CHAPTER INTRODUCTION
Capital efficiency is a critical driver of shareholder value. Improving the management and turnover of assets can significantly improve cash flow and returns. Unfortunately, due to the emphasis on sales and earnings per share growth at many companies, capital management often doesn't get the attention it deserves. Managers and investors who understand the importance of working capital in cash flow appreciate the role that effective capital management plays in value creation. Figure 17.1 drills down into the key drivers of capital efficiency and asset management and highlights the major components of capital employed in a typical business:
- Operating capital
- Capital assets, including property, plant, and equipment
- Intangible assets, including goodwill
The balance sheet is a snapshot of transactions in process. Therefore, it stands to reason that a company with greater process efficiency will have a leaner balance sheet than a company that is less efficient. This leaner balance sheet is evident by better performance on measures of asset utilization and turnover such as accounts receivable days sales outstanding (DSO), inventory turns, and asset turnover. In addition to eroding returns and decreasing cash flow, companies that have bloated balance sheets (i.e. excessive inventories or receivables) are also inherently more risky than their leaner counterparts. A company with excess inventory or slow‐paying customers is more likely to have future write‐offs. A wise CFO once told me, “There are only two things that happen to inventory: you either sell it to a customer or write it off.” A rising DSO may indicate a number of problems, including potential collection problems, aggressive revenue recognition policies, or a delay of shipments to the end of the quarter. Key asset utilization and turnover measures described later in the chapter can also be used to identify potential risks due to excessive asset levels.
In Chapter 3, we noted that different businesses will have distinct operating or business models. Among other differences, capital requirements and asset turnover will vary significantly across businesses. Some will require large capital outlays for manufacturing plants; others will require little capital for this purpose. For example, a consulting firm typically requires little in the way of capital assets, since people and intellectual property are the firm's primary assets. These firms do not require large expenditures for plants, warehouses, and the like that other firms may need. Some businesses will sell products or services on credit and will carry large accounts receivables. Others will collect the money up front in cash or credit card sales. Each of these extremes must be considered in developing the overall business model in order to earn an acceptable to superior return for shareholders. Within specific industries, there is also a wide range of asset and turnover levels. Effective operating capital management is driven by several factors, including management attention and process efficiency.
The critical success factors for achieving improved capital management include management attention, performance visibility, process efficiency, context creation, and accountability.
The extent to which managers emphasize and attend to any specific process, project, or measure will have a large impact on the effort and result of that endeavor. This is very true in capital management. If a manager is only sales or earnings driven, it will follow that operating capital levels will be higher. Conversely, if a manager recognizes the importance of working capital and actively drives and monitors performance, operating capital levels will be lower. In addition, a well‐designed management compensation plan that includes capital utilization (or uses a broad measure such as ROIC that reflects capital) will ensure focus in this important area.
Capital management will be improved if managers have appropriate visibility into key performance indicators (KPIs) on a timely basis. Well‐designed performance dashboards provide managers with key process measures and leading indicators of capital performance.
Capital requirements are very closely associated with process efficiency. Companies that have well‐established process and quality programs will typically require less capital to support the business. Conversely, a manufacturing process that is not efficient and has a high level of rejected products will result in high inventories (and costs).
When managers and employees fully understand the dynamic impact of capital in creating value, more attention is paid to this driver and related processes. However, organizations with an exclusive focus on sales or earnings growth will often view capital as “free,” with the result of higher than required asset levels.
Assigning appropriate accountability for assets such as inventory and receivables is difficult. Out of convenience, many companies look at the functional area responsible for the last step in the related process. For example, manufacturing is often held responsible for inventory, and finance is held responsible for receivables levels since finance people are typically involved in collections. However, most financial measures and other outcomes are the result of a business process that crosses a number of functional areas. For example, inventory levels are certainly a result of manufacturing activities. But they are also a result of the design of products and the product demand forecasts typically furnished by sales or marketing management. Each driver must be disaggregated and assigned to the appropriate process team and leader.
The remainder of this chapter will focus on measuring and improving the management of operating capital. We will explore the other components of capital investment, fixed assets, and intangibles in Chapter 18.
We will focus on measuring and improving the operating components of working capital, primarily accounts receivable, inventories, and accounts payable. We are treating the remaining components of working capital, cash and short‐term debt, as “nonoperating” or financing accounts. Table 17.1 presents the major components of operating capital and includes key activity measures for these accounts. Operating capital assets such as receivables and inventories represent a past investment in cash or a future claim to cash. Reducing either of these balances will increase cash and improve returns.
TABLE 17.1 Operating Capital (Working Capital Less Cash and Debt)
Roberts Manufacturing Co. | |||||
Measure | Sales | ||||
Component | 2018 | Description | Result | % of Sales | Turnover |
Receivables | 20,000 | DSO | 73 | 20% | 5.0 |
Inventory | 18,000 | Inventory Turns | 2.5 | 18% | 5.6 |
Other | 900 | 1% | 111.1 | ||
Payables | −4,500 | DSP | −16.4 | −5% | −22.2 |
Accrued Liabilities | −5,000 | −5% | −20.0 | ||
Operating Capital (OC) | 29,400 | OC Turnover | 3.4 | 29% | 3.4 |
Sales | 100,000 | ||||
COGS | 45,000 |
Accounts payable and accrued liabilities offset these “investments” and reduce the total cash required to support the business. Although increasing accounts payable by delaying payments to vendors will reduce the total investment and improve returns, caution must be exercised with this tactic. It runs counter to developing a partnership with vendors and is inconsistent with motivating vendors to higher performance and service levels. Vendors may seek compensation for delayed payment in the form of higher prices or in other subtle ways.
