Few weeks ago, I had written an article explaining cash constraint and some ways for organizations to overcome it. Subsequently, several readers informed me that I had not done full justice to the article because I had not explained why organizations run into cash constraints and how to prevent them from getting there in the first place. This is my attempt to address these questions and rectify that blemish. First, let’s recapitulate some important aspects. In my previous article, I shared TOC’s five focusing steps to overcome cash constraint within 13 weeks, or one quarter.

Step 1: Identify the constraint. When is cash the constraint?

An organization has a cash constraint if and only if all the following conditions are met:

• Sufficient orders
• Sufficient equipment, manpower and other resources including space
• Right vendors are available but will not give credit any more
• Insufficient raw materials or packing materials
• Additional cash cannot be easily arranged

Simply put, an organization is facing a cash constraint when it has sufficient orders, that is, on time in full (OTIF) < 95%, enough manufacturing capacity, that is, no machine/ equipment/ resource has overall equipment effectiveness (OEE) > 85- 90%, a reasonable number of right suppliers, and yet it suffers from material shortage as vendors refuse to give any more credit.

Step 2: Decide how to exploit the constraint

We need to squeeze as much throughput as possible through effective utilization of existing cash. In cash constraint situation, organizations need to make decisions taking into account a key parameter: cash velocity. Cash velocity is defined as an increase in per unit of cash in a period of time. As an example when the totally variable cost (TVC) is 50% of sales and the time from cash outflow to cash inflow is one month, that is, a cash induction of Rs. 50 in additional material will result in a sale Rs. 100 in a month. Here, the cash velocity per month will be 100%.

Even a small increase in cash increases sales, throughput, and profit significantly. Some of the suggested means for increasing cash velocity are: reducing customer payment time, shrinking manufacturing lead-time, and reducing supplier lead-time.

Step 3: Subordinate everything else to the constraint

All functions, departments and decisions should be aligned to get the most out of the constraint. This step is often difficult to implement, as it requires changes in existing practices and policies of local optimization. For manufacturing companies, rather than purchasing large volumes and producing large batches, it is recommended to buy the minimum raw materials required for making ‘full kit’ for immediate production.

Step 4: Elevate the constraint

In most cases, exploitation and subordination are sufficient to overcome cash constraint situation. However, if required it makes sense to borrow even at a comparatively very high rate of interest, since, for a vast majority of manufacturing organizations the cash velocity per month ranges between 10% and 15%.

Step 5: Go back to Step 1; don’t let inertia be your constraint

Once the cash constraint has been overcome, identify the current constraint. Where is your constraint – is it in orders or operations? The long-term strategic application of TOC does not imply removal of one constraint after another. Rather, the objective is to choose your constraint and manage it well to ensure that cash never becomes your constraint.

In my consulting experience of more than two decades for various types of organizations – small, medium or large, I’ve observed that the senior management usually has a reasonable knowledge of profit. Of course, it’s a different matter that they all may refer to different versions of the profit the company has earned in the previous period. Some of the commonly used profit measurements are EBITDA (earnings before interest, tax, depreciation, and amortization), Cash profit, PBT (profit before tax), or PAT (profit after tax). Some of the more financial savvy managers may also have some inkling of another important financial parameter – ROCE (return on capital employed).

However, most top managements are almost totally ignorant of another very important parameter: free cash flow (FCF). In his book, Conspiracy of Fools, Kurt Eichenwald writes that in 2001, just a month before the collapse of Enron, its chairman Kenneth Lay, CEO Jeffery Skilling, and CFO Andrew Fastow did not know that Enron will run out of cash in a matter of weeks! Often, organizations are unable to assess increased cash requirement while increasing sales, or chasing market share. In some cases, small and medium enterprises (SMEs) that are dependent on just a few big customers accept unfavorable terms in a bid to increase sales, and it increases the squeeze on cash.

The table below depicts the typical cost structure for an Indian manufacturing organization and the impact of increase in sales by 10%.

Here, for net sales increase of Rs. 10 crore per month or Rs. 120 crores per year, net working capital will increase by about Rs. 30 crores immediately. Assuming no increase in fixed expenses at all, this will translate into an increased profit after tax of Rs. 28 crore at the end of the year.

This means that for the first 12 months, the organization would have less cash than the starting cash in hand. Only after the 13th month, cash in bank will start increasing. When the organization does not have enough cash to sustain increased sales, there is high probability of the organization getting into cash constraint. Here, we have neither invested any money in increasing capacity nor increased any fixed expenses. It is obvious that when we invest additional funds for increasing capacity, stress on cash will be more severe. In a vast majority of sick companies or bank NPAs (non-performing assets), there was an expansion in the previous two-three years.

In their quest for growing fast, many companies invest without comprehensively looking at cash flow for various scenarios. Business owners and decision makers need to monitor and plan cash judiciously and ensure that they have sufficient cash buffer at all times. When you have enough cash, it does not matter much. However, if you do not have cash, then nothing else matters.

