In my last post (CLICK HERE) I talked about diagnosing financial challenges in your business based on tracing back the root causes of three symptoms many of us have faced: low cash, low gross margin, and low net profit. In this post, we'll talk about the measurement / discovery process.
Let's take a real world problem we've seen in our firm's own client base.
Stephanie is the owner of a manufacturer of specialty machining filters with a cash flow problem. So the symptom is Low Cash. Upon truly looking at her balance sheet for the first time in awhile Stephanie found that although sales had declined about 10% in the last few years her inventory has steadily risen to the point where she has about three months of inventory. Three years ago she had one month of inventory (click here for the formula for inventory turns). In the last few years she hadn't insisted on monthly physical inventory counts and instead had been looking at profit margins. Although cash had been declining it hadn't really caused a problem until now.
Stephanie walked back to the warehouse and looked around. She found that she didn't have three months of inventory; she actually had just a little over a month of inventory and some obsolete products. When she went to her bookkeeper to ask how inventory is calculated on her financial statements the answer was 'we don't, we just adjust gross margin to 45% because that's what you told us our mark up is always supposed to be.'
You see the problem. Stephanie hasn't raised prices in two years in order to maintain the limited sales drop she's experienced, yet her suppliers have consistently raised prices. By adjusting to an arbitrary gross margin, inventory is over (or under) stated.
What started as a 'Too Much Inventory' problem quickly became a 'Low Gross Margin' symptom with a diagnosis of 'Poor Inventory Control', 'Bookkeeping Error', 'Poor Buying' and 'Poor Pricing' (reference www.brs-seattle/roadmap.html). Stephanie went into action. She immediately adjusted inventory to the correct level after a physical count and implemented a monthly inventory count process. She also instructed the bookkeeper to start adjusting to actual inventory rather than gross margin.
Next, to solve the buying problems she knew she had an early payment option but had not taken advantage of it because she didn't want to utilize her line of credit to pay for it. She realized though that she could pick up 4% gross margin if she borrowed money for thirty days to pay early - the bank's interest rate is 6%. Using real numbers, if the usual cost of goods sold in a month is $55,000 on $100,000 in sales and it will be $51,000 if paid early, Stephanie can pick up $4,000 in gross margin. $51,000 borrowed at 6% for thirty days represents only $255 in interest expense - this represents a good use of debt.
Lastly, she decided to raise prices by 1% as she had not done a price increase in two years and felt that, after looking at her competition, she had a little room to move without impacting customer relationships. She also raised her net 15 discount by 2% to encourage early payment from her customers.
Stephanie decided to start measuring gross margin and inventory turns on a weekly basis as her sales are fairly consistent.
The point here is that until Stephanie decided to start looking, she didn't really know what the problem was. A knee jerk reaction might have been to assume you have too much inventory - which would not have cured the symptom. And had Stephanie not resolved to start measuring, there is a good chance that eventually she would've found herself experiencing the same symptoms. If you don't measure, you can't improve!
In next week's post we'll look at some easy-to-use measurements for common problems. If you don't measure it, how can you improve it #3.