Your Inventory Has Doubled - Now What?

EMS Companies asking
“Why is my inventory increasing?”

“Golden screw” is supply chain slang for that one component you cannot seem to find to complete your demand list. If there are 100 parts on a bill of material and one out of those 100 parts is not available, then you may end up buying the 99 parts but cannot ship the completed assembly. Your cash gets tied up by the 99 parts you purchased, and you cannot free up that capital until you find the 100th part (the golden screw).

At a macro level, when the supply chain has a large swing from being supply constrained to parts becoming more readily available, there is a period of time where the supply of golden screws is still a problem. The longer that the golden screws remain unavailable, the greater the problem since you have so much inventory waiting for one component. And as a result, more working capital is consumed by your inventory.

This is a big problem.

Inventory ties up liquid capital (cash), which means the more inventory you have the less cash you have for other business expenses such as paying employees, purchasing equipment and other business items. Of course, inventory is not the only business item  that can tie up cash so let's talk about the entire cash conversion cycle.

Defining Cash Conversion Cycle

What is the Cash Conversion Cycle (CCC)? It is a financial metric that measures how much time a dollar stays tied up before it is brought back into the business. Think of your business as a cash making machine. To get cash out, you have to put cash in. The cash conversion cycle measures how long your the cash will process through your machine before the machine provides it back. If your business is profitable, the cash coming out will be more than you put in. If it is unprofitable, then you’ll get less cash than what you put in.

The cash conversion cycle has three main components to it which are the three ways your cash can get tied up.

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Days Sales Outstanding (DSO)

Days Sales Outstanding (DSO) is the number of days you get paid after invoice. The scenario would be that after a business makes a sale, finishes building the assembly, ships the goods and invoices the customer, DSO is the number of days after invoice until you receive payment. Payment terms can vary based on the country you are in, but most EMS businesses we encounter receive payment by approximately 45 days. This can vary by the type of business you do, geography and the incentives you offer to your customers.

Formula: (AR/Sales) x Days

Target: Lower is better

Days Inventory Outstanding (DIO)

Days Inventory Outstanding (DIO) is how long it takes to turn inventory into a sale. This scenario would be the number of days from when you receive inventory to when you can bill a customer for shipping the inventory to them. This also applies to the various types of inventory in a factory. For example, receiving raw materials (components) and turning them into WIP inventory. And then converting WIP inventory into Finished Goods Inventory (FGI). And finally, shipping Finished Goods Inventory to the customer, taking it off your balance sheet in exchange for Revenue from the invoice.

Formula: (Inventory/COGS) x Days

Target: Lower is better

Days Payable Outstanding (DPO)

Days Payable Outstanding (DPO) is the number of days you have you pay your vendors after inventory is brought in. While DSO and DIO are tying up cash, DPO is  subtracting out the days because your vendors are giving you time to pay them. Putting it differently, your DPO is the vendor’s DSO. If your DPO is greater than your DSO and DIO combined, then you are generating cash as you grow. If your DPO is less than your DSO and DIO combined, then you will require additional cash as your business grows.

Formula: (AP/COGS) x Days

Target: Higher is better

Improving Your Cash Conversion Cycle

Improving the Cash Conversion Cycle requires a holistic approach to review all three of the elements that go into it. Here are some options for addressing each of the metrics that make up the CCC:

Improving DSO

1. Split invoicing (pre payment): Getting pre-payment for a portion of the sale (usually materials) upfront can increase your cash flow and keep your customer engaged while waiting to receive finished goods.
2. Increase your prices: Adjusting your prices to keep up with current cost of money or inflation level can be another way to address cash flow concerns. Aligning pricing to payment terms can also help incentivize your customers to improve your DSO.
3. Ask customers to supply materials: Consigned inventory for a certain period of time can also help keep cash available so you are not keeping cash in inventory. From a financial standpoint, this is similar to split invoicing. But practically, it comes with some other challenges such as your customer not having the bandwidth to manage purchasing, buying the wrong packaging for your equipment or you having to more thoroughly audit the incoming inventory from your customer.
4. Increase collection efforts / adjust payment terms: Adjusting payment terms for your customers or enforcing the payment terms more strictly can improve your DSO, although you should consider balancing this activity with the customer relationship.
5. Use receivables as collateral for a bank loan: Some banks will allow using Accounts Receivable (an input of DSO) as collateral to a loan. While this doesn’t necessarily improve your DSO, it does turn your AR into a liquid asset (with a cost in the form of bank charges).

