TOOL KIT

How Fast
Can Your
Company Afford to ?
by Neil C. Churchill and John W. Mullins

It takes money to make money,

of course. But exactly how

T ' V VERYONE KNOWS THAT STARTING A BUSINESS REQUIRES CASH,
much money does it take to
f—/ and growing a business requires even more-for working capital,
grow how much? Here's a * -^ facilities and equipment, and operating expenses. But few people
understand that a profitable company that tries to grow too fast can run
precise way to calculate how out of cash - even if its products are great successes. A key challenge for
managers of any growing concern, then, is to strike the proper balance be-
fast you can grow a business tween consuming cash and generating it. Fail to strike that balance, and
even a thriving company can soon find itself out of business-a victim of
without running out of cash. its own success.

MAY 2 0 0 1 135
TOOL KIT • How Fast Can Your Company Afford to Crow?

Fortunately, there's a straightforward Components of an Operating Cash Cycle

way to calculate the growth rate a com-
pany's current operations can sustain Operating Cash Cycle
and, conversely, the point at which it
would need to adj ust operations or find
new funding to support its growth. In Days Holding Inventory-
this article, we will lay out a framework
for managing growth that takes into ac- Days of Accounts
Receivable
count three critical factors:
Days of
• A company's operating cash cycle-the -Accounts-
amount of time the company's money Payable
is tied up in inventory and other cur-
rent assets before the company is paid Duration Cash Is Tied Up
for the goods and services it produces. I
Inventory Payment for Goods Payment
• The amount of cash needed to finance Received Inventory Sow Received
each dollar of sales, including working
capital and operating expenses.
Many factors affect the length of your company's operating cash cycle: how
• The amount of cash generated by each
long you have to pay your suppjiers, how long you hold on to inventory, and
dollar of sales.
how long your customers take to pay for your goods and services.
Together, these three factors deter-
mine what we call the self-financeable
growth (SFG) rafe-that is, the rate at
which a company can sustain its growth
through the revenues it generates with- Chullins Distributors'Financial Statements
out going hat in hand to financiers.
The usefulness of this framework Income Statement (in OOO's)
goes beyond the calculation of a sus-
tainable growth rate. It can also give Sales $2,000 100.0%
managers practical insights into how Cost of sales 1,200 60.0
efficiently their operations are running, Cross profit 800 40.0
how profit margins affect their ability to Operating expenses 700 35.0
fuel faster growth, which of their prod- Net profit aftertax $100 5.0%
uct lines and customer segments hold
the gi'eatest growth potential, and what
kinds of businesses might be attractive Balance Sheet (in OOO's)
investment targets.
Cash $ 10
Three Levers for Growth Accounts receivable 384 70 days*
Inventory 263 80 days
To begin, we'll show how the SFG rate
Total current assets $657
is calculated in a simplified example for
Plant and equipment $25
a hypothetical company we'll call Chul-
Total assets $682
lins Distributors. Then we'll demonstrate
how the three factors work as levers that
Accounts payable $99 30 days
can be manipulated to enhance Chul-
Bank loan payable 50
Total current liabilities $149
Neil C. Churchill is a visiting professor at
the Anderson School at UCLA and a pro-
Contributed capital $350
fessor emeritus of entrepreneurship at
Retained earnings 183
• INSEAD in Fontainebleau, France. John
Total owners'equity $533
W. Multins is an associate professor of
Total equities $682
marketing at the Daniels College of Busi-
ness at the University of Denver and a vis- *Calculatethe number of days as follows. For accounts receivable, divide
iting associate professor of entrepreneur- thedollar amount ($384) by the daily so/es ($2,000^-365)- For inventory and
ship at London Business School. He can be accounts payable, divide the dollar amounts ($263 and $99) by the daily
reached atjmullins@du.edu. cost of sales ($1,200 •;• 365).

