The impact of cost structure on supply chain cash flow risk

What is it about?

Managing supply chain cash flow risk has become a crucial task for many cash stressed businesses. Cash flows usually lag behind operating earnings and exhibit higher volatility than earnings, making them less predictable. Through the three components of the cash conversion cycle -- days in inventory, receivables, and payables, this study investigates the impact of cost structure -- cost ratios and cost compositions -- on cash flow risk (standard deviation) and explains why and how management philosophies, such as Just-In-Time, and new production technologies, such as 3D printing, can lower cash flow risk by shortening days in inventory and shifting cost structure. An analytical model built on a simple demand process examines the basic relationship between cost structure and cash flow risk while a simulation approach studies the same relationship under a more general demand process with additional modeling considerations and a benchmark test. The simulation approach is applied on a publicly traded company's financial data to demonstrate how supply chain process improvement can reduce the cash flow risk.

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Why is it important?

Organizations with a large amount of accruals have a time gap between operating earnings (operating net income) and operating cash flows caused by trade credit terms and production lead time. As such, a company with healthy earnings may still succumb to the cash pressures from customers and suppliers for better credit terms and from its primary bank for a tightened credit line, because it lacks the operating cash to buffer the time discrepancy between cash inflows and outflows.

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