Jun 232009

My Podcast Alley feed! {pca-6c7296ef12a7f56be0cf864a4412a32a}

We’ve seen a lot of queries lately asking various questions about the Statement of Cash Flow so we’re going to take this opportunity to demystify this alien evil.  We’re going to use a basic Statement of Cash Flow for Little Johnny’s Lemonade Stand that he set up in front of his house.  For further information on how to prepare a statement of cash flow or to better understand cash flow and how cash flows through a business, check out Understanding Cash Flow from InstantController.com.

Cash Flow from Operations is where the meat and potatoes of the company are.  A company can have a down month or year so the Net Income could be abnormally low, but the Cash Flow From Operations will tell the whole of the story of the direction of the company.  You will want to at least see a positive number in the Net Income and Cash from Operations.

The Statement of Cash Flow always begins with the Net Income number.  This is because the Income Statement is the basis for cash flow through the business – if you don’t make money on the income statement, you won’t normally have cash flow to worry about for very long.  When looking at a Statement of Cash Flow, Net Income should be the first number you look for because it tells the story of whether the company is profitable.  Little Johnny’s Lemonade made a net of $5 for the day – not bad for the little entrepreneur.  Then add back into the net income the expenses that really didn’t cost cash – just depreciation for most companies.  This is because depreciation is a non-cash expense – the cash was paid out when the asset being depreciated was purchased. In Johnny’s case, he only had $0.50.

Items that go in this section are changes in current assets (excluding cash) and current liabilities – the higher volume accounts that cash churns through.  If an asset increases, it is a use of cash – it’s an asset to the business, but it takes cash to pay for it.  By the same token, increases in liabilities are a source of cash because you are delaying the payment of a bill and you have the opportunity to use that cash for something else.

In Johnny’s case, his friend Henry said he would pay Johnny tomorrow for some lemonade today and he drank eight cups at $0.25 each! Thirsty bugger!  So the 8 times 0.25 equals $2.00 in AR that Johnny has.  While he had the sale, he still doesn’t have the cash until tomorrow when Henry pays him.

Mr. Wilson across the street said Johnny could have all the lemons he wanted for $3.00 and he could pay him tomorrow, after he had made his money selling the lemonade.  So Johnny had the $3.00 in Lemons, but he didn’t have to pay for them on the spot, so this is a source of cash because Johnny can now use that $3.00 to buy Dixie cups for the lemonade!  Johnny’s Accounts Payable at the end of the day is $3.00 to Mr. Wilson.

For the first day of operation, Johnny’s Cash Flow from Operations is Adjusted Net Income of $5.50 – $2.00 due from Henry + $3.00 payable to Mr. Wilson, for a total of $6.50.  Any prepaid expenses would also be listed in Cash from Operations with the same rules as any other asset – increase = use of cash, decrease -= source of cash.

Cash From Investing is the section where any long term assets show their effects.  For most companies, this is only Fixed Assets (gross). At the beginning of the day Johnny had to spend $10.00 on PVC lawn furniture to set his stand up with, so he has $10.00 tied up in fixed assets.

Cash from financing is where the effects of debt and equity show up.  If you issue stock, the cash received for the stock would show up in this section as well as any proceeds received from the sale of bonds or from obtaining cash financing.  In this case, Johnny was only 7 years old and had to get $20.00 in venture capital from Dad.  It sounded risky, but Dad chose to roll the dice any way and loan him the $20.00.

Little Johnny’s Lemonade Stand

Statement of Cash Flow






Cash From Operations



Net income



  Add: Depreciation



    Adjusted Net Income






  Decrease in AR



  Increase in AP



    Cash from Operations






Cash from Investing



  Decrease in Fixed Assets



    Total Cash from Investing






Cash from Financing



  Loan from Dad



    Total Cash from Financing






Calculated Change in Cash









Beginning Cash



Ending Cash



  Change in Cash



From all of this, Johnny had an increase in cash of $16.50, which he had in his cash box at the end of the day.  To prove this out, we can do it by looking at the actual receipts and disbursements:

Direct Method




Loan from Dad




Lawn Furniture




Cash Sales












Cash Sales



Adj Net Income



Cost of lemons



Henry didn’t pay






For further information on how to prepare a statement of cash flow or to better understand cash flow and how cash flows through a business, check out Understanding Cash Flow from InstantController.com.