In order to understand the dynamics of working capital and to be able to predict future levels of operating capital and cash flows, managers should employ the operating capital forecast, illustrated in Table 17.2. This tool is very helpful in understanding the inputs and outputs to receivables and inventories. The basic idea is to start with a projected profit and loss by month. Then, based on past experience and management practices, receivables, inventories, and payables can be projected. Let's take a look at the projected levels and activity for accounts payable. We will discuss receivables and inventories in each respective section later in the chapter.
TABLE 17.2 Operating Capital Forecast – Thomas Industries
History | Projections | ||||||||
Oct | Nov | Dec | Jan | Feb | March | April | |||
Income Statement | |||||||||
Sales | 600.0 | 660.0 | 1,000.0 | 400.0 | 500.0 | 550.0 | 600.0 | ||
COGS | 420.0 | 462.0 | 700.0 | 280.0 | 350.0 | 385.0 | 420.0 | ||
Gross Margin | 180.0 | 198.0 | 300.0 | 120.0 | 150.0 | 165.0 | 180.0 | ||
GM % Sales | 30.0% | 30.0% | 30.0% | 30.0% | 30.0% | 30.0% | 30.0% | ||
Operating Expenses | 165.0 | 174.0 | 225.0 | 135.0 | 150.0 | 157.5 | 165.0 | ||
Operating Profit | 15.0 | 24.0 | 75.0 | −15.0 | 0.0 | 7.5 | 15.0 | ||
Tax Expense | 6.0 | 9.6 | 30.0 | −6.0 | 0.0 | 3.0 | 6.0 | ||
Net Income | 9.0 | 14.4 | 45.0 | −9.0 | 0.0 | 4.5 | 9.0 | ||
Accounts Receivable | |||||||||
Beginning Balance | 950 | 1,150 | 1,310 | 1,810 | 1,452 | 1,310 | 1,285 | ||
Sales | 600 | 660 | 1,000 | 400 | 500 | 550 | 600 | ||
Collections | −400 | −500 | −500 | −758 | −642 | −575 | −510 | ||
Other | |||||||||
Ending Balance | 1,150 | 1,310 | 1,810 | 1,452 | 1,310 | 1,285 | 1,375 | ||
DSO | 57.5 | 59.5 | 54.3 | 108.9 | 78.6 | 70.1 | 68.8 | ||
% sales (annualized) | 16.0% | 16.5% | 15.1% | 30.3% | 21.8% | 19.5% | 19.1% | ||
Collections | CM | M+1 | M+2 | M+3 | |||||
Assumptions | 10.0% | 40.0% | 30.0% | 20.0% | |||||
Inventories | |||||||||
Beginning Balance | 1,300 | 1,220 | 1,112 | 832 | 762 | 902 | 1,077 | ||
Purchases | 140 | 154 | 168 | 84 | 196 | 224 | 280 | ||
Labor | 100 | 100 | 168 | 84 | 196 | 224 | 280 | ||
OH | 100 | 100 | 84 | 42 | 98 | 112 | 140 | ||
COGS | −420 | −462 | −700 | −280 | −350 | −385 | −420 | ||
Ending balance | 1,220 | 1,112 | 832 | 762 | 902 | 1,077 | 1,357 | ||
Inventory turns | 4.1 | 5.0 | 10.1 | 4.4 | 4.7 | 4.3 | 3.7 | ||
DSI | 87.1 | 72.2 | 35.7 | 81.6 | 77.3 | 83.9 | 96.9 | ||
% sales | 16.9% | 14.0% | 6.9% | 15.9% | 15.0% | 16.3% | 18.8% | ||
Accounts Payable | |||||||||
Beginning Balance | 160 | 170 | 184 | 198 | 114 | 226 | 254 | ||
Purchases | 140 | 154 | 168 | 84 | 196 | 224 | 280 | ||
Payments | −130 | −140 | −154 | −168 | −84 | −196 | −224 | ||
Other | |||||||||
Ending Balance | 170 | 184 | 198 | 114 | 226 | 254 | 310 | ||
% of annualized sales | 2.4% | 2.3% | 1.7% | 2.4% | 3.8% | 3.8% | 4.3% |
Payables represent amounts due to vendors. When inventory is delivered to a company, an addition to the company's inventory and payables is recorded. When the invoice is paid, the payment is subtracted from the balance. In Table 17.2, payables will increase by the amount of inventory purchases each month. In January, the company received $84 million worth of inventory and typically pays vendors in 30 days. This transaction will increase both inventory and payables by $84 million. Payables will be reduced in February when the company pays vendors $84 million for deliveries received in the prior month.
It is also necessary to develop estimates of working capital levels for long‐term projections. Projecting operating capital requirements for long‐term projections for strategic plans, valuations, and capital investments is covered in Chapter 14, Long‐Term Projections.
It is not uncommon to find companies that have operating capital levels between 20% and 30% of annual sales levels. Many companies have been able to improve on these levels and achieve ratios of 5% to 10%, and in some cases even negative operating capital levels. In other words, companies such as Dell have created business models that provide for payables and accrued liabilities that exceed receivables and inventory levels. The potential value associated with dramatic improvements is significant. Table 17.3 presents a summary of the benefits of a company reducing operating capital levels by 10%, 20%, and 30%. An income statement, a balance sheet, and key activity ratios are presented. To fully understand the benefits, key measures of operating and financial performance are also shown on the analysis, including earnings per share, asset turnover, return on equity (ROE), and economic profit.
