Management Accounting

Inventory: How Fast Is Too Fast?

A new supply-chain metric, which could help managers gauge the right speed for asset turnover, may be a compelling reason to move to activity-based...
Marie LeoneAugust 18, 2005

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.

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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.)

Further, OAU can be used to focus on managing the supply chain for asset return. And linking the procurement function to a return-on-assets metric, says Sharma, is a useful cost-vs.-benefit test.

OAU also gets nods from Wall Street. Jon Orcutt, and investment advisor with USB Financial Services, says OAU’s big strength is that the model will help companies generate free cash flow, and thereby grow more efficiently. That’s key, especially as a due diligence tool for mergers, says Orcutt, who likes the idea of measuring how much free cash flow a company generates, or burns, before a deal closes.

Although George and other OAU users say that the model is relatively simple to integrate into existing procurement or enterprise resource planning systems, one significant stumbling block remains. OAU only works if used in combination with ABC.

The ABC prerequisite is the biggest hitch in implementing OAU, notes Jason Saner, an executive vice president at Badger Technologies Inc., a contract manufacturer based in Grabski’s hometown of Penn Yan. Saner, whose company adopted OAU late last year, says that shifting the supply-chain process — or any other company function — from cost accounting to ABC can be a sticking point. “The hardest thing about OAU is getting workers to buy into the activity-based costing mantra,” says Saner.

Saner explains that employees and management — especially procurement-department staffers — have been taught to focus solely on purchase-price variance: Historically, price-only comparisons have been the criteria for assessing a good deal. But ABC changed that thinking.

Before operational management guru Robert Kaplan introduced ABC in the late 1970s, virtually all companies used cost accounting to classify and record current and prospective charges so managers could make internal decisions about the business. Applying it to the procurement process, for example, users of cost accounting calculate average overhead costs — such as receiving costs or accounts payable — and spread those costs over the entire procurement department. As a result, cost accounting presents broad assumptions about what suppliers charge.

In contrast, ABC is far more precise, advocates say. Users of the method identify cost drivers, like the accounts-payable and receiving functions, and assign costs to those activities. ABC, after all, includes overhead charges that often create a drag on profits but go unnoticed under cost accounting.

Regardless of the added precision and transparency that ABC affords however, the process has historically been a headache to implement. That’s been especially true at large companies where management has tried to push through ABC projects on a global scale. Deciding which activities to include in the process and what cost allocations to assign is onerous, which is why many companies still avoid ABC.

What’s more, newer metrics, such as the balanced scorecard (another Kaplan model) and economic value added, stole some of ABC’s thunder in the early 1990s, stifling widespread acceptance of the activity-based system. According to George, ABC moves what used to be considered indirect costs like overhead into the direct-costs column, a move that’s counterintuitive for employees and management.

Still, George implemented ABC and OAU simultaneously, recognizing the cash-flow advantage that the tag team was capable of providing. He cut down the implementation project to include only Matric’s procurement process, as to limit the scope of the job. But he contends that the company’s sometimes arduous move to ABC was worth the additional visibility into the supply chain, and the improved turnover performance OAU helped drive.

For his part, Grabski asserts that companies using the basic OAU model will find it easy to refine the process to produce more targeted results, such as tracking which individual suppliers contribute or consume free cash flow, and calculating the amount of the contribution or consumption. Indeed, access to a cash-flow metric like OAU may be the most compelling reason yet for companies to adopt ABC.

The Next Step

Saner says Badger Technologies will “definitely” move to use the more refined OAU model to measure free cash flow contribution of suppliers and customers. But that won’t happen until the company finishes installing and integrating its new Oracle enterprise resource planning system. He expects to complete that project sometime during the fourth quarter of this year.

George reckons that Matric will bring the use of OAU down to the supplier and customer level within a year, once he’s satisfied with the company’s inventory turnover. Meanwhile, he’s been expanding the model’s scope a little at a time.

For instance, last year, George started using OAU to generate supplier report cards from Matric’s automated supply-chain quoting system. The report cards rate vendors monthly on broad criteria, such as quality of product and timely delivery. They also rate sellers quarterly on the merits of their value-added services, including consolidated billing, discounts, consignment arrangements, whether they provide bar coding, and credit terms. The report cards have sparked vendors to approach George about how to improve their ratings, he says.

In general, says the CFO, OAU keeps Matric trained on cash flow, “right where our focus ought to be.” George notes that, “If we don’t take [total cost of ownership] into consideration, overhead could balloon while we try to support customers and suppliers.”