Cracking the Code of Supply Chain Metrics

Ever wondered why your supply chain metrics sometimes don't add up? Join us on the Chain Reaction Podcast as we uncover the mysteries behind fluctuating inventory turnover, return on assets, profit, cash flow, and accounts receivable. Learn how unexpected spikes in energy and labor costs, coupled with time lags in financial transactions, can create short-term financial hiccups. We'll show you how to analyze these metrics and manage cash flows effectively to sustain long-term financial stability in your business.

In our deep dive into the financial flows of a business, we'll examine the delicate balance between accounts payable and receivable. Discover the intricacies of purchasing cycles, invoice processing, and the importance of timely payments to maintain supplier trust.  Additionally, we'll break down the significance of gross margins in supply chain profitability, shedding light on how to set prices and manage costs. Tune in to grasp the critical financial measures that underpin informed business decisions and drive organizational health.

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Transcript

Tony Hines: 0:05

hello, tony hines. Here you're listening to the chain reaction podcast, all about supply chain advantage. Well, great episode coming up and it's all about this question what happens when the numbers don't add up? What should we do? Do we panic, do we try to get to the bottom of it? Do we try to understand the numbers and do we try to take remedial action? And should we take that remedial action? Well, we're going to discuss some of those things in the episode today. So stick around, stay tuned, get informed and get that supply chain advantage.

Tony Hines: 0:40

So, when the numbers don't add up, what should we do? And what do I mean by saying the numbers don't add up? What should we do? And what do I mean by saying the numbers don't add up? Well, it's about metrics. It's about the performance metrics and when the metrics aren't as they should be, for example, what happens if the inventory turns not as fast as it should be? What happens if you can't get a return on your assets like you expected? What happens if your profits are down? What happens if the cash flow numbers drop? What happens if debtors don't pay up and your account's receivable? You just can't get that money in? And what happens if you can't pay your suppliers for the goods that you've bought.

Tony Hines: 1:16

Well, we're going to take a look at that and what it means to the whole supply chain as we look at those metrics. Well, here we are looking at the monthly figures. We're sat in the boardroom and we're looking at profit and we see the profit numbers are down. And then we ask the CFO what's happened to profit? And he says, well, sales volumes have been maintained, but the costs have gone up. And then you begin to look and unpick those costs. Where have those costs actually gone up? You might ask that question. And then you might say well, we've had to spend more on energy than we planned, than we'd budgeted for, and we've also had to spend more on labor costs. We've had to incur some overtime payments that were unexpected, unplanned, and that's because demand has actually gone up, but the sales volumes have been maintained. Demand's gone up, profit's gone down, energy's gone up.

Tony Hines: 2:13

Why is that? Well, there's a time lag. Although we've got the demand, those goods won't be going out until next month. And next month, when they do go out, of course we've got the increase in distribution costs to send out the higher volumes to our customers. Right, okay? So there you get the picture of one scenario where some things aren't quite coming out as we budgeted for oh and, by the way, our cash flow has gone down and that's because those sales haven't gone through the system yet and we haven't got the accounts receivable coming back Ah, okay through the system yet and we haven't got the accounts receivable coming back ah, okay.

Tony Hines: 2:46

So you can see how very quickly things can get out of hand, and not always because, I said, the numbers don't add up. Well, they don't add up in the sense that the numbers are going in the wrong direction, but actually the business plan is going in the right direction because our demands up, we've got more customers, but we just haven't got the goods out there yet to get those things back in. So there's a time lag. Well, anyone used to looking at figures and looking at those profit and loss accounts and the balance sheets and the cash flow statements, and if you do that on a monthly basis, you very quickly begin to get a feel for what's going on in the business and you can tell a story about the business through the numbers that you see in front of you.