TABLE 17.3 Working Capital Improvement Illustration
Improvement Scenario | |||||||||
Base | 10% | 20% | 30% | ||||||
P&L | $m | $ | % Sales | $ | % Sales | $ | % Sales | $ | % Sales |
Sales | 1,200.0 | 100.0% | 1,200.0 | 100.0% | 1,200.0 | 100.0% | 1,200.0 | 100% | |
COGS | 600.0 | 50.0% | 600.0 | 50.0% | 600.0 | 50.0% | 600.0 | 50% | |
Operating Profit | 240.0 | 20.0% | 240.0 | 20.0% | 240.0 | 20.0% | 240.0 | 20% | |
Interest Expense | 14.0 | 1.2% | 10.9 | 0.9% | 7.7 | 0.6% | 4.6 | 0% | |
Profit before Taxes | 226.0 | 18.8% | 229.2 | 19.1% | 232.3 | 19.4% | 235.5 | 20% | |
Taxes | 40% | 90.4 | 7.5% | 91.7 | 7.6% | 92.9 | 7.7% | 94.2 | 8% |
Net Income | 135.6 | 11.3% | 137.5 | 11.5% | 139.4 | 11.6% | 141.3 | 12% | |
Balance Sheet | |||||||||
Cash | 100.0 | 8.3% | 100.0 | 8.3% | 100.0 | 8% | 100.0 | 8% | |
Accounts Receivable | 250.0 | 20.8% | 225.0 | 18.8% | 200.0 | 17% | 175.0 | 15% | |
Inventory | 200.0 | 16.7% | 180.0 | 15.0% | 160.0 | 13% | 140.0 | 12% | |
Net Fixed Assets | 100.0 | 8.3% | 100.0 | 8.3% | 100.0 | 8% | 100.0 | 8% | |
Total Assets | 650.0 | 54.2% | 605.0 | 50.4% | 560.0 | 47% | 515.0 | 43% | |
Accounts Payable | 75.0 | 6.3% | 75.0 | 6.3% | 75.0 | 6.3% | 75.0 | 6.3% | |
Accrued | 50.0 | 4.2% | 50.0 | 4.2% | 50.0 | 4.2% | 50.0 | 4.2% | |
Debt | 200.0 | 16.7% | 155.0 | 12.9% | 110.0 | 9.2% | 65.0 | 5.4% | |
Equity | 325.0 | 27.1% | 325.0 | 27.1% | 325.0 | 27.1% | 325.0 | 27.1% | |
Total Liabilities & Equity | 650.0 | 54.2% | 605.0 | 50.4% | 560.0 | 46.7% | 515.0 | 42.9% | |
Cost of Capital | 12% | ||||||||
Interest Rate | 7.0% | ||||||||
Key Measures | |||||||||
DSO | 76.0 | 68.4 | 60.8 | 53.2 | |||||
Inventory Turns | 3.0 | 3.3 | 3.8 | 4.3 | |||||
Asset Turnover | 1.8 | 2.0 | 2.1 | 2.3 | |||||
Working Capital | 425.0 | 35.4% | 380.0 | 31.7% | 335.0 | 27.9% | 290.0 | 24.2% | |
Net Operating Assets | 525.0 | 43.8% | 480.0 | 40.0% | 435.0 | 36.3% | 390.0 | 32.5% | |
Invested Capital | 525.0 | 43.8% | 480.0 | 40.0% | 435.0 | 36.3% | 390.0 | 32.5% | |
ROE Analysis | 41.7% | 42.3% | 42.9% | 43.5% | |||||
Profitability | 11.3% | 11.5% | 11.6% | 11.8% | |||||
Asset Turnover | 1.85 | 1.98 | 2.14 | 2.33 | |||||
Leverage | 2.00 | 1.86 | 1.72 | 1.58 | |||||
ROIC | 27.4% | 30.0% | 33.1% | 36.9% | |||||
Additional Cash Generated | 45 | 90 | 135 | ||||||
Earnings | 1.9 | 1% | 3.8 | 3% | 5.7 | 4% |
Most attention should be focused on reducing receivables and inventories rather than increasing accounts payable or other liabilities. A focus on receivables and inventories will reduce investment levels and can lead to improvements in the revenue and supply chain management processes, customer service, and profitability.
The base case presents a company with $1,200 million in sales and net income of $135.6 million. The company has accounts receivable of $250 million (76 DSO) and inventories of $200 million (3.0 turns). Let's look at the 20% improvement scenario. What would be the benefit of reducing receivables to $200 million (60.8 DSO) and inventories to $160 million (3.8)? The following changes would result:
The sum of $90 million additional cash is generated.
The additional cash could be used to repurchase shares, pay down debt, or make strategic investments, including acquisitions. In this case, the company pays down debt from $200 million to $110 million.
Reducing debt also reduces annual interest expense from $14.0 million to $7.7 million. Net income increases from $135.6 million to $139.4 million.
Asset turnover increases from 1.85 to 2.14.
ROIC increases from 27.4% to 33.1% (a 21% improvement).
Figure 17.2 presents a drill down into the drivers and critical measures for accounts receivable. Key among these drivers are credit terms, quality of products and paperwork, the effectiveness of the revenue process, and revenue patterns.