136 HARVARD BUSINESS REVIEW

 How Fast Can Your Company Afford to Crow? • TOOL KIT

lins's ability to grow from internally and grow from internal sources. (See the 30-day credit terms with its suppliers,
generated funds. To determine the SFG exhibit "Components of an Operating so cash is not actually expended for
rate, we must first calculate each of the Cash Cycle") inventory the moment it arrives but,
three factors that compose it. To calculate Chullins's OCC, take a rather, 30 days afterward, when the sup-
The Operating Cash Cycle. Every look at its most recent income state- plier is paid. This shortens the time the
business has an operating cash cycle ment and balance sheet, shown in the cash is tied up for inventory and ac-
(OCC), essentially the length of time a exhibit "Chiallins Distributors' Financial counts receivable (ultimately, therefore,
company's cash is tied up in working Statements." At tbe right side ofthe bal- for cost of sales) to only 120 days, or 80%
capital before that money is finally re- ance sheet, we see that customers pay ofthe 150-day cycle.
turned when customers pay for the prod- their invoices in 70 days and that in- Of course, in addition to working
ucts sold or services rendered. Compa- ventory is held for an average of 80 days capital, we must also account for the
nies that require little inventory and are before it's sold. So the cash that Chullins cash needed for everyday operating
paid by their customers immediately in invests in working capital is tied up for expenses - payroll, marketing and sell-
cash, like many servicefirms,have a rel- a total of 150 days. That's Chullins's op- ing costs, utilities, and the like. These
atively short OCC. But companies that erating cash cycle. expenses are paid from time to time
must tie up funds in components and in- Fortunately, Chullins's cash isn't throughout the cycle, and the cash for
ventory at one end and then wait to col- really tied up for the entire OCC. We them may be tied up anywhere from
lect accounts receivable at tbe other need to take into account the delay be- 150 days (for bills paid on the first day of
have a fairly long OCC. All other things tween the time Chullins receives suf)- the cycle) to zero days (for invoices paid
being equal, the shorter the cycle, the plies and tbe time it pays for them. As on the same day the company receives
faster a company can redeploy its cash tbe exhibit shows, the company is on its cash from customers). We shall as-
sume, though, that bills are paid more or
less uniformly throughout the cycle and
Chullins Distributors'Operating Cash Cycle so are outstanding, on average, for half
the period, or 75 days. A summary ofthe
Base Case
duration Chullins's cash is tied up for
cost of sales and operating expenses
Duration Cash Is Tied Up (in days) appears in the exhibit "Chullins Distrib-
Accounts receivable 70 utors' Operating Cash Cycle"; to sim-
Inventory 80 plify this first example, we've included
OCC income taxes within operating expenses
Accounts payable 30 and ignored depreciation.
Cost of sales 120 The Amount of Cash Tied Up per
Operating expenses 75 Cycie. Now that we know how long
Chullins's cash will be tied up, we next
Income Statement calculate how much cash is involved.
Sales $1,000 The income statement shows that to
Cost of sales 0.600 produce one dollar of sales, Chullins in-
Operating expenses 0.350 curs 60 cents in cost of sales, money that
Total costs $0,950 / Chullins must invest in working capital,
Profit (cash) $0,050 which we've already determined is tied
up for 80% of the 150-day cycle. The av-
Amount of Cash Tied Up per Saies Doliar erage amount of cash needed for cost of
Cost of sales $0,600 X (120 ^150) = $0,480 sales over the entire cycle is thus 80%
Operations . $0,350 X (75-r 150) = $0,175 of 60 cents, or 48 cents per dollar of sales.
Cash required for each OCC i $0,655 The income statement also shows
that Cbullins must invest 35 cents per
Cash Generated per Saies Dollar $0,050 dollar of sales to pay its operating ex-
penses throughout the cycle. Since
SFG Rate Caicuiations we've calculated that this cash is tied
OCC SFC rate $0,050 v $0,655 = 7.63% up, on average, for half the cycle, or
OCCs per year 1 3 6 5 ^ 1 5 0 = ___ 2.433 75 days, the average amount of cash
Annual SFC rate 7.63% X 2.433 = 18.58% needed for operating expenses over the
Compounded annual SFG rate (1 + 0 . 0 7 6 3 ^ " " - 1 = 19.60% entire cycle is 17.5 cents per dollar of
sales. So all in all, Chullins must invest

MAY 2 0 0 1 137
TOOL KIT • How Fast Can Your Company Afford to Crow?

