Cash Flow—Your Key to Business Survival

Contributor:  Adam Bowden
Posted:  04/20/2009  5:42:00 PM EDT
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As a wise consultant taught me many years ago, “business survival is like breathing …when you ‘breathe in’ it is like getting cash flow in, and when you ‘breathe out’ it is like spending or investing in the cash flow.” If you breathe out and don’t breathe in for some time, you die.

Managers keep processes the same, but a true leader changes the process to achieve better results. Remember, the definition of insanity is “doing the same thing over and over again and expecting a different result,” which is management, not leadership.

So, as a leader, there are many options for positively impacting cash flow. The one element of cash flow that I have seen by far make the biggest impact is that of inventory optimization. I will not focus on WIP, but i will discuss inventory and how implementing simple, yet very effective processes allows the business to free up significant amounts of cash flow. Do reductions in inventory cost of 50 percent to 95 percent interest you? It should, as it’s a “business survival” cash flow opportunity.

Existing Cash Flow Methods Don’t Work

Most businesses use MRP/ERP systems that are not effective in providing value in the supply chain. Typically these systems are configured by procurement. Procurement employees certainly work hard and are motivated by core metrics, and one of the most common metrics I see is “lowest unit cost.” If metrics drive behavior then the effect is to “buy in bulk to get the lowest unit cost,” which from a higher-level business view is a fallacy.

Impacts of Poor Processes on Cash Flow

An example of these faulty metrics occurred in aerospace where two gallons of specific grade paint were required for some aircraft parts. The procurement people contacted the manufacturer who said they would only manufacture a 45 gallon drum of this paint. So the 45 gallons, which cost $4,500, were ordered. Two gallons of paint were used and the remainder sat in storage. The remaining 43 gallons of paint came to its expiration date and a further $3,000 was spent on it’s disposal—so overall the cost per gallon was not $100 (4500/45), even when factoring in disposal it came to $167 per gallon—the true cost was $3,750 ((4500+3000)/2) per gallon—yet the system showed a unit cost of just $100 per gallon. Even in your own personal life if you are a fan of shopping at the mega-warehouse stores where you can buy a “large lot” for less, is this really a good deal and a wise investment of your own cash flow?



So in reality, what happens in business? We buy large lots, which sends shock waves back up the supply chain—it causes fire fighting and rewards the hero mentality; the longer lead times cause stock outs, which upset customers causing further expediting and dramatically increases overtime and business stress. Fast-paced, hero-mentality businesses are stressful places to work and negatively impact the customer. Successful companies are well organized and have leaders who push for proactive process improvements. Leaders drive “eustress,” a positive stress with positive outcomes. Leaders create businesses that you could even say work in a “boring” yet effective and predictable way.

Holistic View—Designing Optimal Inventory Through a Combination of Lean and Statistical Savviness

By applying “science” to the inventory process it is possible to make massive impacts and improve customer service. You cannot just use cost per item to get a true picture of inventory; there are many facets to consider, and by driving a combination of Lean into the supply chain and using some statistical savvy it is possible to get it “right the first time” rather than padding it then reducing it slowly over a long period of time, which is far too common.

Applying Statistics to Lean: The Science of Inventory Optimization

What is the inventory holding cost in your business? It varies typically from “base” plus 2 percent up to 33 percent. I’d say the average is around 18 percent. Your client demand varies, your supplier lead time varies, shipping is a variable, inventory levels fluctuate, warehousing and write-offs play a role in the overall “holistic” cost of inventory.

Lean methods dramatically reduce inventory and lead time, but most use “averages” in their calculations, which injects a large amount of risk of stock out, and as such they “pad” inventory levels. The application of statistics along with Lean allows the optimum calculation of inventory levels with a calculated level of “stock out” or risk, which can be designed in at 5 percent, 1 percent, 0.1 percent or less. Making data-driven decisions is the only true way to dramatically reduce inventory and minimize the risk of the process failing.

Lean Case Study Examples

The following are Lean case study examples from three very different industries. Each Lean case study example highlights a different benefit from changing the process, reducing inventory/cost and increasing cash flow:

Lean Case Study One: Ground Steel and Stainless Steel Barstock

In an industrial manufacturing facility the finance people considered inventory an asset. The operations and procurement people wanted “enough” inventory and even doubled the floor space with consignment inventory to improve service levels. The issue was that you needed an industrial forklift to move the masses of inventory onto the 12-foot-high racks that make for a more cluttered work space. On night shifts, if there was scrap from the multi-spindle autos or CNC lathes, rather than admit to their sloppy work, they would take the consignment inventory to make the lot size and not report it. This caused significant month-end reconciliation issues for operations, procurement and finance.

