Return on Assets (ROA) - Two Moves to the Hoop

In the book, Financial Intelligence, Joe Knight describes two ways organizations can improve ROA.  Improving Net Profit Margin and Improving Asset Turnover...

The Future of Supply Chain - 8 Megatrends (Part 2)

8 Megatrends – Continued from part one

There are eight megatrends that will impact all supply chain leaders over the next decade.  Here we look at the last four of the eight megatrends.

Internet of Things (IoT)

Gartner analysis estimates that the IoT will include some 26 billion Internet-connected physical devices by 2020.¹ The Gartner research shows by then, IoT product and service suppliers will generate incremental revenue of more than $300 billion.  The connection of data specific to products and the flow of those products from raw materials, to work-in-progress, to finished goods and their flows across distribution networks to demand signals has enormous possibilities for supply chain leaders. 

Machine-to-machine (M2M) Data  

A key part of the IoT is machine-to-machine (M2M) communication.  Machina Research forecasts that there will be 175 million machine-to-machine data connections in manufacturing and supply chain by 2020.²  Fully automated factories have existed for some time.  An example is IBM and a “lights out" keyboard manufacturing factory in Texas that is 100% automated.³ This has many implications for the end-to-end supply chain.  As machine assembly costs are coming down and machines are simpler to install, there will be broader adoption of interconnected machines by leaders.  As an example, initial production runs can potentially be very small but still price-competitive.  These types of installations and results can only be completed profitably for those companies that have the tools to make cost-to-serve tradeoffs using data including M2M efficiencies.   

3D Printing   

According to Gartner research, by 2018 at least seven of the world's top ten multichannel retailers will use 3D printing technologies to generate custom stock orders.⁴  It is forecasted that consumer and enterprise 3D printer shipments will grow at a 95.4% compound annual growth rate (CAGR) and revenue at an 81.9% CAGR from 2012 through 2017. The 3D printer market will grow from $288 million to more than $5.7 billion by 2017 as consumer 3D-printing hype accelerates 3D printer purchases by enterprises worldwide.  With a growing set of materials that can be used to print in 3D devices, these trends will impact inventory, distribution, and postponement strategies for a number of industries. 

Analytics - Predictive and Prescriptive

Combining advanced predictive and prescriptive analytics to the IoT and M2M data, there is more possibility for acceleration of change and innovation.  Analytics tools will pull together data sets that a human mind cannot do alone. A new class of smart machines will disrupt current business models, organizational structures and staffing strategies.⁵ Specific to supply chain leaders, this will cause further tradeoff challenges and opportunities related to setting optimal supply allocations and service level targets.  Gartner anticipates at least three broad classes of smart machines: 

1. Movers—machine-based transit:  Application to various modes of inventory movement up and down the value chain.    
2. Sages—information-based helpers: Application to supply chain planning and financial tradeoffs. 
3. Doers—machine-focused helpers:  Application to supply chain execution through predictive manufacturing and distribution failure analysis and resolution.    

These eight megatrends will continue to separate the leaders from the laggards when it comes to collaborative planning.   The leaders will find ways forward to advance their competitive differentiation through improved integration of sales, finance, and operations.   What are you doing to improve your collaborative planning to address the impacts of these megatrends?

1.       Gartner Says the Internet of Things Installed Base Will Grow to 26 Billion Units By 2020

2.       Machina Research finds that driving supply chain efficiency is a EUR13.5 billion opportunity for M2M 

3.       Fully Automated Factories Approach Reality 

4.       Gartner Identifies Top Vertical Industry Predictions for IT Organizations for 2014 

5.       Gartner Says Smart Machines Will Have Widespread and Deep Business Impact Through 2020 

6.       How Intelligent Machines Are Driving Our Future

The Future of Supply Chain - 8 Megatrends (Part 1)

Introduction

The Jetson’s – Star Trek – Blade Runner.  For those familiar with these TV shows and movies, they may be more like science fact than science fiction.

In the book, 100 of the Most Exciting Future Predictions, Alex Trost and Vadim Kravetsky there are many possibilities for the future related to supply chain.¹ Here are just a few examples: 

• Robots—capable of performing an expanded set human level jobs
• Automotive–Self-driving cars – self-healing roads 
• Aerospace & Defense–exoskeletons and robots

Just as each of the TV and movie examples alone is very different its viewpoint of the future, the future of supply chain has alternatives.  These alternatives have implications on supply chain strategic plans with tangible outcomes demonstrated in financial performance. 

The outcome for supply chain leaders and organizations will hinge on the ability not to just adapt to but to embrace and lead change based on megatrends.  Here in part one of this two-part entry, four of eight megatrends will be outlined.  In the future, will look at more specific implications for supply chain specifically Design Anywhere, Manufacture Anywhere, Service Anywhere (DAMASA).