a total of 65.5 cents per dollar of sales The Maximum SFG Rate Of course, in each subsequent cycle,
over each operating cash cycle. Chullins is earning more and more, and
The Amount of Cash Coming In per Suppose Chullins decides to invest the this calculation has not taken into ac-
Cycle. Happily, Chullins is a thriving, entire 5 cents in worldng capital and op- count the compounding effect. If it did,
profitable business: after using 60 cents erating expenses to finance additional the SFG would come out to 19.60%.^
of each sales dollar for working capital sales volume. Assuming the company As a practical matter, though, unless
to support cost of sales and another has the productive capacity and mar- your operating cash cycle is very short-
35 cents for operating expenses, it reaps keting capability to generate additional less than about 100 days - the simpler
a full dollar at the end of the cycle. To sales, adding the 5 cents to the 65.5 cents straight-multiplication calculation is
finance another trip around the cycle already invested would increase its in- sufficient That's because our framework
at the same level of sales, it will need to vestment by 7-63% each cycle,' which assumes a company's past performance
reinvest 95 cents of that dollar, 60 cents directly translates into a 7-63% increase is an accurate predictor of its future per-
for cost of sales and 35 cents for operat- in sales volume in the next cycle. formance, which most managers know
ing expenses. The extra 5 cents that each If Cbullins can grow 7-63% every 150 is a tenuous assumption at best So using
dollar of sales produces can be invested days, how much can it grow annually? the more conservative SFG figure offers
in additional working capital and oper- Since there are 2.433 cycles of 150 days some measure of protection from unan-
ating expenses to generate more rev- in a 365-day year, tbe company can af- ticipated slips in performance.
enue in the next cycle. How much more ford tofinancean annual growth rate of What does that 18.58%figuretell us?
revenue? A simple calculation will lead 2.433 times 7.63%, or 18,58%, oA the If Chullins grows more slowly than
us to that number - the SFG rate - for money it generates from its own sales. 18.58% (assuming al! variables remain
each cycle. Its SFG rate, in other words, is 18.58%. constant), it will produce more cash

Pulling the Three Levers to Manage Cash for Growth

Lever 1: Lever 2: Lever 3:
Speeding Cash Fiow Reducing Costs Raising Prices

Duration Cash Is Tied Up (in daysj

Accounts receivable 66 70 70
Inventory 74 80 m
OCC 140 150 im
Accounts payable 30 30 30
Cost of sales 110 120 120
Operating expenses 70 75 n
Income Statement Unadjusted Adjusted
Sales $1,000 $1,000 $1,015 $1.0000
Cost of sales i 0.600 0.590 0.600 0.5911
Operating expenses ^.350 0.345 0.350 0.3448
Total costs $0,950 $0,935 $0,950 $0.9360
Profit (cash) $0,050 $0,065 $0,065 $0.0640

Amount of Cash Tied Up per Sales Doilar

Cost of sales $0.4720 $0.4729
Operations $0,175 $0.1725 $0.1724
Cash required for each OCC ] $0,646 $0.6445 $0.6453

Cash Generated per Sales Dollar $0,050 $0,065 itam

SFG Rate Caicuiations
OCC SFG rate 7.73% 10.09% 9.92%
OCCs per year * 2.607 2.433 2.433
Annual SFC rate 20.17% 24.54% 24.15%
Compounded annual SFG rate 21.44% 26.34% 25.89%

138 HARVARD BUSINESS REVIEW

 How Fast Can Your Company Afford to Crow? • TOOL KIT

than it needs to support its growth. But shrinking collection time from 70 days Lever 2: Reducing Costs. Instead of
if it attempts to grow faster than 18.58% to 66. Let's also suppose that manage- speeding up cash flow, management
per year, it must either free up more ment can improve the rate at which It could seek to decrease the amount of
cash from its operations or find addi- turns its inventory, perhaps through bet- cash it needs to invest. Suppose Chul-
tional funding. Otherwise, it could un- ter forecasting, thereby reducing the lins's managers can negotiate better
expectedly find itself strapped for cash.

