The Cash Conversion Cycle – Did You Know CCC=DIO+DSO-DPO?

We are pleased to bring you another insightful article from Michael Lamoureux, who writes for Spend Matters US (we've left the US spelling for authenticity) and for his own website.

At the recent SAP Ariba Live Europe event, there was a session on how to align procurement, finance, and treasury to strengthen your supply chain. The core of the presentation revolved around the cash conversion cycle (CCC) which equals DIO + DSO - DPO .

That’s days inventory outstanding, days sales outstanding and days payables outstanding.  It’s probably not front of mind for many procurement professionals, but optimising that is important for any business – it’s all about effective cash and working capital management, and should be the combined goal of Procurement and Finance.

The CCC combines ratios that tie together accounts receivable, accounts payable, and inventory turnover. The first two, accounts receivable and inventory, are short-term assets but the third, accounts payable, is a liability. The activity ratios, found on the balance sheet, are used to determine how efficiently management is using short-term assets and liabilities to generate cash, the lifeblood of a company.

Now, optimizing CCC sounds like a relatively easy thing to do. But is it? Of the three components of the equation, Procurement has no control over DSO (Days Sales Outstanding), as that is ultimately controlled by Sales and AR. Procurement can influence DIO and DPO. And, more precisely, Procurement can really only control DIO, as AP ultimately controls DPO.

However, Procurement can give AP the tools it needs to pay the invoices at the optimal time by insuring that the terms and conditions in the contract or purchase order are in line with organizational goals and objectives. Furthermore, it can help with the identification of the right suppliers to consider for early payment discount programs.

This is often a case of “easier said than done”. Let's start with DIO. To optimize DIO, Procurement needs accurate insights into demand trends and early insight into trend changes. If Procurement gets inflated demand from Sales and Marketing, DIO will be (too) slow, cash will be tied up, and the risk of inventory obsolescence will increase over time. If the projection is too conservative, there is a risk of stock-out, and if the product is critical to a production line, or is a high sales product, the risk of loss, potentially huge, will increase.

And the situation with DPO is not much better. In order to optimize DPO, Procurement needs to understand what the best payment time frame is for the organization is, and how that might vary by category or supplier – not all suppliers are equal from the view of early payment / dynamic discounting. Procurement also needs to try and align discount programs not only to Finance goals but also to organizational goals.

Here's where things get not only difficult, but of paramount importance. Because when you pay your supplier early, you help your competition. Since you paid early, your competition can pay late and apply their cash to something else. Your organization can't. So every early payment needs to align to a Finance goal or enable a Finance goal, otherwise, you're not just helping your supplier, you're helping your competition -- which is not something you want to do unless you're getting a greater benefit.

So how can Treasury and Finance help Procurement help Treasury & Finance?

  1. Help Procurement Understand the Cost of Carrying Inventory

Inventory is more than just the cost of capital that is locked up in the goods. It's also the overhead to store it. Unless Procurement understands the true costs, it won't be able to build accurate total cost of ownership models that optimize the balance between the carrying cost and the transportation cost and the cost of capital against the risk of disruption.

The reality is that while inventory costs can be high, the costs of extra shipments can be higher. Furthermore, while there is a cost of not having capital available for investment or innovation opportunities, there is a cost associated with stock-outs as well and the cost of maintaining extra stock is often less than the loss that would result from a stock-out even for a single day.

If Procurement has an accurate understanding of all the costs, it can build accurate cost models that optimize the inventory replenishment cycle to balance inventory and logistics costs and ensure capital is not locked up any longer than it needs to be. That can be helped by using the decision optimization capabilities built into a number of modern Source-to-Pay platforms.

  1. Help Procurement Understand the Cost of Paying Suppliers Early

All Procurement sees is the savings that can come from early payment discounts and dynamic discounting, and if they can save an extra 2% on £1M worth of invoices, that's £20K on the savings sheet, and a great return on the 15 minutes of effort required to set up the "opt-in to early payment discounting campaign".

However, that is also a million of cash flow going out the door 30 days early, which could instead be used (for example) as a loan to help a strategic supplier invest in a new production technology that will, perhaps allow that supplier to reduce its unit cost by 15%. That might generate far more benefit for the buyer, with benefits dwarfing the early payment discount.

This is just one example where Procurement might not understand the opportunity cost of early payment. If Finance (with input from other functions including procurement) maintains a matrix of opportunities (ranging from investments and currency hedges to supplier and new product development opportunities) with expected realization on each, it can calculate the opportunity available on each dollar, pound or euro of capital.

Procurement can then accurately calculate not only the value associated with different payment terms but also the relative value of early payment discounts and what the organization needs to make early payment / dynamic discounting worthwhile.

In summary, if Treasury and Finance help Procurement understand the true cost of having capital tied up or go out the door early, Procurement can build better models and make better decisions during contracting and buying that help out the entire organization in terms of that cash conversion cycle.

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