8 Megatrends

There are eight megatrends that will impact supply chain leaders over the next decade.  Any one of these topics could be written about at length.  The point here is to pull together these megatrends and being to explore their interrelationship and potential impact for supply chain leaders.    

Population growth

The current world population of 7.2 billion is projected to increase by 1 billion over the next 12 years and reach 9.6 billion by 2050.   Interesting is the distribution and location of most of that growth.  The 49 least-developed countries are projected to double in population from around 900 million people in 2013 to 1.8 billion in 2050.² As organizations think about go-to-market plans to these emerging markets, supply chain leaders will need to define a profitable strategy to meet these new opportunities.     

Environment

Political debates aside, data from NASA shows the earth is getting warmer.³ With larger, more intense weather patterns, supply chain leaders will need to have more robust risk plans in place to deal with potential supply and delivery disruption. Sustainable solutions to produce and deliver products are in discussion by leaders across industries and will continue to gain momentum if the environmental trend continues on its current trajectory. 

Open Source Design

With the growing trend to share software solutions openly, innovation is moving at a faster pace.   Free and open source software and hardware are opening the doors to new innovative products. One example is a game console.⁴  Another example is a camera.⁵  Opportunities exist for supply chain leaders to provide solutions for these burgeoning products to deliver them to markets. 

Crowdsourcing

Creative funding through crowdsourcing is also enabling innovation and new product development.  Procter & Gamble actively crowdsources new brands through their program “Connect + Develop.” When you consider open source design along with crowdsourcing, innovation cycles can be compressed resulting in the need for supply chain to be even more agile and responsive. 

More to come in part two.

(1) 100 of the Most Exciting Future Predictions, Alex Trost and Vadim Kravetsky 

(2) World Population to Increase by One Billion by 2025  

(3) GISS Surface Temperature Analysis, National Aeronautics and Space Administration    

(4) The Uzebox Project  

(5) Elphel, Inc.  

(6) P&G's Connect + Develop

ROA, EVA OMG! WTH? And other sundry TLAs

“What gets measured gets managed.” - Peter Drucker 

EBITDA, ROE, ROA, ROIC, EVA—the list goes on.  There are traditional performance measures and value-based performance measures.  Some measures are expressed in monetary terms while others are reflected as a percentage calculation.   There are measures that include the cost of debt and the cost of equity while others include neither.  There are many ways to measure business performance and no lack of opinions on which methodology is the best approach.  Upon analysis, the rabbit hole looks to go deeper than we need to go for our purposes in aligning supply chain performance to financial performance.  If you’re interested in further depth, I’ll include a few resources in the footnotes for further reading.  The balance of this entry will summarize what is found in these resources. 

Most important is to understand how your particular organization calculates financial performance.  There are important distinctions to be understood as an organization develops a common language toward improving customer delivery and achieving corporate business goals.  Again, the foundation for success is a achieving a common language.  Understanding finance as that language and understanding the particular dialect of finance is critical to aligning operations to financial performance.  The metrics determine how decisions are made. 

Return on Assets (ROA)

ROA is a traditional performance measure.  It is a profitability ratio based on absolute numbers.  In practice, ROA is sometimes used by businesses as it is easier to compute and understand and to use in comparison with other companies.

For companies using the ROA approach, it is important to understand that: 

• ROA’s primary focus is on operational profitability and utilization of assets, 
• ROA measures the Return on Investment (ROI) of assets, and 
• ROA can be thought of as an internal facing measure.

Economic Value Added (EVA)

EVA is a value-based performance measure.  It is expressed as a monetary amount.  EVA requires more computations and is a dollar amount.  The currency expression can limit comparisons with other companies.

 

For companies using this approach, it is important to understand that: 

• EVA’s primary focus is on cost of capital and shareholder value, 
• EVA measures the impact assets have on value creation, and 
• EVA can be thought of as an external facing measure.

EVA has an important distinction when compared to ROA.  EVA includes the weighted average cost of capital (WACC).  What does this means to supply chain professionals? ROA as a single metric approach will drive improvements to gross and net profits but will not align to shareholder benefits that are required through improving asset turnover.   The main difference is the way the two models handle assets.  Depreciation as it relates to assets reduces the book value of the assets as they age.   

Ram Sriram from Georgia State University¹ outlines three limitations of using only an ROA approach: 

• Encourages division managers to retain assets beyond their optimal life and not to invest in new assets which would increase the denominator. 
• Can cause corporate managers to over-allocate resources to divisions with older assets because they appear to be relatively more profitable. 
• Capital may be allocated towards least profitable divisions at the expense of the most profitable divisions.

While short-term profitability may be trending in the right direction, lack of longer-term efficiency can erode shareholder value.  There is a limit to raising prices to maintain profit ratios.² Often, there is market demand to lower prices.  In short, it is about using fewer resources to sell more products and services. 

