Supply Chain Vector [Electronic resources] : Methods for Linking the Execution of Global Business Models With Financial Performance نسخه متنی

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Supply Chain Vector [Electronic resources] : Methods for Linking the Execution of Global Business Models With Financial Performance - نسخه متنی

Daniel L. Gardner

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The Operating Cycle and Cash-to-Cash Cycle


Two concepts that capture the essence of the relationship between time and asset productivity are the operating cycle and the cash-to-cash cycle. The power of both tools lies in their treatment of business activities as time sensitive and the ability to break down integrated processes into the days (or hours) required to carry out individual tasks. It is the dissection of these processes that leads managers to identify improvement opportunities within each functional area, as well as to isolate the lags that exist between departmental handoffs. The reduction of time lags in both the operating and cash-to-cash cycle affects the performance of short-term assets, and tactical efforts to improve the cycle ultimately lead to better asset utilization.


As illustrated in Figure 11.1, the operating cycle identifies the length of time it takes to convert inventory and receivables to cash. This metric is important for many reasons, all of which create implications for the balance sheet, income statement and cash flow statement.


Figure 11.1: Operating Cycle (From Robert S. Kaplan and David P. Norton, The Balanced Scorecard— Translating Strategy into Action, Harvard Business School Press, 1996, p. 58. With permission.)

The underlying accounting principle that makes the operating cycle so transcendental is "matching," a method through which inventory is drawn down from the balance sheet during the sales process. As transactions are consummated, inventory values are reduced on the balance sheet and appear as cost of goods sold (COGS) on the income statement. The exercise allows accounting managers to "match" sales figures with the original cost of the goods in the appropriate time period, the result of which is the gross profit figure.

This point has implications for revenue and cost recognition on the income statement, but also speaks to the health of the balance sheet due to the inventory values shown in current assets. Based on the fundamentals of accrual accounting and expressed as days of inventory (DOI), the speed with which goods are manufactured and sold is vital to supply chain effectiveness and financial outcomes.

In an effort to understand the importance of the DOI metric, reference is made to Benjamin Franklin's ageless observation that "time is money." Basically, every additional day that an organization has cash tied up in inventory represents a suboptimization of the company's financial resources. When one focuses on issues that include COGS, cost of capital and carrying and opportunity costs, the importance of rationalizing inventories across supply chains is obvious. As such, the goal of this metric is to establish a baseline figure and continue to implement tactics that reduce DOI. With regard to understanding the origins and relevance of the variables in the equation, a breakdown of the calculation is required. The calculation of DOI is expressed as:

Average inventory/(COGS/365)

Focusing on the components of this calculation, as well as understanding that the goal of the metric is to reduce the amount of DOI, a series of intuitive points should come to mind. The first recognizes that the variables in the equation come from both the balance sheet and income statement, an arrangement that emphasizes the interdependencies that exist between the two reports. As the NikoTech analysis moves from the balance sheet to the income statement, several cause-and-effect relationships will become apparent. It is the uncovering of these causal relationships that helps management to identify root causes and take measures to improve performance.

Another key issue involves the use of COGS as opposed to net sales in the denominator of the equation. It has been stated throughout the discussion that sales are linked to inventories. So why not use the net sales figure in the denominator? The answer to this question takes the analyst back to the discussion of revenue recognition, the method through which inventory values are drawn from the balance sheet and appear on the income statement as COGS.

COGS is used in this equation because it reflects the actual cost of the goods before a sale, a figure that is accurately aligned with inventory values shown on the balance sheet (the balance sheet shows the value of the inventory, not its forecasted sales price). Also, if the net sales figure were used in this formula, it would artificially deflate the result of the calculation and distort its significance (more on that in a moment).

Having stated the above, there are but a few methods available to reduce the quotient of the calculation. Specifically, one can reduce the numerator, increase the denominator or create a situation where both objectives are achieved simultaneously. Simply stated, a company must achieve the same or greater sales with less inventory or achieve higher sales with the same level of inventory. Either way, the goal is to do more with less, generating more sales with minimal inventory in a shorter period of time.

Calculation of the denominator (COGS/365) provides an expression of the COGS incurred on a daily basis. This means that production costs, as a purported function of sales volumes, can be expressed as an average daily amount. The average inventory figure in the numerator divided by this daily number in the denominator provides the analyst with the number of days it takes a company to acquire raw materials, produce finished goods and generate a sale. With suppliers and customers all over creation, this process can become an unwieldy exercise. Figure 11.2 displays the entire process.


Figure 11.2: Breakdown of Days of Inventory

A final caveat on the use of the DOI metric involves improving results via increases in its denominator (COGS). From a cause-and-effect perspective, one would assume that sales would have to be growing in order for COGS to increase. While sales growth is always nice, it is a very dangerous assumption to accept that COGS is growing at the same or a slower pace as sales. As illustrated in Figure 11.3, if the slope of the COGS line is steeper than that of the sales line, the two will intersect at some point (and consume margin along the way). This situation implies that COGS is growing faster than sales, a predicament no company wants to find itself in, especially our friends at NikoTech.


Figure 11.3: Sales Versus Cost of Goods Sold Growth

If the increase is COGS is in line with sales increases, the DOI metric is much easier to interpret and understand. However, if the COGS number is increasing due to incremental costs that are independent of the sales figure, the number becomes distorted. Emphasis on the origins of COGS and its importance to the income statement will manifest itself further along in the NikoTech analysis. For now, suffice it to say that no figure or calculation should be taken at face value and that supply chain analysis is much more than simple number crunching.

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