When should companies go about increasing sales and take full advantage of growth opportunities? Recommendation: Before increasing sales, improve working capital turns. Only, thereafter, increase sales slowly, keeping a hawk’s eye on the cash in hand. Instead of targeting new customer segments, exploit current customers segments, solve their pains and generate more from the same segment. Improved service levels will not only boost sales, but will also provide opportunities for increasing prices and cash velocity. Eli Goldratt summed it up succinctly when he said: Focusing on everything is synonymous with not focusing on anything.

The following table shares various stages of an organization as it gets into cash constraint.

Implementation issues

I’ve often said the TOC solutions are simple, though not necessarily easy. The biggest obstacle with cash constraint is that the top management does not accept reality. There is a belief that the situation will improve if we just tighten controls to deal with this temporary situation. Owners or key decision-makers refuse to accept they have severe issues of cash. Therefore, the first step to overcoming cash constraint is to accept that it’s an unusual situation that will not go away through usual means.

It is not just finance managers, but the entire top management team that needs to get involved to create cash flow statement for next 13 weeks or one quarter and make a plan of action. There are challenges in creating this statement sometimes due to distortions in financial reporting (such as inflated or obsolete inventory being shown on books). There are also significant differences in total receivables and collectible receivables, and disagreements between accounts and sales.

The top management team needs to agree on the useable inventory in next 13 weeks. Correcting mismatch in inventory has to be a priority. Often the total inventory available at macro level is enough for few weeks but not for next few days. Some small low-items items are always missing, while cash is blocked in high value materials that were purchased in bulk. Similarly, there has to be clarity and common understanding on the total overdue receivables and due payments that can be collected.

Thereafter, modify cash flow so that closing cash is always positive – cash can never be negative! This means prioritize actions and payments based on the current cash availability. The importance of cash velocity cannot be over-emphasized in this situation. Take actions that will block cash for the least amount of time. Sometimes, it may make sense to defer purchases of raw materials and use air rather than sea shipments, though it would be more expensive. Another action could be to sell obsolete or unusable materials, even at deep discounts.

It is of utmost importance to create a sense of urgency, be transparent with employees, modify current measurements, and take corrective actions to overcome cash constraint in a short period of time. I also recommend creating a weekly dashboard for monitoring key parameters such as free cash flow, overdue payments, cash in hand and stop measuring sales, market share, and local parameters such as efficiency.

I have often observed during my interactions with business leaders that they correctly understand the Theory of Constraints (TOC) to be a management philosophy that looks at an organisation as a chain, where identification of the weakest link and exploiting it suitably can lead to unprecedented improvement in the performance of the system. Yes, that might be an accurate description of TOC, but its scope is much wider than that. Under TOC, there is a fundamental belief that every system is inherently simple. Dr Eliyahu M Goldratt, the founder of TOC, postulated that as there are no conflicts in hard sciences, there must not be any conflicts in the real world. In case we do find one, we should look for the wrong assumptions — one set of assumptions has to be erroneous. Once we are able to surface them, invalidating assumptions is not a Herculean task and, thereby, conflicts can be eliminated. Uncovering these deep-rooted hidden assumptions, invalidating them, not accepting status quo and challenging industry practices are some of the traits one would associate with TOC practitioners.

As a management consultant, these days the common grouse I hear is about the poor macro environment, lack of demand, stagnation of economy, policy paralysis, etc. I am often asked if TOC can help companies in such an environment of multiple constraints. I urge them to introspect instead of blaming the external environment and factors that are not under their control.

Blame it on demand

Most organisations today complain that they are unable to grow because demand is an issue. Though I agree, I would like to challenge the corollary that since organisations cannot secure fresh orders, maintaining or growing profitability is a challenge.

Let me explain. If order flow has reduced significantly, there has to be excess capacity in the system. In other words, companies should be able to deliver existing orders faster and more reliably. But, in reality, how many organisations are able to achieve on time in full (OTIF) of close to 100%? In my 20 years of consulting experience in the manufacturing sector, I have rarely seen organisations achieving OTIF above 50%. When some of my potential clients argue that this is not the case, I ask them that if they are so sure of delivering reliably, would they be okay with accepting 30% of order value as penalty for a delay of one day or delivery of even one piece less. Bedford, a privately-owned company in central Pennsylvania, manufactures structural fiberglass products to serve a wide range of applications and markets. It offers nation-wide distribution through warehouse facilities from coast to coast. The company not only has a unique standard structural performance guarantee, but also is willing to pay a heavy penalty for each day’s delay.

Imagine if one of your competitors were to actually offer this — what would happen to your business? Or, if you could offer this to your customers, what would be the impact on your business? Needless to say, it is assumed that you would then try to develop a delivery process that helped you consistently avoid paying a penalty.

