Web Tool: Strategic Profit Model

Type of Tool: Financial

Description: Measuring purchasing and supply's financial impacts upon the organization. The strategic profit model tool highlights how purchased materials, inventories, investments in fixed assets, operating expenses, and working capital all build up to the key measures of:

  1. net income
  2. capital employed, and
  3. return on capital employed.

Uses: Purchasing and supply professionals can use this tool to trace their actions and impacts on the financial results of the organization; Public organization professionals can also use this tool as a guide toward efficiency improvements; and key insights are also brought to light when making the outsource/insource decision.

Strategic Profit Model -

Financial management today means keeping a careful watch on: a) producing a return on activity (profit on sales) and, b) balancing these results against the amount of resources that are needed to earn profits.

Two organizations with profits of $1 million each might look comparable at first glance. But, if one has an infrastructure of $10 million in assets and the other has $25 million, then they look vastly different. Investors would look more favorably upon the first. The first organization uses fewer assets to earn its profit than the second organization. Also, the stock values might rise with the first organization and/or certainly fall with the second organization to eventually reflect this difference. Thus, the balancing act of both profit and capital (assets) employed in the organization.

All of the costs and investments of an organization are captured in Figure 1. This displays two critical financial impact streams: the income statement (on the left-hand side), and the balance sheet (on the right hand side). The income statement is worked from the bottom upward to determine the net income. The balance sheet is developed upward as well to determine the capital (investment) that is employed in the organization. Together, these two measures produce a "return on capital employed." In the above example, the first organization earns 10% on its capital while the second organization only earns 4% ($1 million divided by $25 million).

Net Income. The income statement side of the model shows that net income is the result of subtracting Total Expenses from Revenue. The Total Expenses are a combination of Cost of Goods Sold plus Other Expenses. The Cost of Goods Sold is a combination of Purchased Materials (Materials) plus Overhead. Typically, this is calculated upwards starting with purchased materials, overhead, and other expenses to be subtracted from revenue to obtain Net Income. The higher the net income, the better the results.

Capital Employed. The right hand side of the model is used to calculate the amount of investment used by the organization. The Capital Employed is a combination of Fixed Assets (factories, warehouses, and equipment) and Working Capital (liquid, or short term financing of the organization). Working Capital is a combination of Accounts Receivable that customers owe plus Inventories less Accounts Payable that the organization owes its suppliers. For many organizations, this can be a negative figure, especially when they take a long time to pay suppliers while operating with fewer inventories. The lower the capital employed the better the result. Figure 2 illustrates the financial postion of a heavy equipment specialty chemical business. Starting on the bottom left, its purchased materials for the year are $7 (million) and overhead are $2 (million). The total is $9 cost of goods sold. Other expenses (depreciation, corporate structure, etc.) are $5. These total $14 (million). The company revenue for the year is $15 resulting in net income of $1 (million).>

On the bottom right, accounts receivables are $3 (million), inventory is $2 (million), and accounts payable to suppliers are $4 (million). These result in a working capital of $1 (million). The fixed investment in factories, etc. is $9. The total capital employed is, then, $10 (million).

The net income tells how well the company performs with its revenues and expenses. The capital employed is the total amount of investment (from investors and lenders) that it takes to operate the company. The return on capital employed is a combined measure that tells the outside world that this company earns 10% profit on the amount of capital that is invested in it.

Where Does Purchasing Come In?

Purchasing and supply plays a pervasive role throughout this financial picture of the organization as shown in Table 1. Its impacts are upon both the income statement as well as the capital investment.

Anything that increases the Return on Capital Employed is for the better. The same applies for the Net Income, since this is also a key reported figure to stockholders and the outside world. Capital Employed, on the other hand, is something the organization seeks to minimize as much as possible.

Figure 3 presents what to emphasize in all areas throughout the model and organization. Expenses are to be minimized as are cost of goods sold and other expenses. Overhead and materials are as well. Inventories are also to be minimized along with working capital and the fixed assets the organization uses in its operations. For most things less is better, without harm to quality, customer satisfaction, and revenues.

Purchasing and supply are increasingly being tapped for contributing to the product/service innovation of an organization. One consumer products organization looks to its purchasing people to find lower material cost suppliers and outsource manufacturing capability. But it also wants them to identify any products that are already being produced, or could be produced, by some of these suppliers that it can have its own label put on for subsequent sale.

Using the Tool -

Most of the popular purchasing and supply initiatives can be traced through this model. Asset reduction with fewer plants and warehouses decrease capital employed. Lower inventories have the same impact as well. Supplier managed inventories are in the form of inventories on site, but they are not on the official books of the buying organization. They are there but they are also not there, with the same decreased capital employed effect. But, many of these initiatives have multiple effects. Lower inventories might prevent a sale from being made (revenue). Supplier managed inventories might reduce inventories and overhead, but they might be at a premium of higher materials cost (price). Lesson: trace all costs and impacts through the model for a total bottom line result on net income, capital employed, and return on capital employed.

Outsourcing, too, has multiple impacts. A proposed outsource might promise to take over an inventory warehouse. This might have the following effects: lower inventory, lower fixed assets, lower overhead, but higher other expenses (in their charges for this entire service). The proposal only makes business sense here if it results in a total beneficial impact upon the three top measures (net income, capital employed, and return on capital employed).

Purchasing and supply managers in very large organizations might look at this model and think that a $500,000 change initiative would not even show up as a decimal figure in the revenue and net income of their multi-billion dollar organization. But, the tool has value here, too. Simply enter the factors and costs that will change and trace them to the top with the results being positives or negatives.

Similarly, the tool described above can be applied by public organizations, including military organizations, which are also under both expenditure and resource constraints. In such organizations, the process noted above is applied in the same manner. Thus, even military organizations use this model to trace through outsourcing decisions. In these situations, the top measure on the income statement side," the left, is "Total Expenses", which is balanced against "Capital Employed" in the form of fixed assets and inventories.

What's Important Today? -

A flinty-eyed, seasoned buyer recently told us, "It was easy when all we had to think about was price." He continued, "But, today, senior management wants even more from us. The old days were simpler." A parable, perhaps, but it drives home the point that purchasing today is more than just price. Purchasing and supply creates several financial impacts upon the organization. In some ways it requires a delicate balancing act of many financial elements. Luckily, most can be boiled down to a simple tool - the strategic profit model.

Taking it Forward -

Price is still king. It directly impacts the organization's income statement and bottom line profit. It also links to the checking account for accounts payable and cash outlays. But as purchasing and supply are pushed to go deeper and deeper for "value add" to the organization, it needs to peel back more tactical layers for financial benefits. So, just what are those additional layers? The strategic profit model has been in the toolkit of the financial world for many years that can be easily used by purchasing personnel who are looking to produce greater financial benefits for their organization. This model presents how to capture the other purchasing and supply "value-adds" to an organization's financials. So, while our friend above lamented that price was king and was the only major measure, this tool helps see how it fits in with the other ways of contributing to the "bottom line".

Table 1

Financial Impacts of Purchasing and Supply
Impact Area Financial Area Root Causes
MaterialsNet Income purchased price
inbound frieght quality costs.
Overhead Net Income warehouses costs
cost of manufacturing cost of services
Other Expenses Net Income adminstrative costs
travel/communications
meetings
offices
salaries
Revenue Net Income New Product innovation
Inventory Capital Employed value on-hand
Accounts Payables Capital Employed speed of paying suppliers
Fixed AssetsCapital Employedwarehouse
factory
equipment
truck/rail fleets
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