Inventory: Significantly optimising cash flow by changing the focus - mini-series (Part 1)
This marks the beginning of a three-part mini-series on the perennial subject of cash flow optimisation, focusing on the manufacturing and Fast-Moving Consumer Goods (FMCG) industries. The series argues that while finance must report on cash flow, operations should own the metrics. For practitioners along a company's value chain, the three posts can also act as a refresher…
Part 1 - Introduction to the topic and Inventory (DOH):
As is commonly understood, a positive cash flow signifies a company's ability to settle debts, reinvest in its business, distribute dividends to shareholders, pay for expenses, and establish a financial buffer against potential future challenges. The COVID-19 epidemic demonstrated that companies with solid cash flow management largely survived without significant impacts. As succinctly stated by one of my colleagues, "no money, no honey."
It is surprising, therefore, that in many companies, cash flow metrics such as Days Purchase Outstanding (DPO), Days Sales Outstanding (DSO), Days on Hand Inventory (DOH), and working capital metrics such as Days Working Capital (DWC) are often considered the “ugly ducklings” compared to EBIT, Revenue, or Capital Expenditure (CAPEX) in boardrooms and among business unit leaders.
Why is there a lack of focus on working capital and cash flow metrics?
Working capital and cash flow metrics are true proxy metrics. They are proxies for the underlying processes that drive inventory management, overdue payments, and shorter supplier payment cycles. Board room triggered actions ( "let's reduce inventory fast"; "let's do a cash run on overdues"; etc.) only address the symptoms rather than the root causes and thus have limited sustainable impact.
The financial terms "cash flow" and "working capital" are often attributed solely to finance. However, managing these metrics at the core requires the business functions of sales, procurement, and supply chain/manufacturing management (in short: business or operations). CEOs and CFOs relying solely on short-term financial tools administered by the Treasury or Real Estate functions miss the opportunity to drive process changes that can significantly impact working capital and cash flow.
Firms that excel in managing their cash flow and working capital focus on these metrics to drive growth and profitability and increase their market capitalisation and resilience in dealings with banks and markets. Working capital, which represents the difference between current assets and current liabilities, is a snapshot of a company's financial health. Current assets typically include cash, marketable securities, receivables, and inventory, while current liabilities comprise payables.
Let’s peel the onion one layer at a time, starting with Inventory.
Why focus on inventory to optimise cash flow & working capital?
For forty-plus years any lean company regards Inventory as one of the seven lean wastes (Japanese: muda). In the human context, it is the body fat and the opposite of agile and lean.
Inventory consists of buffers in the "sell process" (FG=Finished goods), the "making process" (WIP=Work-in-progress), and the "buy process" (RM=Raw materials). An efficient order-to-cash (O2C) process should be void of buffers.
There is even a negative cash conversion cycle (CCC), which is, in this context, something very positive. It consists of near-to-zero inventory, while customers pay before the business pays the suppliers. Negative CCC is more common in the project business (Design-to-order; engineer-to-order) than in normal production processes (Configure-to-order; make-to-stock). Still, even a negative CCC has room for improvement: Every increase leads to higher cash flow.
The simple questions below help you understand whether you have an opportunity around inventory (DoH: Days on Hand) related cash flow.
Here is a list of questions/statements to assess the status quo:
Do you have any Cash Conversion Cycle metrics linked to the compensation of management/sales boni (similar to EBIT/or revenue)?
Do you have an inventory turn / DOH target for your company? Do you measure regular improvements on the management board level?
Do you report inventory individually by Raw Materials (RM), Work-in-progress (WIP) & finished goods (FG)?
Do you have a common sales & operations planning process along your value chain? (hint: if you need to ask around, you can be sure you have none.)
Is 90% of your production floor space used for production? (instead of having inventory (FG; WIP; RM) everywhere in the plant and outside)
Do you not need internal/external warehousing space as permanent buffers?
Do you own only minimal finished goods or raw material inventory since customers or suppliers own the inventory?
Do you run a continuous improvement program which includes lean practices?
Do you regularly review obsolescence (which impacts your EBIT negatively)?
Bonus question: The amount of inventory reported under "Sales in Excess of billing" is minimal (if you have to ask around, and no one knows, you are lucky that your firm has not introduced this topic)
If you answered „yes“ to most questions, great: your cash flow component "inventory" is under control. Do not read any further. Better to focus on other topics.