Tony Hines: 3:35

And it's all a matter of timing when we talk about time lags time lags are very important. You have to understand that if you invoice somebody and you've got 30-day terms, it will take at least part of those 30 days, if not all of those 30 days, to get the money in. If you can get it in sooner, that's good because that means you get the cash in faster. So your cash flow is cranking up and that's good for the business. You also realise that when you buy goods on credit that you get the same kind of terms 30, 60, 90 days. Credit and whatever you've negotiated for that credit period means that you've got time to pay for the goods that you've ordered. So if you could get your goods out the door, invoiced and you get the cash in in three or four weeks and you've purchased materials for the inputs to make those goods six weeks prior, that makes a total of 10 weeks. So if you've got 10 weeks in your credit payment system and on the terms that you get, well that's okay because it will balance out. You'll have the cash in before you have to pay for the raw materials and the labor costs and everything else that has been incurred in getting those goods into the company. Of course you'll have the weekly outlays for wages and labor that you'll have to pay to employees in the company. But if you can keep the cash turning over, that helps with that too. In over, that helps with that too.

Tony Hines: 5:06

And of course, that's been the basis on which banks have operated overdrafts for companies for years and years, because they understand that the flows of money are not always matched and overdrafts are basically short-term loans to facilitate the cash flow situation. Now, in that example that we've just discussed and I said, three or four weeks is the period that you have to get your money in from customers. Now, if customers pay immediately on receipt of invoice, there isn't a problem. Or if they pay within the time period of 30 days, there isn't a problem. But if they're late, of course, then the clock's ticking and there could't a problem. But if they're late, of course, then the clock's ticking and there could be a problem. So if you've negotiated trade terms with your supplier of 90 days, that gives you nearly 13 weeks. It's somewhere between 12 and 13 weeks. It's 12 weeks and six days, actually, isn't it? That's what it is, and you've got 12 weeks and six days. So if you pay within the 10 weeks that we talked about, that's not a problem but say there's a couple of weeks delay from your customer, then you can see you're starting to slip over your payment terms in terms of the cash flow. So unless you've already got cash in the bank or means of payment then in the form of an overdraft, then you'll have a problem.

Tony Hines: 6:24

That's where cash flow problems come into play and, of course, what many companies do to overcome cash flow problems is they enter into factoring arrangements. In other words, as soon as the invoice is issued, they will receive cash from the factoring company. Now the problem is they don't get all the cash. There'll be a deduction 5%, 10%, whatever it is for the factoring company, and that's how they make their profit. They'll give you the cash, but they want to cut. And for some businesses, that can work to their advantage because it means that they don't incur cash flow problems. They don't enter into expensive overdraft arrangements, but they simply are guaranteed on the issue of the invoice that they will be paid within a couple of days.

Tony Hines: 7:09

Now you will know as well as I do that businesses work in cycles and the short-term cycles are what we call the use of working capital, and that's what we're involved with mainly in supply chains. We focus on the working capital of the business and one of the things we'll look at is we'll buy materials in. If we focus on the working capital of the business, and one of the things we'll look at is we'll buy materials in if we're a production firm and we'll buy labor in and we'll incur overhead costs, and those overhead costs will be all the costs for purchasing energy. It might be labor costs and salaries of office workers that we have to pay that aren't directly related to production but are sold in units of time. For example, we work for a salary which is a month and we're paid monthly, usually in arrears, not in advance. Workers give their labour for a month before they get paid, so they're actually giving credit to the organisation too. So businesses live off credit, they live off labour credit, they live off materials credit and they live off credit from other suppliers who provide them with services and goods. And so the credit cycle is very important and it's the credit cycle that determines the working capital.

Tony Hines: 8:23

It's the time in the cycle that's important and it's about getting balance across time. So, for example, we buy materials that we've talked about and then we have invoice terms. We procure those materials from wherever in the world they're delivered to our business and then we have to process the invoice when we receive it from the supplier and pay them. But the payment is a delayed period and it might be 30 days, 60 days, 90 days, whatever the terms of the contract say. And of course, in business, because of ethical considerations and integrity and the fact that you want trust to be in the relationship between yourself and a supplier, because you want to continuously use the supplier to get goods from them, then you have to pay them on time and if you pay late, they will become distrustful or they might be thinking well, what's happening here? Have they got cash flow problems? Have they got an issue about payment? Of course, sometimes we hold an invoice back, don't we? And we hold it back because we're not satisfied with what's been supplied, and we might get in touch with the supplier and discuss the problem with them and decide on a way forward to resolve an issue.