— John

May 292009

In any business setting, you need to be measuring appropriate Key Performance Indicators (KPI’s) to keep on top of the performance of the business.  The basic process for utilizing KPI’s is:

  • Identify what measurements are most important to your business
  • Measure the “current state” of the KPI’s
  • Establish targets for where you want them to get to
  • Measure the KPI’s on a regular (usually monthly) basis
  • Analyze the results and identify opportunities for improvement
  • Hold employees accountable for the numbers that they are responsible for

Working Capital
Working Capital (WC) is Current Assets minus Current Liabilities.  It is a measure of how well you churn cash through your organization.  The two largest components of WC are Accounts Receivable and Inventory.  If your inventory is too high, you are probably paying cash out too early and if A/R is too high, you’re not collecting fast enough.

Working Capital Turns
WC Turns are Sales/WC.  It is a measure of liquidity and how well you utilize your WC.  Higher turns are better – it indicates that you are converting your investments in the business into cash quickly.

Inventory Turns
Invetory Turns are calculated by Cost of Goods Sold (COGS) / Average Inventory.  Higher turns are better.  6 turns means that you turn the inventory six times per year or, conversely, you have two months of inventory on hand.  This ratio indicates how quickly your business is turning over inventory.  A high ratio may indicate positive factors such as good stock demand and management. A low ratio may indicate that either stock is naturally slow moving or problems such as the presence of obsolete stock or good presentation. A low ratio can also be indicative of potential stock valuation issues.

Days of Inventory
This is a sister to Inventory Turns – just expressed in days.  The calculation is 365 / Inventory Turns.

Accounts Receivable Turns
Accounts Receivable (A/R) Turns are a measure of how quickly you are turning sales into cash. The calculation is net sales ÷ average trade accounts receivable.  High ratio means shorter time between sales and cash collection. Lower means the opposite. If ratio is lower than peers, the quality of AR should be examined. Note that ratio may be affected by seasonal fluctuations in sales or if a large portion of sales are cash based.

Days Sales Outstanding
Probably the most prevalent of the A/R related KPI’s.  There are several ways to calculate DSO, including the clawback method, but the most common is 365÷ A/R Turns.  DSO is an expression of the A/R turns in terms of days rather than annual cycles.  The higher the number, the greater the probability of delinquencies. Interpret this in line with the company’s credit and collection policy or payment terms.

Past Due Percent & Past Due Dollars
These are two different measurements, but I list them the together because they should always be looked at together.  Past due percent is the past due dollars divided by the total A/R.  Because of fluctuation in sales month to month or quarter to quarter, the percentage can be skewed one way or the other by the fluctuation in sales.  When analyzing the past-dues always look at both together or you’re only getting half of the picture.

For further assistance in measuring your KPI’s check out the Financial Analysis templates in Excel from InstantController.

For monthly A/R tracking templated with graphs that are ready for your data, check out the A/R Management Bundlefrom InstantController.

– John

May 152009

EOQ is a method for setting a consistent order quantities that both minimize ordering and inventory carrying costs.  EOQ can be used hand in hand with reorder point systems as they function under similar assumptions:

  • That demand is relatively constant and known.
  • The order quantity is usually the same.  (The EOQ will remain constant until the review period or if changes in the supply chain warrant a reformulation of the EOQ.)

EOQ has some additional requirements and assumptions:

  • The product is purchased or produced in batches or lots.
  • Order preparation costs are known.
  • Inventory carrying costs are known.
  • Annual usage is known.
  • Replenishment occurs all at once.

