Forecasts are more accurate in the aggregate. But, for production planning, capacity planning and procurement you can’t use an aggregate forecast. You will need a tool to determine the individual SKU forecast so you may perform your planning functions that allows production to function. There are multiple versions of planning bills but for now we’ll focus on the easiest one which is a straight forward planning bill.

First to use a planning bill you will need to divide your products into product families. APICS defines product families as “a group of products with similar characteristics, often used in production planning (or sales and operations planning).

A planning bill uses past usage history to determine the percentages of sales within a product family. As an example, within the product family widgets the blue ones consisted of 30% of the sales, the red ones 20% and the white ones 50%. This history can be manipulated to take into account seasonality or higher or lower sales. Let’s say your sales group forecasts that the demand for widgets will be 1,000,000. When this planning bill is applied the forecast will be 300,000 blue ones, 200,000 red ones and 500,000 white ones. But it can go further than that. A planning bill can be a multi-level bill that takes into account further variations. Let’s say there are different sizes of widgets. Within the white ones ½” made up 60% of your sales, ¾ inch was 30% of your sales and 1” was the remaining 10% of your sales or white widgets. That would equate to a forecast of 300,000 ½”, 150,000 ¾” and 50,000 1” white widgets. Now, to make a widget you need the corresponding shim… I think you’re getting the idea. There’s an example of a planning bill on CashflowABC for you to use to see how powerful a tool this can be.

Planning bills need to be reviewed and maintained on a regular basis. As you sales change so will your planning bills. Since a planning bill uses historic data to determine product breakdown within the product family you will want to weight the most recent data to capture the latest demand trends.

There are many advantages to using planning bills. It helps to keep your forecasts accurate for the end items. They can be multi-level and even tied into your individual bills of material. It helps facilitate capacity planning and master production scheduling.

The one issue you need to be aware of is variances in demand that equate to the overall product family forecast. As an example, let’s say that in the example given above your demand for ¾ and 1” white widgets was reversed from the forecasted amounts. The person or people initially accountable for the product family forecast will say that their forecast was accurate that it’s someone else’s problem. In this case, which is rare, someone needs to take ownership of it. Not to take the blame but to determine why so future forecasts and planning bills will be more accurate.

As with most things in life if you don’t measure it you don’t know where you are or if you need to improve.  While this can be bothersome in your personal life with measurements such as how much you weigh or your waistline it’s a necessity in business.  So we’re going to talk about several of the most common measurements regarding inventory and supply chain and their definitions.  While some are optional some are vital to understanding your inventory position.  There are also some that provide the same basic measurement just from different perspectives.

 The first one that comes to mind and one that everyone wants to know is inventory turns.  Everyone from operations to finance wants to know the inventory turns, usually from very different perspectives.  The definition is obvious, it’s how many times you have “turned” or sold through your inventory within a given time frame.  The formula is the cost of goods sold for the time period divided by the average inventory value for the same period.  So, if the CoGS was $1,000,000 and your average inventory was $250,000 the calculation would be 1,000,000 divided by 250,000 which equals 4.  The inventory turns in this example is 4.  There is only 2 ways to increase your turns; increase sales (without increasing inventory) or decrease inventory.  There is another way to view this measurement as days of inventory.  If the above example was for a four week period instead of saying you have 4 inventory turns you have 1 weeks worth of inventory.  You can calculate turns using retail value, cost value or units as long as the unit of measure is constant.

 Another common measurement is quantity on hand.  This can be broken down to raw materials, WIP, components, replacement parts and finished goods.  This could also include available to promise which is the uncommitted portion of your inventory or the inventory that isn’t needed for current customer orders. 

 The next measurement is inventory value.  We’ve discussed this in past episodes but it fits in here as well.  You can measure the inventory value either at cost or retail value.  Some companies like to value inventory at cost to represent their investment while others like to value inventory using the retail cost to capture the total value of the inventory including their profit.  Because value changes over time a valuation method will need to be employed to capture this change or to standardize it such as FIFO, LIFO and standard costing.

