DSO - Significantly optimising cash flow by changing the focus - mini-series (Part 3)
The final part of the three-part mini-series on cash flow optimisation focuses 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 3 - Why focus on customer payments (Days Sales Outstanding / DSO) to optimise cash flow & working capital?
Let us consider a hypothetical company named Pompous Inc., where you hold the position of Supply Chain / Procurement Head. The company is facing a cash flow shortage due to seasonal issues (although the company perceives this to be the cause, in reality, it stems from inadequate Sales & Operations planning, as in most cases). At the end of every year's last two quarters, you are ordered into meetings with the Manufacturing and Sales departments, under the leadership of the CFO, to devise strategies to accelerate or delay cash flow elements. These meetings occur when the managing board does not view cash flow as a process but as a situational topic. As a process topic, cash flow should be managed and owned by Procurement, Manufacturing, and Sales. However, as a situational topic, it typically ends with Finance, as in our case.
To improve cash flow, Sales is asked to make overdue calls to customers. During a conversation with you in the hallway outside the meeting, the Sales Head says that the management board will ask for her revenue numbers in a few weeks. If she aggressively pursues payment from their best customers, she risks losing them. She is incentivised revenue-, and not cash-based, so she intends to go through the motions without taking any meaningful actions.
Manufacturing should examine their production schedules and convert inventory (Work-in-progress - WIP; Finished Goods - FG) into billable sales to expedite invoiceable sales. Although the Manufacturing head is cooperative, he will need to push hot lots manually outside the Manufacturing Execution System (MES), which will delay other planned orders. To ensure timely delivery, he will now have to sign off on 10% more overtime for the next few weeks to compensate for the production delay. This results in an increased cost of Sales and a margin squeeze for the subsequent batches - not a great deal either...
Finally, as Head of Procurement or Supply Chain, you will look at due supplier payments and identify those suppliers that Accounts Payable could safely delay into the next quarter. So, you diligently analyse your Pareto of all payments due in the last two weeks before the quarter end and look through the supplier names. Nearly all of them you know to be able to delay, except two:
Supplier A, because you feel obliged to their sales head, who came through to you several times in dicey situations, and you feel you are a preferred customer.
Supplier B, you are not willing to touch. You remember the old saying: Burnt once; shame on you. Burnt twice; shame on me. They are excellent and reliable in product quality and delivery performance and expect the same from their customers. The first time you tried delaying their payments last year, you received, just one day after the payment was due, a call (not email) from their head of Accounts Receivables (not Sales) telling you in no uncertain terms that you are in breach of the contract, and based on her internal policies, she is forced to impose a delivery moratorium until you have paid (nothing personal, she said with a half smile). An hour later, the first calls from the plants poured in since they were alerted by Supplier B that shipments would be halted due to commercial issues caused by Procurement and Accounts Payables. Before you leave that night, you receive a call from the COO of your company inquiring about what the hell is going on. The same night, you get on the phone with your Acc Payable colleague to ensure we pay asap. The following day, you call the Accounts Receivable Head of Supplier B back, telling her it was all just a big misunderstanding due to some systems glitch…
So, based on the above, we can safely say that situational cash flow management causes havoc throughout the whole value chain of Pompous Inc. But we also learn a few lessons about the roles and responsibilities of Sales and Accounts Receivables regarding DSO. Cash flow is squandered since:
invoices are not sent before or at product delivery,
customers do not feel 'preferred', hence as well do not treat you as preferred when it comes to paying your bills
the wrong team follows up on overdues (it should be “tough as nails” Accounts Receivables, not “very friendly and understanding” Sales),
company payment standards for customer contracts and escalation paths are missing,
contractually agreed payment terms are not followed up diligently and end up in overdues,
local market benchmarks are not known,
sales personnel are not trained in cash flow management and/or incentivised,
and milestone payments are not used or executed.
We will dig deeper into this with examples and solutions in “The Supply Chain Dialogues” podcast linked to this post soon. For now, I am sure that most supply chain or sales colleagues will recognise one or the other (or even all) points in their company.
As always in the “Close the Gap” blog posts, we see gaps as opportunities. So, here are a few simple questions to establish whether or not you have an opportunity around free cash flow (still with a focus on DSO). Note that some repeat in other parts of the series since there are overlaps that can be handled with the same solutions)
How many of the below questions can you answer with a resounding, fact-based "yes"?
Do you have any Cash Conversion Cycle (CCC) metrics linked to the compensation of management/sales boni?
Did you update your guidance to sales personnel about accepting payment terms in the last five years, considering the massive change in interest rates in all global markets? Are they trained in payment terms?