Blame it on the slowdown

These days, whenever I ask people in the industry how their business is doing, the standard response is: the market is in the dumps. This is akin to a father asking his son, “How much did you score?” and the son responding, “Shyam failed as well!”
It is very easy to pinpoint the external environment as the cause for our problems (low sales, low profits). Whenever I ask any salesperson in India or abroad why his or her company is receiving fewer orders these days, I get every possible reason as to why business is slow. Not once have I met a sales head who has confessed, “I do not know how to sell”.

To put it differently, I believe that the recession is a state where consumers are no longer excited by the current goods and services in the market. Firms that are able to solve a customer’s pain will be able to command a higher price, no matter what the economic conditions. Of course, to be able to do that, marketers and decision makers need to know the pain points of their customers and develop capabilities to tackle the same.

Just remember that there were overnight queues outside Apple’s stores for buying the iPhone when it was launched in 2007. Again, in 2012, there were queues for buying the new iPad. So much for a slowdown. The real issue is perhaps sticking with our deeply held beliefs.

Most sales managers confess that they are forced to reduce prices to procure orders. Do you know their underlying assumption? More often than not, the assumption is that their product has no competitive edge other than lower prices. (Think about it, does a sales guy ever suggest an increase in prices?) Though not necessarily easy, the answer is quite simple. If a product or service does not have any other competitive edge other than a lower price, then the company needs to work towards creating one. Yes, it may take some months or even years. If not, what is the alternative — can a company sustain itself in the long run without a competitive advantage?

So the next question is: can one create a competitive edge? My favourite example is about an organisation operating in a highly commoditised business — milk. There is a company known as Chitale Bandhu in Pune. When I started my career in Pune in 1972, Chitale Bandhu was commanding a 15-20% price premium for home delivery of milk. Today, not only does it command a similar price premium but also boasts of a waiting period. It must have some competitive edge that customers are willing to wait and pay a premium. The point here is: not only has the company created a competitive edge, it has been able to sustain it over the past 42 years. Now, the typical defence to that will be: “We are not dealing with households, we negotiate with hardcore professionals in the B2B space”. For these sceptics, I can share the case of a privately-owned firm in the extremely competitive automotive component manufacturing business that has been able to increase its profits continuously for the past 37 quarters. The core issue is not the volatile external environment; rather, it is our erroneous assumption that the cause of our problems is outside our control and we have limited ability to influence the environment. Those familiar with Steven Covey’s work know of this concept as ‘circle of concern vs. circle of influence’.

Over the past 15 years, ever since I was besotted with the TOC concept, every year, at least one of my clients has achieved an order of magnitude improvement in its financial performance. They are also operating in an ostensibly volatile environment, but what sets them apart from competition is their mindset.

Measurements: Global and Local

In the last quarter of calendar 2008, Toyota Motor Corporation achieved two distinctions. First, it became the largest seller of vehicles, overtaking General Motors. Second, it declared a loss in the quarter, after 70 years. While ‘sales’ is definitely a means for achieving the organisational goal, it is definitely not the goal.

However, there was nearly a revolt when I suggested that all of them should be evaluated and rewarded by the achievement of the overall organisational goal and not by their respective functional KPI (key performance indices). I requested each one of them to share how many promotions each one got during the same period that the unit was going downhill. The shocking answer: the average number of promotions was two, and some even got three promotions. How come? The answer is painfully obvious — local parameters were not aligned with the global parameters. This is an illustration that excellent local performances do not necessarily measure up to a good global performance.

My mentor, Dr Goldratt, repeatedly emphasised that measurements drive behaviour. When asked to share what is TOC in one sentence, his response was that one sentence is too long, one word would suffice — focus. That being the case, organisations today should worry more about getting their house in order rather than delude themselves in a recessionary cocoon.

Service organizations often try to increase their business by trying to delight their existing customers or offering great benefits to potential customers. However, in many cases, customers end up irritated or annoyed.

We’re all familiar with these attempts, as we are no strangers to phone calls from banks, insurance companies or telecoms offering great deals at the most inopportune times. Service organizations say the market is extremely competitive, making it difficult to grow the business or increase profits continuously.

Many of us would be familiar with Dr. Goldratt’s Theory of Constraints (TOC) that has helped countless organizations increase their profits. Since most of these organizations are into manufacturing, most people assume — erroneously — that TOC is applicable only to manufacturing.

In a previous article for Outlook Business (titled First, get your house in order), I had shared that the essence of TOC is surfacing the assumptions behind our actions. And in almost all cases, the constraint — or limiting factor — for achieving a goal is a wrong, though deeply held, assumption.

