FLOW:
FINANCIAL FLOW
A company must be profitable to survive. Profits reward shareholders, provide growth opportunities for suppliers, and result in increased products and services for the customer. Any form of waste will drain financial resources, a runoff that may be either visible or invisible. Every dollar spent and earned should be treated with disciplined respect. What would our organizations look like if every dollar were treated as if it were our own personal money? The logistics function touches every aspect of financial flow in and out of the organization, from supplier to customer and all operations in between. The three strategic focus areas of Financial Flow are:
Income Statement
Balance Sheet
Cash Flow
These three areas will be discussed in this chapter.
INCOME STATEMENT FLOW
Truism: The income statement paints a mixed picture. On one hand, it shows us the direction we are headed; on the other hand, it fails to uncover significant waste.
Books on Lean and Six Sigma seldom focus on the income statement. They would argue that if you focus on physical inventory flow and the elimination of waste, the results will appear in the income statement eventually. Seemingly, the income statement is a report that outlines the effect of decisions made during the previous accounting period. Managing through your income statement is a rearview mirror approach. A disciplined organization will focus on strategic and operational issues as opposed to the income statement. Even so, in reality, the income statement cannot be ignored. Logistics professionals need to be aware of the income statement and the system feedback that it provides on the following items:
Revenue
Cost of goods sold
Gross margin
Operating expenses
Interest and tax expense
Net earnings
Three key features of the income statement are:
Logistics operating costs may be hidden throughout the income statement.
Logistics processes flow across the entire document.
Inventory carrying costs are not clearly identified in the income statement.
Once again, we stress, Lean is about flow and the elimination of waste. Without argument, reliance on excessive inventory represents the root of many wastes. In other words, a significant majority of the waste that exists in an organization is a result of building and managing unnecessary inventories. Unfortunately, the income statement does not identify the kind or extent of the waste effectively, nor does it tell us what we can do about the waste. In fact, the income statement can actually drive decisions that may have a negative effect on the organization. Figure 13.1 shows a typical income statement and indicates where logistics processes are represented on the income statement.
Figure 13.1. The Income Statement and Logistics Drivers.
Logistics Activities and Hidden Operating Costs
There is no question that logistics is getting more attention in boardrooms these days. Operational costs in logistics can exceed 15 percent of revenue without taking inventory carrying costs into consideration. When inventory carrying costs are considered, total logistics cost can climb substantially higher. Considering the financial impact of total logistics cost, one might think we would manage the income statement and the logistics function from a holistic point of view.
When we say “holistic,” we mean a corporate and perhaps global perspective. To reach this goal, the first step is to examine the income statement and understand where the logistics function is impacting the performance of the organization. The second step is to create a vision of how logistic activities flow across the income statement. From this, we will generate important insights about waste and its financial impact.
To begin, put the income statement into perspective from a logistics point of view. This requires identifying the buckets that make up total logistics costs. Typically, these buckets will be:
Transportation
Warehousing
Material handling
Ordering costs
Inventory carrying costs
We soon find that these key cost buckets are not visible in a neat and tidy manner. For example, transportation costs for inbound raw materials may be hidden in cost of goods sold, whereas transportation costs for outbound finished products may be in the operating expense line. Complicating the situation even further, some transportation costs may be paid by suppliers or customers and factored into piece or finished goods price. This lack of visibility is one reason why logistics and supply chain activities frustrate financial managers. For this reason, logistics has the reputation of being an “evil cost of doing business.” Yet, effective logistics processes are not simply a cost of doing business, but rather a significant point of competitive advantage. Consequently, we need to embrace the fact that logistics costs should be visible and understandable on the income statement.
Logistics Costs Flow Across the Organization
One will inevitably find logistics costs scattered across the entire organization. No particular manager or department is wholly responsible for the impact of logistics on the income statement. The absence of responsibility contributes to the absence of accountability, which contributes to logistics decisions that suboptimize the organization. When we say “suboptimize,” we mean the local decisions made may be optimal, but the overall impact on the firm is not optimal. For example, a purchasing coordinator may get a 10 percent reduction in piece price by buying a full year’s worth of product. In this case, the piece price has been minimized, but the overall total logistics cost will most likely be suboptimized due to the cost of carrying a year’s worth of inventory.