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Improving DIO

1. Sell excess and obsolete inventory: Dead inventory continues to tie up your working capital. Even if you are not able to recover the price you paid for that inventory, sometimes selling at a loss is worth gaining access to cash. Options for relieving excess and obsolete inventory include RMA back to a supplier, broker, etc.
2. Prioritize jobs that free up capital: The production floor will ultimately decide how inventory is used. Work with your production schedule and prioritize kits that can be completed and paid the quickest.
3. Factor in the Total Cost of Ownership: Source from vendors based on total cost of ownership, which can include terms, delivery and other factors. Sometimes a lower price with more rigid terms can be most costly in the end.
4. Use inventory as collateral for a bank loan: Banks often utilize inventory for providing a collateralized line of credit (working capital loan). This is usually a cheaper option than a loan against Accounts Receivable.

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Improving DPO

1. Renegotiate payment terms: Work with your suppliers to secure the payment terms you need to keep growing your business. In the long term, there will likely be a tradeoff between payment terms and the overall price that your suppliers can give you, but it makes good business sense to prioritize the benefits that your business finds the most value from.
2. Utilize vendor managed inventory programs: Move inventory to a vendor manager inventory program so you are only taking possession of it at the last possible moment. This can be especially useful for high value or high frequency.
3. Make use of order rescheduling: Purchasing departments and supplier relationships often get the attention when there is an urgent need to bring in material. But it is equally important to utilize your buyers and suppliers to push out dates on materials when your production schedule moves the requirements out.
4. Monitor early shipped parts: If a supplier is delivering parts early, chances are you are also getting billed early. Compare delivery dates against your receipt dates and work with the supplier to take the inventory back, accept later payment terms or some other fair resolution. If you do not have a policy for days early or days late, look into adding that language to your purchase order to protect your cash flow.
5. Purchase planning based on supply over requirements: Plan POs based on supplier requirements. Adjust your shipments based on full shipment.

Summary

Overall, check your cash flow early and often to keep cash in your business. It's important to communicate excessively with your customers, suppliers and investors to course correct quickly. The companies that do well in their business have good communications with all parties involved in the cash conversion cycle. While profitability still matters, it does not matter without cash.

CalcuQuote Can Help

Here are some CalcuQuote solutions that can help with your business’ cash flow challenges. Contact us to learn more.

• DevCQ: DevCQ allows you to easily incorporate component price and availability search functionality into your own applications. The transparency into your supply chain can allow your purchasing teams to make better decisions on sourcing accurately and efficiently.
• ShopCQ: Designed for electronics purchasing teams. From demand to delivery, ShopCQ reduces cycle time, increases efficiency, and creates the seamless sharing of relevant data between you and your suppliers. Adding efficiency in ShopCQ allows your purchasing team to focus on what matters: sourcing the golden screws.
• StockCQ: CalcuQuote’s online component marketplace is built exclusively for OEM and EMS companies to trade components. Find buyers for your excess and obsolete inventory or find the golden screw from a peer company’s warehouse. StockCQ reduces waste and improves inventory utilization for everyone.
• MSP (Material Supply Planning): MSP enhances the capabilities of your MRP with additional factors such as current supplier inventory levels, part relationships (AVL, substitutions, etc.), and order valuation. MSP brings the sophistication of a high end supply planning solution to the complex world of electronics supply chain management.

‍Want to learn more about how CalcuQuote can help address these issues? Reach out to info@calcuquote.com or click here to book a time.