The basics of TOC

TOC’s basic premise is that the performance of a system is governed by the performance of its weakest link or constraint. Unless we improve this, system performance cannot improve at all. The five steps to improving any system’s performance are:

• Identify the constraint, which could be the suppliers, operations, or the number of customers
• Exploit the constraint. In simple words, this means get the maximum output out of the constraint
• Become subordinate to the constraint. Since the constraint does not operate in isolation, all the other parts of the organisation must support the constraint
• Elevate or strengthen the weakest link
• Go back to the first step, as after the strengthening process, the weakest link may have shifted

Most service organizations invest an enormous amount of time and money to attract more customers. Why? The obvious answer is that they believe the existing number of customers is the constraint. So, they pull out all stops to woo new customers or retain existing ones by introducing new schemes and offers.

We know that most service organizations complain about customers being fickle and changing their suppliers at the slightest opportunity. In fact, on the face of it, organizations are actually trying to follow the five steps outlined above. So, why aren’t the results materialising?

My hypothesis is that wrong assumptions about the current reality (in this case, the customers) are the real culprit. Let me explain this with examples from various service sectors, including some of my own experiences. Telecom companies come up with new plans on a weekly, if not daily, basis. So much so that customer service representatives are often clueless about most of these plans. So, what are the wrong assumptions here?
The first is that all customers want lower prices all the time. Is that really true? How often have we all gone through frustration due to call drops? Aren’t we willing to pay slightly higher prices so that these call drops become rare, instead of the norm? What ends up happening is that since we are not sure about the performance of any operator, we choose the lowest price as the default option.

The second wrong assumption is that more number of offerings means more sales. In fact, more choices also confuse customers. I am not saying that we should have no options, but I do have problems choosing when I see a 20-page menu in a restaurant! Apart from confusing customers, these countless plans take a heavy toll on the front line serving the customers. Since service organizations are primarily people businesses, reducing variability from person to person is a big challenge.

For instance, I faced some unnecessary trouble at home, with one of the largest direct-to-home (DTH) service providers. Last year, I observed that we stopped getting quite a few channels. On enquiring, I was informed that they have upgraded their systems — to improve picture quality, etc — and so, we need to change our set-top boxes. The customer service representative informed me that we do not have to pay anything for this, but the decision makers of this service provider do not understand that though customers are not paying any money, they will have to waste their time for the technician to come and change the set-top boxes. Incidentally, after the change, I did not observe any improvement in the reception at all. The wrong assumption here is that the operator’s representatives have a good enough understanding of customer issues.

Frankly, most service providers don’t have to delight their customers. They just have to make sure customers are given what they have been committed and are not inconvenienced for receiving the promised service.
Banks aren’t much better. I have a savings account with an international bank, where I have a few term deposits. I received monthly statements with details of the individual deposits, but the total was missing. Even though I approached the country head of the bank to have this feature incorporated, it was implemented only after five or six years. I wonder what delight this bank could provide if it takes years to do something this simple. The result: I am in the process of closing my accounts (and my family’s) with this bank.

And then there are credit cards. An international credit card company offered me free domestic return air tickets, provided there was a certain amount of purchase within a particular period. I can only share that the conditions were such that it would be impossible for anyone to make use of this generous offer. Net result: I discontinued my relationship with the bank.

Most customers do not want to change service providers, so long as they get what they have been promised. Losing a customer should be viewed as sacrilege for the organisation, because only when things get out of control will a customer walk out. So, that should be seen as a red flag for the company. Moreover, companies also need to realise that the acquisition cost for getting a new customer is also rising.

In short, service providers can do a world of good by focusing on a few things. First, deliver what you promised. No more, no less. Second, don’t assume that all customers are the same — each one has a different pain point. Identify and solve these through customer engagement.
Finally, I would like to share a quote from Warren Buffett in response to a question from the audience at the 2003 AGM at Omaha, on how to achieve success. He said, “Take a few right decisions, provided you do not take too many wrong decisions.”

I recently attended an event by FICCI in Kolkata to support Prime Minister Narendra Modi’s Make in India appeal. In his speech outlining the opportunities for the manufacturing sector, I noticed that there was one aspect that hadn’t been addressed at all — delivery reliability. When the Indian market opened up to the global economy in the ’90s, the quality of our products left a lot to be desired. However, in the last 20 years, Indian organizations have improved product quality to a great degree, to the extent that it is no longer a significant issue. But delivery reliability is the one aspect of Indian manufacturing where a similar improvement is yet to be established.

India exports a huge amount of garments, which can be found in almost all major brand outlets. But if you ask any of the buyers about their biggest pain point, the unanimous answer would be delivery reliability, and with good reason. Often, consignments are not ready for dispatch as per the original shipment dates.

I know quite a few auto components manufacturers who could legitimately claim that they always supply on time, be it domestic sales or export orders. But, in reality, vehicle manufacturers struggle to adhere to their planned assembly schedules. The operations head of a large two-wheeler manufacturer once told me that the company always meets its daily target of vehicle production but not necessarily of the models that are actually planned or required by the marketing department; instead, it makes the models for which it has material readily available.