Pulling the Levers Many entrepreneurs understand in a general way

Chullins may see a market opportunity the importance of effectively managing cashflow.
to grow faster than 18.58% and, for any
number of reasons, may want to fund it With the tools in this article, they can calculate the
by internal, not external,financing.The real impact of any proposed changes in their working
company could afford to grow faster by
manipulating any of the three levers capital on the rate at which they can grow.
that determine its SFG rate. Our frame-
work shows how each of these decisions time its cash is tied up from 80 days to prices from key suppliers, thereby re-
will change the maximum growth rate 74. These changes reduce the OCC from ducing the cost of sales from 60% to 59%.
Cbullins can afford to finance by itself. 150 to 140 days. Tbe company is still pay- Suppose they can trim operating ex-
Lever 1: Speeding Cash Flow. Sup- ing the same 60 cents for every dollar df penses by half a percentage point as
pose Chullins's accounts receivable man- inventory, and it's still on 30-day terms. well, dropping from 35% to 34-5% of
ager can get customers to pay faster. Now that the 60 cents is tied up for sales. That would reduce tbe cash re-
only 110 out of 140 days, the cash needed quired to finance the next cycle from
for inventory over the entire cycle is re- 65.5 cents to 64.45 cents, a savings of
duced from 48 cents to 47.1 cents (see 1.05 cents per dollar of sales. If Chullins
the figures for Lever 1, calculated in tbe passed on these savings to its customers
same way as in the previous exhibit, in to hold its profit margin at 5%, the sav-
Puiling Muitiple Levers
"Pulling the Three Levers to Manage ings would have little impact on its abil-
Cash for Growth"). Operating expenses ity to finance further growth, as its SFG
remain at 35 cents and are still tied up rate would increase infinitesimally from
for half the OCC, so 17.5 cents is still 18.58% to 18.88%.
74
needed each cycle for operating ex- But if prices were held constant, the
140
penses. Thus, the company needs 64.6 extra cash generated in each cycle would
30
cents cash to generate one dollar of sales rise from 5 cents per dollar of sales to 6.5
110
in each cycle. It still generates 5 cents cents. Now, needing only 64-45 cents to
70
profit, so the extra 5 cents will generate generate each dollar of sales in each
7.73% more sales (5 divided by 64.6 cycle and generating 6.5 cents profit
cents) for each cycle. There are now on each dollar, Chuilins can generate
$1.000
more cycles per year (2.607 rather than 10.09% more sales in the next cycle, for
0.590
2.433), so that slight increase in growth an annualized SFG rate of 24-54%- (See
0.345
per cycle worksf' out to an annual SFG tbe figures for Lever 2 in the exhibit.)
$0.935
rate of 20.17%. The framework clearly Look at the power of the profit mar-
$0,065
shows the effect of better asset man- gin. An increase of 1.5 percentage points
agement: by modestly decreasing the in the net margin led to an increase of
amount of time for inventory turnover six percentage points from the original
$0.4636
(7.5%) and for collecting receivables 18.58% in the rate at which Chullins can
$0.1725
(5.7%), Chullins increases the amount grow - that's an increase of 32% in its
$0.6361
it can afford to grow by slightly more SFG rate. Companies witb huge gross
than 1.5 percentage points. margins, such as many software com-
$0,065
Many entrepreneurs understand in panies (which can produce CDs for only
a general way the importance of effec- a few dollars and sell tbem for bun-
10.22% tively managing cash flow. Using the dreds), are able to grow so fast because
2.607 tools presented in this article, they can they need to tie up relatively little cash
26.64% calculate the real impact of any pro- for inventory and because their high
28.87% posed changes in their worldng capital profit margins generate lots of cash for
on the rate at which they can grow. growth.

MAY 2 0 0 1 139
 TOOL KIT • How Fast Can Your Company Afford to Grow?