Do you have payment terms maximum thresholds for sales contracts of 30 or whatever days are customary in your industry (and is it monitored with automatic tracking in your CRM, ERP, or whatever other order tracking system you use)?
Do your salespeople understand the cash flow benefits of pre-payments? Are they incentivised?
Do you measure the difference between contractual payment terms & actual payment of your Accounts Receivable?
Do you manage cash collection via Accounts Receivables rather than through Sales?
Do you have regular over-due reporting with time-based escalation paths for resolution?
Do you track On-time-delivery performance in the context of DSO / CCC? And if so, do you have consequence management linked to it?
If you answered „yes“ to most questions, great: you have your DSO under control. Congratulations - well done! Do not read any further; better to focus on other topics.
Size of the Prize
However, if you do not know or answered several questions with a "no", you can make your company more stable and cash-rich…To understand the „size of the prize“, please use these simple steps to establish the gap and a target:
Divide your total annual revenue by 365 (=calendar days). Now you have your DSO cash flow per day.
Now set your DSO/payment terms average target (Tip: depending on your sales footprint, your DSO target should be negative (through pre-payment or milestone payments) to 60 days).
Now subtract your current DSO from your target DSO and multiply by the DSO cash opportunity per day…voila!
For a company with $10b of revenue, $ 400-800 m of cash improvement in less than a year is very likely, if there was less focus (incl. no disciplined overdue management) on this topic in the past.
How to set up the Cash Flow improvement project
Time plan: 6 months (depends on average order backlog turnover)
Board Sponsor: COO (if sales reports into this function; otherwise, CFO)
Lead: Head of Sales / Business Unit Heads & Head of Accounting (joint target)
Project set-up: weekly task force with clear objectives, monthly reporting on board level by CFO with clear output KPIs (=DSO, Overdue development, # of contracts with aligned payment terms, total revenue/countries covered (%)). Establish clear roles & responsibilities for Sales and Acc. Payables. Do training calls to customers and contract negotiations in role-play set-ups - this must be felt viscerally by your people, not just understood intellectually. Establish customer “driver’s licenses”, ensuring that only trained people can talk to his/her “majesty, the customer”.
Sustain success: Establish and regularly update training for sales & Accounting; develop procedures on working level; update General Terms / Conditions, etc...
Digitalisation/Automation opportunity: High. Everything hangs together: Procurement, Manufacturing & Sales. If you look at the Order to cash process, all elements must be linked in data lakes to identify patterns, gaps, and interdependencies. This is not difficult, but you (at this point) can only do it inside - yet. It needs focus, and some excellent data scientists and machine learning people are also trained in operations.
Risk: Low - In the end, the market dictates the payment terms you can accomplish unless you have a market-dominating position. Still, watch out for large customers that as well are large suppliers. Weigh your options...
Cost: Minimal internal: data lake, ERP, CRM like SalesForce. You should have this already. But even if you still operate an excel based order management process (and I wish you luck in this case), you can run a few monthly inquiries to see the gap/opportunity. Training should be done in-house so that you keep the knowledge.
Watch out’s:
Expect pushback from sales & accounting: Sales will claim to lose orders, and accounting, if not doing the overdues already, will claim to be too far from the customers to do the cash collection.
Mitigation: Case-based training for both departments. Make it clear to sales that cash is valuable to your firm and that they were hired to manage cash and revenue (while you are at it...as well margins). Accounting must learn to align more with sales to understand customers (i.e. access to CRM files, clear call logs, and clear communication targets for customers).
Conclusion of the mini-series on cash flow management
We covered three main ingredients of value chain cash flow in any manufacturing/FMCG company: inventory, supplier payments, and customer payments (included in DHO, DPO, and DSO). We concentrated on those since they impact cash flow the most.
The series argues that while finance must report on cash flow, operations (Sales, Production, Procurement) must own the metrics. This means: measured, incentivised and consequence-managed.
Every mom-and-pop store knows that life can get tough if you do not have money in your cash register. Quoting my former colleague at the end as I did at the beginning: "No money, no honey."
I hope we can show that proxy cash flow metrics stand for something very direct and relevant in the value chain. The “ugly duckling”, if treated with knowledge and focus, can turn into a swan that impresses your customers, investors and banks...and I mean white swan…the black swans we hold at bay with implementing a 21st century supply chain.
Thank you for reading through the last part of the mini-series on cash flow optimization in the value chain.
'And now for something completely different' in the next blog post.
Stay safe. Be bold.
Daniel
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