Since the production for each day is not for the models planned, this either results in sales loss or by having a large finished vehicles inventory in the distribution system. This surge in production of unplanned vehicle models leads to an rise in the finished goods inventory for obvious reasons.

Failure To Launch

But why are Indian manufacturers not able to deliver products on time? To quote the late Sumantra Ghoshal, it is because we are “satisfied with our underperformance”. Indian organisations were forced to improve product quality after liberalisation and if India aims to be the manufacturing hub of the world, the next step would be to improve delivery reliability significantly. Many business owners and decision-makers are not even aware of the impact of being able to deliver on-time-in-full (OTIF) on their bottom line — senior industry leaders gave me a 10-30% increase ballpark figure on being asked this question. Thanks to 15 years of theory of constraints (TOC) consulting experience, I have observed that significant increases in OTIF almost always results in a minimum profit before tax (PBT) increase of 100%, even shooting up to 400% in some cases.

Even the conservative assessment of a 10-30% increase in profits should be sufficient for further exploration of obstacles that stand in the way of achieving high delivery reliability. But most organisations continue to ignore this because of one crucial wrong assumption — the belief that we must always control costs, as if the organisational goal is not ‘make more money’ but ‘control costs’. In my opinion, a simple switch from the cost-benefit to the benefit-cost analysis could do the trick, as cost-benefit analysis often leads to tunnel vision and companies end up thinking that they can’t afford even a marginal increase in costs.

Roadblocks

Some very commonly cited reasons for delivery reliability are inaccurate forecasts, unavailability of material and inadequate manpower. But how much of an impact can these factors have on delivery? First of all, to be honest, the term accurate forecast is an oxymoron — forecasts are supposed to be wrong by definition, or else they would be called prophecies instead, and prophecies are reserved for imbeciles.

The real issue, in fact, is how to manage material availability in the absence of a highly accurate forecast, and we don’t have to look too hard for a solution. Almost all homes stock hundreds of items of regular use and yet, how often do we run out of these items? We may experience a stock-out at home every once in a while but it is certainly not a regular occurrence. Who provides forecasts in this case? The same logic applies to kirana stores, which, again, stock hundreds and thousands of different products. On the other hand, I have personally experienced the material shortages that a large vehicle manufacturer in India faced on a daily basis. Items such as tyres and fuel injection pumps, which were on shortage lists nearly 30 years back, still appear regularly on these lists to date. Stock-outs occur so regularly that most organisations have standardised the formats for material shortages; that they are updated on excel spreadsheets is the only difference from the situation three decades ago.

Is it possible to have almost no stock-outs without increasing the inventory through the roof? A visit to any retail chemist shop will point you in the direction of the solution — frequent replenishment of items sold; there are simple solutions to every seemingly complex problem. TOC creator Dr Goldratt believed that there should be no conflicts in the social sciences, just the way they don’t exist in hard sciences; in case there is one, we need to check our assumptions. Because solutions are always readily available, provided we are ready to let go of some deeply held but intrinsically incorrect assumptions. I can personally vouch for the fact that a somewhat advanced version of the frequent replenishment system that chemists practise — called the TOC rapid reliable replenishment system — has eliminated shortages for quite a few industrial organisations, without forcing them to increase inventories.

As for the manpower excuse, most companies face labour shortages both on an ongoing basis and during the festival season and almost all of them employ temporary workers. This is despite the fact that the companies know employing temporary workers creates a high level of uncertainty in availability, never mind the skill issues involved.

Most companies still continue this practise, if only to lower standalone labour costs or labour costs as a percentage of total cost or sales, or some other such metric. Unfortunately, the ultimate organisational goal is to make more money, not to subscribe to such surrogate parameters. At best, these parameters may help make the company a little more money but they are definitely not substitutes for the goal itself.

I am not suggesting that companies only have permanent employees. What we need to ensure is that there are a sufficient workers with the right skills available on board at all times, whether temporary or permanent. Frankly speaking, this issue of manpower shortage due to absenteeism is blown out of proportion — what about the loss in output due to wrong selection of manpower or inadequate skill development?

Indian manufacturing may have gained volumes in the last two decades thanks to its price competitiveness, but if low prices are the only criterion, then any company can take away your orders by lowering its prices. But committing to high delivery reliability — with significant penalties for delays — is something that competitors cannot achieve in a short period of time. This gives your organisation the ability to increase volumes with existing customers and prices with new customers. I am aware that adding buffer manpower and training or worker skill upgradation will cost organisations a fair amount of money. However, if improving OTIF could impact sales by even 30-50%, I believe that the benefits of the 100%+ increase in profits would more than adequately compensate for the corresponding cost increase. The goal, after all, is to keep making money as you Make in India.