Tony Hines: 9:42

Similarly, when it comes to making a sale, we make the sale usually on credit terms and those credit terms, again, could be 30, 60, 90 days, whatever the terms of our contract with the customer say, or there might be instant, of course, if it's a consumer that's purchasing our goods directly. It might be paid with a credit card, or it might be paid by cheque or some other means of payment, a bank transfer, but it will be paid according to the terms of sale. Consumers don't expect credit unless they've arranged a special arrangement, a credit arrangement with the company in some sense. And of course, for big ticket items that's often the case Goods will be purchased on a higher purchase agreement or on the basis of some credit given from the company, so you can pay over a number of months, or maybe on a bank loan that they've obtained for the purchase. If it's a big ticket item, such as an automobile or some white goods, or for some housing renovation, some building work, whatever, but if it's a large amount, they will probably have negotiated some credit Once the sale is made.

Tony Hines: 10:53

If it's a credit sale the sort that we've talked about, where it's invoiced and there are terms involved 30 days, 60 days, 90 days, whatever it is then you have to keep an eye on the payments coming back from those customers. So somebody has to be responsible to chase up those accounts receivable Because, of course, if they don't, it could be the case that they get overlooked or they get pushed back. The customer may simply just have forgotten to pay the invoice, or the customer might be deliberately withholding the cash because they've got a cash flow problem themselves, or they might be withholding the cash to test what they've purchased in some way in their own organization. First, it might be a machine part, or it might be some other piece of equipment, and they want to make sure it's working properly before they actually hand over the cash to you. They want some kind of leverage, in other words, to come back and negotiate if something is not quite as it should be. So it's important to find out, and the person who chases the accounts receivable is the person who will find out the reasons why a company may not be paying. Now, in the next episode of the Chain Reaction Podcast, I'm going to be talking to Josh Simon, and Josh is the Global Risk and Receivables Manager for a company called JAS Worldwide, and they're a freight forwarding company and they operate in 100 countries around the world, and Josh will give us his insights into managing accounts receivable. So you'll find out much more about accounts receivable in that particular program and why it's an important part of managing a business risk.

Tony Hines: 12:39

Of course, when people think about supply chains, they often think about material flows and operations, but of course, managing a supply chain is much more than that. It's a central part of the business. It's not just material flows and it's not just operations. It goes beyond that, it stretches. It's about information, managing data, keeping on top of things, finding out from the data what's happening in the supply chain and having those antennae out to understand how the world about you is working. And so we take into account all these notions of the risks in the external environment, in our supply chain networks and the ecosystems that we're involved in with other suppliers and customers, government influences and the geopolitics, and also the financial flows. And financial flows shouldn't be overlooked. They come from our supply chain activities are very essential to understand and manage for the well-being of the organization.

Tony Hines: 13:43

It determines the organization's health, and the health check is the data, some of the key metrics that we actually work out when it comes to looking at things like accounts payable and accounts receivable, that's, debtors and creditors in balance sheet language. Then, when we look at the accounts receivable, we quite often look at a ratio that's called cover. We quite often look at a ratio that's called cover. So, for example, how much cover do we have in terms of days? We can narrow it down to days and we simply work out what the proportion of debtors to sales as a ratio actually is. So, for example, if we sold £500 or $500 worth of output and we have on our balance sheet currently £2,000, the ratio of outstanding receivables or debtors for the goods that we've sold is 4 to 1. And we can calculate that in terms of our turnover in days and we can do the same for our own purchase payments and we can work out the cover on credit. Do we have enough cash coming through the system to pay creditors as it falls due? And that's a ratio of purchases to creditors on the balance sheet. Effectively, we're trying to measure the conversion cycle how quickly does a credit sale turn into cash, or how quickly does a credit purchase have to be a cash outflow? And by having these guidelines, these metrics, we can make.

Tony Hines: 15:19

The data tell us the story about the cash flow in the business and managing debtors and creditors will tell us part of the story, and a very important part. It is because those we can manage very tightly. And the third part of the story is managing inventory and how quickly inventories turn over. So, for example, if you've got thousands of dollars worth of stock that's in the warehouse, you have to know how quickly that stock is going to turn over and become cash, because the whole purpose of storing it in the warehouse is that it's temporary. It's not a permanent storage arrangement, although it might feel like that sometimes.

