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Lean Six Sigma, Working Capital

Working Capital Meets Lean Six Sigma

Working capital is influenced by a complex system consisting of external and internal factors as well as strategic decisions. External drivers are composed of economy, cost of capital, regulations and market position. Strategic decisions include geographies of customers and suppliers, customer mix and vertical integration. Tactical factors are policies, processes and metrics, systems and tools and also the degree of execution of the former. Whilst external drivers and strategic considerations cannot be subject of short-term changes to gain cash advantage, tactical factors definitely are. Lean Six Sigma helps to analyse the drivers and their impact on the working capital situation. Working Capital meets Lean Six Sigma.

Working Capital

Forecast to Fulfil – Inventory Management (Work In Progress)

Deliveries to the customer are often delayed due to lack of appropriate product mix. Meanwhile the factory floor looks like it could serve the same number of customers or more for the next two years without replenishing any inventory. Raw material fed into the production unit seems to be never enough. WIP goods are stacked along walls and corridors or any available space – until a new warehouse is available. Work centres are filled beyond capacity and people and machines work around the clock to make the next customer order. Those are examples of bad inventory management.

Working Capital Area: Inventory Management

Working Capital Area: Forecast to Fulfill

Sounds somewhat familiar?

Inventory management vexes many production professionals year round. Seasonality or not. Total inventory management from raw material through finished goods can be tough. Balance sheets tell an approximate story in relation to where inventory might be residing within the value chain of a firm. This week’s focus is on Work in Progress (WIP) inventory.

Primarily residing on the ‘shop floor’, WIP commonly results from several factors:

  • Poor quality in the manufacturing / assembly process (not to be confused with process quality)
  • Inappropriate batch sizing: often to ‘fit’ a particular operation these batch sizes then throw off other operations in terms of flow
  • Overly large batch sizing / continuous runs: often a result of ‘scientific management’ which proposes that efficiency and productivity KPIs are the be-all-end-all solutions to measuring performance
  • ‘Running bottleneck’ operations: where the shop floor and sequential operations were set up in a logical fashion from an engineering perspective – though it may not be conducive to helping inventory ‘flow’ through smoothly

An opportunity presented itself on such a manufacturing shop floor to us. A re-engineering (clean sheet) approach was utilized.

Operational shop floor layouts were adjusted to facilitate ease of flow throughout the plant from raw material incoming to final assembly and packaging. Changes made to operating batch sizes (minimised to a local and logical quantity) for every finished good SKU ensured that bottle-necking (capacity constraints) in sequential operations were well understood and controlled.

After a week-long pilot with a portion of the finished goods SKUs produced by this plant for proof of operational capability of the process with new batch sizes we proceeded to adjust inventory requirement settings in the plant’s MRP system (SAP). Time fences for production were adjusted at the same time to account for the increased speed owing to the dramatically reduced batch sizes. Raw material coming in was adjusted in relation to these changes.

Lean Six Sigma ‘lite’ was introduced to the plant personnel. Over the duration of the project lasting 9 months this program eradicated 85% of quality issues found in processes thus increasing velocity further.

Benefits of WIP Inventory Management

We chose WIP as a starting point for inventory management (in a production setting) as this is the area that determines how raw materials are ordered and how well finished goods are capable of being delivered on-time-in-full (OTIF) to customers.

Project yields:

  • An increase in customer service levels, OTIF, to internal distribution centres from 78% to 95%
  • In-plant inventory levels decreased by 70%
  • Product velocity (per standard order) decreased from 3 weeks to 4 days
  • WIP rejects and re-work decreased by 85%
  • No plant personnel were let go as a result of these improvements. They were re-assigned to bottleneck operations to provide interim manual assistance in clearing bottlenecks as and where these occurred.
Working Capital

Customer to Cash – Customer Segmentation for AR

Collections represents the ‘end’ of a sales cycle. It also represents the firm’s ability to convert cash expended from when a customer order arrives through fulfillment and payment. For many firms the operating motto in this area of working capital management is to simply try to collect faster. Few go beyond to address this ‘end of sales cycle’ activity that is the key provider of cash for the firm.

