How to balance your supply chain? Use ROCE or EVA?

In this article we want to make the link between ROCE and Economic Value Added (EVA). We’ll see that both are holistic measures that span across the three corners of the Supply Chain Triangle. We will assess the pros and cons of using one versus the other.

In 2018 I published my book “Supply Chain Strategy and Financial Metrics”. In the book I explore the relationship between supply chain, finance and strategy. A core concept is the “Supply Chain Triangle of Service, Cost and Cash”. In a recent article I have used the triangle to show how supply chains are currently impacted by COVID19. The triangle allows us to link supply chain to finance, as balancing the triangle equals optimizing value, as measured by the Return On Capital Employed (ROCE).

In 2 other recent articles I have tried to link ROCE to other common finance KPI’s. In a first iteration I tried to link ROCE with growth, EBIT and Free Cash Flow. In a second iteration, I focused on the link between ROCE and Free Cash Flow. That article explains that if you control the variable components of the ROCE, namely the EBITDA, the working capital and the capital expenditures (CAPEX), you also control the Free Cash Flow. So controlling ROCE equals controlling the Free Cash Flow. Both can be done from a tactical process such as S&OP and with a forward looking view, not just backwards.

When I explain the concept of the Supply Chain Triangle and the link to ROCE, people intuitively like it and use it. So far it has triggered supply chain people, as well as finance people. Though it seems intuitive and common sense, the strange thing is that so far I haven’t encountered ROCE as a tactical metric in companies. One of the explanations might be that some parts of ROCE are relatively fixed in that tactical horizon, namely the Depreciation and Amortization and the Fixed Assets. While I obviously agree these are fixed, I still don’t understand why we wouldn’t measure and report on ROCE and try to visualize in an S&OP process how changes in EBITDA, working capital and capex are impacting ROCE. We need a holistic metric that brings it all together to manage the trade-offs between the individual components.

As already mentioned in earlier articles, one alternative for ROCE I do have encountered is subtracting a cost of the cash and fixed assets used, from the margin. A colleague referred me to Economic Value Added (EVA) as a metric that does exactly that.

The Economic Value Added (EVA) calculates the value created in excess of the required return by the securities holders, including both equity and debt. It can be calculated as

• EVA = (r – c) x capital employed, with
• r = rate of return, or the Return On Invested Capital (ROIC), and
• c = cost of capital, or the Weighted Average Cost of Capital (WACC)

The WACC looks at the composition of the capital, in simple terms, the amount of debt and the amount of equity, and the cost of the debt and the equity. As the WACC includes the cost of debt, we want to exclude the interest from the ‘rate of return’. That is why we use the ROIC instead of the ROCE, as the ROIC is defined as

• ROIC = EBIT x (1 – tax rate) / Capital Employed

The EBIT x (1 – tax rate) is also called the Net Operating Profit After Taxes (NOPAT).

That’s a lot of definitions to say a simple thing. What did we earn as a company, what do we need to pay to the holders of debt and equity, did we earn enough (EVA > 0), or are we in trouble (EVA < 0).

The EVA can be rewritten as follows

• EVA = EBIT x (1 – tax rate) – WACC x Capital Employed

This form shows that EVA ‘looks at the profit’ and ‘accounts for the capital employed’ by subtracting the cost of the capital employed from the NOPAT (Net Operating Profit After Tax = EBIT x (1 – tax rate)). That also helps in balancing our triangle. We avoid that sales would only focus on volumes or on margins. If the inventory turns are low, the cost of inventory goes up and the EVA goes down. If due to a high fragmentation we lose a lot of time to change-overs and the asset utilization is low, we will need to charge a disproportionate amount of fixed assets to the EVA of the product group at hand.

So EVA (Economic Value Added) also measures the three corners of the supply chain triangle and in that sense is quite similar to ROCE (Return On Capital Employed). The good thing of EVA is that it translates a balance sheet item (Capital Employed = Working Capital + Fixed Assets) into a P&L type of cost. Many people find it easier to reason in + and – than to reason in returns. We can allocate costs to product groups, and allocate capital employed to product groups, we can calculate EVA on product group level to improve tactical/strategic decision making. That can be done through Activity Based Costing (ABC), and it seems more natural to do so on costs, for EVA, than to do it for a return metric like ROCE.

