Increase Cash Flow by Reducing Inventory

January 1, 2011

More companies fail for lack of cash than from lack of profit. One of the largest drains on a manufacturing company’s cash is inventory. Reduce inventory and you will increase the amount of cash available to run the company.

It takes cash to buy or build the inventory you are going to sell. The cash you have to spend before you can get paid is called working capital. Working capital is used to fund operations and inventory. Many companies, if not most, borrow to support their short-term cash needs. If they do not manage cash well, they can run out and the bank may not be willing to lend more. No cash, then no way to make payroll and no way to pay suppliers. This is death spiral that too many companies go down.

In addition to affecting cash flow, inventory levels also affect profitability. Every dollar in inventory reduction, leads to a dollar reduction in working capital requirements which means you have to borrow less. The less you borrow, the less you pay in interest and since every dollar you pay in interest is a dollar taken from profit, every dollar you reduce in inventory leads to an increase in profits.

Figure 1, courtesy of the Inventory Quality Ratio (IQR)

In the example illustrated by figure 1, the company has $33,241,000 dollars in inventory. Their current turns are 4 and they estimate they can increase turns to 6. They have calculated their cost of capital to be 12%.

When you do the math, the increase in turns reduces inventory by $11,080,300. Given the 12% cost of capital, this company can increase their bottom line by $1.33 million just by decreasing the amount of inventory they have relative to sales.

The job of supply chain professionals is to jealously guard the company’s cash by making sure that only the inventory that is needed now is bought or built. Even knowing this many companies struggle with keeping inventory down. Some of the major reasons that inventories creep up include:

  1. Inventory systems and metrics, like turns and Days Inventory Outstanding, are backward looking.
  2. ABC classifications are out of date.
  3. Order quantities and safety stock levels are based on past usage.
  4. Planners plan part quantities rather than manage inventory dollars.

To manage inventories effectively, inventory management tools need to be demand driven and they need to provide a dollar focus. Forward-looking, demand-driven ABC classifications are needed to revise our order quantities and safety stock levels. A dollar focus is needed so that planners and buyers can be more effective in choosing the most important part numbers to work on first. Since they have limited time to work the issues, their tools need to make it easy to identify the parts with the biggest dollar returns.

The Inventory Quality Ratio tool is one example of a tool that provides an effective way to manage inventory dollars and improve inventory performance. The IQR tool presents inventory dollars instead of quantities and dynamically calculates ABC codes to revise safety stocks and order quantities consistent with current demand, all of which make the planners’ and buyers’ jobs easier.

Whatever tools are used, companies must do a better job of managing inventory levels and working capital. Planners and buyers must reduce inventory and increase the amount of cash available to run the company.

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