Lever B: Raising Prices. Rather than over a company's OCC (in the United than 5%). But if we assume that the com-
reduce costs, Chullins could achieve es- States, for example, taxes are paid quar- pany spends all of its depreciation al-
sentially the same result by raising terly), and their calculation includes lowance on asset replacement to main-
prices (assuming the market would bear noncash expenses such as depreciation. tain its current sales level, the SFG rate
it). Suppose management thinks it can Let's assume that 40% of pretax prof- fails to 16.25%. This makes sense, be-
raise prices 1.5% without dampening de- its are paid quarterly in income taxes. As cause tbe cash being invested in asset re-
mand. That too raises profit margins we did with operating expenses, we'll placement exceeds the cash generated
from 5 cents to 6.5 cents. If all costs re- treat income taxes as if we paid them from tbe tax break.
main the same, the higher prices would. uniformly throughout the 90-day quar- Making adjustments for taxes, depre-
ciation, and asset replacement can be
tedious, and as their impact on the SFG
The period over which a company finances its fixed rate is generally extremely small, we sug-
assets has a marked effect on its abi-lity to grow, gest that for preliminary, back-of-the-
envelope planning, managers should
perhaps more than many managers would expect omit them, in a spreadsheet analysis, the
calculations are relatively easier, and we
in effect, lower the cost of sales and op- ter such that cash for taxes will be tied include them in our remaining compar-
erating expenses. The result is that Chul- up for 45 days and will accrue for 45 isons to be more precise.
lins would be able to sustain a growth days. To make the example comparable,
rate of 24.15%, slightly lower than it we must adjust the figures so that Investing over Many Cycles
could afford if it instead reduced costs Chullins generates 5% profit from oper- So far, we've assumed that Chullins Dis-
while keeping its price steady, since in ations after taxes ratber than before tributors has enough capacity to ac-
that case, slightly more cash is invested (which we do by raising pretax profits commodate an increase in sales with-
during the cycle. (See the figures for from sales to 8.3%). Cash for cost of sales out increasing fixed assets; we've also
Lever 3 in the exhibit.) and operating expenses remains the assumed that all marketing and R&D
Puliing Muitipie Levers. There is, of same, but we must now include cash for expenditures could remain at their his-
course, nothing to prevent management income taxes (3.3% for 105 ofthe cycle's torical levels as a percentage of sales.
from using more than one lever at a time. 150 days, since we subtract tbe 45 days At some point for almost all compa-
If Chullins could manage to both speed when taxes will not have been paid). nies, however, these assumptions fail to
its cash fiow and reduce costs, it would Chullins's ability to grow according to hold. Plants are working around the
be able to sustain an annual growth rate this more precise treatment, 18.39%, is clock, perhaps. Maybe Chullins's ware-
of 26.64% - 43% more than its original barely less than the 18.58% in our origi- house is bursting at the seams. Or the
growth rate-without going to external nal example. That's because cash tied company needs to embark on a major
sources of capital. (See thefiguresin the up for income taxes is very small relative promotion or costly R&D effort. In such
exhibit for using multiple levere.) to the amount needed for cost of sales cases, a portion ofthe cash generated in
and operating expenses. eacb operating cash cycle must be set
Adding Complexity to Depreciation and Asset Repiace- aside to fund expenses that span a num-
the Framework ment. In most companies, depreciation ber of cycles.
So far, we've considered a simplified expenses are offset wholly or mostly by investing in Additional Fixed As-
situation: the operating cash cycle en- real cash used to maintain their asset sets. Tbe period over which a company
compasses all the cash flows involved in bases. Equipment must be replaced, finances itsfixedassets has a marked ef-
generating saies, and there are no non- facilities updated, and so on, just to fect on its ability to grow, perhaps more
cash expenses, so profit equals cash at maintain a company's current rate of than many managers would expect.
the end of each cycle. We've included in- sales. To include these costs, we will use Let's say that Cbullins needs $400,000
come taxes in operating expenses and ig- the depreciation figure (1% of sales) that to expand its facilities in a year in which
nored depreciation. In reality, however, Chullins historically shows on its in- its annual sales volume is $10 million. It
the effects of taxes and depreciation are come statement, together with our as- must therefore set aside 4 cents of each
more complex than tbis, and we can ac- sumptions about the company's asset annual sales dollar for expansion, i.e.,
count for them within the framework. replacement history. 4 cents in cash for each sales dollar in
(Detailed calculations for the examples If Chullins doesn't need to invest cash Chullins's 150-day cycle. Deducting this
that follow are posted on the Web at to upgrade assets (which may be true amount and the 1 cent for asset replace-
www.hbr.org/explore.) in the Short term), its SFG rate rises to ment from its 5-4% profit leaves 0.4 cents
Income Taxes. Two complications 19.94%. That's because the depreciation to fund growth in subsequent cycles,
arise regarding income taxes for most allowance saves on taxes, yielding more and the SFG rate drops to a mere 1.48%.
companies: taxes are not paid uniformly cashfromoperations (5.4% of sales rather Chullins, therefore, may be unable to