There are entire chapters in books written on the distinctions between these two models.  A single blog entry cannot fully define all the unique characteristics of each model but can simply raise the awareness that distinctions do exist, and as a result create different measures of success.  What gets measured gets managed, and knowing some of the details behind the measure will drive improved alignment between supply chain performance to financial performance.

(1)    “Investments in Assets: Both A Strategic and a Control Issue” Ram Sriram 

(2)    “Measuring the Value of the Supply Chain” Enrico Camerinelli

Additional Resources

• Adding Enterprise Value: Mitigating Investment Decision Risks by Assessing the Economic Value of Supply Chain Initiatives, Oliver Schneider
• Financial Intelligence: A Manager’s Guide to Knowing What the Numbers Really Mean, Karen Bergman and Joe Knight
• A Note on the War of Metrics, Gunther Friedl and Tim Kettenring 

Two Financial Frameworks: Part 2 - EVA

EVA—Economic Value Added

In its simplest terms, EVA is a measurement of enterprise performance.  The model was created in 1993 by the consulting company Stern Stewart Management Services.  EVA is defined as, “a measure of a company's financial performance based on the residual wealth calculated by deducting cost of capital from its operating profit (adjusted for taxes on a cash basis).” ¹ EVA is also sometimes referred to as Economic Profit (EP). 

The EVA model is helpful in light of supply chain contribution as it comprehensively captures the causal drivers for financial performance and the interrelationship between these drivers.  Many of the operational tradeoffs in operating profit and invested capital become complex very quickly.  The EVA Model is a good tool to build a common framework and language for both financial and operational leaders in an organization.  

There are certain components that are important to the model but less applicable to our purposes related to supply chain.  The tax rate and WACC portions of the model are components excluded for our supply chain specific analysis. 

Here is a visual overview of the EVA Model:

There are distinctions between the EVA and ROA model that are important to highlight as they relate to operational performance and integration.  We will look at the differences between the models and why they are important in our next entry.

(1) http://www.investopedia.com/terms/e/eva.asp

Two Financial Frameworks: Part 1 - ROA

In an earlier entry we discussed the importance of A Supply Chain Finance Lingua Franca—a common language leading toward an integration of operational metrics and financial corporate performance.   This is possible through the linking of tools like SCOR, DuPont Model, and EVA in defining the ability for supply chain to be the strategic enabler of financial performance.  

Before we dive into the details of each of The Seven Prime Supply Chain Performance Metrics, it is important to have a working understanding of the broader context of financial performance models.   The intent is not to be cost accounting experts.  However, a fundamental understanding of basic business math is needed.  The good news is it is primarily simple addition and subtraction.  It gets a bit complicated with some division but no calculus required!  

Two models will be reviewed.

1. Return on Assets (ROA)
2. Economic Value Added (EVA)

ROA—Return on Assets

Return on Assets (ROA) looks at an organization’s profitability relative to its total asset base.  Also known as the DuPont Analysis Model, the ROA ratio was developed by F. Donaldson Brown, a financial executive at DuPont and General Motors.  The ROA model was originally designed to coordinate financial controls across the organization. ¹ ROA measures the combined effects of profit margins and asset turnover. ²

The ROA calculation looks like this:

Here is a visual depiction of the model and the related operational levers:

There is some debate over the finer points of this model as it relates to inclusions and relationships.  Some of these points are related to items like Return-on-Equity (ROE) and Return-on-Investment (ROI). As an example, is ROA the same as ROI?  That depends on various schools of thought.  It is good to be aware that there is not a uniform glossary of terms across financial models.  For our specific to supply chain purposes, we will leave those nuanced definitions out for now and focus on the model as it relates to building a common language for finance and operations professionals.  

Next, we will look at the Economic Value Added (EVA) model.  

(1) http://history.gmheritagecenter.com/wiki/index.php/Brown,_Donaldson

(2) Groppelli, Angelico A.; Ehsan Nikbakht (2000). Finance, 4th ed. Barron's 

The Seven Prime Supply Chain Performance Metrics

We will use two of the financial ratios from the profitability category and four of the financial ratios from the efficiency category for the primary gauges on our supply chain financials dashboard.

Supply Chain Profitability Ratios: 

• Gross Profit Margin Percent (GPM) 
• Return on Assets (ROA)

Supply Chain Efficiency Ratios: 

• Days Payable Outstanding (DPO) 
• Days In Inventory (DII) 
• Days Sales Outstanding (DSO) 
• Total Asset Turnover (TAT)

We will also add in Revenue Growth ($Rev) as a primary gauge for supply chain.  We will define the rationale for this metric as it relates to supply chain in future entries. 

Here is what our dashboard looks like graphically:

For each of these dashboard gauges we will connect the supply chain sensors through a common process improvement tool to help us identify the direct relationship of supply chain actions to financial performance.