Let’s look at EOQ’s requirements and assumptions one at a time:

  • The assumption that the product is purchased or produced in batches or lots is due to the consistent nature of the EOQ and the demand that determines it.  In other words, you won’t be ordering 7 now, 3 tomorrow and 12 next week.  The EOQ is formulated and is set until the next review period.  However, if the EOQ calculates to a number not divisible ty the batch or lot size you will need to round the EOQ up to a quantity divisible by the batch or lot quantity.
  • You will need to know your order preparation costs.  This holds true for both purchased and manufactured items.  You’ll need to know:
       – The number of orders placed annually.  This is determined by the annual demand / the standard order
         quantity.  If there is no standard order quantity use the average order quantity understanding you will need
         to review the EOQ sooner than anticipated.
      – How long it takes to process an order and the overhead costs associated with that process such as employee 
         salaries and the costs of purchase orders.
  • The inventory carrying costs in the EOQ are expressed as a percentage of the average annual inventory.  The inventory carrying costs fall into 3 main categories with the following sub-categories:
      – Capital
         – Inventory capital
         – Insurance
         – Taxes
      – Storage
         – Handling
         – Security
         – Storage
         – Record keeping
         – Space
      – Risk
         – Deterioration
         – Theft
         – Obsolescence
  • You will need to know your annual usage.  If that isn’t known you can extrapolate the data but you will need to review the EOQ sooner than anticipated.
  • Replenishment arrives and is ready for use all at once.  No partial shipments or a portion of the order quantity held in a QC queue for example.

 The calculation for the EOQ is: the square root of 2 x the annual demand x ordering costs / annual carrying costs x the unit costs.  As an example:

Annual usage = 1,000,000

Ordering costs = $5

Inventory carrying costs (as a percentage) = 0.20 (20%)

Unit costs = $2

Square root of:

2 x 1,000,000 x 5 / 0.20 x 2  or…

Square root of:

10,000,000 / 0.40  or…

Square root of:


EOQ = 5,000

If you wish to lower your EOQ you must take into account the following:

  • As your annual demand increases so does your EOQ to satisfy the increased need.
  • If your inventory carrying costs decrease your EOQ will increase as it is now more cost efficient to carry more inventory compared to unchanging unit costs and ordering costs.
  • If the unit costs decrease your EOQ will increase as it is now more cost efficient to purchase more inventory compared to unchanging carrying costs and ordering costs.
  • If you decrease your ordering costs your EOQ will decrease as it is more cost efficient to place more frequent orders compared to unchanging carrying and unit costs.

So, to lower your EOQ batch size you must lower your ordering costs.  This can be achieved through applying lean principles or mapping the process, identifying the waste and then removing the waste from the process.

If the EOQ assumptions and requirements are not valid for your company there are many other methods for ordering replenishment but you should always use a method that will keep your carrying costs and ordering cost to a minimum.

May 132009

Asset protection

Form an LLC or incorporate to protect your personal assets – Don’t comingle.  Use a business entity to separate your personal and business self.



Payroll first – pay your employees first or they will soon be former employees.

What will generate cash?  Figure it out and and pay those bills first to generate the short-term cash flow and keep the cash churning.



Don’t vanish – keep the communication going with your suppliers, customers and employees.  No matter how bad it is, never let them see you sweat – always be confident or they won’t be confident either.

Kill the rumor mill – as the environment gets worse, the rumor mill will take on a life of it’s own.  Show confidence and kill the rumor mill before your competitors start feeding it.


Use the business’ resources

Customers – look for sales and prompt-pay opportunities.

Suppliers – look for sales, return opportunities as well as extended terms.


Cut the crap

Fire-sale the overstock – it’s time to get rid of the crap that you’ve been leaving in the back of your shop -turn it into cash!

Look at new opportunities on Ebay, Craigs List, etc..


Think unconventionally

Can I leverage what I do into other markets?  This is a great opportunity to grow the breadth of your business doing the things that you already know how to do!


Cost control

Don’t throw the baby out with the bath water – control the costs rather than cut them.

Employees – take care of them!  If you’ve normally bought lunch every Thursday try to continue it to avoid throwing up a red flag with your employees.

Marketing – This goes along with not throwing out the baby with the bath water.  Tough times are when most companies cut back, but the ones who do the best and recover the strongest are the companies who come out of the funk with a strong marketing effort.


Loan covenants

Don’t let them bite you – If you’ve normally not had to worry about your covenents, they can sneak up on you really quick if you’re not careful.

