Every time a brightly colored ball bursts out of an air rifle and splatters red, green, or blue paint all over someone's shirt, Tod George knows his supply chain is in good shape. George is the CFO of Matric Ltd., a $30 million contract manufacturer in Seneca, Pennsylvania, that provides loaded circuit boards and cable assemblies to makers of paintball guns, medical devices, mining equipment, and a host of other electronics-based component manufacturers.
Nevertheless, George keeps a close eye on Matric's supply chain. As a contract manufacturer, Matric stands between its clients and its clients' end customers. That means that Matric's profits are heavily tied to its managers' ability to convert purchased components into products — and then cash — in the most efficient way possible.
George and others believe that a big part of running an efficient supply chain is linked to how much information a manager can gather about buying, using, and replacing inventory.
To be sure, up until a few years ago, certain aspects of the buy/replace cycle — also known as asset turnover or inventory turnover — weren't completely transparent. Specifically, it was hard for managers to understand the full effect of inventory turnover on free cash flow. But a four-year old metric, called optimal asset utilization (OAU), is giving managers a window on exactly how inventory turnover generates or consumes free cash flow.
In general, managers know that by speeding up inventory turnover, they can generate more free cash flow. Consider two hypothetical companies with identical sales and profit margins over a one-year period: American Widget and Colonial Claptraps. American buys $100,000 worth of widget parts only one time, at the beginning of the year. It sells the finished products by year's end at a 10 percent profit, generating $110,000 in total revenues.
Meanwhile, using more aggressive inventory management, Colonial buys parts four times during the year, spending only $25,000 at a time, and reordering just before running out of components. Essentially, the company reinvests the same $25,000 to replace sold inventory. By year's end, Colonial generates the same $110,000. However, since Colonial is only investing $25,000 at a time, it's spending $75,000 less on inventory than American. Colonial has also reduced capital risk for the year compared to American, putting $25,000 rather than $100,000 into play.
The admittedly oversimplified example shows how increasing inventory turns can generate more free cash flow. And a company with greater amounts of free cash flow has more opportunities to make higher-yielding investment instead of tying up cash in idle inventory. Colonial, for example, can choose to put its extra $75,000 to work paying down debt, or growing the business by purchasing more inventory, investing in research and development, hiring new employees, or launching new products.
But accelerating inventory turnover comes at a price. That's because it increases the need for related transactions and boosts transaction expenses like the cost of receiving, inspecting, and paying for inventory. Because of economies of scale, a company that buys inventory only one time a year can get a cheaper overall price than a more frequent buyer.
Eventually, accelerating inventory turnover will reach a point of diminishing returns. The expenses will catch up to the additional cash flow the turnovers are generating, and the supply chain will reach a tipping point, says supply-chain expert John Grabski. He defines the OAU point as a "zero-cash" situation. Beyond that point, the costs will push the supply chain into a negative cash-flow position.
Grabski, the founder of Clear Momentum Inc., in Penn Yan, New York, developed OAU "sort of by accident," while trying to prove the economic benefit of buying a kit of components as opposed to individual parts. He still has the napkin he used to scratch out the fundamental model.
At its most basic level, OAU is a metric used for calculating the optimal number of inventory turns that can be completed before a company starts consuming the free cash flow that it set out to generate. When refined, it can help managers understand how different suppliers, customers, product lines, or business units contribute to or consume free cash flow, Grabski says.
A Metric for Matric
Two years ago, Matric's George decided to use OAU to track and measure the free cash flow generated by increasing the number of inventory turns. Matric runs the OAU model over its existing procurement and quoting platform, which is an activity-based costing (ABC) system.
So far, says George, Matric has sped up inventory turnover by 23 percent since launching OAU in late 2002, while keeping turnover expenses at sustainable levels. The private company's CFO won't provide specific free-cash-flow-improvement numbers, but he says that OAU "has had a positive effect on the company's cash position and return on assets."
Vishal Sharma agrees that the model can be useful. Sharma, a vice president at supply-chain software maker and consultancy Ketera Technologies, doesn't use OAU in his practice. But he says that the value of the model is that it captures the total cost of ownership for inventory. (The total cost of ownership includes the bid price, value-added services, and the effect those services have on the purchase cost.)
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