This dynamic of costs flowing across functional boundaries creates a need for collaborative management of the income statement. In other words, the income statement cannot be managed in a vacuum. When this occurs, poor management decisions are made and impenetrable functional silos develop. More importantly, without collaborative management of the income statement, it will be virtually impossible for an organization to execute the Lean task at hand successfully. This is the task of uncovering, articulating, managing, and eliminating inventory carrying costs.
Inventory Carrying Costs and the Income Statement
Most companies struggle to capture inventory carrying costs on the income statement. To understand why, it is necessary to review the DNA of inventory carrying costs. As discussed in Chapter 3, the key inventory carrying costs are:
Capital costs: Represent the cash cost or opportunity cost of inventory investment
Inventory service costs: Include insurance and taxes relative to inventory investment
Storage space costs: Include internal space costs as well as any third-party space in use to store inventories
Inventory risk costs: Include obsolescence, damage, shrinkage, and relocation costs
We are on familiar terms with the all-too-obvious fact that inventory carrying cost items are not plainly represented on an income statement. Case in point: an income statement will not have a placeholder for opportunity cost of capital, cost of space being used specifically for safety stock, or relocation costs of inventory that is obsolete. The income statement does not give us a clear representation of inventory carrying costs that can be used to make effective management decisions. The good news is that Lean and Six Sigma teach us principles that can be used to guide our decisions.
One of these principles is the inventory carrying cost principle:
All inventory carrying costs move in a positive direction with the level of inventory.
This principle states that each and every inventory cost moves up and down with the inventory level. Therefore, if inventory levels go up, so do all inventory carrying cost components. Similarly, if inventory levels go down, so will each inventory carrying cost component (over time, of course, with fixed costs). This principle is good news for us relative to the income statement: Even though inventory carrying costs may not be visible on the income statement, we know intuitively that they will go down as inventory levels go down. As inventory carrying costs go down, positive results will be evident in the bottom line. This is an extremely important learning point because it influences decisions in organizations about whether or not to pursue Lean.
Vision of Excellence and the Income Statement
The income statement attempts to draw a picture of corporate performance over a period of time. Having a time-lapse dimension makes the income statement valuable for understanding flow. As flow happens over time, it is good to be able to see how revenues and costs flow over a specific period. However, as discussed previously, the income statement does effectively identify the costs associated with carrying inventory. Inventory is waste. Lean is about eliminating waste. As a result, we are reminded that inventory carrying costs will go down as inventory levels go down. The job at hand is not to manage the income statement, but rather to focus attention on the elimination of inventory. Excellence will follow when the organization works collaboratively to eliminate unneeded inventories at all levels.
Progressive companies that embrace Lean will reduce their focus on the income statement during the implementation phase of the Lean initiative. If you make decisions based on short-term, quarterly profit goals, then you will never realize the true benefits of Lean or Six Sigma. For Lean to be effective, decisions need to be driven by total cost, and therefore, these decisions may have counterintuitive impact on the income statement. These counterintuitive effects need to be recognized, embraced, and applied so that Lean can achieve success.
Recall that transportation cost is the largest and most visible cost of the logistics activities. It generally has a budget line, which means that it can be managed to a plan versus actual expense from the income statement. Typically, if a large expense line can be measured from a planned number to an actual number, then some employee will no doubt have compensation tied to the actual number in some fashion. The result is a logistics manager who has personal motivation and incentive to keep transportation costs below plan.
In the event that the company in this example embarks on a Lean initiative, the logistics manager will eventually be involved in conversations about increasing frequency of deliveries to the plant in order to reduce inventories. If we are embracing Lean in totality, then this is a given, as delivery frequency is the most powerful Lean tool to reduce raw material level at a plant. To be sure, the results take time, and overall financial benefits may not be realized immediately. That is, the income statement may not show positive results right away. Compounding the issue is that transportation costs may, in fact, go up in the short term to facilitate the increase of delivery frequency, although they will eventually be stabilized with sound logistics design processes. This short-term increase in transportation costs creates a serious problem. First, because transportation cost is visible on the income statement, any trend upward will receive attention and concern. Second, the logistics manager will now look at how personal compensation potentially may be impacted as a result of transportation costs perhaps exceeding a planned budget. What motivation will exist to implement Lean principles if compensation is reduced?