It seems that as there are seasons in nature, there are seasons in large organizations as well. For example, people in many large organisations are totally occupied in the last quarter of the financial year in an activity called budgeting. You can observe this even as an outsider, since you can see people hurrying from one place to another, with all the meeting rooms being completely booked; so much so that even family members know not to disturb the employees unless there is some life-threatening situation. After the budget season comes the appraisal or review season. Once again, one can observe anxiety writ large on the faces of employees. It does not matter whether one is in the top 10% or bottom 10%.

Though organisations invest a lot of time in these annual rituals, what is the net impact? I have never witnessed any budget where budgeted profit is less than the previous year’s profit. Are companies able to increase their profits year after year? As per a survey published in a business newspaper on September 24, 2005, only 23 out of 3,000 organisations listed on the BSE could continuously increase their profits year after year in the previous decade. And since there was no meltdown from 1995-2005 in India, most organisations were not able to achieve the goal of making more and more money period after period. I believe that the situation is not better in 2015 either. Each year, managers and top management spend weeks and months negotiating targets, with both sides playing the regular annual game. At the end of the day, the entire process leaves the team exhausted.

Most organizations have a large number of metrics for every business unit, division, department, employee level and band. I have observed that most senior executives are familiar with local measurements but are ignorant of the overall financial measurements. Most organisations measure a large number of local metrics and, at times, local measurements are in conflict with each other. For the average employee, seeing the effect that any action has on net profit or return on capital employed or free cash flow is impossible. Often, the constraint of the organisation is a wrong measurement.

The only purpose of measurements is to take appropriate corrective actions. At the organization level, a few simple parameters are good enough. I have observed that at every organization, there is a missing link between global and local parameters. Measurements are useful only if everyone is able to relate these to global parameters. In case of conflict, global parameters supersede local parameters. This requires challenging the commonly held belief that financial measurements cannot be simplified enough to be understood by everyone. Finance can and should be simplified as there is a definite need for financial literacy across corporate India.

In one of my previous assignments, the unit had been losing money for the previous seven years and the decision-makers were considering closing the unit. Here, the constraint of the unit was cash availability for meeting the vendor payments on time. Correspondingly, all the supplies were also delayed, resulting in delay in dispatch of finished products to its customers. Cash was available from the head office but the finance manager was not seeking it because interest cost would increase, and his KRA was interest cost control.

Before suggesting any changes to the current process, let us first understand why budgets are required in the first place. What are the desirable effects of annual budgets? Is it to achieve higher performance or prevent complacency? Or is it to identify high performers and segregate good from bad? How about motivating everyone to give their best?

Most Indian organisations have severe negative side effects built in the budgeting process. Managers take conservative targets. On the other hand, top management then demands totally unrealistic targets. A significant amount of time of managers and top management is invested in the budgeting process. If the objective of budget process is to set ambitious targets and enable employees to take ownership of these targets, could there be an alternative process? The team could set and try to achieve ambitious targets if and only if they have a safety net in case these ambitious targets aren’t achieved. The decision-makers must assure the managers that in case the ambitious targets are not achieved, there will be no repercussions as long as these are better than the past results. Will this not lead to people becoming complacent? My experience has been the other way round.

I have experienced that a small change in the approach to budgets can lead to a huge transformation in the outcome. To set ambitious targets, the focus should be on a few parameters chosen by decision-makers. Now, the managers need to collectively decide the ambitious targets without taking into account current perceived constraints. Once the targets are decided, team members detail the possible obstacles for achieving these targets. Thereafter, the team generates a game plan for overcoming all the possible obstacles raised by everyone involved. Expansion plans are to be planned on current cash availability rather than expected cash generation during the year.

Most organizations do have some form of periodic formal review, where the CEO reviews with the mangers either individually or collectively. Often, the review frequency is monthly. But what is the purpose of the review? Is it to find the reason for variance of actual results with budget parameters or find the culprit? Or take corrective action? In my experience, the current review process in most organisations is rather quite frustrating. In the rare event of targets being achieved, complacency sets in.

I once participated in the quarterly review of a global software organization. The participants travelled from all parts of the globe for this one-day review. First, there were severe disputes about the data presented. In all, it took six hours to correct and validate the data presented. The next 90 minutes were invested in sharing the reasons for variance. Just about 30 minutes were left for corrective actions. One can understand the feelings of the managers who flew all the way from the other side of the globe.

So, what should be done? Since the purpose of reviews is corrective action, the shorter the interval between reviews, the better they will be. In most cases, a week is good enough. There should be no exceptions for not holding the review meetings on time and reports for the period must be available on time. There should be no questioning of data in the review meeting and no analysis paralysis. Too much time should not be wasted in analysing the reasons for not achieving the target. The focus should always be on corrective action only.

