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Manufacturing Cycle Time 


PART IV. 

 

Cycle Time Reduction and Ratio Analysis

Table 2 compares the ratio analysis before cycle time is reduced to the ratio analysis after cycle time reduction has been achieved. Again, this is a real case. In a situation where sales remain flat, the inventory reduction results in lesser assets being employed for the same sales. This causes the Sales to Total Assets ratio to increase. Not withstanding the textbook answers, this means we can increase this ratio with cycle time reduction without major capacity increases. Often what happens is that assets remain flat hut sales actually go up as customers respond to better response times and lower costs. The revelation comes when we realize that cycle time reduction affects the entire organization. The largest definition for cycle time reduction I have seen is the time spent between the expression of a customer's need and the fulfillment of that need. I will go one step further and lengthen it to include when the cash is collected. As quality improves and the customer has a greater tendency to get what was ordered, when ordered, collection problems start going away. Greater speed means fewer misunderstandings and better collections. This has the effect of reducing the trade receivables, which means even less assets are being deployed for the same volume of sales. There is a positive double impact.

The Average Collection Period begins to go down and the collection manager begins to look like a hero. He or she may get the bonus but the real reason may be the improved manufacturing cycle time. Next time you go to the collection department, tell them they owe you a beer.

Obviously, as the cycle time reduction reduces cost of goods sold, the Net Profit Margin is increased. The same volume of sales with a reduced cost results in a higher Net Profit Margin. Of course, this improvement goes down only to the gross profit line. The overhead costs remain the same. The cycle time reduction opportunity in overhead areas is much larger than on the manufacturing line but this is the subject of another paper. At least the manufacturing people can spearhead the way.

The Inventory Turnover ratio is directly effected by cycle time reduction. Inventory reduction is really a manifestation of cycle time reduction. A decreased inventory results in a greater Inventory Turnover ratio. For years, financial people have known this was a good sign without knowing, perhaps, all of the ramifications. Most focus was placed on the concept that high inventory turns indicated little obsolesce. In fact, cycle time reduction not only decreases the likelihood of obsolescence as problems are noted and corrected sooner but also decreases inventory on hand. Again, there is a positive double impact.

Now for the average payment period. There are financial people within your company staying awake nights looking for ways to increase your cycle time. This is not their intention but it is a result of focusing on one aspect of the business instead of the business as a whole. It is a truism in finance that everything costs something in some way. Financial people are looking for ways to keep cash so they can invest it. Often I hear of the Very Important Company that requires payment terms of 45 days from its vendors. Regardless of intentions, sometimes the financial realities dictate a momentary change. If a small company is facing a payroll next week and is short of cash, the harsh fact is that the company has to ship to a customer with a shorter payment period. The company may want very much to satisfy the Very Important Company but payroll is payroll and cash is cash. A variation on the theme is the company that makes payments on stated points of the month.

An example is a company that cuts checks Friday for invoices received by the previous Wednesday. The vendor has a much greater incentive to ship and bill on Tuesday than it does to do it on Friday. The point is, cycle time reduction has to take place from the vantage point of the business as a whole instead of the individual parts. One solution is to pay within a short period of receipt of the goods with amounts deducted for each day a shipment is late and each day a shipment is early.

We mentioned earlier that the Return on Total Assets is the product of the Sales to Total Assets ratio and the Net Profit ratio. Take care of the latter two and the first will be taken care of.

It is interesting to note that the financial people squirreled away in the dark may never have heard of cycle time reduction. All they may know is that something right is going on. Fortunately, the ratio analysis is giving the correct answer.

Cycle Time Reduction and the Venture Capitalists

Now, about those venture capitalists. How does cycle time reduction show up in the valuation? The answer is: it doesn't, not directly. There are basically six reasons why a VC wishes to invest in a company. They are: management, management, management and market, market, market. Inherently, good management has always sought out short cycle time, even way before the phrase was coined. A market is usually good because of a lack of competition. This is probably because the enterprise had a short research and development cycle time. Short cycle time has been there all along.

Short cycle time probably results in increasing revenue, high earnings and correspondingly increased book value. All of these factors lend themselves to an increased valuation but because the iffyness of the calculations it is hard to break their impact out. In successful emerging companies, short cycle is such an integral part of the whole business it can't be broken out. Large companies are trying to implement short cycle time; successful emerging companies start out that way.

Conclusion

So there it is. We have examined the impact of cycle time reduction on the financial analysis. The discounted cash flow calculation demonstrates the impact of a cycle time reducing capital expenditure. Ratio analysis is used to evaluate entities ranging from large divisions to companies. We have also seen how venture capitalists value cycle time reduction. Note that in each case the financial analysts secluded away in their dark, remote towers have little direct knowledge about the details of the operations involved but are drawing conclusions and interpreting them for the big boys. Ultimately, their decisions will impact the directions a company and your career (paycheck) take. You may ignore their tools if you wish.

To be Continued


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