A significant determiner of a company's actual DSOs is the credit terms extended to customers. There tends to be wide variation in credit terms by industry, country, and competitive situation. Even within a company, it is fairly typical to see a wide range of terms extended to customers for different products, channels, and regions. A useful way to evaluate receivable management is to compare actual DSO to the “best possible DSO” (BPDSO). This computation estimates the DSO level if all customers paid invoices on the contractually agreed date. It is computed by weighting the credit terms for each type of customer, region, or business line by annual sales and is illustrated later in this chapter in the “Best Possible DSO Estimate” table. Companies should also consider the possibility and merits of reducing credit terms to customers, resulting in a reduction to the BPDSO.
It stands to reason that receivables collections will be affected by the quality of products and services and customer‐facing processes such as billing. The typical customer is not anxious to part with cash in the first place. Obviously, if the product is not performing, the customer will not pay. The same is true for nonconforming or incomplete paperwork. If the invoice does not match the customer purchase order or does not provide required supplemental information, the payment cannot be processed without additional action.
We all recognize that the impact of quality problems goes far beyond slow collections. It reduces customer satisfaction and loyalty, increases costs for both you and your customer and may jeopardize future sales. By examining slow‐paying accounts and identifying underlying reasons, managers can learn a great deal about any customer dissatisfaction and take steps to deal with underlying product or process problems.
The effectiveness of the revenue process is a key driver of accounts receivable. The timeline of the revenue process for a typical company is summarized in Figure 17.3. The process starts long before a product is shipped, when the company is engaged in the product design and preselling activities with the customer. In addition, the setup of the order processing software and product definitions can also facilitate or encumber later stages of the revenue process.
Other activities preceding shipment include order processing and manufacturing and quality control. Imagine the downstream process implications of botching the order entry step by entering an incorrect part number or shipping address. The wrong product will be shipped to the customer, or the product will be shipped to an incorrect location. The ability to reduce defects at this stage in the process can save a great deal of time, money, and customer goodwill.
When available, the product is shipped and an invoice is generated and delivered to the customer by post or electronic means. Understanding what happens at the customer's facility to process purchases and payments is essential to speed collections. What process and system does the customer employ to receive the product, test that it works properly, review the transaction, and initiate payment? Does the customer require special paperwork to facilitate processing? How does the customer identify and resolve problems and discrepancies? Does the customer pay on negotiated terms or routinely delay payment to help its own cash flow, often called the cash management lag (CML)?
A best practice is for customer service to contact the customer shortly after delivery to ensure that the customer has received and is satisfied with the product and has everything necessary to pay the invoice. If any issues exist, they are identified early and can be addressed at this time. Unfortunately, many companies wait until the receivable is past due to contact the customer. They may be unaware that there is a problem with the product or paperwork preventing payment. Under even the best of circumstances, this situation results in an unsatisfied customer and delayed payment for 40 days or more.
The specific measures utilized will vary based on the individual circumstances. However, there are some common measures that are useful in evaluating and measuring improvements in this area.
Days Sales Outstanding (DSO). DSO is a measure of the length of time it takes to collect from customers. It will be affected by the industry in which the firm participates, the creditworthiness of customers, and even the countries in which the firm does business. In addition, DSO is affected by the efficiency and effectiveness of the revenue process (billing and collection), by product quality, and even by the pattern of shipments within the quarter or the year.
The basic DSO formula is:
In Chapter 2, we computed the DSO for Roberts Manufacturing Company (RMC) as follows:
The basic formula can be adjusted for use as a quarterly or monthly measure by annualizing sales for the period. For example, DSO for a quarter would be computed as follows:
Assuming that Q4 sales for Roberts Manufacturing Company were $35,000, the quarterly DSO would be computed as follows:
Many financial and operating managers prefer to examine DSOs based on average levels of receivables throughout the year, since year‐end receivables levels may be large due to the year‐end push (hockey stick):
DSO Count‐Back Method. This measure is a terrific variation of the basic DSO concept that considers variations in shipment patterns. The traditional DSO measure described earlier can be significantly impacted by shipment or billing patterns during a period. For example, if a disproportionate levels of shipments are made at the end of the quarter, DSO will rise since it is very unlikely that these invoices will be collected within 10 to 15 days after shipment.
The DSO count‐back method accumulates sales starting with the last day of the quarter and continuing backward until the total equals the receivables balance as illustrated in Table 17.4. The number of days counted results in the DSO count‐back.
TABLE 17.4 DSO Count‐Back Illustration
Cumulative | |||
Sales | Countback | Days | |
October | |||
Week 1 | 700.0 | 35,000.0 | |
Week 2 | 900.0 | 34,300.0 | |
Week 3 | 1,200.0 | 33,400.0 | |
Week 4 | 2,000.0 | 32,200.0 | |
November | |||
Week 1 | 2,200.0 | 30,200.0 | |
Week 2 | 2,300.0 | 28,000.0 | |
Week 3 | 2,700.0 | 25,700.0 | |
Week 4 | 3,000.0 | 23,000.0 | |
December | |||
Week 1 | 3,800.0 | 20,000.0 | 7.0 |
Week 2 | 3,200.0 | 16,200.0 | 7.0 |
Week 3 | 3,700.0 | 13,000.0 | 7.0 |
Week 4 | 3,800.0 | 9,300.0 | 7.0 |
Week 5 | 5,500.0 | 5,500.0 | 7.0 |
Total Sales | 35,000.0 | ||
Ending Receivables | 20,000.0 | ||
DSO, Quarterly Basis | 52.1 | ||
DSO, Countback | 35.0 |
The count‐back method results in a DSO of 35 days, approximately 17 days lower than the traditional DSO computation. The difference is a good estimate of the impact of a nonlinear revenue pattern during the quarter.