Work with your banker – Your banker wants you to succeed too!


Cash forecasting

Start small – 4 weeks:  It’s tough (and inaccurate) in the beginning until you get over the initial learning curve.  As you get better at it, start extending out into the future.


Grow – 8 weeks:  If you can effectively forecast cash eight weeks out, you are probably miles ahead of the competition.

Triumph – 13 weeks:  13 weeks is the goal of most cash forecasts – that’s three months!  Of course, the further out it is, the less accurtate, but it at least starts to paint the picture.

— John

Apr 282009

A reorder point is a calculated stock level that, when reached, generates replenishment either through procurment or manufacturing while leaving enough inventory to satisfy demand during the replenishment process.

Reorder points work better in situations where demand is more or less constant and predictable or with slight variation.

All reorder points contain safety stock to absorb variations in demand. The purpose of safety stock is to reduce or eliminate stock outs due to variablility in either demand or replenishment. Safety stock levels are determined by various issues such as lapses in inventory integrity, receiving delays, supplier issues, scrap, damage and demand variability. Safety stock is also dependent on order frequency, desired service levels and forecast accuracy. We’ll cover safety stock levels at a later date.

Reorder points are based on demand history and therefore reactive. Regular periodic review is necessary to maintain the proper reorder point.

When using reorder points it’s very important to maintain communication with your suppliers as reorder points have a degree of “surprise”.  This surprise is due to the order being generated by a stocking level rather than set ordering schedule as with periodic ordering. Reorder points usually use consistant order quantities which is usually beneficial for suppliers.  The surprise can be deminished through open communication of the demand and changes in the demand, safety stock and any changes in the supply chain parameters that would affect the safety stock.

As with so many issues discussed here you will need to know and understand your demand.  You will also need to know your replenishment lead time.  Your replenishment lead time must be from the moment your reorder point is reached to the time the replenishment is ready for your use. This means you will need to take into account:

  • Purchasing or manufacturing planning lead time.
  • Supplier or manufacturing response or production lead time.
  • Transit lead time including any possible transit delays such as harbor inspections.
  • Receiving process lead time.
  • Any inspection or QC leadtime.

The calculation for determining a reorder point is:

(demand x replenishment lead time) + safety stock

Below is a graphic example of the reorder point with simulated usage:


As stated above the order quantity used is usually fixed but should be large enough to ensure you’re not at or below your reorder point when the replenishment is available for use.

For a reorder point system to work you will need a reorder point signal.  This can be done using several different methods such as:

  • Visual reorder points – This is the infamous crack in the wall method and can be very effective providing you can move the crack when the reorder point changes.  Any visual que can work such as: an empty bin, shelving or other indicator.  At the company John and I worked together we used a rolling sign on the floor next to the product as a visual reorder point.
  • Automated reorder points – These are calculated using a computer and sometimes using MRP.  When the item in question reaches the reorder point it is placed on an replenishment exception report or a planned PO or work order is created.  Then the planner or procurement specialist reviews the planned orders and releases them as they see fit.
  • Kanban – This system is usually used with a card.  When the reorder point is reached a card is retrieved and taken to the person assigned to replenish that item.

Reorder points are powerful tools that you can use to ensure material availability without maintaining excessive amounts of material.  They do, however, require that you review them at regular intervals to ensure they’re accurate.

Apr 212009


Lets talk about cash flow & understanding the statement of cash flow.

Revenue, or sales, accounts are the selling value of goods or services billed to the organization’s customers.  Revenue, also called “the top line” because of it’s location on the income statement, is the starting point for calculating net income.

Expenses are subtracted from revenues to get net income, which is the starting point for the Statement of Cash Flow.  The reason that net income is the starting point is that, in a perfect cash-only world, net income would, in fact, be your cash flow.  Even in an imperfect world, net income or loss is the basis for the direction of the cash flow.

After you have the net income, you add the non-cash expenses back into net income to arrive at an “Adjusted Net Income”.  This is for items such as depreciation and amortization expenses because the cash was paid out at the point of acquiring the asset and the depreciation and/or amortization is only an administrative entry that has no effect on cash.