Many organizations end up in the undesirable position of running out of cash. All the time and attention of the top management is then consumed in fighting one payment crisis after another. The RBI’s new takeover policy has once again brought stressed loans in the spotlight and forced companies and banks to find effective means to improve operational performance and cash management. A recent report by ratings firm Fitch confirms that pressure on asset quality will continue in future. In FY15, the system non-performing loan (NPL) ratio rose to 4.6% of total assets from 4.1% in FY14. As per RBI’s financial stability report (FSR), this ratio might increase to 4.8% by September. After the RBI’s new guidelines have been issued, banks have become more aggressive in recovering dues. The new rules allow banks to take control of repeated defaulters by converting debt into equity and recover the arrears by selling the assets.

Initially, when an organization starts making losses, it starts withdrawing from its past reserves. Over a period of time, as past reserves are exhausted, working capital starts getting depleted in a non-linear manner. Cash crunch illustrates the case of a company that is precariously balanced. A small increase or decrease in cash can make or break an organization. The writing on the wall is clear — partial measures will not suffice. Theory of Constraints (TOC) provides some unorthodox solutions for getting out of this life-threatening crisis. In most cases, it is possible to overcome this constraint within 13 weeks, or one quarter. Here are five questions that the managements of stressed companies need to ask in order to take control of the situation and take corrective actions that lead to fast results.

Question 1: Where is your organization constraint currently? Is cash really your constraint?

TOC improvement methodology provides a simple and effective process for systemic improvement. The first step is to identify the weakest link or the constraint. The following step-by-step approach will help identify the constraint of a for-profit organization. The organization has a constraint in the market if it has a very large (~50%) share of the world market. Most organizations other than Microsoft, Intel or some niche players are unlikely to have this constraint. An organization has a constraint in orders when it delivers consistently more than 95% and on time in full (OTIF). Most organizations do not even have OTIF of 50%.

Cash Crunch: Precariously Balanced System

*All expenses excluding raw material; Raw material cost assumed as % of Net Sales = 50%

There will be a constraint in operations when organizations do not achieve OTIF of more than 95% despite receiving input materials on time. In case any organization’s equipment has an overall equipment effectiveness (OEE) greater than 90% on a 24X7 basis, then it will have a constraint in this equipment. If that’s not the case, then operational policies are turning a non-bottleneck into bottleneck, creating an artificial constraint.

When an organization has OTIF less than 95% and is unable to get input materials on time due to its inability to pay suppliers, it faces the worst type of constraint, that is, cash constraint. Cash shortage is not the same as cash constraint, though cash shortage will lead to cash constraint in due time.

Precariously Balanced System: Slight dip in cash at the beginning of the second month leads to rapid deterioration

Cash outflow to cash inflow time = 1 month

An organization has a cash constraint if and only if it has sufficient orders (OTIF < 95%), enough manufacturing capacity (OEE < 90%), a reasonable number of suppliers and yet suffers from material shortage as suppliers refuse to give credit. In this situation, the key issue is not sales, not even profit or loss — it is cash. Companies need to make decisions taking into account a key parameter, cash velocity. Cash velocity is defined as an increase in cash per unit of cash in one period of time. Let us assume that the totally variable cost (TVC) is 50% of sales and the time from cash outflow to cash inflow is one month. In other words, a cash induction of Rs. 50 will become Rs. 100 in one month’s time. Here, the cash velocity will be 100% per month.

Question 2: How are you making full use of the constraint? 

We need to squeeze as much throughput as possible through effective utilization of existing cash. Even a small increase in cash increases sales, throughput, OTIF and profit significantly. In most cases, it may be possible to overcome cash constraint in less than 13 weeks by increasing cash velocity. Therefore, it is imperative to prioritise actions to reduce cash-to-cash cycle time.

Reduction in customer payment time: More often than not, customer payment time is the single-largest component of the cash-to-cash cycle time.  Most managers think that when they reduce payment time by one week, they save interest cost only for one week. It is extremely important to note that even this small decrease in cash-to-cash cycle time increases cash velocity significantly, thereby impacting throughput non-linearly. As we get huge benefits from shrinking customer payment time, we must explore all possibilities, including discounts for immediate payment.

Shrinking manufacturing lead time: Drum-Buffer-Rope (DBR), the production solution of TOC, shrinks the manufacturing lead time by a factor of 2-10. This is particularly effective when manufacturing lead time is a significant part of the cash-to-cash cycle. For organizations that make capital goods, these tools help immensely in reducing manufacturing lead-time. In several cases, this paves the way for increased selling prices by offering reduced lead time. Firms that make to stock also benefit by reduced work in progress (WIP), and finished goods inventory, thereby releasing cash.