140 HARVARD BUSINESS REVIEW

serve potential new customers just be- resulting tax savings means that cash
fore expansion, although it could re- from operations falls 2.4 percentage
sume a faster rate of growth afrer the points rather than 4 points. For working
facilities are in place. capital, Cbullins now needs 66.8 cents
But what if the company decides to instead of 65.9 cents for each cycle to
take two years to set aside tbat $400,000? fund the higher level of operating ex-
Then each annual sales doUar would pro- penses. Thus, allowing for tax savings,
vide cash for grovrth of 2.4 cents per dol- Chullins would now be generating cash
lar of sales, because only 2 cents per sales at the rate of 2 cents per sales dollar, for
dollar must be set aside for expansion an SFG rate of 7.29% during the period
during each 150-day cycle. Chullins's pa- in which the additional 4% expense in
tience would permit a faster SFG rate, R&D or marketing takes place.
8.86%, during the funding period.
After making the investment in new
capacity, Chullins could resume its pre-
Different Product Lines Within a
Business. Different product lines, dif-
ferent customers, different business
not ideas
vious full SFG rate, assuming that its units, and so on ofren exhibit different
levels of operating and working capital
remain unchanged. If, however, the new
investment reduces the cost of sales or
cash and operating characteristics. Some
customers, for example, may need ex-
tended terms, thereby requiring greafer
not talent
operating expenses, as it might, Chul- investments in working capital. Others
lins's growth rate would increase. Of may demand volume discounts. Let's

Counterintuitively perhaps, serving large new

customers with their equally large demands - even
at higher margins - is not always the most attractive
route to growth.

course, the company could, perhaps, give Chullins two product lines to illus-
lease its additional facilities, to avoid the trate how to use theframeworkto mal?e
initial cash outlay entirely. Doing so decisions about their growth potential.
would avoid depressing its SFG rate for Product A is its original line, which
a year or two, as in tbe examples above, bas a net profit margin of 4%. At 7%,
but would add costs over the life of tbe Product B is a higher-margin line of
lease. Projecting the extra costs and customized items sold to a few large cus-
comparing them to any additional cash tomers who require extended terms.
the new facilities would generate would When we calculate the SFG rate for
enable the company to calculate its SFG each in the usual way, wefindthat even
rate for this scenario. though Product A carries lower mar-
Investing in R&D and Mari<eting. gins, the duration of its cash cycle is so
Suppose the company invests a hefty much shorter (92 days versus 271 days)
$400,000 in R&D or marketing, paid tbat its SFG rate comes to 27.08%, nearly
out evenly over the year. How that ex- twice Product B's 13.65%- If we assume
pense is accounted for has a major effect that the prospects for growth are equal
on Chullins's ability to finance future for tbe two product lines, Chullins will
growth. If the investment is treated as grow faster in the long run by pursuing
a capital expenditure, it becomes the the lower-margin Product A. Since its
equivalent of purchasing a fixed asset, annual SFG rate is twice as high, a dol-
and the SFG drops to the same 1.48%. lar of cash invested in efforts to grow
But how about expensing the invest- Product A will bring slightly more net
ment in the current year for tax pur- profit (4% profit on 27.08% additional
poses? That will reduce Chullins's tax- sales will yield 1.08% more net profit)
able income from 7.3% to 3.3%. The than that same doliar would reap if in-

MAY 2 0 0 1
T O O l KIT • How Fast Can Your Company Afford to Crow?

