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What the Chiefs CIOs, CFOs and COOs Need To Know About Logistics
How can logisticians traditional focus on operational improvements be translated into language that CEOs understand in their pursuit of higher return for shareholders? Heres how to create a bridge between these two perspectives, and how improvements in logistics at one company improved its shareholder value.
By John T. Mentzer, Ph.D.
The Chiefs, or C-Level executives (CIO, CEO, COO, CFO, etc.), often do not care about logistics. After all, logistics is about such tactical stuff as trucks and trains, where to put the inventory, and how to manage the information about product movement and storage. So why should the Chiefs care?
The Vice President of Logistics at a $1 billion (sales) retailer requested assistance on a project to update the operations of their only distribution center (DC). All inbound product from vendors, and outbound to stores, went through this one facility. We were surprised at how uninterested in this project the C-Level was. After all, the total proposed impact of this project is to only lower the annual DC operating costs by $2 million, said the CFO in our presentation. This is less than one percent ($2 million divided by $1 billion) of what we worry about. It just does not come up on our radar screens. It also was about such mundane (to the Chiefs) topics as Advance Shipment Notice, Cross-Docking, and Pre-Packing the Chiefs had more important things to think about, right?
Wait a minute, we said. Your sales are $1 billion, but your profitability is $50 million. So reducing the annual operating costs of the DC from $5 million to $3 million will increase profitability by 4 percent (a $2 million increase to a base of $50 million). Surprisingly, it was difficult to get the CFO to see why this was important.
The reason is logistics managers and the Chiefs do not speak the same language. What the Chiefs care about is the decision impact on shareholder value. Since logistics managers typically think, and talk, in terms of operational improvements, we often forget to put the impact of logistics decisions in the language of the CIO, the CEO, the COO, and the CFO.
Take inventory as an example. Two of the main documents the Chiefs regularly watch are the Income Statement and the Balance Sheet (we are not going to deal with the third one, the Cash Flow Statement, in this paper). Logistics managers tend to think of inventory from what I call the Income Statement mentality. That is, inventory is a good thing and a bad thing. It is a good thing because inventory affects availability, which affects the top line of the Income Statement Sales. Inventory is also a bad thing because it costs money the cost of the money invested in inventory, to store the inventory, and insure the inventory against loss, damage, or obsolescence which affects the middle lines, General Selling and Administrative costs (GS&A) of the Income Statement. So logistics managers are constantly trying to find the right balance of inventory to support sales and control costs. Part of the problem for the Chiefs, however, is there is no line on the income statement that specifically shows the impact of inventory level on sales and GS&A, so inventory remains a real issue for logistics managers and a somewhat abstract concept for the Chiefs.
This problem is heightened by the fact that inventory is a good thing on the Balance Sheet i.e., it is an asset. What happens if we reduce inventory? That asset line goes down without a completely corresponding decrease in liabilities (money owed), so the asset decrease is partially matched on the other side of the Balance Sheet with a decrease in Retained Earnings. Wait a minute, getting rid of inventory hurts Retained Earnings, so the logistics manager lowering inventory is a bad thing, right?
If you think this does not happen in companies today, ask yourself how much of the inventory listed on your company Balance Sheet is actually obsolete inventory inventory that is costing us money to keep in storage but we have no hope of actually selling (remember the income statement). Why are the Chiefs reluctant to get rid of this inventory? Because it directly impacts (decreases) Retained Earnings.
Lets look at a different way to analyze the impact of logistics to see if the Chiefs really should care a model of the impact of improved logistics on shareholder value. C-level executives are not interested in investing corporate dollars to improve logistics performance unless it can be translated into higher return for the shareholders. Remember, this is what the Chiefs ultimately care about and is the language they speak. We will also demonstrate how improvements in logistics in one company improved its shareholder value.
The improvement in shareholder value resulting from improvements in logistics can be visualized with the help of the famous du Pont model of financial performance (Figure 1). The du Pont Model is a framework for viewing the impact of changes in sales, capital, and operating expenses on return on net assets. In this model, we start with sales revenue and subtract from it all the costs of doing business. This is not a gross margin calculation, where only the costs of goods sold are subtracted from sales revenue, but rather all costs (fixed and variable) are subtracted to give us the profitability of the business unit.