Size of the prize
If you, however, either do not know or answered several questions with a "no", you have an excellent opportunity to make your company more resilient and efficient.
To understand the „size of the prize“, please use these simple steps to establish the gap and a target. This is quite basic, so forgive me if you do the calculations as a standard. In this case, your issue is not the metrics but missing action:
Calculate your average inventory level (add monthly inventory levels together (for January, use the 1st and 31st, then divide by 13. If you do not have a lot of inventory fluctuations, take Jan 1st and Dec 31st, and divide by 2)
Divide your average inventory by your annual cost of goods sold (or Cost of Sales, the difference is in most companies minor)
Multiply by 365 days. Now you have your Days Sales of Inventory or Days on Hand). An alternative is to divide 1/inventory turns and then multiply by 365.
Divide your average inventory by 365 to get your inventory per day metric.
Now set your DHO / payment terms average target (Tip: depending on your manufacturing business, the DoH should be between 50 to 30 days with Inventory turns 7+. B2C businesses should go for even higher turns. There is only a theoretical physical limit here: If you replenish, for example, three times a day, your inventory turn could be (3*365=) 1’095.
Now subtract your current DOH from your target DOH and multiply by the inventory per day…voila - you have your cash opportunity!
A 15-20% inventory reduction (=cash flow improvement) in 12 months is easily obtainable for most companies. From there, with consistent focus by operations and sales, combined with higher competency, transparency, and cross-functional teamwork, the level of inventory reduction can go as high as 50-70% over three years - with additional positive impacts on revenue and gross margin.
How to set up the Cash Flow improvement project
Time plan: 12-24 months (depending on the lack of current focus)
Sponsors: Business Presidents / Business Unit Heads
Lead: Head of Operations / Business Unit Heads (instead of CFO and finance)
Project set-up: weekly task force with clear objectives, monthly reporting on board level by Business Presidents with clear output KPIs (=Inventory trend, DoH trend, Development of FG, WIP & RM). Tracking is to be done by finance and normal GAAP (Generally Accepted Accounting Principles) mechanisms. Understand that GAAP standards are good for financial reporting but not for value chain changes. You need to have FG, WIP, and RM shown separately to know whom to incentivise or apply consequence management (sales, procurement, S&OP, manufacturing).
Sustain success: Become a Lean Six Sigma company with an ingrained sense of speed; develop inventory threshold KPIs. Without this, you will reinvent the wheel on something that has been proven for many decades now in thousands of companies. Today, there are fantastic companies out there that do most of the training online up to the black belt level - choose the best - they will have an ROI of the cost for the services generally in a month if you keep the focus on it.
Digitalization/Automation opportunity: HIGH. Several elements have a massive impact on inventory levels. Most of them are related to managing the current systems better. Here process mining software can help to find the gold nuggets quicker. In many companies, the Sales & Operating Planning (S&OP) process and software have huge potential simply because sales and operations often are not given the right incentives to work together. Hence, each optimises depending on their respective KPIs and bonus criteria. It is up to the management board to fuse these two departments at the hip regarding S&OP and set common objectives.
Risk: LOW - Potential stockouts at the beginning when calibrating how low you can go will lead to manufacturing bottlenecks - this is the price to pay to improve.
Cost: MEDIUM - either set up an internal task force full-time or employ external support (if you take externals, ensure they are “shadowed” by internal personnel to retain knowledge). Train operations and sales personnel in inventory minimisation (i.e. with role-play or one of the hundreds of available value chain inventory & flow games). Just showing a video and a multiple-choice test has never worked if you like to go for real change.
Watch out for:
Expect pushback from business and operations leaders claiming that they have optimised inventory levels in the past already. They will point out that they need to maintain a certain amount of inventory due to unreliable forecasts (= a sign of a lack of a well-managed S&OP). And, the all-time favourite: Do you want us to focus on selling/making products or on inventory?
The simple answer is: "From now on - both."
Thank you for reading through part one of a mini-series on cash flow optimization. The next post will be on supplier payment optimization (Days Payable Outstanding: DPO), followed by DSO (Days Sales Outstanding).
Stay safe. Be bold.
Daniel
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