vested in Product B (7% net profit on

13.65% additional sales will yield 0.96%
more net profit). As sales growth com-
pounds, the advantage of Product A
over Product B can only grow. Counter-
intuitively, perhaps, serving large new Where Is the Most Growth Potential?
customers with their equally large
demands - even at higher margins - is For simplicity's sake, we've used a dis- for infomercials long before sales are
not always the most attractive route to tribution company for our hypotheti- made, and neither postal services nor
growth. cal example. But different kinds of television stations are likely to offer
businesses vary in their ability to grow trade credit. In such cases, the OCC in-
Bringing Together from internally generated funds. Our creases dramatically But tbat doesn't
Operations and Asset framework can demonstrate how. necessarily depress a company's ability
Management Manufacturing Companies. Rather to finance growth, as we can demon-
operating management decisions (which than being a distributor, what if strate if we reconfigure Chullins Manu-
usually focus on the income statement) Chullins were a retailer or a manufac- facturing intoChultins Imports.
and asset management decisions (which turer? The variables work in essentially Let's say the company decides to
typically focus on the balance sheet) are the same way for retailers, and they're begin importing all of its inventory
often made by different groups of man- almost the same for manufacturers. from Asia instead of buying domesti-
agers within an organization. Our frame- But rather than figuring in operating cally. Its suppliers require letters of
work provides a way to bring together expenses throughout the operating credit, backed by Chullins's cash, be-
these discrete kinds of decisions and cash cycle, manufacturers factor in fore the merchandise is sent on its
managerial perspectives for a common laborcosts,the duration of which is 40-day trip across tbe Pacific, through
discussion of the merits of various op- slightly shorter, leading to a small dif- customs, and on to Chullins's domestic
erating andfinancialstrategies and their ference in the SFC rate. If we keep all warehouse. This requirement in-
impacts on the ability of a company to variables comparable and now include creases the company's operating cash
finance its own growth. labor costs, Chullins Manufacturing cycle from 150 to 190 days. And since it
This collaboration need not be re- could sustain a self-financed growth has no trade credit from suppliers any
stricted to companywide decisions. SFG rate of 16.35%, practically identical to more, its cash for cost of sales is now
rates can be calculated for companies Chullins Distributors'16.25% (account- tied up for tbat entire 190-day period
of any size, for business units, or for mar- ing for taxes, depreciation, and asset instead of Chullins Distributors'120
ket segments. They can be calculated replacement). The greater capital in- days. Those changes alone would dra-
from historical financial data or extrap- tensity of the manufacturing business matically depress Chullins's SFG rate.
olated from planned future perfor- bas virtually no effect, given our as-
But we must factor in tbe reason for
mance assumptions to facilitate what-if sumption that all depreciation allow-
switching suppliers, which is, typically,
planning. As such, the SFG framework ance is used to fund asset replacement.
to reduce overall merchandise costs.
can be the source of a new, more com- But, to the extent that fixed assets
So let's assume that, despite the added
plete, and more powerful understand- must be added to grow, the SFG rate
transportation costs, overall costs drop
ing of the consequences of managerial would be reduced. In fact, unless gross
by ten percentage points, lowering
decisions. ^ margins are extraordinary, as they are
cost of sales from 60% to 50%. If
for software companies, SFC rates for
Chullins's operating expenses remain
1. Calculation discrepancies are due to Excel spread- manufacturers are not likely to be very
at 31-7% of sales, the pretax profit mar-
sheet rounding anomalies; calculations in the high relative to other kinds of busi-
spreadsheets use more precise figures. gin rises 10 percentage points over
nesses because ofthe ongoing need to
2. To account for compounding, we must raise the tbat in the manufacturing example, to
multiple for each subsequent cycle (1.0763, in our add capacity to support sales growth.
17.3%, resulting in a dramatic rise-to
case) to the nth power, where n is the number of
cycles in a year (2.433 here), and then subtract i Direct Marketers and Importers. 28.09% peryear-in its ability to fi-
to get the SFG rate as a percentage. In this exam- nance growth.
ple, (1.0763 to the 2.433 power = 1.1960) -1 = 19.60*. For companies like these, working caf>
ital can be tied up in more arenas than So even though Chullins Imports
inventory and accounts receivable. had to tie up its cash for inventory 58%
Reprint R0105K
To order reprints, see the last page Importers, for example, must typically longer (from 12O days to 190 days), the
of Executive Summaries. post letters of credit before merchan- power ofthe profit margin pays big
dise will be shipped, essentially paying dividends in its ability to grow. It's no
For a complete set of this article's
spreadsheets, which can be used as for goods some 30 or 45 days before wonder we see so mucb movement of
templates to create your own, go to they are received. Direct marketers manufacturing activities to lower<ost
www.hbr.org/expiore. often mail catalogs or buy media time locations.

142 HARVARD BUSINESS REVIEW

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