Working Capital Area - Customer to Cash

Working Capital Area – Customer to Cash

Collections management represents an opportunity to fully utilize a firms systems and resources. Leveraging simple technology is possible and enhanced through customer segmentation.

An ability to segment one’s customers, for the larger firms particularly, allows for differing policies and treatments when it comes to receivables management. Intuition plays a large part in determining the amount of investment required in a given relationship in most cases but this should be applied only to one segment of customers. Policies dictating the handling of other relationships may be drafted according to the resourcing and strategic requirements of the firm. Resources, electronic and otherwise, can then be planned for accurately given business cycles.

How to Segment

Customer Segmentation

Customer Segmentation

Often the first step is to naturally want to segment customers by the revenue streams provided. Pareto breakdowns are feasible and may be determined internally to fit a firm’s risk and resource capabilities. In the example provided the large or ‘A’ customers form some 55% of revenue over the last 12 months. ‘B’ customers form 31% of sales and the rest falls into the ‘C’ segment.

Note that there are indications of percentage past dues for each segment. This is an arbitrary number based on the risk the firm is willing to accept. As segments ‘A,’ ‘B’ and ‘C’ are parsed we develop a risk profile of the existing customer base and this is divided generically into ‘high’ and ‘low’ risks as may be seen in Figure 2.

Following segmentation we develop policies for each particular segment reflecting on the resource capabilities and intended commitment levels.

Simplified example of a Collections Strategy following customer segmentation for receivables management:

  • A & B High Risk – Proactive calling, incoming orders > dynamic credit limit held, referred to collections
  • A & B Low Risk – Reactive calling, incoming orders > dynamic credit limit approved if no past dues
  • C High Risk – Reactive calling / dunning letters, incoming orders > dynamic credit limit held, referred to collections
  • C Low Risk – Reminder letters, incoming orders > dynamic credit limit approved if no past dues

Collection activities are now much more focused. Management has a line of sight into the behaviour of customers allowing for the strategic reallocation of resources. Not only is working capital more visible – which allows for action plans – the opportunity for operational expenditure to decrease presents itself.

Segmentations based on corporate and debt risk profiling can also give rise to actions beyond collection activities and include mandates for customer service levels and even fulfillment obligations. Customer segmentation is also a prerequisite activity leading to others, covered in future articles touching on the C2C area of total working capital, resulting in a potential reduction of DSO or receivables. Combined with these other activities we have seen reductions in overall receivables ranging from 20% to 60% in some instances.

Operations, Working Capital

Tightening Credit Terms for Almost Free

How do we know if receivables are well managed to credit terms? Are we performing at our best? What if we are the best in industry according to external benchmarks? How may we then do better or is it possible at all? Credit managers often face these questions in the never-ending quest to collect to terms and to drive down terms where possible. An analysis of the customer master is requisite to answering these questions as well as to enable one aspect of credit term optimisation.

Customer Master Analysis

As firms grow a variety of factors lead to an accumulation of ‘multiple’ customer line items. These items are found or logged in the customer master (or equivalent in an ERP or accounting system) are the details for each customer including entity name, billing details, terms and other notes that relate to the customer. We have found common errors in both paper and IT based systems of firms we have worked with and these include:

    One customer listed multiple times due to spelling differences or billing/contact address differences
    Multiple differing terms due to numerous customer listings from the point above though this results more often as a result of legacy resulting from personnel turnover
    Both points above are found as a result of M&A activity where names, addresses and terms are inherited or grandfathered

Understanding this level of detail permits one to commence investigation into terms granted to a customer from the working capital management perspective. Conducted either together or apart from an aged trial balance for third party receivables this analysis allows the firm to ‘clean’ up administrative details such as multiple names for a single entity (see ‘client’ in table below). Sales is often involved in this project to enable an organisational understanding of where the client stands and should stand. A cross functional and cross-business unit project – customer analysis enables a common understanding among different business units that may be selling to the same client.

