Financial Fundamentals for SCM

SCM Practitioners need to understand the cost structure of every organization in supply chain. Following diagram shows the impact of cost structure of one entity on the other entity.

An important activity in managing the SCM is to reduce costs in the entire supply chain network. In order to achieve this, first we need to understand the inventory valuation or costing methods that help to arrive at product cost. Following are some standard costing methods used across world:

• Standard Costing method: In this method, the standard cost of the items is defined by cost accountant and it is updated periodically to reflect the changes in the actual prices.

• First in First Out (FIFO): The cost of goods sold is based upon the cost of material bought earliest in the period, while the cost of inventory is based upon the cost of material bought later in the year. This results in inventory being valued close to current replacement cost. During periods of inflation, the use of FIFO will result in the lowest estimate of cost of goods sold among the three approaches, and the highest net income.

• Last in First Out: The cost of goods sold is based upon the cost of material bought towards the end of the period, resulting in costs that closely approximate current costs. The inventory, however, is valued on the basis of the cost of materials bought earlier in the year. During periods of inflation, the use of LIFO will result in the highest estimate of cost of goods sold among the three approaches, and the lowest net income.

• Weighted Average: Under the weighted average approach, both inventory and the cost of goods sold are based upon the average cost of all units bought during the period. When inventory turns over rapidly this approach will more closely resemble FIFO than LIFO.

Following are the major steps in the accounting cycle that will help to understand the fundamental aspects of accounting:

• Analyze Business Transactions
• Record entries in Journal
• Post entries to Ledger
• Prepare a Trial Balance
• Prepare Adjusting entries and Post to the Ledger Accounts
• Prepare Adjusted Trial Balance
• Prepare Financial Statements
• Profit and Loss Statement
• Balance Sheet Statement
• Closing entries are made

Balance Sheet:

It is a financial statement that summarizes organization’s financial position at a specific point of time. It’s a numeric illustration of the balance between a firm’s assets on one hand and its liabilities and owner’s equity on the other hand in a given point of time.

To Analyze the cost structure of the Supply Chain Network, following financial ratios are widely used:

Liquidity Ratios: Liquidity Ratios are used to examine the firm’s ability to meet short-term cash outflow

needs.

Profitability Ratios: Profitability Ratios are ratios used to measure the profitability of the firm.

Activity Ratios: Activity Ratios are ratios used to measure the efficiency with which the firm conducts its

business.

• Inventory Turnover: measures number of times that average inventory turned overduring a period of time. Inventory Turnover Ratio = Cost of Goods Sold (COGS) / Average Inventory (inventory of finished goods)
• Accounts Receivable Turnover: the average length of time it takes to collect the sales made on credit. Accounts Receivable Turnover =Sales/Average Accounts Receivable (Sales/Accounts receivable)
• Days (Inventory/Receivable) Outstanding: measures number of days each is outstanding. Days (Inventory/Receivable) Outstanding =365/Inventory Turnover; 365/Accounts Receivable Turnover
• Total Asset Turnover: a measure of the utilization of all the firm’s assets. Total Asset Turnover = Sales/total assets during period

Leverage Ratios: Leverage Ratios are ratios used to measure firm’s ability to meet its long-run debt service obligation.