Tony Hines: 16:00

But we want to turn over the stock and we call it stock turnover or inventory turnover. That we are managing and we want to turn over that stock in the same way. So we'll manage inventory in exactly the same way. We need a measure that determines how much inventory is being sold through the business and turning into cash and how quickly that is happening. And there are, of course, other ratios to determine the inventory turnover and I'll summarise these in a few moments. But those three things together managing the accounts receivable, the debtors, the accounts payable, the creditors, and the inventory or stock in the warehouse, and how quickly that turns over are the three elements of our working capital. So that's our immediate cash inflow and outflow. Anything longer than that is capital that has to be invested in land, buildings, machinery, equipment and other assets.

Tony Hines: 16:59

When it comes to inventory turnover, we'll look at the cost of goods sold and we'll divide it by the stock that we have or the inventory we have on hand. So, for example, if it cost us $52,000 to make the sales that we've made using the inventory and we have on hand $6,250, that would tell us that our inventory is turning over 8.3 times in a period. And then we can divide the 8.32, which is the number, into the 365 days a year to get the number of days, and it comes out at 43.87, which is actually rounded up to 44 days. So we've got 44 days of inventory on hand and we calculate ratios to help us understand how that material is flowing through the business in terms of days. And what we don't want to do, of course, is fill the warehouse with 365 days of inventory. So we will stage our purchasing of inventories again carefully to manage our cash, conserve our cash and make sure that we can convert the inventory into sales in a reasonable time period. Whatever we determine that to be, that's up to us managing the business.

Tony Hines: 18:14

We can estimate the cash collection position also using the debtor to sales ratio. So, for example, if our debtors on the balance sheet outstanding stand at $5,500 and our sales are $90,000, then if we work that out, multiplying it by 365, the number of days in the year, we'll see that it's 22.3 days, or rounded up to 23 days. Now if in the following period that went up to £6,000 worth or $6,000 worth of debtors and £100,000 in sales and we did the same calculation, times 365, that would work out to be 22 days. We'd have reduced our debtor period by a day effectively. So you can see, this is an important idea that we're collecting our debts in 22 or 23 days for those two periods that we've just looked at. And that's a very important measure to get to grips with because that will tell us how long we have to wait for the cash to come back from a sale. And we can do a similar calculation, as I've said, for creditors, where we'll look at the trade creditors divided by the purchasers and work out number of days in exactly the same way that I've just explained. And if we found out that the number of days outstanding in creditors was 37 days, for example, and we're getting our cash in in 23, then we've got a 14 day period of latitude if there's any slips with any of the money coming in to pay our creditors on time.

Tony Hines: 19:51

So you begin to build up a picture of what the organization looks like from the data that you're gathering and, when it comes to inventory, turn the debtors on hand and the creditors. You'll note from all those calculations that we just talked about that the period involved was 365 days, so it was a year. So there were annual sales or annual purchases that we were referring to, and it's important to understand the period. So if it was just 90 days, if it was quarterly data that you were looking at, you'd divide it by three months data that you were looking at, you divide it by three months 90 days whatever the three-month daily period was to get an accurate figure. So I'm just telling you that.

Tony Hines: 20:34

So, as you understand the period, and when we want to look at the liquidity of the organisation, a simple liquidity measure would be to take the current assets of the business and divide them by the current liabilities of that business to work out a ratio. And the current assets are the amount of cash that we have on hand in the bank, the stock and any debtors or accounts receivable falling due, the amount of those. So, whatever that is, and the current liabilities, of course, are creditors and short-term loans, but we usually are interested in the working capital, which is current assets, less inventory over current liabilities, and that's called the acid test. And the acid test is important because that tells us essentially how much we have in immediate assets and how much we have in payments that are about to fall due. And so if we've got cover of 1 to 1 on that ratio, it's tight but it's okay. If we've got cover of 1.5, then we're quids in, as they say, or dollars in. So what we're measuring in these particular ratios is the liquidity, how much cash or near cash we have on hand to make the payments that we need to make when they fall due. So you can see that the cash and the cash flow and the throughput of inventories in the organisation and the flows of materials and data are all important indicators of how our supply chain is working and it ensures that we get paid and we're able to pay our suppliers as they need payment and it ensures that we receive sufficient money in terms of cash.

