Valuation Methods for the New Supply Chain

by John Grabski

April 14, 2001

Measuring the cash flow contribution of each customer provides management with the ability to align resources to customers and business processes to optimize shareholder return.

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As technology enhances our ability to manage the supply chain, new and more
sophisticated methods of measuring value are needed. Gone are the days of measuring
supplier performance by PPV, or measuring a customer’s worth by gross profit

Understanding asset & liability intensity and other financial metrics allow
us to begin the process of measuring contributions to cash velocity and the
generation of free cash flow. The new method of valuation, while not new to
financial managers, enables today’s supply chain manager to optimize resources
and align them with activities that generate and enhance the cash model.

Cash Velocity

All customers, suppliers, products, and services have one thing in common.
They either contribute to free cash flow – or they consume it. In some cases,
customers or suppliers are neutral in that they neither consume nor contribute
to the free cash flow stream within the company.

Wall Street largely relies on a company’s ability to generate cash flow when
determining its stock price. Net profit margin as a percentage of sales is
but a mere component, albeit an important component used to determine the value
of the company. The ability to cycle assets and cash to perpetuate growth is
of primary importance – and rightly so. A company with a positive cash model
is rewarded heavily on the street with seemingly no traditional upper limit

Significant opportunity exists for companies that choose to align management
resources with business activities that contribute to free cash flow rather
than consume it. Many customers, suppliers, or product lines may actually return
an operating profit, but cause a drain on cash flow. This occurs when an inordinate
asset level is required to support the business activity, or when the cost of
capital necessary to support the assets exceed the short-term return.

A Performance Thermometer

The thermometer indicates general health to the doctor. Similarly, cash velocity
illustrates the general performance of a business activity or relationship.

Cash velocity, in the distribution model is affected by inventory turnover,
transaction costs, current liabilities turnover, growth rate, net profit margin,
and the tax rate. Any one of the group, including net profit margin, may be
satisfactory when measured by itself but undesirable as a group.

A free cash flow stream is indicative of the general health of the business
activity. It means that inventory is adequately turning, an appropriate amount
of trade credit is being used to finance growth, and that transaction costs
necessary to manage the assets are appropriately balanced with the cost of
the asset itself. Measuring the percentage of free cash flow to sales or the
velocity of cash created for each customer or business activity greatly enhances
our ability to understand the true value of each customer.

Profit, “Just A Component”

The cash velocity model recognizes profit as a component of value rather than
value itself. Measuring the free cash flow impact of each individual customer
becomes especially meaningful for companies without infinite resources.

The notion that all processes, customers, suppliers, and product lines either
contribute to or consume free cash flow creates a compelling incentive to measure
the performance of each. This valuable information serves as the foundation
from which to create powerful management strategy. Resources could be aligned
to support and accelerate customers and product lines that increase cash velocity
and free cash flow.

A Likely Scenario

A likely scenario is that approximately 20% of the customers or product lines
create 80% of the free cash flow within the company. Plus, 20% of the customers
consume 80% of the cash that is consumed below the line.

Asset Optimization

Deploying Optimal Asset Utilization (OAU) strategies can be one method of increasing
liquidity and accelerating cash velocity. Solving for the OAU point for inventory
levels increases turnover without negatively impacting transaction costs. A
precise understanding of acquisition transaction costs combined with several
financial measures allow the manager to solve for the OAU point. The OAU point,
while similar to the older Economic Order Quantity point (EOQ) is more refined
using Activity Based Costing and recognizing the ROA for improving cash availability.
OAU normally points to the fact that we can economically justify a more aggressive
inventory management strategy. OAU improves inventory turnover without increasing
the number of transactions.

Activity-Based Costing

In order to provide high levels of supply chain decision support, activity-based
costing is needed now more than ever. In order to measure supplier cost effectiveness
and Total Measurable Cost of Ownership (TCO), it is essential that the manager
understand internal transaction costs and then how each supplier value-added
service impacts those same transaction costs. Only then can we understand which
suppliers deliver the maximum value to our company.

Event-Driven Costing

The use of ABC methodologies are more critical today than ever before. New
and more complex value-added services are being created daily as suppliers and
service providers race to differentiate themselves from one another. The challenge
to determine cost effectiveness between supplier choices is becoming ever more

ABC systems, though recognized as beneficial, are sometimes overwhelmingly
complex to implement. Today, more specialized ABC application tools make it
easy to focus on one aspect of the business. Event-driven costing tools work
on the basis of ABC but focus on business processes like the material acquisition

Event-driven costing will play a critical role in providing high-level decision
support to the supply chain manager of tomorrow. Each “event” that makes up
the supply chain, from receiving material to electronic funds transfer must
be accounted for to determine the TCO and optimize both asset utilization and
management resources.

Cash Velocity Levers

Measuring cash velocity down to the customer level can be difficult at best.
Event-driven cost and optimization tools available on the market today can simplify

Measuring cash velocity requires that we capture all critical aspects of the
relationship. Accordingly, we must understand the asset intensity, liability
intensity, transaction costs, profit margin, tax rate, and the rate of growth
in order to solve for cash flow either generated or consumed by the customer.
Once values are established for each lever, we may solve for performance levels
necessary to reach zero cash impact. The manager may choose to implement specific
value-added services geared to reach the zero cash impact objective. For example,
if the manager determined that customer “A’s” cash velocity was unacceptable,
the model would recommend which levers to pull to bring customer “A” into an
acceptable range. Receivable turnover, inventory turnover, gross margin, or
number of transactions may all be considered levers that balance with each other
in a Zero Sum environment. The manager may then recommend a specific value-added
service designed to respond to the under-performing business process.

Who Will Benefit?

Distributors create value by managing raw material assets. Their ability to
consolidate purchases and manage assets more efficiently than their customers
enable them to save the customer money while extracting a small profit for themselves.
Contract manufacturers, in a sense, provide the same service but include the
manufacturing process as well. Again, operating more efficiently than the customer
allows the contract manufacturer to save the customer money while extracting
a small profit. The key is efficiency. Both the contract manufacturer and the
distributor must cycle assets faster than ever before to remain a viable part
of the supply chain.

Any company that invests in assets to support their customer base will benefit
by measuring the cash velocity of each customer. The higher percentage of assets
to sales, the more dramatic and important the measure becomes.

As with activity-based costing, the result is not to “fire” the under-performing
achievers. Rather, it enables the manager to understand precisely what measure
or lever is needed to return the customer to the appropriate level. Profitability
may be achieved a number of ways, none of which include raising the customer’s

Cash Velocity Optimization

Optimizing to maximize the return on invested capital means simply aligning
business processes and resources with customers, products, and services that
provide the company with the greatest return.

A distributor for example may choose to invest in inventories to support a
specific customer group that will generate a positive cash cycle to offset a
similar investment in a poorer performing segment.

Cash Velocity “Lever for Success”

Obviously, measuring the cash flow contribution of each customer does not guarantee
the company success. It does, however, provide management with the ability to
align resources to customers and business processes to optimize shareholder

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