This video we discuss the important area of Supply Chain Management! Watch now…
VIDEO SUMMARY
We are talking about purchasing. I am going to start with a common scenario. Imagine you are running a business, and this year you make a small profit. As the leader of your company, you are going to take some of this profit and reinvest it back into your business. You are going to ask yourself, where can I put this money, to have the best return on investment? Many businesses will look at investments in sales or operations. However, my recommendation is that the first place a business should look for investment opportunities is Purchasing. The reason I am making this video, is because so few businesses do this. Purchasing is often the last place people think about putting money into. I am going to explain to you mathematically why it makes sense to invest in purchasing.
The purchasing department for many businesses consists of the Accounts Payable’s person in the Accounting Department. You might have an individual who creates Purchase Orders and authorizes purchases. If this sounds like your company, that purchasing role can be expanded dramatically. Purchasing has developed into a whole field of study called Supply Chain Management. It is no longer just an accounting role, it is a whole separate department that can be a strategic role for your organization. In order to create a Supply Chain Management Department, it takes investment. You need to hire experts in the field, train your employees, have the right software, bring in best practices, and that all costs money.
The reason why nobody invests in purchasing, is because the Supply Chain Management Department does not generate revenue. When leaders are looking to make a return on investment, it is difficult to look at investments that you cannot directly tie to revenue. With sales and operations, there is a direct link to revenue. Most people look at Supply Chain Management as a cost center. It is just overhead. However, if you look a little closer, Supply Chain Management has a significant impact on company profits.
You can see this impact through something called DuPont analysis. Last week, we talked about the DuPont equation. The real insight from the DuPont equation, was that you could take an accounting ratio and drill down to see what was driving that ratio. DuPont analysis continues that concept by continuing to drill down. This activity helps you understand what is truly driving your organization.
I am going to show you how this works. We are going to start with ROA (return on assets), which is our good friend productivity. ROA is net income over assets. The question is what is driving ROA? ROA is profit margin times asset turnover, two more accounting ratios. That provides more understanding, but we can go even further. Net income comes from revenue minus cost of goods sold. Assets is a combination of current assets and capital assets. You can model your entire organization with these little boxes. This allows you to see how changes in each box impacts your organization’s productivity.
We are going to perform a couple of examples. Assume you decide to invest in sales. In your cost benefit analysis, you determine that sales will increase by five percent. If sales increases by five percent, that means your cost of goods sold also has to increase by five percent. By the time that five percent trickles back to ROA, you likely have about a three percent increase in productivity, depending on your assumptions. Now imagine the different example of investing in purchasing. Purchasing does not impact sales, but it impacts three of these other boxes: cost of good sold, current assets, and capital assets. If you are able to decrease your purchasing cost by five percent, you are looking at a double digit increase in productivity. That is a massive difference. And this does not have to just be about purchasing things cheaper. Making better purchases could also mean getting better quality or more value, which would also increase productivity.
Please do not misunderstand me. Sales is clearly important. I have made videos in the past on how important sales is for generating revenue. The problem is that many companies are choosing to invest everything in sales and forget about purchasing. Purchasing is a department where you could make easy investments and ramp up the productivity of your organization.
Let us bring this back to accounting. If you are an accountant, you have the ability to have these kinds of insights. You are looking at accounting ratios on a regular basis. You know about things like DuPont analysis. You can make the recommendation to your leaders on what is a good return on investment. We are talking about massive productivity gains. If we all did this for our organizations, forget about supercharging your business, we would supercharge the economy. These type of insights are the unique ability that accountants bring to an organization.
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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.