The good thing about ROCE is that it is a relative metric. Is Henkel doing better than P&G? Or is one business unit doing better than the other? A relative metric allows comparing the performance relative to the size. Maybe P&G has a higher EVA, because it has a bigger size, but the inherent return could still be lower, if the ROCE would be lower.

Another thing we like about ROCE is that it allows to nicely show the impact of strategy. A hard discounter will have a lower EBIT but compensate with a lower capital employed. If I have a broader assortment my capital employed will go up, but from a ROCE perspective that is fine if my EBIT is going up. So, I need to be able to drive premium from my customer. Both on the sales side, and the supply chain side, that dynamic is poorly understood. ROCE as a ratio allows to elegantly capture that.

You can easily image using a 2-by-2 matrix where we say: if both ROCE and EVA are low … we may want to divest, if ROCE is low and EVA is high … we need to turn around or divest, if ROCE is high … we will try to grow the business.

However, instead of combining ROCE and EVA, it probably makes more sense to look at ROCE and growth potential, as shown in the following graph. If ROCE is low and there is little growth potential, then most probably you don’t want to put a lot of effort and money into that business. If ROCE is low and growth potential is high, you want to investigate how to turn around that business. A high ROCE and high growth potential will be the primary target for CAPEX, whereas for a high ROCE and low growth, we are focused on sustaining the business. The combination of ROCE and growth potential is very helpful in creating focus for the strategic plan.

So in summary, we can say that EVA does a comparable thing to ROCE. It accounts for the three corners of the supply chain triangle and as such is a holistic metric. EVA accounts for the cost of the capital employed and subtracts that from the NOPAT (Net Profit After Operating Tax = EBIT x (1 – tax rate)). ROCE is a ratio of EBIT / Capital Employed. For many people reasoning in + and – is easier than with a ratio. In that sense EVA can help to create awareness that working capital and fixed assets come at a cost. ROCE seems more helpful to compare companies and business units as it is a relative metric. It more easily shows the impact of strategic choices. Operational excellence will generate the same ROCE but starting from a lower EBIT and compensating with a lower Capital Employed. As you start differentiating through expanding the product portfolio (customer intimacy) or better products (product leadership), both the Capital Employed and the EBIT should go up if we want to generate the same value. Combing ROCE and growth potential also seems a good way to decide where to invest.

Let us know whether you agree/disagree, share your experiences. Let’s debate and learn together!

I also kindly refer you to our LinkedIn group on the Strategy-Driven Supply Chain where we have described a vision of how we need to transform the supply chain function if we want to better balance the triangle to generate more value as measured through ROCE.

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Epilogue: how to confuse the Russians … or in this case the rest of the organization

I believe that finance is the second worst in using abbreviations that seem to be meant to confuse the Russians, or in this case, the rest of the organization. The worst is probably the IT department.

In analyzing the above, and if your start googling, you’ll bump into 3 return metrics: Return on Capital Employed (ROCE), Return on Invested Capital (ROIC) and Return on Net Assets (RONA). Their definition is given below

• ROCE = EBIT / Capital Employed
• ROIC = NOPAT / Invested Capital
• RONA = Net Profit / Net Assets

The three of those metrics are ‘return’ metrics but have a different numerator: EBIT, NOPAT (which equals EBIT x (1 – tax rate)) and Net Profit. Try to remember that for more than 10 seconds. What is even more confusing is that, as far as I can see, Capital Employed = Invested Capital = Net Assets = Fixed Assets + Working Capital?! Try to remember that for more than 10 seconds.

So we change the name of the denominator (CE, IC, NA) … not because the denominator is different (CE = IC = NA) … but because the numerator is different (EBIT <> NOPAT <> Net Profit). How to confuse the Russians … or how to confuse the rest of the organization?