The optimisation that occurs upon analysis of the customer master is that of simplifying billing (to a single entity as opposed to multiple entities) and reducing the opportunity for disputes (spelling error, legal name error, billing address errors etc) that delay payment.

Terms Analysis (BPDSO)

A derivative of fields from both the customer master as well as current receivable data we are able to calculate what an appropriate Best Possible Days Sales Outstanding (BPDSO) would be.
This is performed by aggregating the receivables found listed across the differing ‘entities’ that represent one client or one segment.

Credit Terms Analysis for a single customer

Sample of Terms Analysis for a single customer

Table 1 demonstrates the receivable data put together with the customer master and ‘open’ or ‘uncollected’ receivables data. Adding all weighted terms (% AR * Real Terms) for this particular customer, represented by 7 recorded entities, yields a summed number of 36.94. BPDSO therefore represents in real terms that at this point in time there should be not more then 36.94 days worth of sales in terms of uncollected receivable for this customer – with the assumption that all receivables are paid on time and in full. This is despite that there are a variety of terms ranging from 15 days through 90 days.
BPDSO is far more accurate since there is a weightage assigned to the oustanding receivables, unlike a simple average terms analysis – 42.86 days outstanding in Table 1 – which many credit managers are prone to use as a measure of best possible performance when faced with a multi-credit term customer.

Term Optimisation

Combining the customer master file analysis reveals terms that a customer already finds acceptable. For sales conducted across multiple business units (supplier and customer) this information represents an optimal credit term which the customer finds acceptable. A Credit Terms Analysis yielding a BPDSO tightens overall credit terms and assists credit managers as well as sales persons to keep customers on a well defined credit scheme.

BPDSO is also a useful indicator for best possible internal performance (internal benchmark) especially when one may already be performing at relative industry ‘best.’
For several clients with whom we have performed Account Receivable projects for this portion of the project yields:

    An overall tightening of terms by 10% to 35% resulting in and from simplified credit schemes for customers – resulting in quicker cash in and also lower operating costs as a result of less conflicts and confusion between sales and finance
    An ability to forecast cash requirements resulting from open AR (a portion of cashflow forecasting)
    Management’s ability for clearer insight into customer behavior and opportunity to formulate strategic sales deals utilizing credit as a facility responsibly
    An ability to gauge AR and credit term performance particularly when external benchmarks are no longer applicable

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Operations, Working Capital

Forecast to Fulfill – SKU (Product) Proliferation

Supply chain strategies often take second or third place to operations in the growth and development phase of an organisation.  One of the unintended (though sometimes strategically intentional) operational consequences of aggressive growth, both organically as well as through M&As, is that of product or SKU proliferation. As a result, forecast to fulfill gets slowed down.

Working Capital Area: Forecast to Fulfill

Working Capital Area: Forecast to Fulfill

SKU proliferation manifests itself as a hindrance to supply chain efficiencies in a variety of forms including:

  • An ‘impressive’ range of product
  • Dramatic levels of raw material or WIP, the latter held as a strategy of postponement
  • Elaborate operational set ups that often challenges productivity and efficiency KPIs resulting in large production batches
  • Loss of operational and commercial control as batched production produces a bull whip effect in finished goods inventory
  • An inflated balance sheet where inventory is concerned and gradually thinner margins due to missed or short ships as a result of batch & efficiency metrics

Taken individually, these anomalies can be dealt with, and they frequently are, in a piecemeal fashion.  Slashing SKUs across the board delivers instant results but a trade off is that of falling efficiency levels measured at the plant level.  Inventory can be shifted onto a VMI strategy where costs are kept off as long as is possible though this eventually strains supplier relations.  Moth-balling entire plants are not uncommon once ‘demand’ is perceived to have dropped though this leaves much to be desired in terms of industrial relations.  Micro-management becomes the order of the day and a fairly immobilized organisation results.  Undue force is applied to ‘balance’ the balance sheet in an effort to improve margins.

