nancial impact of supplier innovation on speed to market, price, volume and market share. The second stage (protect and capture) is to optimise the cash-flow efficiency, ensuring a balance between customer payment and supplier payment terms. This balance will depend on whether or not the supplier is key to business development.

The third and final stage (quantify and focus) is to measure the total estimated financial impact against key accounting and shareholder value indicators such as return on investment, Ebit, gross margin, free cash flow and risk, and communicate the results internally.

Here today, here tomorrow

Sustainable shareholder value is not a fashion that is here today, gone tomorrow, but a pre-requisite to attracting global funds in what promises to be an ever-more-diffi cult global marketplace. Competitive advantage will depend more and more on the quality of communication, trust and confi dence between senior management and investment analysts. It will also depend on the capacity of companies to produce free cash flow and to use it to the advantage of shareholders and stakeholders. Corporate bonus systems need to give credence to value growth as expressed through key supplier relationships and not just to shortterm working capital management.

Measuring the value impact of procurement on gross margin, Ebit and free cash flow will become more important owing to increased outsourcing and the management of truly global suppliers.

The value impact of procurement refers essentially to guaranteeing supply from key suppliers that also help with ideas to continually remove unnecessary cost from the business. It also includes all forms of cost avoidance (especially what would happen if the company were not supplied) and all areas where procurement can affect sales, price, innovation, speed to market, investments, mergers and acquisitions, currency hedging and risk management.

Key performance indicators should reflect this value impact, using relevant timescales that take account of all different types of risk. A key supplier should be selected primarily on what it can bring to the business and not just on how much the company spends with it.

The quality of the relationship is extremely important to success and all effort should be made communicate effectively. Indeed, relationships often fall apart because the “good relationship” is based on supposition rather than real communication and face-to-face meetings.

A key supplier should be able and willing to quickly inform the CPO that it is unable to supply the requested quantities of a material because it has given most of it to one or two competitors, allowing the CPO to find a sourcing solution. Mutual understanding, trust and confidence can only exist if there are frequent meetings between senior cross-functional individuals who represent one voice from their company. It will also rely on value-capture mechanisms and their alignment to key business drivers.

However, procurement’s attractiveness will only be improved if senior management recognises and captures this value contribution and gives credence to our belief that it is a major contributor to sustainable shareholder value.

Take a look at what Future Purchasing stands for and how our procurement consultants can work with you to achieve your business goals.

by Clive Gallery and Duncan Brock

Tagged by topic: Cost Reduction , Procurement Transformation

  by Allison Ford-Langstaff

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