Lean implementation will flourish in an environment where Lean principles are understood and embraced. Of course, we need to manage the income statement responsibly; however, it is important to know that Lean has income statement dynamics that are counterintuitive. In order to realize the benefits of Lean fully, we need to focus on eliminating inventory and the negative effect of inventory carrying costs. To accomplish this requires faith that single line items on the income statement may trend upward, but overall corporate performance over the long term will be improved dramatically.
BALANCE SHEET FLOW
Truism: Warehouses and inventory show up on the balance sheet as assets, yet a Lean practitioner knows they are, in reality, liabilities.
As discussed previously, the income statement provides feedback about organizational performance over a period of time. This may be a month, a financial quarter, or a full year. Similarly, the statement of cash flow shows the aggregate of actual events where cash is being paid out or taken in by the company over a period of time.
The balance sheet, on the other hand, represents a different view of organizational health. The balance sheet shows the current condition of financial and operational dynamics at a particular point in time. This allows us to compare current and past balance sheets in order to understand how managerial decisions impact items such as assets, liabilities, and owners’ equity. The challenge with the balance sheet is that it can create false perceptions of what is good or bad for the organization. For example, two balance sheet paradoxes are:
Inventory sits on the balance sheet as an asset, which implies that inventory is liquid and as flexible as cash.
Inventory turns are calculated by comparing inventory levels from one period to another from the balance sheet.
In addition to these two paradoxes, it is important for the logistician to understand that the overall goals of the firm typically can be described by the balance sheet. Rarely should the goal be to accumulate assets on the balance sheet. Instead, the goal of any organization should be to increase the return on shareholder equity. The balance sheet provides us with a snapshot view that helps to complete the picture and to improve our understanding of these concepts.
Inventory as a Current Asset
A current asset is loosely defined as an asset that can be turned into cash with reasonable ease. This is extremely important to the organization as current assets are used to pay employees, pay suppliers, and fund growth. To look at it from this perspective might suggest that inventory is a good thing. This sounds logical — inventory produces sales, sales produce revenue, and revenue produces profits. The Lean logistician knows that nothing could be further from the truth.
Perhaps the most significant waste outlined in the Lean concept is the waste of overproduction. In fact, other wastes are created because of overproduction. For example, when a company builds finished products for which there is no demand, the next thing it does is to store them. This need for storage creates warehousing expense, another waste caused by overproduction. The overall impact of overproduction is major, but a balance sheet point of view is confusing as it implies that inventory that has no immediate demand is an asset.
Inventory cannot be perceived as cash! If inventory were equated to real dollars, then the automobile industry would not need to discount vehicles in its desperation to sell and retailers would not be so obsessed with sales promotions. Companies have sales to move inventory and to generate cash. Organizations need cash to pay expenses such as employee payroll, suppliers, and overhead. These expenses are the cost of manufacturing a product that is in demand in the marketplace. In other words, if we consume cash by building products that are not required in the marketplace, we force the organization to sell these products at a heavy discount in order to cover the costs of production. This sounds absurd, yet it happens on a regular basis.
Consequently, when managing the balance sheet, Lean Six Sigma logisticians need to have an objective view of inventory. They need to understand inventory levels and whether or not the inventory holdings actually represent
Figure 13.2. The Balance Sheet and Logistics Drivers.
an asset. Figure 13.2 shows a typical balance sheet and where logistics processes are represented on the balance sheet.
Inventory Turns and the Balance Sheet
Inventory turns are an extremely important metric. In a Lean environment, we want inventories to be at a minimum. Therefore, we need to be able to measure our operational initiatives relative to their impact on inventory levels. Typically, this is done by dividing sales (at cost) by the average of on-hand inventories. Average on-hand inventory levels are derived by averaging inventory levels as reported on the balance sheet. The challenge is to ensure that the balance sheet reports an accurate representation of what inventory is actually on hand. Creating false images of inventory levels is all too common and, in the end, accomplishes less than nothing for the organization. We need to ask why this happens.
