Assessing the Economic Value Added (EVA) of Supply Chain Initiatives
Logistics managers often have problems in communicating quantitative benefits of their management decisions, which go further than reporting service level improvements and cost reductions, to the boardroom. On the other hand, financial managers have problems assessing the real contribution to enterprise value of supply chain initiatives (SCIs). Many assumptions have to be made when, for instance, calculating the economic value added (EVA) of such projects. As a result, investment decisions about SCIs use to carry a certain level of risk.
Economic value added (EVA) is a metric for representing enterprise value. EVA is positive, i.e., value is generated, when an investment activity leads to higher NOPAT than the weighted average costs of capital (WACC) invested in the assets required for generating that income.
In other words, value is only generated when the investment is expected to provide more profit than the stockholders would get by alternative investments on the market. The equation is therefore:
$E V A=N O P A T-W A C C \times$ value of fixed and current assets
Hence, the challenge is to provide transparency on the benefits and risks of the various supply chain structures and SCIs used for improving the performance of the supply chain - generally the reduction of inventory and reduction of lead time - in terms of the financial variables like EVA.
activities. From a logistics perspective, this increased the reliability of shipping and storing processes, with shorter lead times at lower costs per product. Because of lower return rates and higher product availability, the number of sold products and therefore turnover increased by $$\$ 22,980$$. The higher volume results in higher total SC cost of $$\$4,589$$ and higher taxes of $$\$ 5,517$$. From a financial perspective, the NOPAT is disproportionately higher $$(\$ 12,874)$$.
(GRAPH CANT COPY)
In addition to the perspective of the profit and loss statement, EVA integrates the changes on the balance sheet. The logistics performance improvements described above affect working capital in two dimensions. Shorter lead times reduce the cash-to-cash cycle time, representing the time capital is locked up as material in the supply chain. In addition, because costs per product could be reduced at several stages of the supply chain, the valuation of the material in the different inventory accounts is reduced, too. These relations are visible in Figure 1.7.3.1. Both effects result in reduced capital lockup of $$\$ 54,713$$. After being multiplied with the WACC of the company of $15 \%$, this value and the NOPAT effect make up the total EVA contribution of the SCI of $$\$ 21,081$$.
Consider now the following scenario: A central distribution center (CDC) located in Switzerland wants to evaluate whether it would be beneficial to change the transportation mode to the regional distribution center (DC) located in the south of Norway. Currently, transportation is by truck in order to achieve short transportation cycle times (3 days). Transportation by ship would take 7 days but is cheaper. The title of inventory is transferred as soon as the products arrive at the DC. The relevant average inventory value at the CDC is $$\$ 300,000$$ in the finished goods warehouse, plus average $$\$ 25,000$$ in-transit inventory with transportation by truck. The average in-transit inventory would double when changing the transportation to ships. At the same time, the annual transportation cost would decrease from $$\$ 20,000$$ to $$\$ 15,000$$, with payment terms toward any carrier of 60 days. The WACC of the company is $8 \%$.
What is the effect of the modal change on NOPAT and EVA after one year? Would you advise changing the transportation mode? Please also consider a sensitivity analysis in your reasoning, as the values of the initial variables can vary in practice.
Hint: As the SCVC method only calculates the change of the EVA contribution from a baseline to a changed scenario, you need to consider only values that differ between the scenarios.
Solution:
- NOPAT: $$+\$ 5,000$$ (same sales $$-\$ 5,000$$ less transportation cost)
- Average value of accounts payable: from $$\$ 3,333$$($$\$ 20,000$$ / 12 months * 2 months payment terms) to $$\$ 2,500$$
- Capital lockup: $$+\$ 25,833$$ ( $$\$ 25,000$$ higher average in-transit inventory plus $$\$ 833$$ lower accounts payable)
- EVA change: $$\$ 5,000$$-$$\$ 25,833$$ * 8 \%($ WACC) $=+$$\$ 2,933$$