By Gerard Rijk
Profit chain analysis increases transparency about value of benefits and capacity to incur costs to resolve ESG issues
Farmers, plantations, mining companies and other upstream companies often are perceived to be the crucial beneficiaries of critical and sometimes contested input materials like palm oil, soy, timber, cacao, metals, and fossil fuels. Although these upstream companies have a great responsibility to create a sustainable supply chain, this Expert View shows that the downstream participants often benefit most from the embedded value of palm oil, soy, and other products. A profit chain analysis offers insights for civil society and other stakeholders about which participants in the supply chain benefit most and therefore should contribute most to the solution of sustainability issues. This could shift the focus of campaigning and intervention to fast-moving consumer good companies (FMCGs) and to retailers or other business-to-consumer (B2C) companies, like fast-food companies and do-it-yourself (DIY) chains.
Why is a profit chain analysis so crucial?
The basis of the profit chain methodology is a supply chain analysis. The supply chain analysis shows how for instance Brazilian soy flows from farmer to consumer - traders, refiners, animal feed producers, European livestock and dairy farmers, slaughterhouses, dairy companies, FMCGs and supermarkets can be distinguished. In all these steps, value is added to the embedded soy products, sometimes by just re-packaging the material. Every stage in the chain generates a gross profit and an operating profit, based on its action.
The most direct way to learn how big this profit on embedded soy is, is to ask the specific participant. However, these companies often do not want to disclose the volume and do not want to disclose the value and profit on the embedded soy. In general, they do not have an accounting system for that. However, many other stakeholders like civil society organisations and investors are interested in the size of these embedded profits. Civil society (NGOs) is eager to know how much an FMCG, with large brands like Nestlé is earning on embedded Brazilian soy from deforested land. This knowledge can support NGOs in campaigning for a fair contribution of every participant in the supply chain, for instance to share the costs of segregated soy streams; currently, FMCGs’ narrative is that segregation is too expensive for them. Investors could be interested in this to understand which part of Nestlé’s profits are at risk as deforestation linked to Brazilian soy might impact Nestlé’s share price. The size of the impact might correlate with the materiality of the linked volumes, values, and profits.
How is a profit chain analysis constructed if companies do not cooperate?
If companies don’t provide details, the second-best solution to calculate the linked values and profits is to use various sources ranging from conversion rates (how much kilogram soy for one kilogram meat) and annual reports. Supply chain analysts can trace the volume flows, and financial analysts can use the reported gross margins and operating margins to calculate the values, the pricing-up, and the profits linked to embedded soy. Companies publish the cost of goods sold (COGS: raw materials, packaging) and the revenues. The difference is the pricing-up, or the gross profit. This gross profit still includes expenses, such as labour costs, use of machines, marketing costs, management costs, bonuses, restructuring costs and other costs. After deduction of these costs, the remaining profit is called the ‘operating profit’. Shareholders, bondholders, and banks benefit from this, as well as governments via corporate tax proceeds.
The ’gross profit’ is a broader profit definition than ‘operating profit’, but it is worthwhile to mention them both. The weak point of the ‘operating profit’ definition is that it is a profit number after deduction of marketing costs, restructuring and bonuses, which can be seen as benefits for management and shareholders. The disadvantage of the ‘gross profit’ definition is that many companies publish it as a number before deduction of labour costs, meaning that it is not the profit remaining for shareholders, management and financers.
Mentioning them both therefore gives the best insight in who is benefiting most from the added value created in a supply chain. For instance, the profit chain analysis of the global palm oil supply chain (Chain Reaction Research) showed that USD 281.7 billion of embedded palm oil value was generated in the whole chain, of which USD 52.5 billion ended up as gross profits of companies in the supply chain. After costs were deducted, USD 18.1 billion in operating profits resulted for these companies. Of these total gross profits and operating profits, respectively 66% and 52% was generated by FMCGs and retailers (including McDonald’s).
In which reports has it been applied and what was concluded?
The above-mentioned profit chain analysis not only revealed the large share of FMCGs and retailers in the total profits made in the supply chain, but also the top-11 companies earning most on embedded palm oil. Despite small volumes but due to the high margins, McDonald’s was on the number 10 position in the top-11. The company earned much more per ton embedded palm oil (USD 2,111 gross profit per ton) than number one Wilmar (USD 94), completely due to the high gross margin at McDonald’s. The profit chain analysis also enables the discussion about financial responsibility: to make the palm oil chain 100% NDPE (No Deforestation, Peat and Exploitation) compliant, it would require FMCGs to increase sales prices by 1.8% to pay for that.
Profundo also applied the methodology to the Dutch soy supply chain showing Albert Heijn (subsidiary of Ahold Delhaize) was the number one company in earnings on Brazilian soy (approximately EUR 40 million). Dutch retailers dominated the gross profit generation with 33-35% of the total. A profit chain analysis for the sugarcane sector showed that the FMCGs were generating respectively 52% and 50% of the gross profits and operating profits made in the global supply chain of embedded sugarcane, due to the very high margins of Coca Cola, Nestlé and PepsiCo.
All reports, in which Profundo applied the methodology, showed the weakness of the narrative by FMCGs/retailers that sustainability measures are too expensive for them. The annual profits they make on embedded controversial commodities are often much higher than the costs of implementing a sustainability policy across the entire supply chain. With the profit chain analysis in their toolbox, civil society and investors have an instrument to start discussions about fair contributions by downstream (FMCGs, retailers) actors. And governments have strong arguments to counter the efforts by big companies to dilute the supply chain due diligence regulation discussed at present in the EU. By spending a small annual amount, sometimes combined with raising prices marginally, companies and investors can generate multiple returns because of reputation and investment value increases, in one example 9 to 45 times.
Interested to learn more about the profit chain analysis, please contact Gerard Rijk (firstname.lastname@example.org or +31 637433429). A triple peer review by an asset manager, a broker and a bank has approved the methodology.
(Photo: Zdeněk Macháček on Unsplash)