Lean practitioners know that systems thinking is an important part of Lean. As we have examined, systems thinking leads to systems optimization, which means that we are focused on the overall system rather than individual functional output. Consequently, we want the balance sheet to draw an accurate picture of the system, as opposed to a purposely manipulated picture. To accomplish this, logistics managers must not fear having inventory on the docks at the end of the period or month. If inventory levels are high, they should be reported and a continuous improvement team should be created to understand and fix the problem. We need to know that inventory level reporting is accurate and that the balance sheet is, in reality, a view of the normal system at work. This course of action prevents the distortion of the facts, which can lead to unwarranted, reactionary tampering with the system.
The Balance Sheet and Business Strategy
It is difficult to draw conclusions relative to an organization from a balance sheet. Organizations have differing strategies, and that will be evident on the balance sheet. For example, one organization may buy assets whereas another firm may lease assets. Another firm may prefer centralized, privately owned warehouses when its competitors use decentralized, public warehouses. All of these strategies will appear on the balance sheet in one form or another.
It is hard to say whether or not Lean has a specific strategy relative to the balance sheet. Nowhere is it written that assets should be owned or leased. However, a couple of Lean principles need to be considered relative to balance sheet management. These are flexibility and visibility.
Flexibility
Lean systems need to be flexible. In a Lean environment of pull replenishment and continuous improvement, assets need to be flexible. Pull replenishment means that we replenish inventory as the internal or external customer consumes it. By definition, if demands change, so does the replenishment cycle. To accomplish this, assets need to be flexible in order to accommodate the variation in demand. For example, transportation and warehousing assets should have some flexibility in their procurement. Even if the organization’s balance sheet strategy is to own real estate and warehouses, it should keep flexible a minimum of 20 percent of forecasted space requirements. This will allow continuous improvement initiatives to have a better chance of being implemented as opposed to being caught in the middle of internal politics and functional barriers that typically result when assets are owned.
One Lean paradox is that Lean strives for perfection even though perfection is not attainable. Striving for perfection means to improve processes continuously. This is the spirit of kaizen. Kaizen means slow, incremental improvements instead of drastic re-engineering. However, our systems and asset base need to be flexible in order for improvements to take place. Although it may not seem obvious, this flexibility is part of the balance sheet strategy of the organization.
Visibility
The second Lean principle, visibility, is another concept that is not normally associated with the balance sheet. Yet, the balance sheet provides people with a “picture” of the organization, so assets should be visible to the reader. As Lean Six Sigma logisticians, we need to focus on asset productivity and eliminating waste in the form of underutilized assets. How can we do this if assets are not visible to our managers? By reading the balance sheet, it is crucial that we are able to dig down into the organization and determine where assets are used, where assets can be redeployed, and where assets can be eliminated.
The balance sheet is one of the three main financial statements used to manage an organization. Consequently, the Lean Six Sigma logistician needs to understand the strategy used by the company from a balance sheet perspective. Inventory should not be considered an asset; inventory turns need to be reported accurately, and the organization needs to develop a balance sheet strategy based on flexibility and visibility. With this systems approach, decision making will be easier, better, and more effective management decisions will result.
CASH FLOW
Truism: If cash is king, then logistics represents all the king’s horses and all the king’s men.
If you think of a company as a human body, cash would be the blood. Positive cash flow permits a company to operate, grow, invest, and work toward organizational potential. Without sufficient cash flow, a company is unable to meet payroll, will default on payments to suppliers, and operations will cease. Cash is necessary to sustain the life of an organization.
So what does this have to do with logistics? Once again, the answer is “everything.” To survive, organizations must focus on cash management, which means (yet again) understanding the business from a systems point of view. That is, we need to understand in totality the cash implications of decisions across functional areas. This means understanding the drivers that affect cash flows inside our companies. We need to manage and to control these key cash drivers. When we begin to do so, we will soon recognize that we are managing the supply chain. To manage the supply chain successfully, we need a commitment to sound and disciplined logistics processes.
