CashFlow ABC

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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.

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:

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

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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:

25,000,000

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.

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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.

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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

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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:

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.

-David