“Cash is king,” we hear. I have seen this in the core values of major, multi-national corporations. If you travel for your company, you likely face restrictions on the amount and/or cost of travel which you can book without very senior level approval. I know of one company with revenues of about $15 billion in which the CFO has mandated approval of any air fare over $500, even for employees who routinely must book and re-book travel on short notice due to the nature of their duties. I do not debate the wisdom of such policies. I only use them to illustrate how carefully the expenditure of cash is scrutinized in many cases. Capital expenditures require even greater examination and multiple approvals, perhaps even from the board of directors. Despite these procedures, I pose this question: “Do you really know who his spending your cash are how they are doing it?”
Consider where most of the cash is spent and who spends it. In most manufacturing firms, the largest single expenditure of cash is for the acquisition of raw materials and their transformation and distribution, namely, the cost of goods sold. What is not sold remains on the balance sheet as inventory. A manufacturer with 40% gross margin is doing very well in most industries, although there are notable exceptions in pharmaceuticals and a few other manufacturing industries.
A 40% gross margin would mean that 60% of the cash inflow from sales is spent on inventory – inventory that is either sold or stored. In fact, manufactured product (or at least the raw materials, components or intermediates/work-in-process) in every manufacturing operation is stored at some point before it is shipped to a customer. That is why inventory turns or days in inventory (both relating inventory to sales through the cost of goods sold) are the most appropriate kinds of metrics for inventory rather than the absolute amount.
So, given the relative proportion of cash flow in the majority of manufacturing firms that is spent on inventory of one kind or another compared to, say the proportion of cash flow spent on travel, one might assume that the level of scrutiny and approval required for spending on inventory would be extraordinary and performed at the most senior level of the firm. Is that true in your company? Of course not. Manufacturing and distribution operations would be paralyzed and servicing customers effectively would be precluded by such a bureaucratic approach.
Many firms, today, have a position called buyer/planner. These are people who must determine how much should be procured, when, and where. Purchasing or sourcing professionals whose mission is to make sure that the purchase price is minimized support the planning function, but purchase orders are issued by buyer/planners.
Even if “buying” is separate from “planning”, it is the planner who decides how much is needed when and where.
Planners do not rank among the highest paid employees, yet they are pulling the lever to spend the majority of the company’s cash flow.
Most planners today have access to advanced planning and scheduling (APS) tools which embed material requirements planning (MRP – I know this should be “little mrp”, as opposed to “big MRP” for manufacturing requirements planning, but allow me this convention here for visual ease) and distribution requirements planning (DRP) calculations to aid them in determining how much to purchase. These tools are very helpful. They are particularly helpful if the forecast is exactly right, if forecast error is always normally distributed, if stated transit lead times are always reality, if yields are constant, if service from one internal manufacturing or distribution point to another is always constant and known. However, almost none of these conditions are ever true, and they are never true all at the same time.
So, not only do planners have to ultimately determine what to move, make and buy for every item in the bill of material (or formula/recipe) at every location in every future time period in the planning horizon, they must do so in an environment with many unknown inputs.
(At this point, I will include a plug for recruiting, training and retaining the very best planners – not vp’s of planning or directors of planning, but planners themselves since they are likely spending most of your cash!)
This problem is called multi-echelon, inventory optimization (MEIO). MEIO is fast becoming a best practice requirement. MEIO optimizes the answer to the very challenging problem of how much extra inventory a planner should plan to have at each location, for every item, at every level, given the many other unknown factors as well. Put differently, “What is the inventory safety stock level that should be targeted for every item at every location, such that the cost of holding inventory for achieving a given service level is minimized.” This question must be answered across all nodes while considering all of the unknown factors mentioned above.
When solved, the result is a lower required buffer inventory than could be planned with just MRP or APS in order to achieve an optimal service level. That means more available cash and more revenue and profits.
Solving the MEIO problem remains a massive challenge for which many planners still do not have sufficient tools at their disposal. However, algorithms have been developed and can be implemented through commercially viable software such as that offered by Opalytics. As MEIO continues to be adopted, more planners can go about their normal planning process of determining what to move, make and buy, but with a much better starting point, namely the amount of inventory buffer required at each item, location.. This buffer, or safety stock, already a standard row in a supply planner’s gross-to-net calculation in his or her advanced planning system, allows planners to perform their work without disruption while achieving significantly better results for the cash management of their firm – when populated through MEIO.
1) How do your planners account for the unknown factors in determining how much cash to spend on which inventory in which locations and when?
2) Are you thinking about evaluating MEIO? If not, why not?
3) Can you afford not to pay more attention to where the majority of your cash flow is going?