Best Potential DSOs. A useful way to evaluate the actual DSO performance is to compute the best possible DSO (BPDSO) (Table 17.5). This computation estimates the DSO level if all customers paid invoices on the contractually agreed date. It is computed by weighting the credit terms for each type of customer, region, or business line by annual sales. This is a key step in understanding an important variable in receivables management and in setting realistic targets for DSO levels.
TABLE 17.5 Best Possible DSO Estimate
Credit | Estimated | |||
Geography/Channel | Terms | Revenue ($m) | % of Total | Weighted |
Product Line 1 Direct | 30 | 30.5 | 31% | 9.2 |
Product Line 1 Distributor | 45 | 7.5 | 8% | 3.4 |
Product Line 1 Export | 60 | 15.0 | 15% | 9.0 |
Product Line 2 Direct | 30 | 30.0 | 30% | 9.0 |
Product Line 2 Distributor | 50 | 5.0 | 5% | 2.5 |
Product Line 2 Export | 60 | 12.0 | 12% | 7.2 |
Total | 100.0 | 100% | 40.2 | |
Best Possible DSOs |
Weighting is computed as: Credit Terms x % of total
Past‐Due Collections. Receivables that are not collected in a reasonable period (a cushion beyond agreed‐upon terms) will obviously have a significant impact on DSOs. Tracking this level of past‐due receivables on a monthly, weekly, and even daily basis allows for timely identification and faster resolution of emerging problems and is a leading indicator of accounts receivable performance.
Returns. Product that is returned by customers represents a costly transaction on a number of fronts. Performance problems culminating in product returns are likely to have a significant negative impact on customer satisfaction. By identifying the root cause of these returns, process failures and problems can be identified and addressed. There is also a significant transaction cost of shipping, receiving, and carrying the returned product. Depending on the specific circumstance, some companies choose to track the dollar value of returns; others prefer to measure the number of transactions.
Revenue Patterns. In Chapter 16, the impact of revenue patterns on operating efficiency was discussed. Revenue patterns, especially those with revenue skewed toward the end of the quarter, also impact working capital requirements. As evident in the count‐back method, accounts receivable will be higher if the revenue pattern is a hockey stick since a greater percentage of revenue will be uncollected at the end of the period. Inventories will likely be higher since more inventory must be carried to meet last‐minute orders.
Revenue patterns within a quarter can be plotted as shown in Figure 16.3 in Chapter 16. The revenue linearity index is a useful measure to track revenue patterns over time.
Depending on the specific facts and circumstances, several of these measures should be selected and combined to create a dashboard for the revenue process and accounts receivable, illustrated in Figure 17.4.
A number of tools can be employed to help in assessing and improving the revenue process and accounts receivable management.
Accounts Receivable–DSO Drivers Chart. The chart in Figure 17.5 presents a high‐impact visual summary of DSOs. We begin with the best possible DSOs (BPDSOs) of 40 days and then identify the number of days associated with significant factors resulting in an actual DSO of 64 days. In this illustration, three factors account for most of the 24 days: customer cash management lag (CML), revenue linearity, and past‐due collections. Each of these items represents high‐leverage improvement opportunities for managers to address.
Accounts Receivable Aging Schedule. A useful tool for managing accounts receivable, customer satisfaction, and the revenue process is the standard accounts receivable aging report. An example of an accounts receivable aging report is presented in Table 17.6. This report simply details the current accounts receivable balance for each customer by age of invoice. Invoices issued in the past 30 days would be included in the 0–30 days column. Invoices issued in the previous month would be reported in the 31–60 days column, and so on. This report allows the identification of macro payment patterns such as slow‐to‐pay customers, but will also identify specific overdue invoices for review and follow‐up. The report is used by accounts receivable and collections staff but is so rich in information about customers and payment delays that it may also be useful for managers to review from time to time.
TABLE 17.6 Accounts Receivable Aging Schedule for Morehouse Company
Customer | Total | Current | 30–60 | 60–90 | 90–120 | >120 | |
A | 83,000 | 50,000 | 20,000 | 10,000 | – | 3,000 | |
B | 54,000 | 20,000 | 20,000 | 10,000 | 2,000 | 2,000 | |
C | 40,000 | 10,000 | 20,000 | 10,000 | – | – | |
Others | 50,000 | 30,000 | 20,000 | ||||
Totals | 227,000 | 110,000 | 80,000 | 30,000 | 2,000 | 5,000 | |
Sales | 1,500,000 | ||||||
DSO Impact | 55.2 | 26.8 | 19.5 | 7.3 | 0.5 | 1.2 | |
Aging % of Total Balance: | |||||||
% | 100.0% | 48.5% | 35.2% | 13.2% | 0.9% | 2.2% | |
Last Month % | 100.0% | 60.0% | 30.0% | 5.0% | 5.0% | 0.0% |
Root Cause Analysis: Past Due Collections. A very effective way of assessing key aspects of the revenue process and accounts receivable management is to perform a root cause analysis of any invoice exceeding a certain dollar level and past due for a certain period of time. This also serves as an extremely important tool to identify customer service problems, since an unsatisfied customer will not pay the invoice. Once identified, overdue invoices can be reviewed to determine the root cause for the delay. Overdue receivables generally will fall into one of several root cause categories. For example, key process problems such as invoicing errors or poor quality associated with a particular product may be contributing to overdue receivables. An example of a simple root cause analysis is shown in Table 17.7.