Tony Hines: 22:16

What it doesn't determine, of course, is profitability, because that's a different measure and I'll talk about profitability a little bit separately in the next section. So when we think about profitability and supply chains, the most obvious profit measure is the gross margin, and that's a difference between the sales value and the cost of sales, and what's left is the profit, the gross profit before any deductions for overheads and other costs. And so if I sell one item for $20, and it costs me $10 to make the sale, the cost of goods sold is $10, the profit would be 10, and hence the ratio is 1 to 2, a half. So therefore that's 50% gross margin and that's what we mean by that gross margin measure, and it's an important measure. For example, if we think about retail procurement, many retailers will look at the gross margin figure to see how much they need to make in profit over the volume of goods that they plan to sell in a period.

Tony Hines: 23:21

And if it's not making what they determine it to be, they either have to reduce the cost or increase the price. So in supply chain terms, what they might do is fix on a selling price what the market will bear for the goods, and then work down to the cost that they have to achieve to buy in goods to achieve the profit margin that they require. So, for example, if a retailer wants to make $10 from the sale of one item, it might work out that it has to sell that item for $50 at five times or six times the cost in order to cover every other cost that it has to bear when it comes to the rest of the costs beyond that gross margin. So those are all the overhead costs and the cost of having the retail store and the lighting, the heating and everything else that goes with the whole display of the goods for sale. So it becomes a very important measure on which to base other decisions, and it's a supply chain decision in the sense of you might have to work out how many you're going to buy. So that's the volume.

Tony Hines: 24:32

So if I'm going to buy 10,000 of a particular garment, for example, that I'm going to sell in a retail store and I have to achieve a margin at the gross margin level of 50%, then I might have to work out how many I'm going to sell at full price, how many I'm going to sell at discounted prices, and look at that mix, and how many in fact I'm going to have at discounted prices and look at that mix, and how many in fact am I going to have to give away or dispose of at the end of a particular time period, and so I'll take all that into the mix and determine the price and the cost. And that ratio becomes even more critical at that point and most buyers will tell you that's what they have to do. And if they can't achieve the price point then they're likely not to go ahead with the sale. So it'll mean they won't buy those goods and they'll look elsewhere until they can get goods where they can achieve the margin, because all those goods on sale in a retail store are competing for space in the store on the basis of these gross margins. Now if we look at this another way, if we talk about our $100 garment and we have to make 50% at the gross margin, that would give us $50 to play with, and that $50 has to cover the other costs and we still want to make our 10% margin. Overall, that's $10 on the $100, that means we have to get everything else on each unit down to other costs of just $40. Now if we couldn't do that say it came to $50, we make no profit at all. So we might want to put our price up even more if we can, if the market will bear it, by another $10 to take account of the fall in value. But then we risk, of course, a fall in demand because people will wait for the discounted prices to come and it might mean that we have to sell more of the garments at discounted prices. So you can see the criticality of that particular decision. We may, of course, have to go back to the supplier and renegotiate the price that we're going to pay to the supplier to get back an extra $10 to make sure that we can make a profit if we keep the prices set at $100 per unit at the end of the transaction. There are, of course, another whole raft of ratios and profit measures that we use to work out returns on investment, return on capital, return on assets, but I'll leave those for another day. So that's it for this episode.

Tony Hines: 27:12

I hope you've enjoyed the episode and you can see why it's important that the numbers add up. Timing is everything and balance is important. Well, that's it for this particular episode. I hope you've enjoyed the episode. I hope you found out something new that you didn't know before you sat down to listen, and I hope that it's been informative and it's given you some ideas about how we can achieve supply chain advantage when the numbers do add up. And it's about making those numbers and the information and the data work for us so that we understand our business and our supply chain performance better, and I've done it in this particular episode, using financial measures, which are, of course, the ones that can be deterministic about the future of the business. So I'm Tony Hines, I'm signing off. Don't forget to subscribe to the Chain Reaction Podcast, so you'll be first to know and I'll see you next time. Bye for now, thank you.