Cash from Investing

    Buying & selling of investments & fixed assets

Cash from Financing

Activities related to debt & equity


Cash from Operations


The term, “operations”, is used broadly here.  It means cash generated from the regular operating of the business, doing what the business normally does in the regular course of business.

Increases in assets such as prepaid expenses and Accounts Receivable are considered a use of cash.  In the case of prepaids, cash has already been spent which caused the asset to increase.  An increase in Accounts Receivable is considered a use of cash as well, because Accounts Receivable is nothing more than materials, labor, overhead, and profit monetized together in the form of an invoice to the customer which is now receivable.  Conversely, a decrease in prepaids would indicate that it has flowed through the Income Statement and is a source of cash.  A decrease in Accounts Receivable also implies the receipt of cash, so the decrease in Accounts Receivable is considered a source of cash.

On the other side of the coin are accrued expenses and Accounts Payable.  Increases in liabilities, such as Accounts Payable and accrued expenses are a source of cash because we are delaying payment on these items, thus we are able to use that equivalent cash somewhere else in the business. 

As an example of this, think about a $150 invoice from an electrician to fix a light switch.  The work is performed in March and you have net 30 terms.  In the Statement of Cash Flows, the effect of the $150 in March is to reduce net income by $150 and, because you have net 30 terms, it would be a source of cash in Accounts Payable because you didn’t pay for the expense.  The effect on cash in March is zero and is shown by a “use” in the reduced net income and a “source” in the increased Accounts Payable.  In April, when the bill is paid, Accounts Payable is reduced which becomes a use of cash on the Statement of Cash Flows.

Operational Impact


Inventory is an asset so it’s a good thing, right?  What about Accounts Receivable, or overall working capital?  Yes and no to all of these.  But we have great terms – we get net 60 days!”  Great!… but while extended terms for Accounts Payable is a great thing for your cash, too much of a good thing (Accounts Receivable, inventory, etc..) can kill a business.

 Many private companies have three months, or more, of raw material inventory on hand, two weeks in work-in-process, six weeks in finished goods, and then they have sixty days of sales outstanding in their Accounts Receivable.  In this scenario, you bring material in and it will be seven months before you turn it into cash (3 months + two weeks + six weeks + 60 days).  If the firms’ suppliers give net 30 terms, then it’s down to six months.  These numbers are very common and in this situation, the company has to have the ability to finance its’ self for the six or seven month period before the company sees the cash for the product that it just brought in last month.

For more on understanding cash flow, see Understanding Cash Flow fom Instant Controller.

Also mentioned in the episode are the books, The Goal, and The Great Game of Business.  Click here for more details.

Apr 162009

A forecast is an estimate of future demand based on market indicators and/or past performance plus market indicators.   We forecast to reduce the amount of uncertainty in order to prepare for demand.

Who is impacted by a forecast?

  • Finance
    • Investment capital
    • AP forecasting
    • Operational budgets
  • Inventory planning – for make to or order to stock environments.
  • Capacity planning – to ensure forecast does not exceed the ability of the company.
  • Procurement – to obtain the raw materials or products to support the forecasted sales. The finished goods forecast is broken down further into the materials planning requirements through the bills of materials.
  • Operations
  • Investors

Issues you need to consider

  • Data
    • Quantitative
      • Seasonality
      • Sales history
        • Record “actual” demand not sales history.
    • Qualitative
      • Expert opinion
      • Customer groups
      • Market estimates
  • Supply availability
    • Supplier or production issues.
  • Capacity
  • Available Capital
  • Current market conditions
  • Frequency of the forecast
  • Your planning horizon
    • Your longest lead time item will determine your planning horizon.
    • Aggregate forecasts are more accurate.
      Determine detail through product families and planning bills.  Below is an example of a product family planning bill:
    • Planning bills use individual item and family demand history to breakdown an aggregate forecast into individual item requirements.

Measure your forecast performance.




