Six Sigma and the Seven Drivers of Cash Flow
What Every Operations Manager Should Know about the Drivers of Cash Flow1
If you think of a company as a human body, cash would be the blood. Positive cash flow allows a company to operate, grow, invest and work toward its potential. Without sufficient cash flow, a company is unable to meet payroll, defaults on payments to suppliers and ceases operations. Make no mistake: Cash is necessary to sustain the life of any business, and what business couldn’t use a little more life-giving power right now? An operations manager must understand his or her role in cash flow management. The improvements brought forward by Six Sigma must be expressed in terms beyond one-time cost savings. Rather, the implications of our actions on the important drivers of cash flow are to be explored.
Cash Flow Drivers
There are seven main drivers of cash flow. These are:
- Accounts Payable
- Accounts Receivable
- Revenue Growth
- Gross Margin
- Selling, General and Administrative Expense
- Capital Expenditure
We will examine each in turn.
Accounts Payable and Cash Flow
No business is an island; we rely on suppliers and trading partners to provide us with goods and services, without which we could not serve our customers. When we purchase goods and services from our supply base, we typically buy on account with a pre-determined payment agreement. When payment is due, we use cash to settle our debts. Consequently, the faster we can receive and transform purchases into our own products, the faster we will have product to sell to our customers, which ultimately means cash in our till. This translates into a need to: 1) reduce supplier order-to-consumption lead time, 2) reduce work-in-process inventories and 3) focus on inbound logistics in order to optimize use of credit terms with suppliers. Lending Six Sigma resources to suppliers is one way to improve terms with suppliers.
Accounts Receivable and Cash Flow
Accounts receivable is a significant driver of cash flow. In fact, your outstanding day’s receivables can often be the differentiating factor of the company’s fiscal viability. Remember, cash is the life force of your business. Employees cannot pay their mortgages with receivables from customers. In fact, it is tempting to make all salespeople responsible for collections in addition to selling products. To be sure, the order is not complete until the payment has been received.
For this reason, the Dell model is enviable. They receive their cash payment for their product before they must pay for raw materials. Unfortunately, unlike Dell, most of us have to accept the existence of cash receivables. Yet our ultimate goal can be to receive payment as quickly as possible after we make a sale. Key to this outcome is delivering the perfect order. The perfect order will provide the customer with the right product at the right place at the right time and in the right quantity and condition, thereby encouraging the customer’s prompt payment. Therefore, we should: 1) deliver the perfect order every time and 2) reduce order-to-delivery lead times so payment is received quickly. Six Sigma can contribute in both regards.
Revenue Growth and Cash Flow
Many management gurus have argued that the only purpose of a business is to develop a customer. The logic here is that without a customer there is no business proposition. However, some customers are better than others. Therefore, it is important to understand that cash is generated from good customers. A good customer can be defined as one who has a genuine need for our service and allows us to generate a competitive rate of return on our investment.
Increased revenue from good customers will result in increased cash flow. So how do we secure the loyalty of good customers? The most effective way is to retain these "most valuable customers," and to be cost and quality leaders in our industry as we solicit new business. These goals require a strategic focus on supply chain operations. Try to: 1) identify "good" and "bad" customers based on the profitability of individual accounts, 2) retain current customers and develop new, profitable customers to generate increased cash flow, 3) reduce inventories to become more cost competitive and 4) work to achieve Six Sigma quality in processes and products.
Gross Margin and Cash Flow
Gross margin is generally defined as net revenues less cost of goods sold. Gross margin is the first line of profit contribution that the firm will see from operations. Logically, the larger the gross margin, the more gross income we will have to contribute to corporate overhead burdens and net profit. This will result in cash generation (after dealing with receivable issues described earlier). To increase gross margins, we need to ensure that our cost curves do not grow proportionately with our revenue curves. That is, we need to be able to generate increased revenues without a one-to-one increase in cost of goods sold. This is the quintessential example of doing more with less. To reach this goal, we need to focus on the activity drivers of cost of goods sold. We must: 1) reduce overall supply chain and manufacturing lead times and 2) reduce work-in-process and raw material inventories in order to reduce inventory carrying costs and therefore reduce overall cost of goods sold.