TABLE 17.7 Accounts Receivable Past Due Analysis
Invoice | Date | Division | Customer | Product | Amount | Root Cause |
220921 | 11/3/2005 | A | Mangham | M‐1 | 22,000 | Dead on arrival |
230073 | 10/4/2005 | B | Rhodes | B‐1 | 15,000 | Installation problem |
223578 | 9/30/2005 | B | Webster | C‐1 | 140,000 | Paperwork discrepancy |
The analysis can then be summarized to provide useful insight into the root cause of problems that can lead to the development of a corrective action plan as shown in Figure 17.6.
Accounts Receivable Roll‐Forward Summary. This tool is a subset of the operating capital budget tool discussed earlier in the chapter. It is a great way to understand and communicate the dynamics of accounts receivable. Accounts receivable represent amounts due from customers for products delivered or services rendered. Receivables are increased by sales and reduced by amounts collected from customers. Sales for each month are taken from the profit and loss (P&L) forecast. Collections will be estimated based on past and projected payment patterns. In the example in Table 17.8, it is estimated that 10% of sales will be collected in the current month, 40% in the next month, and then 30% and 20% in months 2 and 3, respectively.
TABLE 17.8 Accounts Receivable Roll‐Forward Summary
Accounts Receivable | Oct | Nov | Dec | Jan | Feb | March | April | |
Beginning Balance | 950 | 1,150 | 1,310 | 1,810 | 1,452 | 1,310 | 1,285 | |
Sales | 600 | 660 | 1000 | 400 | 500 | 550 | 600 | |
Collections | −400 | −500 | −500 | −758 | −642 | −575 | −510 | |
Other | ||||||||
Ending Balance | 1,150 | 1,310 | 1,810 | 1,452 | 1,310 | 1,285 | 1,375 | |
DSO | 57.5 | 59.5 | 54.3 | 108.9 | 78.6 | 70.1 | 68.8 | |
% Sales (annualized) | 16.0% | 16.5% | 15.1% | 30.3% | 21.8% | 19.5% | 19.1% | |
Collections | CM | M+1 | M+2 | M+3 | ||||
Assumptions | 10.0% | 40.0% | 30.0% | 20.0% |
For example, collections in January of $758 million are estimated as follows:
January shipments: 10% of $400m | $40m |
December shipments: 40% of $1,000m | 400m |
November shipments: 30% of $660m | 198m |
October shipments: 20% of $600m | 120m |
Total estimated January collections | $758m |
Assess Effectiveness of Revenue Process. Before embarking on a project to establish measures and improve the revenue process and accounts receivable, many companies first assess the effectiveness of the process by evaluating each segment of the process and identifying high‐leverage improvement opportunities. Using tool kits or best practices surveys for the revenue process, a rating (on a scale of 1 to 5) can be assigned to each stage as illustrated:
Preorder | 3.0 |
Credit assessment | 4.0 |
Manufacturing | 4.0 |
Quality | 4.5 |
Invoicing | 2.5 |
Follow‐up | 2.0 |
Problem resolution | 4.0 |
Visibility: metrics and reporting | 1.5 |
Overall | 25.5 (out of 40) |
This evaluation will set the focus on weak segments of the process, in this case invoicing, follow‐up, and visibility.
Many businesses must build, manufacture, or hold products for resale to customers. Inventory levels are the result of several key drivers and the effectiveness of the procurement and conversion process as shown in Figure 17.7.
Market and Industry. The very nature of certain businesses and industries often determines the level of inventory required. For example, retailers must purchase and hold inventories for resale to consumers. Manufacturing companies must acquire materials, assemble products, and distribute finished goods to their customers. However, service companies, including consulting firms, do not have to hold significant levels of inventory.
Effectiveness of Procurement and Conversion Processes. Inventories as well as manufacturing costs can be reduced by improving procurement and manufacturing or conversion processes. For example, by evaluating and then improving vendor quality and delivery performance, the company can reduce lead times and inventory levels. Over the past 25 years, tremendous improvements have been made by many companies in improving the flow and efficiency of the manufacturing process.
Product Life Cycle Issues. The evolution of a product from conception to full‐scale production and to end of life has significant impact on inventory levels. Two critical phases in the product life cycle are new product introduction and the end of the product's life.
New Product Introduction. Many companies carry high inventory levels associated with problems in the design and introduction of new products. If a new product is transferred to manufacturing before all design issues are resolved, there are likely to be high inventory levels associated with the product. In addition to tying up excess capital, this inventory may be at risk for obsolescence if the design of the product is changed.
End of Life. The company must carefully plan and manage the end of a product's life cycle. If this is not done effectively, the company may carry and ultimately have to write off inventories that are no longer salable to customers.
Design for Manufacturability. Many companies have reduced costs and inventory requirements by designing products that are easier to manufacture. Examples include using common components and requiring fewer complex assembly steps. These types of improvements reduce costs and inventories, improve quality, and prevent delays associated with introducing products to market.
Product Quality. If a company manufactures a quality product, inventory levels will be lower than for a similar product with quality problems. A firm with high‐quality manufacturing processes will require lower levels of material input; less time and inventory in test, repair, and rework; and lower levels of inventory returned from customers.
Breadth of Product Line. The company that offers a broad selection of products will typically require higher inventory levels. Conversely, a firm with limited product alternatives will typically have less inventory. Many firms have reduced inventory levels by limiting product variety to fewer options and choices (e.g. color, size, configurations, and power).