  • Rate of forecast consumption.
    • Divide your forecast into smaller periods to track the consumption.  As an example, divide a weekly forecast into daily checks.  If the forecast was 100 for the week you should sell 20 per day if your demand is flat.  Take into consideration any increases or decreases based on your historical demand or known forecast indicators.
    • If possible adjust the forecast to match the new rate of consumption.
  • Compare forecast to actual demand.
    • Track forecast accuracy by period.
    • APE (Absolute Percentage of Error) – The absolute of ((actual demand – forecasted demand) / actual demand) x 100.
      • Does not consider the direction of the variance.  Used to calculate the absolute variance for a single period.
    • MAPE (Mean Absolute Percentage of Error) – The average of the APE across a range of periods.
    • MAPE (Mean Absolute Percentage of Error) – The average of the APE across a range of periods.
      Does not consider the direction of the error.  Used to calculate the absolute variance across a range of periods. Below is an example of the APE and MAPE.
    • MAD (Mean Absolute Deviation) – The absolute of (actual demand – forecasted demand) / # of periods.
      • Does not consider the direction of the error.  Used to calculate the absolute variance across a range of periods.
      • Also is approximately the standard deviation / 1.25.
    • Standard Deviation – The square root of the absolute of the actual demand – the forecasted demand squared / the number of periods.
      • Does not consider the direction of the error.  Used to calculate the absolute variance across a range of periods.
        Also is approximately the MAD x 1.25.  Below is an example of the standard deviation equation:
    • Bias – Forecast bias is a consistent variation from the average (mean) in one direction.  The goal is a bias of zero.  This demonstrates that any variance is due to normal fluctuation and is not attributable to the method or data.  In the example above the variance total is 700.  That divided by the number of periods is +54.  This is a positive bias and you need to determine why the forecast is higher than the actual demand so you will understand the reasons for lowering your forecast or why demand has fallen short of forecast. 



  • Understand the inaccuracy.
    • Reasons for forecast inaccuracy
      • Lack of participation
      • Inaccurate data
        • Qualitative
          • No hedging or “sandbagging”.
        • Quantitative
      • Incorrect method
      • Inappropriate data
      • Insufficient data
      • Lack of monitoring
      • Oops
  • Apply what you have learned.



Forecasts are nothing more than educated guesses.  And, as human beings, we do best what we do most often.  So that being said the more often you follow proper forecasting processes, understand that it won’t be “perfect”, understand your variances and apply what you have learned to your next forecast your forecast will only get easier and more accurate.  This will help you service your customers and keep costs down.

– David

Apr 102009

This episode of CashFlow ABC is on effective AR management. 

Accounts Receivable is one of the largest components of working capital for most companies, and the one most easily turned into cash. 

We highlight and discuss the essentials to maximize your current and future cash flow through accounts receivable.

1.  Measure, analyze, improve
   a. If you don’t measure, it won’t improve
   b. Accountability & incentives
   c. Cash flow from operations
   d. Percentage past due
   e. Dollars past due

2.  Tools
    a. Spreadsheet
    b. Graphs
    c. Credit policy
       i.   Credit application
       ii.  Personal guarantee
       iii.  Credit checks
       iv.  Credit limits

2A.  AR Management Bundle

3.  Develop a process
      a. Pro-active calling
      b. Past due calling
      c. Credit hold
      d. COD/CIA
      e. Positive cash flow
      f.  Prompt pay discounts
      g.  Records & notes
      h. Letter writing services
      j. Collection agencies
            i. Commission goes up with age

4.  Risk management
      a.  Credit limits
      b.  Credit insurance
      b.  UCC filings
      c.  Consignment
            i.   Doesn’t belong in risk management
            ii.  Increased risk limited to stock value
            iii.  Increased sales
            iv. Leverage for UCC filing
      d.  New customers
            i.   Customers fleeing their past due accts
            ii.   Financials
            iv.  Do they use asset based lending or factoring?

5.  Customer relations
      a.  Think win/win
      b.  Positive cash flow
      c.  No news is not good news
      d.  Little things matter

We welcome your comments and participation.