 Inventory accuracy is measured by performing cycle counts and is reported in 3 different ways.  The first is overall accuracy; this is the number of locations counted without discrepancies divided by total number of locations counted.  As an example, if you count 50 locations and 49 of them are without discrepancies (the counted item matches the perpetual inventory) your inventory accuracy is 98%.  The other two ways are by number of units and by cost.  Both of these measurements should be measured using absolute numbers.  In other words, no negative counts.  Whether you’re short 3 units or over 3 units the variance is 3.  If you take into account if a variance is positive or negative opposing variances will cancel each other out.  It reminds me of the old joke of the 3 accountants that go bow hunting together; the 1st accountant sees a buck in the distance, he draws his bow and fires missing to the left of the buck.  The 2nd accountant draws his bow and fires missing to the right.  The 3rd accountant exclaims, “You got him!”

 There are other measurements but we can cover them later.  If you have questions about what we’ve discussed here today or if there is another measurement you would like to know about please send us a message at www.cashflowabc.com.

This week’s episode is an open forum discussion regaring the pros and cons of physical inventories and cycle count programs.  We discuss why physical inventories need to be performed, the benefits of cycle count programs and what must be accomplished before physical inventories can be replaced with a cycle count program which will save you money and improve your CashFlow.  So, listen to the episode and turn your cash flow into a cash flood.  Or at least stop the leaks.

Thanks for listening,

John & Dave

The How & Why

Direct vs. Indirect method

Net Income & adjustments

Cash from Operations

a. Sources & uses of cash

b. Prepaid expenses

c. Accrued expenses

d. Accounts Payable

e. Accounts Receivable

Example:  think about a $150 invoice from an electrician to fix a light switch. The work is performed in March and you have net 30 terms. In the Statement of Cash Flows, the effect of the $150 in March is to reduce net income by $150 and, because you have net 30 terms, it would be a source of cash in Accounts Payable because you didn’t pay for the expense. The effect on cash in March is zero and is shown by a “use” in the reduced net income and a “source” in the increased Accounts Payable. In April, when the bill is paid, Accounts Payable is reduced which becomes a use of cash on the Statement of Cash Flows.

Cash From Investing

Cash related to investing activities is the change in long-lived assets

Cash from Financing

Cash from financing reflects any activity in the equity (excluding retained earnings) section of the Balance Sheet or changes in any long term liabilities such as notes or bonds payable.

Change in Cash

Ending cash balance in your general ledger minus beginning cash balance. All cash accounts should be included – general accounts, Accounts Payable accounts, Payroll accounts, petty cash – all accounts that had any balance.

Example: Cash Flow Through a Retailer

 From a cash flow perspective, it doesn’t usually get any better than retailing.  In a perfect world, everything purchased from suppliers would be on net 30 terms and inventory would turn more than 12 times per year.  In this scenario, the customer would be buying the product (usually in cash) from the company before the company paid for it.

At -15 days (fifteen days prior to the sale) $20 is paid – this could be phone expense, wages (related to purchasing or receiving the product), etc..  At 0 days (the day the sale happens) another $17.50 is paid out in expenses related to this sale.  Once again, this could be wages, advertising, or any other non-product expense.  The sale was in cash, so $150 is received from the customer, putting the retailer at a $112.50 positive cash position (150-20-17.50).  At +15 days (fifteen days after the sale) the product that was sold is paid for at $75 and another $7.50 is paid in related expenses, leaving a net cash increase of $30, which is equal to the net profit on the sale.

 As you can see, in an ideal situation, only minor expenses are paid for prior to the sale.  This example is only an example – many retailers have significantly lower turns and have to carry those costs in advance of a sale.  This is the reason that the Finance Department is always pressuring Operations to reduce inventory and many deep discounts can be found on slow moving inventory.  It is also the reason that many retailers fail – too much cash was tied up in slow moving inventory and the business found itself undercapitalized.

The Statement of Cash Flow is the evolution of the Statement of Changes in Financial Position. It is a highly useful tool within the guidelines of Generally Accepted Accounting Principles (GAAP) to effectively analyze the operations of an organization from a financial perspective.

It is a common, and true, statement that “Cash is King”. This is why the Statement of Cash Flows is so important. When you understand what it’s telling you it becomes an enlightening view of the company. It is as if you have been going through a room in the dark for years and then you see it with the light on.

One of the companies where I have been Controller had a division that was privately held prior to it’s acquisition as a division of our company. The company ran about 40+% gross margins with 20+% net margins and wound up being acquired by our company for the amount of its’ debt to us. How could this highly profitable company come to such a demise? The company was excellent in sales, marketing, pricing, and product quality but what they didn’t do was effectively manage the inflow of cash into the business and it cost them the business.