Selling, General and Administrative (SG&A) Expense and Cash Flow
Although not all companies call it the same thing, Selling, General and Administrative (SG&A) expense is the most common term used for corporate overheads. Reducing the corporate overhead burden will result in increased cash to the bottom line. Substantial operations activities and costs are often rolled into SG&A. Unfortunately, many of these activities and their costs are regarded as necessary evils—merely costs of doing business. In today’s business climate, where 1 percent of sales can mean the difference between viability and bankruptcy, these supply chain operations represent a key area of concentration and, perhaps, means of competitive differentiation. To achieve advantage, the company must: 1) improve internal processes and reduce SG&A expenses ultimately to increase cash flow, 2) reduce customer order-to-delivery lead time and 3) reduce finished goods inventory.
Capital Expenditure and Cash Flow
Capital expenditures (CapEx) are the best example of how cash flow and accounting income diverge. For example, if you purchase a building for a million dollars, you may decide to outlay 1 million in cash to close the purchase. But, the cost of the building will appear on the income statement as depreciation expense over the useful life of the building. The first month’s accounting will show $5,000 in depreciation expense, but a full million disappeared from the cash drawer. Capital expenditures are an immense drain on cash and a common source of heartache in businesses.
Private fleets, warehouses and advanced supply chain software are three examples of capital expenditures that require significant amounts of cash to finance. How do we know if we are making the right decision? Why would we invest in a private fleet when our for-hire trucking companies have all the latest technology and years of experience in the trucking industry? Why do we continue to build warehouses when we should be focusing on eliminating the inventories that we store in them? Likewise, there is no magic software pill to cure our supply chain woes. Capital expenditures drain our companies of cash that can be better used in revenue-generating activities. Therefore, we need to focus attention on strategies that take advantage of existing infrastructure, and we need to focus on effective supply chain processes and the people who will perform them. The role of Six Sigma is clear here. We should: 1) reduce reliance on fixed assets and allow cash to be used on revenue-generating activities and 2) focus on reducing inventories as opposed to building more warehouses for inventory that we do not need.
Inventory and Cash Flow
Inventory is the most elusive of all the cash bandits because everything about inventory is counterproductive. For example, inventory is represented on the balance sheet as a current asset. Inventory sitting in our warehouse consumes cash and can be difficult to liquidate (while ease of liquidation is a pre-requisite to being a current asset). So, we could argue that inventory is, in fact, a liability. Besides, the more inventory you have, the less likely you are to have what you need when you need it. To store and move surplus inventory drains cash from the business.
The third and arguably most significant point about inventory is that inventory itself is visible, but its costs and cash impact are not. Although we can walk the floors of our facilities and see inventory, we cannot easily go to our financial statements and determine how much cash is being consumed by this inventory. Risk costs such as obsolescence and shrinkage drain cash. Service costs such as taxes, material handling, and interest drain cash. In addition, there is an implicit opportunity cost when money is tied up in inventory and the space used to store that inventory. Any way you slice it, inventory consumes cash. Consistent, high-performing processes call for less inventory to back them up. We should, therefore, try to: 1) eliminate inventories and conserve cash and 2) have the courage to gather the data required to calculate and articulate the cost of carrying inventories.
Vision of Excellence and Cash Flow
No question. . . cash is king! To be competitive in today’s market, we need to manage cash like the life force of the business that it is. Supply chain activities affect the seven key cash drivers within the firm in diverse and pervasive ways. Accounts payable, accounts receivable, revenue growth, gross margin, SG&A and capital expenditures can all be more effectively managed by focusing strategically on our operations. The reduction of the seventh cash flow driver, inventory, should become the relentless pursuit of all operations executives. Unfortunately, holding inventory remains an addiction in most businesses—a habit that is difficult for us to break. Six Sigma can help us to break this addiction.
Alone, each of these seven cash drivers acts independently. Together, they form the organization’s cash-to-cash cycle. This cycle must be measured and managed in order for a business to reach its potential. Understanding and communicating the linkages between operations and cash flow gives us a place at the table where we can intelligently discuss—and contribute to—the company’s critical ability to sustain and grow the business.
1Note that this article contains excerpts from the book Lean Six Sigma Logistics: Strategic Development to Operational Success (J. Ross Publishing, 2005) by Thomas Goldsby and Robert Martichenko.