Reducing supplier lead time: This aspect is often overlooked and companies pay heavily by not modifying supplier policies in a cash-constraint situation. Reduction in supplier lead time is one of the important means of crashing the cash-to-cash cycle time, as the raw material inventory holding requirement comes down with the reduction in supplier lead-time. In some cases, it may also be worthwhile to switch to a supplier who has a higher price per unit but faster and more reliable deliveries, or is willing to supply in small lots. This may impact the gross contribution or throughput (though not significantly) but it can provide some much-needed liquidity. These decisions should be taken after evaluating the impact on affected parameters such as input price increase, reduction in cash-to-cash cycle time, reduction in raw material inventory requirement and, most importantly, improvement in cash velocity. While the above might seem like common sense, this is not common practice. Local measurements or departmental KRAs often prevent companies from adopting these practices.

Question 3: Can you subordinate policies to the constraint?

Functions in organizations do not work in a vacuum. Actions and decisions in one department invariably impact performance in other functions. All functions, departments and decisions should be aligned to get the most out of the constraint. In our experience, this is often difficult to implement, as it requires changes in existing practices and policies of local optimization.

Many organizations waste their most precious asset — cash — for purchasing more than the immediate requirement just because the purchase team can get a volume discount. This cash outflow starves the organization of other required materials, thereby jeopardizing full material availability. We have often observed that dispatches are held up because of non-availability of one of the insignificant inputs. This increases cash-to-cash cycle time and hastens bankruptcy. It is recommended to buy just the minimum quantity required for making ‘full kit’ for immediate production.

Similarly, chasing local optima in manufacturing leads to more production to achieve better capacity utilization. Plant managers produce more quantity of some products to save on set-up times. The additional production blocks cash and increases cash-to-cash cycle time, delaying other products. There is one common behaviour that I’ve observed almost every time I am called upon to turn around operations of a stressed unit. Organizations are extremely reluctant to change current business practices, be it in buying materials, manufacturing or selling.

Let me illustrate this through a case study. This client was in the business of making switches. It declared a loss for the first time after making profits for 42 years. The situation became extremely critical as suppliers stopped selling material unless paid upfront. Consequently, capacity utilization dropped to less than 50%. Totally Variable Cost (TVC) as a percentage of net sales was 40%, manufacturing lead time was three days and realization time was 60 days, as it was selling primarily to retailers. Every additional Rs. 40 would generate additional sale of Rs. 100 and cash inflow of Rs. 100 after 63 days, meaning every additional Re. 1 gets converted to Rs. 2.5 after 63 days.

When I asked the owner if it would be feasible to shrink realisation time by offering discounts, he refused point-blank, as this would increase losses even further. I suggested that we do this exercise on paper. I suggested that he could offer 50% discount for payment upfront. For every additional Rs. 40, we will have sales of only Rs. 50 (50% of 100). However, the conversion time now gets reduced to six days (three for manufacturing and three for getting the credit in the bank). Or, every additional Re. 1 will now generate cash of Re. 1.25 but after six days. After another six days, the Rs. 1.25 realized would generate Rs. 1.56 (1.25 X 1.25). Continuing this for 60 days, the initial Re. 1 would get converted to Rs. 9.31, a little less than four times of Rs. 2.5 being generated the conventional way. The organization offered this proposal in a segmented market and turned around in less than three months. Segmented markets are those where volumes sold in one segment do not impact volumes and prices in others.

There’s no magic to this — we just need to work out the rate at which cash is being generated in a period of time. Here, the existing cash velocity was about 55% per month and in the proposal, it was 205%. Ten years later, the company was sold to an MNC for Rs. 650 crore.

Question 4: Should you elevate (borrow or induct) cash at significantly higher rate of interest?

In most situations, recognizing that cash is the real constraint and exploiting and subordinating all organizational measures and policies to the cash constraint will shift the constraint either to orders or operations within 13 weeks. However, in extreme situations, it may be necessary to induct additional cash. For stressed assets, cash may be available only at a significantly higher rate of interest. Here, we must understand that for most organizations, cash velocity varies from 10-30% per month.  Hence, it makes sense to borrow even at a very high rate of interest, so long as it is less than the cash velocity. Another caveat is that partial induction of cash will not work. Either induct the total minimum required cash or none at all.

The main obstacles in overcoming cash constraints are the local measurements (sales, market share, tonnage, freight cost control and interest cost control) that companies continue to improve when in cash constraint. Continuing to use the same measurements leads to further deterioration of the situation. Companies do not fold up when they make losses, they shut when they run out of cash. Survival time is the period of time in which the existing cash can cover fixed expenses. Any action that has beneficial impact after the survival time is irrelevant. All actions should be taken to increase survival time by shrinking cash-to-cash cycle time.

Question 5: What should you do when cash constraint is broken?

Once the constraint has been overcome, go back to step 1: identify the current constraint. Where is your constraint now — is it in orders, operations or supplies? Do not let inertia be your system constraint.

This article was co-authored by Ira Gilani Lal