By understanding the Statement of Cash Flow and looking at the information as it applies to your organization you can greatly increase value and longevity for your company.

The objective of the Statement of Cash Flow is to show you both where your cash is coming from and what you are spending it on. That is it plain and simple. By seeing the numbers quantified it will, to a large degree, confirm what you already know – it may be that all of the cash is coming from the bank or investors and the money going for capital investment or customer financing.

The Balance Sheet is a point-in-time report providing a birds-eye view of the financial health of the company while the Income Statement is an operational report telling how well the company did over a period of time. The Statement of Cash Flow is the bridge between the Balance Sheet and Income Statement and, like the Income Statement, is an operational statement and completes the picture of what happened in the business from one Balance Sheet to the other. Knowledge is power and cash is king.

Treatment of Revenue & Expenses

Components of Net Income

Usually a Source of Cash

Treatment of Assets

Types of Assets

Usually a Use of Cash

Treatment of Liabilities

Types of Liabilities

Usually a Source of Cash

Treatment of Equity

Types of Equity Accounts

Can be a Source or Use of Cash

Operational Impact

Effects of extended terms to your customers (A/R)

Effects of extended terms from your suppliers (A/P)

Effects of high Accounts Receivable and/or Inventory

Effects of lowering Working Capital

Digging out of a cash hole

For further explanation and illustrations, check out Understanding Cash Flow

Whether you operate a warehouse, retail sales, service or manufacturing business you have some form of inventory.  In the past we have discussed some of the methods for maintaining the proper levels of inventory now we will discuss where to put these items within your facility.  You will have items that you use frequently and those you use infrequently.  You will have items that you use in large quantity and those that you use sparingly.  Where you place or profile this product is just as important to your efficiencies and costing as controlling the amount.

 

The overall amount you use or sell during a specific timeframe is called the volume.  The number of times you need the product or to be more specific the number of times an employee needs to visit the location holding the product is called the visits or hits.  The difference between the two is you can have an item that uses or sells 50 units within let’s say a week but only have 2 visits or hits.  This could be because the item is used in 25 unit increments or perhaps, if sold, a customer purchased 30 on Tuesday and on Wednesday another customer purchased 20.  Either way if this is the average usage then the volume would be 50 per week while the visits or hits are 2.

 

Determining the hits and volume is easy.  I recommend exponential smoothing over a 13 week period.

The hits determine the proximity to the usage point while the volume and size of the product determines the size of the location.  That may sound simple but that’s it, but as with all business practices what is easy on paper may not be easy in application.  You may lack space in close proximity to the usage point or you lack the space to have the locations large enough to cover demand.  Generally, depending on your business, you will have a variety of location sizes near the usage point.  In warehousing these are usually pallet, carton and bin locations.  In manufacturing you could also add barrels, drums, spools and a variety of other location types.

To summarize; to properly profile your items:

* Understand the average volume per the time period you choose.

* Understand the average number of times the item is ordered or how often it is needed.

* Rate your items from highest hits to lowest hits (or visits).

* Arrange the highest hitting items nearest to the point of usage in a location that is appropriately sized to handle the volume.

Profiling can be implemented with any 5S projects or it can be a project unto itself.

Proper profiling of your facility will lead to higher efficiencies and lower costs.

Valuation methodologies

 Weighted Average

Weighted average is, perhaps, the easiest of the valuation methodologies. You have no variances to analyze, only variation.

As the title implies, weighted average costing averages the purchase price of products and absorbs any price variation into your P&L through Cost of Goods Sold.

 Standard Cost

In Standard Cost, you establish a standard that you want to value your inventory at.  This may be the initial PO price, a vendor quote, or an estimate based upon industry or process knowledge.

With standard costs, also come variances that must be analyzed for the system to be effective. 

There are Purchase Price Variances (PPV) which are differences between your purchase price and your standard price.

There are Closed Work Order (CWO) variances that are the difference between your standard cost and the actual cost to produce a given product.

There are also Labor Variances, Factory Burden Variances, and Material Burden Variances that, like those already mentioned, are differences between the standard and the actual cost to produce a product.

Many company use the standard system as target costing and then manage to the variances.

