Cash Management and Controlling Purchasing with the “Open to Buy” System

By Paul Winters

It's surprising how many of the companies that seek our help are conducting their purchasing activities without clear knowledge of their ability to pay. The old-fashioned concept of not buying anything until you know can pay for it is often overlooked by companies using accrual-based accounting. The results can be disastrous -- but the "Open to Buy" cash forecasting system provides a simple way to get back on track and stay there.

With the sophistication of modern accounting systems, why does this happen? In our experience, the problem occurs because the buying function and the accounting function are in different departments. The buying function simply recognizes the need to purchase items for the business and doesn’t understand the cash flow cycles of the business. The accounting function ultimately receives the vendors’ invoices and then tries to figure out when they can pay for it.

And, guess who gets punished? The Vendor!! Due to the company’s lack of control, the vendor doesn’t receive timely payment.

Open to Buy

We developed the “Open to Buy” system based on the needs of a client in the retail industry. This retail client had nine stores in Oregon and Washington. As happens in many retail operations, the company had four buyers, each responsible for certain product lines in the stores.

Buyers many times have an insatiable appetite to acquire products for their areas. The difficulty arises in controlling and coordinating how much the buyer is allowed to acquire. The “Open to Buy” system allows the manager to forecast the company’s ability to pay future bills and then compute a daily or weekly upper limit for each buyer.

The "Open to Buy" system uses a simple form to schedule in advance, week after week, the amount of cash on hand, cash receipts expected, and commitments (payroll, taxes, invoices due, etc.) that must be met. Once the information is collected and put on the form, it is quite easy to determine the amount of buying that can be done now, knowing that cash will be available in the future to pay for the invoice.

This system works ideally in a spreadsheet model because of the number of computations and carry-forward balances.

Caution

The "Open to Buy" system only tracks the ability to pay. It is not a substitute for a properly run purchase order system (PO System). A PO System is a buying process that authorizes specific purchases in advance. It is designed to approve the appropriateness of expenditures by requiring various levels of authorization, depending on the nature of purchases and their total value. If properly used, a PO System also forecasts the future ability to pay.

Furthermore, we must keep in mind that this or any other cash management system is only a tool to help companies meet their payments. It will not alleviate the fundamental operating problems that create cash-flow shortages in the first place -- the performance issues that cause companies to lose money, or the growth issues that cause them to lose liquidity.

While these problems are being addressed through strategic planning, cash forecasting can restore control and credibility to company management.

Troubled Company

How does the "Open to Buy" system apply to a company in trouble?

Typically, such a company hasn’t controlled its buying process and is now engaged in beating up its vendors because of its own mistakes. Accounts payable are getting old, and vendors are getting annoyed. The vendors may show their annoyance by calling and demanding collection, sending threatening letters, or having their attorneys send threatening letters. Maybe they're putting the company on C.O.D., refusing future shipments or services until payment is made, or putting liens on company property.

Our advice to this company, if it wants to stay in business, is to take two very clear steps. Right now! Today!

· Recover control of what you're going to buy. Using the "Open to Buy" system, set a limit on purchases and stick to it, period. Clearly communicate to all employees that all purchases must be approved prior to the order being placed.

· Start regaining credibility in the eyes of your vendors by communicating with them and establishing plans for payment.

The number one, singular, most fundamental thing most companies avoid in this situation is open honest communication with vendors. Long-term success requires a partnership with vendors. We all know what happens to all forms of partnerships when communication breaks down. Communication is hard when you know you are in the wrong, but it must not be avoided.

The reality here is that this company has more payables than it can handle. The solution is obvious. Once the company has declared that its goal is to stay alive, it must develop a plan to amortize or pay off old accounts.

In order to do this, we suggest that the company classify its vendors in three categories:

· A Items—payroll, taxes, critical supplies or raw materials. Anything that is absolutely critical to the short-term survival of the business. This list should be ranked according to priority.

· C Items—small amounts that can be identified by sorting the payables by the amount owed. As a rule of thumb, these small items are approximately 20% of the total dollar amount of the payables. Many times this group will constitute a surprisingly large number of vendors.