Collectively however, addressing such a situation at the strategic level while selectively ‘leaning’ some operations yields results that are relatively more ‘stable’ to the organisation.

A multi-variate analysis of product selectively utilising Pareto principles ought to produce an SKU range that is manageable both from the marketing / margin perspective as well as the operational perspective.  Combined with some innovative product re-design resulting in ‘multi-use products’ as well as postponement, the results are appreciable.

Some of the variants to be considered are:

  • Movement (traditional ABC)
  • Value in dollar terms
  • Margins
  • Inter-operability
  • Market positioning & share
  • Ability of the product to be innovated upon
  • Strategic position for consolidation

Forecast to Fulfill – Benefits of Managing SKU Proliferation

A diversified industrial client we worked with in this area managed to lower overall (RM, WIP & FG) SKU counts from some 5,500 to 4,200 over the duration of an 18 month long project.  A 22% reduction.

Project yields beyond SKU consolidation were:

  • Overall decrease in inventory of 15%
  • Short / missed shipments decreased by 60% resulting in less commercial and financial penalties
  • Expedite (both for production and shipping) occurrences decreased from a monthly average of 370 to under 100

Less tangible benefits were an improved working relationship between the front and back ends of the firm and an improved understanding of how better sales and marketing could work together with production to ensure a lid on SKU proliferation.

Customers, Operations, Working Capital

Procure to Pay – Spend Policies

Spending, apart from capital investments, tends to grow a little faster then organisations in most cases. Left unchecked firms face a ‘mid-life’ crisis where working capital is stretched to levels requiring borrowings incurring heavier and heavier finance costs. This is often bringing down the Procure to Pay cycle.

A lack of policies guarding the growth of spend is often an underlying cause. Naturally, many other factors come into play as well – an extreme focus on growth, inorganic growth (M&As), lack of standardization for spend reviews, infrequent and irregular supplier reviews, poor supplier maintenance, spend policy over-riding behaviour or a ‘just get it done now’ (covered as maverick spend in an earlier article) culture among others

Procure to Pay – Spend Policies

Working Capital Area: Procure To Pay

Working Capital Area: Procure To Pay

A strong spend policy put in place for both core and non-core spend that governs both buying behaviour as well as spending limits encourages stable growth of spend as an organisation grows. The requirement to ‘just get things done by hook or by crook’ often played out in the earlier growth phases of any commercial undertaking should be steadily replaced by regulatory equivalents covering especially:

  • Spend limits & authorization levels
  • Constant ongoing periodic reviews to bring in non-core and ad-hoc spend onto contractual terms
  • Annual supplier / vendor councils for both core and non-core spend
  • Supplier / vendor innovation councils (as opposed to simple ‘cost down’ demands)
  • Pre-M&A spend policy reviews where possible or immediately upon acquisition to bring in potentially detrimental terms and conditions that may cause ‘grandfathering’ or legacy terms and spend behaviours
  • Strict policies negating, as far as is plausible: ‘emergency’ payments, supplier ‘loans,’ ad-hoc payments and on terms other then contractual unless business needs so dictate
Procure to Pay - Spending Trends

Procure to Pay – Spending Trends

Policies together with a rigorous procedure to ensure adherence forms the major key to achieving a state of ‘ideal spend’ where as the business grows, again barring capital expenditures, the margins from running the business increases. While applicable primarily to larger firms with multiple cost centres the same principles apply to small and medium sized enterprises in efforts to gain this critical core competency every firm should possess.

Benefits of this program will show up in an organisational capability to effectively manage spend. For a large retailer with $5 bn of spend some $200 m were recovered from terms corrections, extensions, standardization and process improvement within 8 months of program implementation. A further $150m was liberated by contract negotiation spanning a 15 month period.