Vertical Integration/Outsourcing. Companies that are highly vertically integrated will carry higher inventory balances than a firm that outsources a substantial part of the manufacturing process to other firms.
Forecasting. In Chapter 15 we discussed that most businesses must anticipate future demand for their products so that products can be ordered or manufactured and be available for customers at the time of purchase. The revenue forecast typically drives procurement and manufacturing schedules and activities. The accuracy of forecasts will have a significant impact on inventory levels. If demand is overestimated, excess inventory will result. Even if the total revenue forecast is accurate, if the mix of products is different than projected, the company may miss sales and build products that were not ordered, leading to an increase in inventory. In Chapter 16, we outlined several measures that can be taken to improve the forecasting process. In addition to improving the forecasting process, managers should also strive to increase flexibility and response times, for example by reducing lead times.
There are a number of performance measures that can be developed and tracked to provide visibility into key drivers of supply chain and inventory management.
Inventory Turns. In Chapter 2, we computed inventory turns and days sales of inventory (DSI) for Roberts Manufacturing Company (RMC), as follows:
Inventory turns measure how much inventory a firm carries compared to sales levels. Factors that will affect this measure include effectiveness of supply chain management and production processes, product quality, breadth of product line, degree of vertical integration, and predictability of sales.
Days Sales of Inventory (DSI). This measure is a derivative of inventory turns and is computed as follows:
This measure is affected by the same factors as inventory turns. The advantage to this measure is that it can be easier for people to relate to the number of days of sales in inventory. As a result, it may be easier to conceptualize the appropriateness (or potential improvement opportunity) of carrying 146 days' worth of sales in inventory than to conceptualize 2.5 inventory turns.
Slow‐Moving and Obsolete Inventory Levels. It is important to identify and manage excess and obsolete inventory. Excess inventory is the inventory on hand in excess of foreseeable demand over a defined period such as 12 months. Excess inventory results from overestimating demand or from radical changes in demand patterns. Obsolete inventory results from holding inventory that is no longer salable or usable in the ordinary course of business. A useful summary of excess and obsolete inventory is illustrated in Figure 17.8. A good first step in managing excess and obsolete (E&O) inventory is to trend the levels over time. Measuring levels of E&O inventory will provide visibility and identify trends. This measure is complemented by a root cause analysis that provides insight into the underlying causes of E&O inventory. Typical causes include product life cycle issues (end‐of‐life issues, new product introductions) and forecasting errors.
Number of Unique Inventoried Parts. Tracking the number of unique inventoried parts may provide insight into a key driver of inventory management. The company may be able to reduce inventory levels by reducing the number of unique inventoried parts. This objective may take time to achieve and must consider supplier, customer, and manufacturing issues.
Past‐Due Customer Orders. If customer orders are delayed past the requested delivery date, the inventory must be carried until the order can be completed. Perhaps the inventory for an order is completed except for a single integral part that is out of stock. Obviously, past‐due orders are likely to negatively affect customer satisfaction as well.
Supplier Performance. Companies should measure the quality of parts supplied by vendors. Poor quality of incoming parts will delay internal processes and result in higher inventories. Late deliveries from suppliers will also wreak havoc with production schedules, resulting in higher inventories and potential delays in shipments to customers.
Forecast Accuracy. Measuring the accuracy of sales forecasts compared to actual demand levels will help to explain inventory shortages and excesses. It will also provide visibility into a key performance driver and serve to establish accountability for sales projections. Measures of forecast accuracy were presented in Chapter 15.
Cycle Time. A very effective measure of supply chain management and inventories is the amount of time required to produce a unit of inventory. The shorter the cycle time for a product, the less time the product spends in the factory. Reducing cycle times typically leads to lower manufacturing costs, lower inventory balances, and increased flexibility. It can also lead to higher levels of customer satisfaction.
Additional measures for supply chain management are discussed in Chapter 16.
Several of the measures just discussed can be selected and combined to create a dashboard for supply chain management and inventory. (See Figure 17.9.)
Assess Related Business Process. Similar to the approach suggested for accounts receivable earlier in the chapter, it may be helpful to assess the supply chain and related processes before selecting performance measures. Using tool kits or best practices surveys for the supply chain management process, a rating (on a scale of 1 to 5) will be assigned to each stage as illustrated:
Product design and new product introduction | 2.0 |
Forecasting and production planning | 3.0 |
Manufacturing | 3.5 |
Quality | 4.5 |
Management of end‐of‐life, excess and obsolete inventory | 2.5 |
Visibility: metrics and reporting | 3.5 |
Overall assessment | 19 (of 30) |
This assessment will focus on attention on weak segments of the process, in this case, product design and new product introduction, forecasting, and management of excess and obsolete inventory.
In addition to the dashboard and assessment, there are a number of reports and tools that are very useful in identifying trends and providing visibility into key drivers of inventory.
Inventory Trend Schedule by Major Category. Much can be learned by drilling down into the major components of inventory and tracking trends in each over time. It is also useful to compute turnover for each significant category of inventory (see Table 17.9).