· B Items--everybody else -- all the accounts that are still important for the long-term, but not absolutely critical for the company's short-term survival.

Now comes the hard part. Using the “Open to Buy” system, proceed as follows:

1. Determine the amount of cash currently available.

2. Forecast cash receipts from customers and other sources (interest, new loans, new equity, etc.) and enter them on the form for each week.

3. Enter on the form necessary shipments already on order that will arrive COD. Keep a separate list of COD orders that can be canceled, or delayed.

4. Starting with A Items:

· Identify by week in order of priority all items that must be paid-in-full each week, e.g. payroll.

· For the remaining vendors determine a regular and realistic payment schedule that would encourage them to continue shipping to the company.

5. Working with all departments in the company, develop a projection by week of items to be purchased. Rank them in order of priority and determine minimum quantities that can be ordered. It is important to recognize that the company may need to order smaller than normal quantities. Cash conservation generally has more priority at this time than the lowest possible unit cost.

6. Moving to the C Items, the nuisance category. These accounts consume staff time and other resources out of proportion to their value. The company should make it a goal to pay them off quickly.

7. Finally, develop a plan for paying off the B Items. By necessity, this group will be stuck with longer terms than the A Items.

8. At this point, troubled companies will discover that the “Open To Buy” form indicates there isn’t enough cash to meet all of the commitments. The difficult process must now begin to balance the levels of payments to vendors in order to leave adequate amounts to buy additional necessary materials and supplies.

Commitment

Once the “Open to Buy” system is in balance, the company must communicate with its vendors, state its commitment to each vendor, and then keep this commitment. Meeting commitments is critical for regaining credibility in the eyes of the vendors, which in turn is critical to the company's success in regaining control of its ability to pay.

Vendors see the company making a sincere effort to get current again, and sticking faithfully to the payment schedules it has established. Rarely do they receive that kind of treatment from customers, and they appreciate it. Of course they would rather have payment in full, but when they see the company living up to its promises, their sense of investment and partnership comes back stronger than ever.

We repeat, the "Open to Buy" system is not a cure-all for fundamental operating problems. It will not improve a company's overall performance or give it a handle on growth. What this system does is simply set up a link between available cash and ability to pay, thus helping to get the company on an even keel and keep it there.

An Excel spreadsheet template for the “Open to Buy” system is available at no charge by contacting us.

OPEN TO BUY

			WEEK
			1	2	3	4	5

BALANCE FROM PREVIOUS WEEK			9500	0	900	3600	-3500

CASH RECEIPTS			15000	21000	80000	55000	25000

TOTAL CASH AVAIALABLE			24500	21000	80900	58600	21500

A ITEMS--CRITICAL VENDORS
Payroll			7000	7000	25000	7000	7000
Payroll taxes			1400	1400	5000	1400	1400
COD shipments			6000	10000	35000	35000	6000
Vendor 1			2000				2000
Vendor 2			1000			1000
Vendor 3			1500				1500
Vendor 4			600		600		600
Vendor 5			200	200	200	200	200


TOTAL A ITEMS & COD			19700	18600	65800	44600	18700

BALANCE OF CASH REMAINING			4800	2400	15100	14000	2800

AMORTIZATION OF C-ITEMS (attach list)			1000	1000	1000	2500

AMORTIZATION OF B-ITEMS (attach list)			3800		5000		5000

	Subtotal of C and B Items		4800	1000	6000	2500	5000


OPEN TO BUY			0	1400	9100	11500	-2200
	Orders can be placed and scheduled based on Vendor terms
	Order cannot allow cash in any period to be negative

Detail of Orders To Be Placed
	COD			500	2500
	New Orders payable in 2 weeks				3000
	New Orders payable in 4 weeks					15000




	Subtotal (Must not exceed open to buy)		0	500	5500	15000	0


ENDING CASH BALANCE			0	900	3600	-3500	-2200

		Note that order placed for payment in week 4 resulted in negative balances in weeks 4 and 5.
		To balance, company must either reduce size of order, or cut payment to C & B Vendors.