Cash Flow Drivers
There are seven main business activities that affect cash flow. These are:
Accounts Payable
Accounts Receivable
Revenue Growth
Gross Margin
Selling, General, and Administrative Expense
Capital Expenditure
Inventory
To understand the impact of logistics on these key cash drivers fully, it is important to study them individually. Next we fuse them, creating a picture of the system that describes how these seven drivers work together inside the organization. Figure 13.3 outlines the seven key cash flow drivers and how logistics processes interact with these seven drivers.
Accounts Payable and Cash
No business is an island; we rely on suppliers and trading partners to supply us with goods and services, without which we could not serve our customers. When we purchase goods and services from our supply base, we typically buy on account with a predetermined payment agreement. When payment is due, we use cash to settle our debts. Consequently, the faster we can receive and
Figure 13.3. Cash Flow Drivers and the Logistics Function.
transform purchases into our own products, the faster we will have product to sell to our customers, which ultimately means cash in our till.
Note to the logistician regarding Accounts Payable:
Reduce supplier order-to-consumption lead time.
Reduce work-in-process inventories and focus on inbound logistics in order to optimize use of credit terms with suppliers.
Accounts Receivable and Cash
Accounts receivable is a significant driver of cash flow. In fact, your outstanding days receivables can often be the differentiating factor of the company’s fiscal viability. Remember, cash is the life force of your organization. Employees cannot pay their mortgages with receivables from customers. This is so important that it is tempting to make all salespeople responsible for collections as well as for selling their product. To be sure, an order is not complete until the payment has been received.
For this reason, the Dell model is enviable. Dell receives its cash payment for its product before it must pay for raw materials. Unfortunately, unlike Dell, most of us have to accept the existence of cash receivables. Yet, our ultimate goal can be to receive payment as quickly as possible after we make a sale. This means we need to focus on the perfect order. The perfect order will provide the customer with the right product to the right place at the right time and in the right quantity and condition, thereby alleviating customers withholding payment.
Note to the logistician regarding Accounts Receivable:
Deliver the perfect order every time.
Reduce order-to-delivery lead times so payment is received quickly.
Revenue Growth and Cash
Many management gurus have argued that the only purpose of any business is to develop a customer. The logic here is that without a customer, there is no business proposition. However, some customers are better than others. Therefore, it is important to understand that cash is generated from good customers. A good customer can be defined as one that has a genuine need for our service and allows us to generate a competitive rate of return on our investment.
Increased revenue from “good customers” will result in increased cash flow. So how do we secure additional customers? The most effective way is to retain current customers and to be cost and quality leaders in our industry as we solicit new business. These goals require a strategic focus on logistics and supply chain issues.
Note to the logistician regarding Revenue Growth:
Be able to identify “good” and “bad” customers based on the profitability of individual accounts.
Retain current customers and develop new, profitable customers to generate increased cash flow.
Reduce inventories to become more cost competitive and increase visibility on product and process quality.
Gross Margin and Cash Flow
Gross margin is generally defined as net revenues less cost of goods sold. Gross margin is the first line of profit contribution that a firm will see from operations. It plays a significant role in cash flow. Logically, the larger the gross margin, the more gross income we will have to contribute to corporate overhead burdens and net profit. This will result in cash generation (after dealing with receivable issues described earlier). To increase gross margins, we need to ensure that our cost curves do not grow linearly with our revenue curves. That is, we need to be able to generate increased revenues without a proportional increase in cost of goods sold. This is the quintessential example of doing more with less. To reach this goal, we need to focus on the activity drivers of cost of goods sold. As capable logisticians, we must recognize that many of these drivers are logistics related.
Note to the logistician regarding Gross Margin:
Manage inbound logistics and reduce overall supply chain and manufacturing lead times.
Reduce work-in-process and raw material inventories in order to reduce inventory carrying costs and, therefore, reduce overall cost of goods sold.
