A primary focus for a CFO is on the capital (cash) available to support the business. The time frame can be narrow and operational for companies with tight cash situations or strategic in looking to finance high growth or acquisitions. In most companies the lowest cost source of cash is when it is tied up in working capital: inventory or accounts receivable. Because convincing customers to pay earlier or in advance is typically a challenge or conflicts with sales growth objectives, the most actionable source of balance sheet cash is inventory or stretching vendor payables. For the moment, let’s look to inventory.
Exploring Inventory Management Strategies
Most companies that have inventory rely on a computerized system to help them plan the re-ordering and buying of material, using one of two concepts; reorder points or material requirements planning (MRP). If you wish to drive inventory lower and free the cash, the levers on these reordering systems, or perhaps a change from one to the other, could be in order.
ROP Systems: Optimizing Re-Order Points
A re-order point system operates with the simple approach that when the stock level of a given item drops to the ROP, it is time to order more stock. Establishing the ROP is done by projecting demand during the time it would take to get more stock or the product lead time. Invariably projected demand is based on historical demand or usage, and customer demand is never exactly even. Thus, projected demand must cover the average demand and some allowance for the fact that demand might be higher than average. This allowance for uncertainty is typically called Safety Stock (SS).
Utilizing the EOQ: Balancing Ordering and Holding Costs
The second common element in ROP systems is figuring out how much you order once the ROP is triggered. The reorder quantity is alternatively referred to as the ROQ (Re-order Quantity) or EOQ (Economic Order Quantity). EOQ is a concept from the operations and financial management literature that advocates the balancing of the fixed costs of placing an order and the costs of holding inventory for a longer period of time. These two costs move in opposite directions – big orders spread the fixed order costs over a lot of units reducing the total cost per unit and big orders increase the amount of inventory on hand and increase the cost per unit of storing inventory.
Material Requirements Planning (MRP): A Shift in Demand Projection
MRP systems share some elements with ROP systems. These are the ideas of safety stock and EOQ, reorder quantities. The idea of Projected demand changes dramatically. MRP systems rely on an explicit projection of future independent demand; independent demand being the customer demand for end products. From this projection, dependent demand is calculated (dependent demand is the demand for parts that go into or are used to make end-use parts) and the total demand is the combination. MRP demand is EXPLICIT and time based as it is in the future, i.e. it can vary from period to period. ROP demand is IMPLICIT based on historical actuals, assumes a constant mix of end-use products and is typically calculated based on past sales and usage.
The CFO Perspective: How to Reduce Inventory
A CFO looking for cash is fundamentally looking at how can inventory be reduced, ideally, without impacting other performance factors of the business, such as service levels.
Levers for Financial Optimization in ROP and MRP Environments
- In ROP environments, implement data analytics to better define demand and demand variability to lower ROP’s through reduced Safety stocks. Additionally, should demand follow a predictable seasonal pattern, develop procedures to change ROP on a regular seasonal basis. This tactic can be viewed as a halfway step to a MRP solution.
- In both environments, work to reduce the fixed cost of ordering. Ordering costs can be reduced with the implementation of efficient materials management systems, negotiated blanket orders with simplified releases, potentially outsourcing cost elements, automating order placement, and payment systems with advanced IT systems.
- In both environments, reduce holding costs. In a cash-constrained situation, the opportunity cost, or Holding, can skyrocket way above the typical line of credit costs to the level of equity costs or 35-40%. This level of increase will usually distort the simple EOQ formula reducing purchase lot sizes (a good thing for cash) but potentially increasing total cost (price and freight increases). Other Holding costs can be reduced by increased vendor terms, consignment inventory, and right-of-return clauses in supply contracts. For a given purchase lot size, reduced holding costs will always decrease the total cost.
- Recognize the business situation where demand patterns are fundamentally inconsistent with the assumptions of static and recurring demand. In these situations, a conversion to an MRP-based system can be worth the effort required.
Typically, responsibility for material management systems falls outside the specific purview of the CFO but judicious inquiries into the assumptions and drivers of these systems. Instead of taking a siloed approach, by working collaboratively with the CFO, they can be used as a tool to drive down inventory and find additional cash.
Unlock the potential of your working capital today with the expertise of a fractional CFO. Let us help you optimize your inventory management, enhance your cash flow, and drive sustainable growth. Ready to take the next step? Reach out to us at FocusCFO for a complimentary consultation.
Todd Peter is a FocusCFO Principal, based in Cleveland, OH.