Home' MHD Supply Chain Solutions : MHD Jan-Feb 2017 Contents without stock. Production is being kicked
everywhere. Sales have been missed; the
company has been unable to invoice $50,000 in
sales due to the inability to supply.
Let's now have a look at set of financial
statements for a new company called Example
Co. to see the impact of the stock reduction.
You can see by comparing Figure 1. and
Figure 2. that net profit before tax has reduced,
cash flow has reduced, sales have reduced,
return on sales has reduced, ROI has reduced,
and standard product cost/unit has increased.
This was not the intent of the exercise.
Without a change in the fundamental process
by which production occurs, the stock level
cannot be maintained at this low level and have
high customer service levels as before.
Decisions will be made, either stock level will
return to previous levels, or customer service
levels will be allowed to decline -- no one is
happy. Customers will look at alternatives and the
production manager has a miserable life; at the
next operations review, they will be castigated for
the low service levels and the increased costs.
Stock reduction that drives greater customer
service and improved profitability, while
simultaneously reducing costs, can be achieved.
Scenario Two: Stock
reduction - the right way
YourCo seeks to improve its return on
investment by reducing the cash held in stock.
The company is exceptionally focused that this
change must not have any negative impact on
its customers. In order to have a lower level of
cash tied up in the order to delivery process
without hurting the customers the speed of the
order to delivery process must increase.
The financial statements are above.
You can again see the reduction of the raw
materials purchasing, and the drop in stock. As
you can see the financial metrics all improved,
cash flow improved.
The key driver of this was that the changes
were implemented without reducing the sales.
Hurting sales is absolutely unacceptable.
Scenario Three: Buying
A common scenario is that a business is
making a decision involving the purchase of
new equipment. The motivation for buying
new equipment can be many. Reducing costs,
improving efficiencies, and opening new
market opportunities are amongst the most
Should you buy the new piece of equipment?
The only sensible answer is "it all depends".
We should make sure we model the impact
of the new piece of equipment through the
financials and make the decision that way. It is
far too tempting (I have seen it happen) to have
a rush of blood to the chequebook during a
machinery exhibition or over a very nice dinner
and a few bottles of red.
In this scenario, we will build on the original
model (Figure 1. Before stock reduction.).
A piece of equipment will cost $50k that is
paid in cash, there is expected to be a $10k
reduction in labour costs, and a scrap reduction
that means we can reduce our raw material
purchases by 5% or $20k.
As you can see in Figure 4., in the first year
the financial performance deteriorates. This is
not surprising, really, as the cash outflow ($50k)
is greater than the savings. In this case I would
be very dubious about buying the equipment;
cash flow is reduced, net assets increase. The
longer-term cash flow benefits of the equipment
may however outweigh the initial negative cash
flow impact and this will have to be assessed
carefully on a case-by-case basis.
We have walked through the three financial
statements, constructed them for a fictional
company and calculated some measures of
financial performance that look at the global
performance of a business. You can now
basically perform simple 'what if' analysis
on the financial impact of the strategies and
actions they wish to undertake, ideally before
financial commitments are made.
The financial statements are most effective
when utilised as 'global' measures. That is, they
look at the entirety of a business operation.
This is what shareholders care about, it is
what CEO and CFO care about. This global
perspective is caught in an apparent conflict
with the desire of the same CEO's and CFO's
desire for control at a detailed business unit,
even individual level. We wish to be able to
monitor, control, and judge the performance
of individuals so as to drive performance even
higher. This desire to measure at a very detailed
level leads to another whole suite of detailed
measures being created and utilised to give us
the feeling of being in control at a detailed level
and of providing for us a simple and clear way
to assess individual performance.
The whole thing is an illusion. The premise
The premise is that by measuring small,
detailed performance in all areas, and improving
those local measurements in each area we
will achieve an improvement in the global
performance of the enterprise. This is such an
erroneous perspective that it is worthy of its own
special edition program of 'Mythbusters'.
Figure 3. Financial
statements -- after stock
reduction, the right way.
Figure 4. Buying new
"Stock reduction is a great way of rapidly lifting
your return on investment."
MHD SUPPLY CHAIN SOLUTIONS --- JANUARY / FEBRUARY 2017 43
SUPPLY CHAIN 43
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