Selling, General, and Administrative Expense and Cash Flow
Although not all companies call it the same thing, selling, general, and administrative (SG&A) expense is the most common term used for corporate overheads. Reducing the corporate overhead burden will result in increased cash to the bottom line. Many companies have outbound logistics rolled up into SG&A. Some companies believe that outbound logistics is purely a necessary evil, a cost of doing business. It may come as a surprise to some C-level officers that logistics costs could exceed 12 percent of their revenue. In today’s business climate, where 1 percent of sales can mean the difference between viability and bankruptcy, logistics needs to be an area of concentration. The logistics function can, in fact, become a strategic area for differentiation. There are definitely opportunities for cost reduction with respect to logistics; there are also remarkable opportunities to create a strategic advantage over the competition.
Note to the logistician regarding SG&A:
Improve internal processes and reduce SG&A expenses ultimately to increase cash flow.
Reduce customer order-to-delivery lead time and reduce finished goods inventory to yield competitive advantage.
Capital Expenditure and Cash Flow
Capital expenditures are the best example of how cash flow and accounting income diverge. For example, if you purchase a building for $1 million, you may decide to outlay $1 million in cash to close the purchase, yet the cost of the building will show up on the income statement as depreciation expense over the useful life of the building. The consequence in the first month will show $5,000 depreciation expense, yet a full million disappeared from the cash drawer. Capital expenditures are an immense drain on cash and possibly an area where ineffective decisions are being made. If so, these ineffective decisions may be due to ill-conceived logistics strategies.
Private fleets, warehouses, and advanced supply chain software are three examples of capital expenditures that require significant amounts of cash to finance. How do we know if we are making the right decision? Why would we invest in a private fleet when our for-hire trucking companies have all the latest technology and years of experience in the trucking industry? Why do we continue to build warehouses when we should be focusing on eliminating the inventories that we store in them? When will we learn that there is no magic software pill to cure our supply chain woes? Capital expenditures drain our companies of cash that can be better used in revenue-generating activities. Therefore, we need to focus attention on logistics strategies that take advantage of existing infrastructure, and we need to focus on effective supply chain processes and the people who will fulfill them.
Note to the logistician regarding Capital Expenditures:
Reduce reliance on fixed assets and allow cash to be used on revenue-generating activities.
Focus on reducing inventories as opposed to building more warehouses for inventory you do not need.
Inventory and Cash Flow
Inventory is the most elusive of all the cash bandits. The reason is that everything about inventory is counterproductive. For example, inventory sits on the balance sheet as a current asset. Inventory sitting in our warehouse consumes cash and can be difficult to liquidate (a prerequisite to being a current asset). We have already argued that inventory is, in fact, a liability.
Another counterproductive aspect of inventory is that the more inventory you have, the less likely you are to have what you need when you need it. In other words, too much inventory means inventory that is not needed and may never be needed. To store and move surplus inventory drains cash from our organization.
The third and arguably most significant point about inventory is that inventory itself is visible, yet its costs and cash impact are not. Although we can walk the floors of our facilities and see inventory, we cannot easily go to our financial statements and determine how much cash is being consumed by this inventory. Risk costs such as obsolescence and shrinkage drain cash. Service costs such as taxes, material handling, and interest drain cash. In addition, there is an implicit cost of lost opportunity when money is tied up in inventory, as well as the value of space being used to store that inventory. Any way you slice it, inventory consumes cash.
Note to the logistician regarding Inventory:
Eliminate inventories and conserve cash.
Have the courage to gather the data required to calculate and articulate the cost of carrying inventories.
Vision of Excellence and Cash Flow
To be competitive in today’s market, we need to manage cash like the life force of the organization that it is. Logistics and supply chain activities all affect the seven key cash flow drivers within a firm. Accounts payable, accounts receivable, revenue growth, gross margin, SG&A, and capital expenditures can all be managed more effectively by focusing on logistics issues strategically. The reduction of the seventh cash flow driver, inventory, should become the relentless pursuit of all logisticians.
Alone, each of these seven cash drivers acts independently. Together, they form the organization’s cash-to-cash cycle. This cycle must be understood, measured, and managed in order for an organization to reach its potential. As a logistician, you can learn about cash flow function. Support the placement of a skilled logistician at a C-level position within your firm and as part of boardroom discussions within your organization.
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