Increasing Cash Flow through TOC (Theory Of Constraints)
In the last 23 years we had the good fortune to collaborate with many clients
to increase cash flows in diverse industry sectors including steel, textiles,
automotive component manufacturing, packaging, engineering, printing, and
even in life insurance, and general insurance organisations. The common key
ingredients in all these successful assignments were:
1. Clear articulation of the Organizational Goal and its measurement
2. Aligning the entire top management with the chosen goal and its
measurement
3. Financial literacy for the top management
4. Identification of the organisational constraint and leveraging it to increase
free cash flow.
5. Weekly review process for developing a culture of B2B i.e. Better Than
Before.
1. Clear articulation of the Organational Goal and its measurement
The very first step is to have clear articulation of the organizational GOAL
and its measurement. We define this as: make more and more money
(4M). 4M is also an index of customer satisfaction and employee
satisfaction. Most companies set targets for top line increase in the
assumption that sales increase will necessarily enhance profits. In many
cases it is not true. Even increase in profits does not automatically
increase Free Cash Flow (FCF) in all cases. Profits and many other
financial measurements like ROCE etc. are impacted by accounting
policies - revenue recogonition, inventory valutation, depreciation policy,
amortisation etc. However one financial parameter that is very difficult,
if not impossible to change is to increase / decrease cash in the bank
or decrease / increase in net debt.
2. Aligning the entire top management with the chosen goal and its
measurement
Irrespective of the the chosen Goal of the organization, the top
management team must have complete buy-in for this Goal and its
unambigous measurement. The goal of every cricket team or for that
matter any team sport is to win the match. All other parameters are just
the means to achieve the same. Hence, it is imperative for the top
management team members to have total alignment with the
organizational Goal and its measurement.
3. Financial literacy for the top management
In our experience of working with both large and small organizations, the
top management team members are mostly aware of the sales turnover or
in some cases even profits. However we have observed that while
individual functional heads are quite aware of their own functional Key
Performance Areas (KPA), parameters like Free Cash Flow (FCF) or even
ROCE are quite foreign to them.
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Accordingly, imparting financial literacy to the top team manangement
members is a must for them to identify the levers for increasing FCF.
4. Identification of the organisational constraint and leveraging it to
increase free cash flow (FCF).
FCF is impacted by two parameters: profits and changes in working
capital. Generally most organizations focus only on increasing profits
through increased sales or cost reductions. However quite often profits do
increase, but the increase in working capital is higher than the profits. This
in turn results in negative FCF.
The common parameter for improving both profits and working
capital is surfacing and challenging commonly held but erroneous
assumptions.
Increasing output of the system does not depend upon increasing the
output from every sub-system. Rather it is to focus on increasing the
output of the constraint resource only.
In the same vein, increasing profits does not require reducing costs
everywhere. When increasing cost/ expenses in one area can bring in
much more contribution, then profits will increase automatically.
Similarly, the inventory level is not a function of lead time. Rather it is a
function of the frequency at which we are buying. Shorter the frequency,
shorter the inventory requirement.
The output of the system is governed only by the output of its weakest link
– constraint and not by the performance of other resources.Most
organizations are unaware of their real organizational constraint. This
results in demanding that every one must improve in their local area. This
is a suboptimal use of most critical organizational resource - top
management time. When the real constraint is identified, and the entire
top management is focusing on increasing output from the constraint, we
have observed output increase by 30-40% in one year. Imagine the
increase in profits if sales increase by 30-40% without increasing fixed
expenses!
As shared earlier, many times increase in sales, and profits also entail
corresponding increase in working capital and thereby reducing FCF and
some times it becomes negative too. Accordingly while on one side the
output from the constraint must be increased (sweating the assets),
organization must focus on reducing 2-3 main componnents of working
capital – inventories (RM, WIP, FG), receivables (overdue, and due but not
overdue), and vendor payables. In fact, in many cases we first shrink
working capital before increasing sales by shrinking cash to cash cycle
time. Quite often we have observed 30-40% reduction in working capital
in one year even with increased sales!
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Before increasing sales, our recommendation is to first improve working
capital turns. Thereafter, increase sales slowly, keeping a hawk’s eye on
the cash in hand. Further increase in sales or investment for expansion,
can be funded by the cash generated from operations including working
capital reduction.
5. Weekly review process for developing a culture of B2B i.e. Better
Than Before.
It is not very difficult to achieve great results one time. However sustaining
and improving these is altogether a different ball game. Basically it is
about changing the organizational culture itself. We have observed that for
achieving great results over long periods of time, the key factor is the
ownership of targets by the managers. We do have a unique review
process for this - Weekly reviews. Here the focus is not on comparison
with budgets or with reference to a month or the year before. Rather every
week, it is expected that the team will focus on improving the last 13
weeks moving average of the chosen parameters week after week.
We have observed that people do want to improve but often they do not
own the targets. However, when we ask teams to improve upon their past
performance the resultant ownership is quite high. As an example, the
operational and financial performance of most companies is significantly
less in Quarter 1 as compared to Quarter 4 of the previous year. However
many of our clients have achieved Q1 performance higher than the Q4 of
previous year.
Decision making - The only purpose of any measurement is to help make
better decisions for increasing the Goal unis. Since the organizational
Goal is 4M as measured by FCF, we use cash velocity as a key decision
metric for taking decisions. This helps in faster and improved decision
making.
The weekly review meetings actually serve another long term objective -
increasing the capabilities of managers to become business leaders,
and think like entrepreneurs.
We encourage team members to take stretch targets. And there is a
safety net provided for them even if they are unable to achieve these
as long as these are Better Than Before (B2B). One of our clients that
was losing money for 11 consequitive years, starting making money within
3 months of TOC implementation. However, the remarkable aspect is that
it has been making more and more money continuously for the last 15
years year after year!
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