In a previous lesson, we learned the cash cycle is the delay between making payments for inventory and receiving payments from your customers:
In order to reduce the duration of the cash cycle, you must:
- Decrease the average level of inventory relative to your sales rate
- Collect accounts receivable from customers more quickly, or
- Slow the payment of your accounts payable
Although useful as a framework, this is a static picture of the cash cycle. It begs the questions like, “What’s the cash impact of growth?” To answer those sort of questions, we need to convert this snapshot into a movie. That is, we need a dynamic model of these interdependencies.
Let’s Start with Inventory Policy
Your inventory policy addresses two questions:
- How much should I order?
- When should I order?
Setting a target level of inventory is one way to express policy. For example, you might have a policy that calls for having 90 days’ sales on hand at all times. Whenever your inventory falls below that target level, you’ll be prompted to purchase an amount equal to the shortfall. (For the time being, let’s sidestep complicating factors such as minimum order quantities, volume discounts, and order-delivery delays.)
For instance, if you anticipate demand for 20 units of your product per month, your target inventory would be 60 units:
(20 units/month ÷ 30 days/month) × 90 days = 60 units
If your starting inventory is 0 units, your initial purchase would be 80 units: the 20 unit demand you anticipate for the coming month plus the 60 unit inventory buffer you wish to maintain. Here’s how this expressed using the Sysdea modeling tool:
The Impact of Sales Growth on Inventory
An inventory policy that calls for 90 days’ sales worth of inventory means that you’ll need to purchase 3 additional units for every 1 unit/month growth in demand. As long as your purchase rate exceeds your shipping rate, your inventory level is going to go up. For instance, if you anticipate that demand for your product will increase by 2 units per month, your investment in inventory will increase, too:
The faster you grow, the more inventory you’ll need. Changing your inventory policy to, say, 60 days’ sales will decrease your investment in inventory over time, but it will also increase the chance of a stock-out and lost sales.
Measuring the Financial Impact of Inventory Policy
The preceding addresses the physical stock and flows of inventory. In the next lesson, we’ll assign costs to the inventory in order to gauge the financial impact of inventory policy.