Customers, Operations, Working Capital

Customer to Cash – Dispute Management (Receivables)

A portion of collection activities often relegated to ‘customer service’ is that of actual dispute management. Customers who need ‘correction’ on invoicing information, goods returned, quality claims, delivery issues among others get directed to a generic ‘customer service’ department. This department attempts to secure resolutions from throughout the organisation. As opposed to ‘customer service’ per se we see these activities specifically as ‘dispute management’ as it relates to receivables management. They turn customer to cash.

Working Capital Area - Customer to Cash

Working Capital Area – Customer to Cash

Customers utilise a myriad of reasons for slow or delayed payment. Often these reasons are ‘valid’ to some extent.

“Sorry, we are unable to process your invoice as the address is different or wrong.”

“Your invoice information is incorrect …”

Crossing t’s and dotting i’s hardly figures in most finance functions but we have seen these very reasons result in late payments. This happens often after a costly (both time and money) rectification exercise that can span the entire firm in terms of inputs from different departments. Production, logistics, marketing, sales and even management sometimes gets involved in the resolution of these ‘disputes.’

Other common reasons we have come across for delayed payment are:

  • Incorrectly addressed billing entity (billing entity name)
  • 3rd party billing that has not been verified
  • Lack of ‘documentation’ such as Delivery / Purchase / Variation / Confirmation Orders
  • Quality / Quantity / Time issues
  • Incorrect credit or other terms reflected on the invoice – relative to the contract

Dispute Management to Turn Customer to Cash

A dispute management system helps address these issues by collating information on ‘reasons’ provided by customers – to turn customer to cash. Properly, though sometimes arbitrarily, categorised, these are then worked upon systematically for eradication. Inter-functional or inter-departmental work is required but this is considered a ‘one off’ exercise rather then for random late invoices that come up every so often.

Customer to Cash Disputes (AR)

Customer to Cash Disputes (AR)

While true that a smaller firm will gain in terms of organisational learning and that such a formal system may not be an absolute requirement but for sizable firms which face regular resource turnover it is much more difficult to retain ‘institutional’ memory that will quickly resolve ‘disputes’ resulting in delayed payments. These memories, in such an informal system, are also stored across departments in bits and pieces making a whole picture difficult to obtain at critical times.

As a medium and long term measure to address late receivables a dispute management system can yield results that go beyond lowering DSO (as a KPI of late receivables) to improving organisational understanding and work flow. Inter-departmental disputes are also reduced over time.

While this system is not a panacea for ‘cheques signed but locked in drawers’ customers we have worked with to design and implement such a system reap benefits of lowering their chronic overdues by some 40% to 80% permanently. As best practice for the establishment of a Financial Shared Services Centre (FSSC) or greenfield projects a dispute management system ensures that the set up of operations do not quickly degenerate into constant fire fighting exercises. Customers typically respond positively to such activities when they realise that there can be no reasonable excuses for late payments.

 

Operations, Working Capital

Cheap Cash – Working Capital Reduction

Credit lines drying up are common phenomena these days. Past credit performance, even with a great history, seems to have no impact on the decisions of banks to lubricate the wheels of commerce. There is, however, a relatively cheap and available source of cash many firms have that may be tapped into now: Working Capital. Working Capital – or the cash flow of a firm – can broadly be categorised into:

1. Customer to Cash (Receivables Management)
2. Forecast to Fulfil (Inventory and Supply Chain Management)
3. Procure to Pay (Payables Management)

Often simply referred to as ‘cash flow,’ working capital resides on the balance sheet of a firm. Improvements in this firm-spanning area yield many returns including the reduced need for cash to keep operations running, a reduced requirement for finance facilities that attract interest payments (Weighted Average Cost of Capital or WACC), well tuned and simplified processes which often mean a reduction in operating expense and P&L impacts. All these are some of the critical fundamentals that every analyst looks for in all economic climates. Even more so today.
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