Need a Competitive Edge? Look into Cash Conversion Cycle

When the leadership team of a large medical device manufacturer announced that improving Cash Conversion Cycle would be a key part of the strategic plan, it made a lot of folks uneasy. Many of the staff privately admitted they didn’t fully understand the measure. What they did know made cash conversion seem too “high level” to be useful. But an announcement by the VP of Supply Chain made its importance crystal clear: “No more external investment. If you want to grow, you will have to finance it from operations.” Freeing up cash became a top priority. A Cash conversion cycle in excess of 100 days highlighted the low hanging fruit like no other measure could: Too much cash was tied up in inventory.

Long cash conversion cycle is like an old lady driving a 69 Camaro SS; though the car is capable, it won’t win many races. The shorter the cash conversion cycle the closer the driver gets to the car’s full capabilities. If the driver is Amazon, she can do a big, smoky burn out…blowing away the competition. That is what cash conversion can do for your business.

Cash conversion is a highly visible measure of your organization’s supply chain performance. Connecting performance objectives and improvement ideas with a specific cash conversion outcomes can be transformative for your business. Here are some things you should consider if you want to supercharge your organizations cash conversion cycle.

Cash Conversion for Supply Chain Managers

First, let’s demystify the concept. After having spent a fair amount looking through old textbooks (and Google of course), I am taking a crack at "defining" cash conversion for regular, non-financial type managers. This is as simple as I know how to make, so if you need something more official sounding I encourage you to look it up on Wikipedia:

Cash Conversion Cycle is a measure of the time between receiving materials from a supplier and receiving money from buyers of your finished products.

Cash conversion is typically expressed in a number of days and generally ranges from a few hundred to less than zero. Companies like Amazon and Wal-Mart are so good at cash conversion they have negative cash conversion cycles. When cash conversion goes negative it means the business is turning product into cash before the bills come due! This provides maximum financial flexibility and is the place to be if your company is trying to grow through acquisition.

Cash conversion cycle is composed of three primary components:

1)      Days Payable Outstanding or DPO

·         How long creditors give you to pay them. Since payment terms are usually governed by contract terms, and procurement usually negotiates contracts, Procurement often has the most influence over DPO.

2)      Days Inventory Outstanding or DIO

·         How long your inventory will last at current sales levels.  DIO performance is most often directly controlled by supply chain functions (e.g. Manufacturing, Logistics, Distribution, Operations)

3)      Days Sellable Outstanding or DSO

·         How long you give customers to pay you. Generally, accounting and/or corporate finance functions have the most influence on DSO performance.

Benchmarking Cash Conversion Cycle

Many times leaders don’t react well to external benchmarks. While it is fair to say that no two business are exactly alike, external benchmarks can help you craft the change message, especially if there is a significant gap between your company’s performance and that of a competitor.

According to the Medical Device and Diagnostic Industry Web sitethe companies listed below are among the top 10 medical device companies in the US. They provide an interesting industry perspective to illustrate cash conversion cycle
Here is an example:

Company	CCC	DSO	DIO	DPO	Inventory Value (USD Bn)
Johnson& Johnson	70	61	41	-32	$12.90
GE Healthcare	44	45	53	-55	$13.70
Seimens AG	98	62	73	-37	$20.60
Medtronic	114	86	41	-13	$1.80
Covidien PLC*	137	52	128	-43	$1.70
Novartis AG	72	65	43	-36	$6.70
Cardinal Health Inc*	8	22	28	-42	$7.90

 *Note: For consistency, I calculated cash conversion using a negative value for DPO. Rocket’s financial analysis depicts DPO as a positive value. Sources: 

http://www.stock-analysis-on.net  & Rocket Financial

(To give you an idea of how easy it is to develop external benchmarks, this table was compiled with a slightly-better-than-dial-up internet connection in less than an hour.)

I like the contrast between Cardinal Health and Covidien. Cardinal is heavily involved in hospital and wholesale distribution, whereas Covidien is primarily a medical device manufacturer. Cardinal’s DIO of 28 days suggests that they are the best product mover on the list. Covidien may have less money tied up in inventory, but a DIO of 128 days suggests that their inventory position (compared to sales) is at the very least conservative. Comparing the two make a pretty clear statement about Covidien’s potential opportunity to lean out inventory.

Obviously this is not the whole picture. I am sure the management at Covidien has perfectly good reasons for their cash conversion cycle. But I think the analysis illustrates the utility of the cash conversion metric, and how it might be useful to supply chain leaders.

Putting it all Together

So, let’s say you're on track to understanding Cash Conversion Cycle and after perusing the analysis you think it could really help your organization. Before you jump in head first, here are some tips that can help you secure buy in and maximize results:

·         Educate, educate, educate – If you find your colleagues scratch their heads when you mention cash conversion, arm them with information. A couple of slides with references are easy to develop and can lead to much broader buy in.

