Integrating Basic Inventory Management Concepts into the CFO Role
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.
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 (Re-Order Point) Systems
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 the uncertainty is typically called Safety Stock (SS).
If we look at an example above, we see a part with a history of demand 50+/-25 units for one month and we’ll assume that the lead-time is one month. In statistical terms an estimate of the variability is the standard deviation(SD) and AVERAGE + 2*SD covers 95% of months demand.
Using terminology from above the SS = 26 and the Average Demand = 50. With one month1
The second common element in ROP systems is how much do 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.
The EOQ formula is well documented as !(2 ∗ 𝑆 ∗ 𝐷)/𝐻 , where S = the fixed cost of an order, D = the demand per period, and H = the holding cost per period for one unit. The fixed cost of placing a purchase order or replenishment order can include items such as the time to place the order, receive it, put it away, and pay the vendor bill. Holding-cost-per-unit includes the unit cost and more importantly working capital costs, storage costs, obsolescence and spoilage costs. It is important to note that the EOQ formula ASSUMES that the per unit price and the % cost of holding is constant (H=iC). This assumption is often breaks with quantity break pricing, freight costs, and the cost of capital being situation dependent; more advanced formulas can compensate for these assumptions.
We will return to these ideas shortly.
MRP (Material Requirements Planning) systems
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.
1 Note that different brands of ERP systems will use slightly different definitions of SS and ROP and which “term” refers to the amount on hand that flags a reorder must be checked.
The CFO perspective
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 a CFO can work within the organization to pull.
1. In ROP environments, implement data analytics to better define demand and demandvariability to lower ROP’s through reduced Safety stocks. Additionally, should demand follow 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.
2. In both environments, work to reduce the fixed cost of ordering. Ordering costs can be reduced with 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.
3. 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 total cost.
4. 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 fall outside the specific purview of the CFO but judicious inquiries into the assumptions and drivers of these systems can be used as a tool to drive down inventory and find additional cash.
Todd Peter is a FocusCFO Principal, based in Cleveland, OH.