TABLE 17.9 Inventory Trend Schedule by Category
$m | ||||||
Jan | Feb | March | April | May | ||
Raw Material | ||||||
Incoming Inspection | 2 | 2 | 5 | 7 | 7 | |
Supplies | 6 | 6 | 6 | 6 | 6 | |
Electronic Components | 22 | 25 | 27 | 22 | 22 | |
Total | 30 | 33 | 38 | 35 | 35 | |
Work In Process | ||||||
Fabrication | 4 | 4 | 4 | 4 | 4 | |
Assembly | 12 | 13 | 14 | 18 | 18 | |
Burn In | 1 | 1 | 1 | 1 | 1 | |
Rework | 3 | 3 | 3 | 3 | 3 | |
Test | 1 | 1 | 1 | 1 | 1 | |
Final Inspection | 4 | 4 | 4 | 4 | 4 | |
Total | 25 | 26 | 27 | 31 | 31 | |
Finished Goods | ||||||
Manufacturing Plants | 5 | 4 | 6 | 4 | 5 | |
Warehouse | 7 | 7 | 7 | 7 | 7 | |
International Locations | 12 | 12 | 13 | 12 | 10 | |
Sales Offices | 6 | 6 | 6 | 6 | 6 | |
Total | 30 | 29 | 32 | 29 | 28 | |
Total Gross Inventory | 85 | 88 | 97 | 95 | 94 | |
Less: Inventory Reserves | −15 | −15 | −16 | −16 | −17 | |
Net Inventory | 70 | 73 | 81 | 79 | 77 | |
Purchase Commitments | 15 | 17 | 22 | 25 | 30 | |
Total Inventory Commitments | 85 | 90 | 103 | 104 | 107 | |
Key Performance Indicators | ||||||
Inventory Turns | 2.9 | 2.7 | 2.5 | 2.5 | 2.6 | |
Days Inventory | 127.8 | 133.2 | 147.8 | 144.2 | 140.5 | |
% of Total | ||||||
Raw Materials | 35.3% | 37.5% | 39.2% | 36.8% | 37.2% | |
WIP | 29.4% | 29.5% | 27.8% | 32.6% | 33.0% | |
Finished Goods | 35.3% | 33.0% | 33.0% | 30.5% | 29.8% | |
Inventory Reserves % of Total | 17.6% | 17.0% | 16.5% | 16.8% | 18.1% | |
Committed Inventory % Cost of Sales | 43% | 45% | 52% | 52% | 54% | |
Cost of Sales (annual) | $ 200 |
This schedule includes outstanding purchase commitments to provide visibility into the inventory that the company has ordered and is contractually obliged to take in the near term. Tracking and managing the purchase commitments and the total inventory commitment provide a leading indicator of future inventory levels.
Inventory Roll‐Forward Summary. Similar to the schedule presented for receivables, the inventory roll‐forward summary shown in Table 17.10 displays the transactions projected for each month that will increase or decrease the inventory balance. Inventory will be increased by purchases, manufacturing labor, and overhead applied to inventory. It will be reduced by cost of goods sold (COGS); including cost of product sold, write‐offs, and so on.
TABLE 17.10 Inventory Roll‐Forward Summary
Inventories | Oct | Nov | Dec | Jan | Feb | March | April | |
Beginning Balance | 1,300 | 1,220 | 1,112 | 832 | 762 | 902 | 1,077 | |
Purchases | 140 | 154 | 168 | 84 | 196 | 224 | 280 | |
Labor | 100 | 100 | 168 | 84 | 196 | 224 | 280 | |
Overhead | 100 | 100 | 84 | 42 | 98 | 112 | 140 | |
COGS | −420 | −462 | −700 | −280 | −350 | −385 | −420 | |
Ending Balance | 1,220 | 1,112 | 832 | 762 | 902 | 1,077 | 1,357 | |
Inventory Turns | 4.1 | 5.0 | 10.1 | 4.4 | 4.7 | 4.3 | 3.7 | |
DSI | 87.1 | 72.2 | 35.7 | 81.6 | 77.3 | 83.9 | 96.9 | |
% of Sales | 16.9% | 14.0% | 6.9% | 15.9% | 15.0% | 16.3% | 18.8% |
This schedule is a great tool for tracking and communicating the key variables that will affect inventories. It also allows us to understand why inventories are higher or lower than we projected they would be as shown in Table 17.11. Did we purchase more material than projected? If so, inventories will be higher than expected. Did we sell less product, resulting in lower cost of sales relief from inventory? If so, then inventories would also be higher.
TABLE 17.11 Inventory Forecast Analysis
December | |||
Inventories | Actual | Forecast | Variance |
Beginning Balance | 1,112 | 1,112 | 0 |
Purchases | 235 | 168 | −67 |
Labor | 185 | 168 | −17 |
Overhead | 93 | 84 | −9 |
COGS | −710 | −700 | 10 |
Ending Balance | 915 | 832 | −83 |
Inventory Turns | 9.3 | 10.1 | |
DSI | 38.7 | 35.7 | |
% sales | 7.5% | 6.9% | |
Sales | 1,021 | 1,000 | |
COGS | 710 | 700 |
Tracking Top 20 to 50 Inventory Items. Focusing attention on the inventory items that have the greatest value can provide insight into inventory performance and allow managers to focus on specific items that account for the lion's share of the inventory value. It is common for the top 20 to 50 line items to account for 50% to 80% of the total inventory value. See the illustration in Chapter 5, Building Analytical Capability.
The capital required to support a business and the effectiveness of management in managing capital assets are significant drivers of performance and value. Major components of capital include operating capital; property, plant, and equipment; and intangible assets. The level of assets required to support a business is driven by a number of factors, including the nature of the industry, the business model, and the level of efficiency in key business processes such as supply chain management and revenue processes. Significant improvement in asset utilization is possible by improving the effectiveness of the related business processes.