– John

Apr 022009

Materials management is the sumo arena the company’s other departments wrestle in.  Each of these departments; sales & marketing, production and finance will have different ideas on how the company is to prosper and make a profit.  Sales and marketing want a seemingly endless supply of finished goods and replacement parts to maintain sales without a single stock out, production wants an endless supply of raw materials and WIP so they can meet all the production requirements of sales and marketing and finance want to keep just enough material on hand to satisfy customer orders without any material left over.  Materials management must balance these often conflicting objectives while maintaining high levels of customer service.

You must remember that every dollar not spent is a dollar of profit.

To maintain the proper level of inventory you need to understand the demand for your products.  You’ll need to understand your company’s:

·     Sales trends

·     Any sales seasonality

·     Demand for replacement parts

·     Any variations in your demand whether they are random or cyclical. (Random is any fluctuation that doesn’t follow a pattern while cyclical fluctuations follow a pattern.)

When you do encounter fluctuations in the demand you will need to record the reason for the fluctuations.  This understanding will help provide more accurate inventory levels and forecasts. (More on that later…)

The focus this week is on finding some “low lying fruit” or those items that obviously have excessive levels of inventory.  You’ll need to begin by tracking your usage or demand.  The time frame will depend on your business needs and model but the most widely used is weekly average demand.  You can use daily average demand but that will require a larger commitment as you will need to track demand more frequently.

Then determine the “Mean Absolute Deviation” of the data you’ve collected.  The “MAD” is the average of the absolute value of the difference between the demand and the weekly average of the data being collected.  As an example, if the data for a fore week period is 5, 15, 15 and 5 your weekly average would be 10.  The absolute value of the difference between each data point and that average is 5.  Add the MAD to the weekly average to arrive at the proper inventory level.  In this case 10 + 5 or 15.  Below is an example:


Period 1 2 3 4 Avg. Inventory 
Demand 5 15 15 5 10 Level
Weekly Avg. 10 10 10 10 MAD 15
Absolute Difference 5 5 5 5 5

If you’re a manufacturer you will need to blow this down through your bill of materials to ensure there is sufficient stock of your subassemblies and raw materials.


Now track your average on hand inventory.  To keep this simple just take the beginning inventory level and the ending inventory level for the period being tracked and use the average of the two.  Make sure you didn’t have a last minute receipt or reduction in inventory that would give a false average.

Also review your demand to make sure there isn’t a recurring spike in demand that isn’t captured within the MAD plus average.  That would be an example of cyclical variation.  You don’t want to reduce your inventory so this demand is backordered or otherwise unfilled.  Depending on the type and frequency of the high demand and your material lead times it is possible to lower your inventory while meeting this demand.  But, for now, let’s stay focused on the low lying fruit.  Below is an example:


You’ll need to inform and work with your suppliers and production team as they may need to reduce the flow of product to make the reduction a reality.

This all sounds overly simplistic and it is.  As I mentioned earlier we are looking for the low lying fruit.  There are more complicated methods for inventory tracking and reduction but every company I have ever worked for was able to track demand for a short time, measure the inventory levels, make immediate reductions and save cash.  I wanted to provide you with the means to achieve a quick win so you can reap early benefits and see the value of these methods.


Mar 252009

Welcome to the kick-off for CashFlowABC, where we teach you the ABC’s of cash flow. 

CashFlowABC will be a bi-weekly podcast covering all avenues to improve your cash flow.  We will be looking at how you manage inventory, accounts receivable, accounts payable, your supply chain, lean principles, kaizen events and more.

Most importantly, we need your input.  There will be at least one blog post for each podcast with the show notes and we need you to post your questions as comments to the post so that we can follow up.  Also, if you have insight into someone else’s issue, please post your response – this is a community.  It’s important that you post your questions because this is about solving your issues, not us talking about our problems.

This podcast & blog are by John Leonard and David Dahl– to see their bio’s click on their names either here or at the top of the page.

The podcast will cover administrative areas such as accounts payable and accounts receivable and demonstrate how they impact your cash flow, as well as operational areas such as supply chain management, continuous improvement, and lean.

We will discuss methods for controlling excess inventory and improving out-of-control A/R in the first couple of episodes, and in all cases we will use real-world examples of solutions that have working in Fortune 50 companies as well as small businesses.