In the lower right part of the model, we examine the total investment by shareholders in capital, both working (primarily accounts receivable and inventory) and fixed. Ordinarily, to this is added retained earnings of the company to arrive at shareholder value. However, retained earnings is a financial decision by the Board of Directors and the shareholders whether to leave money not invested in capital in the company or take it out. Further, since we are solely concerned here with the impact of logistics decisions on shareholder value, retained earnings is irrelevant and, thus, left out of the decision model in Figure 1.
Dividing profit by shareholder value (capital investment) gives us a return on shareholder value, or the percent of capital invested that is returned in the form of profits each year. This is a primary factor for any decision made by Chiefs.
Figure 1 illustrates an actual example of how improved logistics performance impacts shareholder value. Although the numbers have been slightly altered to protect the identity of the example company, this company originally had sales revenue of $2,000,000,000 and total costs of $1,900,000,000 (annual profit of $100,000,000), on a working capital base of $200,000,000. The fixed capital base (consisting primarily of plant and equipment and three distribution centers) was $500,000,000. This resulted in a return on shareholder value (RSV) each year of 14.29 percent.
Based on an extensive logistics benchmarking project, we revealed to the company a number of areas for potential improvement. As a result, management authorized a series of actions to implement recommended improvements to these logistics processes.
From the start of this effort, we presented to upper management dollar measures of the impact of these changes upon lower logistics costs and increased sales from improved customer service. We quickly realized that the latter of these two could not be fully and accurately measured, so we settled for documenting only the improvements in inventory available to meet customer demand in other words, when sales were made because the inventory was available, as opposed to a lost sale due to stockouts. Increased sales, as a result of improved in-stock situations, were $2,000,000, while the operating costs of meeting total demand decreased by $7,000,000 resulting in increased profit of $7,010,000.
The operating cost savings fell into three main categories. First, inventory held by the company to meet demand was reduced $45,000,000 (also note that the reduction in inventory resulted in lower Working Capital). This resulted in savings in the cost of money on those invested funds, lower risk costs on the inventory (obsolescence, shrinkage, and damage), and lower facility costs. The total of these three cost components is typically referred to as Inventory Carrying Cost, which was reduced $5,000,000 per year. Second, improved warehouse management processes led to a reduction in warehousing costs of $1,000,000. Finally, improved transportation management processes lowered annual transportation costs by $1,000,000 a year.
Although fixed capital was negligibly affected by these changes, working capital (money invested in inventory) decreased by $45,000,000. This resulted in a decrease in capital invested in the company by the shareholders of $45,000,000. As we mentioned, whether this $45,000,000 is paid out to the shareholders as a dividend or kept in retained earnings for future investments is irrelevant to the financial impact evaluated here.
The result of all these changes in logistics performance was improvement in profit by $7,010,000 each year, the capital investment base went down by $45,000,000 and return on shareholder value increased from 14.29 percent to 16.34 percent. The total cost of all the logistics process improvements was less that $2,000,000, which means the Return on Investment (something the CFO particularly watched) was slightly over 350 percent! All this clearly shows that improvement in logistics can have a dramatic effect on corporate profitability and shareholder value precisely what the Chiefs care about.
The most important lesson learned from this example is that we should estimate the potential impact on return on shareholder value (RSV) prior to making investments in logistics. We make a serious mistake in logistics management when we go to upper management with a proposal to spend money to improve logistics performance, without indicating what impact it will have on shareholders. It is important to remember that there is nothing wrong with projecting operational improvements in logistics, but without carrying this to the final step the ultimate impact on shareholder value we are not providing upper management with the information necessary to make informed business decisions. We are not telling the Chiefs what they need to know about logistics. The result of all these changes in logistics performance was improvement in profit by $7,010,000 each year, the capital investment base went down by $45,000,000 and return on shareholder value increased from 14.29 percent to 16.34 percent.