 Specific Identification

Specific Identification is probably the most data-intensive method.  Specific identification requires you to serialize every piece of inventory.  While this may be appropriate for tracking blades for a Sikorsky helicopter, it’s definitely inappropriate for producing millions of homogenous, low-cost items.

 FIFO

First-In-First-Out tracks inventory as being used in the same order in which it was purchased, and is probably the way in which most companies consume inventory. 

LIFO

Last-In-First-Out is similar to FIFO, but considers the most recent purchase as the first one to be consumed.

There is a lot of talk regarding Lean improvements for business.  Removing waste, improving efficiencies and increasing profitability has become the battle cry of businesses around the country and the world.  But this is untested ground.  Where does one take the first step?  How does a company begin to head down this road to continual improvement?  Some will say Value Stream Mapping is the first thing you should do, but in order to properly create a current state VSM you need to bring your house in order.  I have seen VSMs rendered inaccurate only because the physical layout wasn’t maintained resulting in a changing process with changing process times and material queues.  The first step down the Lean highway is implementing 5S.  5S is nothing more than an organization and maintenance of your facility.  Some will consider it a bit anal in its approach but 5S is a proven method of organization and visual controls that will improve your company’s productivity and efficiencies by itself.

In the podcast I gave as an example of 5S the Batcave from the old Batman TV series starring Adam West.  Here are some photos to show you what I meant.  Notice the signs depicting each gadgets function:

5S stands for Sort, Set in order, Shine, Standardize and Sustain.  If you take a current look around your facility I think you’ll find that you’re already using 5S, but it’s a different form of 5S.  You’re probably using Sponge, Steal, Store, Scramble and Seek.  This means that currently if an employee is looking for something like a tool or another process necessary item they will sponge it off another employee leaving that employee to wait for its return, steal it from another work station or employee, store or hide items at their work station so others won’t be able to inconvenience them, scramble around wasting time and using that as a plausible cause for low productivity and endlessly seek for what they need sometimes getting others to join in the search.  All of these S’s are unproductive and frustrating for management and employee alike.  The 5S’s you need to use are:

* Sort – This is the first S to work on.  Sorting means going through the materials and tools of a work area and removing the unneeded and leaving the needed.  By properly communicating what is needed at each work station employees become more productive and quality improves through the use of the proper tools and materials.

* Set in order – This S means to organize the tools and materials of a work station so they are easily accessible to everyone who works at that particular station.  It also makes it obvious what tool belongs where.

* Shine – This S means just what it sounds like… clean!  This means more than clean it once it means to clean it and maintain that cleanliness.  Shine means putting in place processes and procedures that maintain a clean work area.

* Standardize – This S means to incorporate 5S into your daily processes or adding them to your SOPs.  This could involve using shadow boards, painted lines outlining functional areas or tools and labeling.

* Sustain – This is the guard dog of the S’s.  This S will take discipline.  If you don’t put in place the safeguards to maintain your efforts they will be in vain.  You will need empower and hold accountable your employees to maintain and improve the first 4 S’s.

If properly and attentively implemented 5S can not only set you on the right road to Lean it c...

Turning Supply Chain Management into a Profit Center

There are a number of ways to generate value for your organization through the management of the supply chain. 

One thing that you will want to do is publish your results publicly within the company. 

 This will serve three purposes:

    (a)  Toot your horn – you won’t have to toot your own horn as much because it will be in black and white

    (b)  Good results will set a precedent that will keep you going to constantly improve

    (c)  It will inspire those around you to maybe compete in the process improvement arena

    (d)  If you are an employee, it will set you up for your next review and if you are the owner it will increase your bottom line.

We’re going to pick some low hanging fruit here.  This is by no means an exhaustive list of things to do, but it will get you on the right track and we can do an update in the future to expand the list.  For the carrying cost calculations we will use a rate of 8% which is a reasonable rate for the purposes of these illustrations.

Inventory reduction

This is what almost every company wants to do.  Reducing inventory squeezes cash out of the business on a dollar-for-dollar basis.  There are two numbers that you will want to quantify when it comes to inventory reduction: (1) dollar value of the reduction and (2) annual carrying cost on the dollar value of the reduction.

For instance at one location I was involved with, we reduced the inventory from $17 million to $12 million over the course of a few months.  What this produced was a cash infusion to the business of $5 million and another $400,000 reduction in annual carrying cost.