By applying advanced Lean techniques, which involved analysis of demand, lead time, ship and unit cost, statistically sized Kanbans provided the following inventory reductions:

 

  Previous Inventory Quantity Kanban Quantity Percent Change Previous Lead Time: Days New Lead Time: Days Percent Reduction
Steel 58, 608 7750 756 42 3 1,400


There was a significant financial benefit by “Leaning out” this inventory, but this was not the most significant benefit. Other less tangible benefits of using Lean were:

  • Employees—A Fax Kanban system was implemented (FaxBan), which meant that employees sent the fax trigger directly to the supplier creating an empowered team (Union shop also).
  • Suppliers—Initially I have to say it was a learning curve for the suppliers, but after two months they were actively looking to add more parts onto this scheme as it dramatically simplified their process and costs.
  • Procurement—As the employees were placing the “Kanban triggers” their time was freed up to proactively work with suppliers to negotiate better prices. Previously they struggled to keep up with the “reactive” paperwork pushing process.

Lean Case Study Two: Retail Marketing

At a large financial institution its retail marketing group warehoused supplier for stores, for marketing events and for “giveaways” for clients and end users of its service. These items were located in one main warehouse and two other overflow warehouses. The same process was used for all items—buy in bulk to get the lowest unit cost. Unfortunately, this meant buying years' worth of inventory for each item, and many had to be “destroyed” annually as promotions expired or brand images changed.

It is necessary as the first stage to segment the line items to start with driving dramatic reductions in inventory. A lot of companies use A, B, C categorizations, but I like to simplify and use language that the team can relate to such as: new line items, fast moving, slow moving, sunset and obsolete. The reason for these broad categories is that there is a different process for each—if you treat all inventory the same “process” way, then you end up with unnecessarily poor decisions being made that inflate inventories. Kanbans are well suited to “fast moving” items, which typically constitute 85 percent of all sales. But a word of caution…you also have to understand and implement “common cause” and “special cause” processes with Kanban. The first “fast moving” item to be analyzed was as follows (Click on diagram to enlarge.):



By modeling key data such as supply and demand patterns, unit cost vs. Kanban quantities, warehousing and shipping costs, etc., it is possible to determine the optimum range of a statistically-sized Kanban shipment. This particular item costing $36 each used to be ordered and shipped in lots of five semi-loads at a time, thus causing significant warehouse issues and overflow capacity at other warehouses. After taking a “data driven” approach it can be seen that a Kanban trigger quantity of between 300 and 400 provide maximum benefits. I know those wishing to get exact numbers also need to understand that a model is an approximation and that common sense prevails. Thus after implementing a Kanban trigger system on this one item the benefit was $15,000. This may not sound like much, but it was the first item and there were a further 56 items in this category of fast moving. By setting appropriate processes and controls for the other categories destruction charges were minimized, overflow warehouses were eliminated along with the associated trucking costs.

Retail marketing employees and procurement then spent significantly less time on processing orders and could spend time undertaking forecasting and analysis to ensure zero stock outs and provide maximum client satisfaction.

Lean Case Study Three: Manufacturing—Low Cost Plastic Assembly

This manufacturer assembled four components into a sub-assembly and shipped them to a sister business, out of country, to assemble into a final part. It attempted to maintain 2.5 weeks of inventory at the sister businesses site, and due to variation in demand, scrap and seasonality, there were frequent “stock outs” that shut down its production line. This caused significant levels of overtime and expedite freight costs of $24k above normal shipping rates. By analyzing the four base components’ demand patterns statistically and involving the suppliers in the design of the new Kanban system, the following benefits from using Lean were achieved:

 

  Previous Order Quantity Kanban Quantity Percent Change Previous Lead Time: Days New Lead Time: Days Percent Reduction
Plastic Housing 120,000 120,000 None 7 2 350
Resistor 1,000,000 350,000 286 84 7 1,200
Covers 2,152,600 732,800 294 28 2 1,400
Glue 15 15 None 42 2 2,100


This use of Lean dramatically reduced inventory levels, improved flexibility of supplier service, simplified re-ordering and reduced inventory holding cost. The reductions in lead time and inventory levels are typical. With this item it was necessary to increase final sub-assembly inventory levels to minimize stock out and to allow floor demand, etc., fluctuations. Increased inventory levels of $3k in inventory holding cost eliminated $24k in expedite costs and also wiped out the overtime. (Click on diagram to enlarge.)



Based upon optimum shipping cost/lot size, statistically-sized Kanban trigger size, variation in demand and variation in shipping lead time, the optimum inventory can be calculated as shown below. (Click on diagram to enlarge.)



Based upon demand patterns and optimal ship quantities, etc., the benefit for this one sub-assembly equated to approximately $41k per year.

Adam Bowden Contributor:   Adam Bowden


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