·         Benchmark – External benchmarks are good, but the best benchmark is your own organizations past performance. If you are part of a larger corporation, look into how other business units are doing. Worst case, you can start measuring it right now.

·         Collaborate – Changing cash conversion results is truly a team effort because of its broad scope (receivables, inventory, payables). That makes coordinated cross functional effort vital to creating and sustaining improvement.

·         Create meaningful performance objectives – Typically, ERP systems have gigabytes of information on inventory, so it might be easy to break total inventory value down by stock type (i.e. Raw Material, Work-in-Process, Packaging Material, Finished Goods, Etc.) Pushing the data as low as possible enables driving the target as low as possible in the supply chain organization.

·         Align performance objectives with Cash Conversion results – particularly in supply chain, but also across the entire organization, it is possible to drive cash conversion targets into the performance objectives of every team member.

Here is an example of how you might segment accountability:  

Function	CCC	DPO	DIO	DSO	Inventory Value
Leadership Team	X
Sales					X
Marketing					X
Supply Chain	X		X		X
Logistics			X		X
Operations			X		X
Manufacturing			X		X
Scheduling					X
Demand Planning					X
Procurement		X			X
Finance	X			X	X

Notice the Leadership Team is measured only by cash conversion.  It tends to be a good measure of the whole leadership teams effectiveness. As you drive the target down, more detailed targets will help keep the objective smart for each person. For example, a raw material planner could have an aligned inventory value target for the portfolio they manage, but because Cost of Goods Sold is typically only accrued against finished goods, a DIO target would probably seem too abstract.

Leverage Cash Conversion Cycle for Success

Cash conversion can be a fantastic tool for defining meaningful opportunities to improve your company’s financial performance. Even better, it can be sliced and diced at detail levels that enable comprehensive vertical alignment with even rudimentary enterprise data systems. Take a look at cash conversion and think about how your boss, you customers, and your company’s shareholders would view breakthrough, best-in-class outcomes. You might find it is worth a look.

The Benefits of Post Event Analysis

When something unexpected happens in the supply chain, how does it respond? You might expedite materials, hijack production plans, work overtime and short circuit processes to minimize customer impact. It doesn't take long before the tired but apt cliche, "fire fighting" comes to mind.

Usually we move on to the next fire right away, leaving in place work around solutions with a promise to return one day to fix it for good. But when the problem comes back, we are again out of time and under the gun, so we hit it with the fire with the hose in the name of momentum. And so the cycle is repeated to the immense frustration of continuous improvement minded supply chain professionals.

"We just don't do that here; we don't have time," said a senior supply chain executive in a major information security company. The fire fighting mentality was pervasive there. It impacted operating profit, supply chain cost, and staff morale. The leadership simply did not see the value of reviewing the quality of responses to unexpected problems. The unanswered question was, how many mistakes were they repeating and at what cost?

By analyzing the response (even beyond Supply Chain) to unexpected problems, valuable insight can be gained about the organizations capabilities and resource needs. The most effective post event reviews result in reduced cost, improved morale and, most importantly, minimizing the negative impact on customers.

If your organization is ready for Post Event Analysis Review, here are some elements that can help maximize its value and impact:
 

• Make it cross functional – Single function reviews are great, but they tend to focus on one aspect of results, at the expense of a full appreication of cause and effect. For example, DC operations might have great fill rates, but customer service can bring real customer feedback to the discussion.
• The sooner the better - Post event reviews are most effective when the results are fresh in the collective mind. Knowledge of the events details is highly perishable: it is quickly covered up with new and more pressing needs.
• Present successes as well as opportunities - This process quickly looses momentum when it is perceived as an "accountability" session. Time should be spent in equal parts on what went well and opporutnities for improvement.
• Encourage cross functional investment – A good facilitator is important, but a succinct investment of analysis from a key resource in each functional area will ensure broad buy in and better support for any resulting recommendations.
• Examine cause and effect– Focus on how changes in one area impact results others. For example, achieving lower inventory cost is great, but if it is at the expense customer experience, something needs it is not ideal.
• Make time – Resist the natural urge to move on. What is more wasteful: a time out to problem solve or repeatedly making the same mistakes?
• Communicate outcomes – Valuable insights and recommendations should be communicated to the executive leadership team. Their support can be critical if additional resources are required to enable improvements.

A lot of great companies are good at post event analysis. Afterall, it is not a new concept. But it can be challenging to get it working in organizations where it is not the norm. If you decide it is necessary, following these principles will help maximize the benefits Post Event Analysis Reviews can offer.