In episode 2 of CashFlow ABC’s we covered how to find the low hanging fruit, in episode 6 we showed you how to properly determine your reorder points and in episode 8 we address economic order quantities and all of these play a part in the equation.  We’ll spare you a rehash of the three episodes that would surely be as juicy as microwave toast – check out those three episodes for the details.  Suffice it to say, reducing the investment that your company has in its inventories pays off in real dollars to the organization.

Extended terms

As we seen with the discussions about the statement of cash flow, which I know had everyone on the edge of their seats, getting extended terms from your suppliers adds to the cash balance of the company.  In addition, this will have carrying costs implications just like the inventory reduction.  If you have a supplier that you have net 30 terms with a supplier that you normally have a $100,000 balance with.  If you get the supplier to go to net 60 terms, you wind up with the equivalent of an interest free $100,000 loan because you now have an average A/P balance of $200,000.  Like a reduction of inventory, this will inject the additional $100,000 into the company’s bank account and end up with a benefit of $8,000 in reduced carrying costs on this one vendor over the course of a single year.

Prompt pay discounts

Prompt pay discounts are commonplace in every industry.  A supplier might offer 1% 10, net 30 terms or something similar – I’ve seen as little as 1/2% and as much as 5%.  In many organizations, the effect of carrying costs isn’t seen until you get up to parent companies, so it isn’t as appreciated as much at the division or plant level and discounts are more tangible and evident and therefore more appreciated.  Also, some companies can’t offer extended terms because of company policy, but they can offer the discounts.

Objectively, you have to determine your requirements and at what threshold you need for a discount to be preferable.  If cash is an issue in your company, then usually management is valuing extended terms over discounts because the cash need is immediate and, by the same token,

The purpose of safety stock is to protect against fluctuations in demand or supply or any uncertainty.  Safety stock is based and dependent on:

 

Frequency of ordering

Variability of demand (compared to the forecast)

Desired service level

 

We’ll address these one at a time:

 

Frequency of ordering – How often you order or manufacture your products will affect your safety stock.  The more frequent your ordering the less your demand during lead time therefore the amount of replenishment is smaller than less frequent ordering.  However, due to the smaller quantities your risk of a shortage increases but exists for a shorter period of time.  Less frequent ordering decreases the risk of a shortage but stock outs last longer.  It’s been my experience that it’s better to have more frequent stock outs for shorter periods of time than to have less frequent stock outs for longer periods of time.  Customers may understand or have safety stock of their own that will be lower if any stock outs are for only a short period of time

 

Variability of demand – No matter how accurate your forecasting is you will experience variability in your demand.  Safety stock is primarily to absorb this variability.  To set the proper levels of safety stock you will need to understand the absolute error between your forecast and your demand.  Then you will need to determine the standard deviation of that variance.  This was discussed in episode 4 of CashFlowABC.  Please review that episode for more details and examples.

 

Desired service level – The amount of safety stock you carry will be directly affected by your desired service level.  For those dreamers or naïve individuals in your company a 100% service level is unrealistic.  It serves as a goal but realistically cannot be attained.  If you do have a 100% order fill rate I guarantee you have too much available stock or your forecast was overstated.  Additionally, if your product is extremely low in cost and stock outs are unacceptable to your customers then it may necessary to carry enough inventory to eliminate stock outs.  But if your product isn’t next to free then you should choose a realistic service level and put waste reduction processes in place to continually reduce your inventory levels while increasing your service level.  For those realistic individuals APICS has come up with safety factor multipliers to help set safety stock levels based on desired service levels.  The higher the service levels the higher the multiplier and safety stock.  As an example, if your standard deviation is 100 and your desired service level is 95% your safety stock would be 100 x 1.65 or a safety stock level of 165 units.  If your desired service level is 99% your safety stock multiplier is 2.33 or a safety stock level of 233.  This means for a 4% higher service level you will need to carry twice the safety stock.  This is why removing waste from your processes and lowering your inventory will save you cash.  Also, reducing your forecast error will reduce the variation and your safety stock.  Below are the service level multipliers for both the standard deviation and the MAD:

 

Desired Service Level %

        SafetyStockMultiplier

 

Standard Deviation

MAD

50.00%

0.00

0.00

80.00%

0.84

1.05

84.13%

1.00

1.25

90.00%

1.28

1.60

95.00%

1.65

2.06

97.72%

2.00