Is it a good idea to reduce working capital in a supply chain? Yes, in general. On the face of it, “working capital” might sound like something you’d want to increase. However, it corresponds to the amount of money you need to keep your supply chain working, so in reality, you want to decrease it – without hurting supply chain performance, of course.
To put a figure on working capital, it can be defined as current assets minus current liabilities. Current assets include inventory and accounts receivable, i.e. payments you are waiting to receive, notably from your customers. Current liabilities are typically accounts payable, meaning the money you are due to payout, for example to suppliers.
As a result, if you can get paid by your customers before you have to pay your suppliers and reduce inventory to boot, your current assets can be reduced to below your current liabilities. Then, hey presto, supply chain working capital becomes negative, and your supply chain is effectively being financed by others. Negative working capital was part of the initial business model for the UK wine shop chain Oddbins. Fast cash in from its retail sales outlets and generous payment periods offered by suppliers gave the company added liquidity with which to make short term, profitable investments.
Some other large companies have applied a similar model. McDonald’s, Amazon, Dell, General Electric, and Wal-Mart are examples. However, while this works in their favour, it may be detrimental to the financial health of their suppliers (who are waiting to be paid). This can hit smaller suppliers particularly hard. The short term crises they face can then turn into longer-term crises for the large companies if their smaller suppliers start to go out of business. In the US, the Obama Administration’s SupplierPay initiative was put in place to encourage bigger players to help ease the working capital challenges facing small firms, by speeding up payment of invoices.
Decoding Working Capital Numbers
Calculating working capital as assets minus liabilities is straightforward enough. It can also be expressed as the ratio of these two items, i.e. assets/liabilities. Negative working capital is then indicated by a ratio of less than one (assets less than liabilities). A ratio of between 1 and 2 suggests that for the supply chain as a whole, there are enough short term assets to cover short term debt. A ratio of more than 2 may be a sign that inventory is increasing too much or that the company is slow in collecting payments.
Yet this ratio is not the whole story, either. While reducing working capital may be a deliberate goal for the reasons above, working capital that trends downwards all by itself may be a warning sign. It may indicate that sales volumes are decreasing, meaning that receivables (and perhaps inventory) are also decreasing. As we mentioned above, a decrease in working capital must not be allowed to happen at the expense of supply chain performance, whether in terms of overall profitability or end-customer satisfaction.
Who Has the Biggest Working Capital of Them All?
As you might suspect, some industry sectors operate with more working capital in their systems, making them less efficient in their use of working capital than others. According to recent statistics from consultancy firm PwC, the aerospace and defense sector is the most inefficient in using its working capital. In second and third places respectively are healthcare equipment and supplies, and then pharmaceuticals. At the other end of the scale, the most efficient sector is travel and leisure, followed by transport and logistics, and in third place, retail and wholesale.
In capital intensive industries like mining, which must also cope with an economic downturn, reducing working capital becomes a priority. Mining supply chains have typically been characterised by the large “insurance” spare parts inventory they hold, for maintenance and repair to ensure that remote locations remain constantly operational and productive. Now, desperate times mean desperate measures: some companies have started to delay equipment maintenance and run machines until they fail before repairing, thus making short term savings in working capital on the cost of spares.
Levers for Reducing Working Capital
In general, there are two main levers available to companies for reducing supply chain working capital. The first lever is the enterprise’s finance department. By working with finance and accounting, a supply chain can optimise its cash management (meet expenses without excessive cash holding costs), its debtor management (customer payments), and its short term financing (using supplier credit or factoring of customer invoices, for example).
The second lever is inventory management. Companies can either seek to reduce the levels of inventory they hold or reduce the unit costs of inventory.
- To reduce levels, a company can use JIT (just in time) methods to bring inventory levels down to the minimum for uninterrupted production to meet demand, reducing raw materials, WIP (work in process) and finished goods accordingly.
- To reduce unit costs of purchase and holding, a company can order in economic order quantities (EOQ), and get credit from suppliers before paying for the inventory received. Its suppliers can also help it be more efficient in its use of working capital in terms of maintenance and repair of equipment. For example, airline companies must have jet engines periodically removed from aircraft for maintenance by the jet engine manufacturer. The longer the maintenance operation time (the “wing to wing” or W2W cycle, as it is called), the greater number of spare jet engines the airline must hold. As a supplier, General Electric Aircraft Engines (GEAE) helped its customers to reduce W2W and therefore spares inventory and working capital. It increased the number of its engine overhaul sites worldwide to bring them closer to its customers, decreasing travel time for the jet engine to and from the workshop, and therefore reducing overall W2W.
The two types of lever are also interlinked to some degree. For example, inventory reduction should still allow a company to deliver perfect orders, so that customer payment will not be delayed because of any discrepancies or disputes.
How Much Savings do Inventory Reductions Bring?
While excessive levels in inventory in general and finished goods inventory, in particular, should be avoided, it is important to see savings from lower inventory for what they are. Suppose your enterprise makes business widgets with a raw material cost of $10 per widget, and a price to customers of $100 per widget. Suppose also that you manage to reduce finished goods inventory by 10,000 widgets. From a potential revenue point of view, 10,000 widgets at their selling price of $100 each mean $1 million sittings in your warehouse. From a cash point of view, on the other hand, 10,000 widgets at their raw material cost price of $10 each mean just $100,000 in your warehouse. In other words, axing inventory by 10,000 units and mistakenly thinking that you are recovering $1 million in cash could lead to a poor supply chain management decision overall, especially if your plan is to trade off inventory reduction against lower levels of customer service.
Real savings in inventory reduction may fall somewhere between two limits in the example above. Factors that affect these costs include extra costs of duties, transport and buffer stock for low-cost country sourcing, inventory holding costs such as damage or shrinkage, and interest rates (the cost of financing the working capital that is tied up in the inventory).
Inventory reduction can nonetheless have a positive effect on financial ratios by which a supply chain’s performance may be measured. Examples are returned on assets and return on invested capital. Lower inventory levels and consequently improved cash flow has also been seen to have a positive impact on the share price when the supply chain is part of a publicly held company.
Practical Steps Towards Reduced Inventory
A recent study from Deloitte Consulting LLP of working capital in different enterprises found that “inventory management was a big variable that separated the strongest performers from the weakest”. As an overall approach to improving working capital levels by optimising inventory management:
- Define clear top-down goals. Benchmark information is available for different industries and activities, although specific factors (country, for instance) must also be taken into account.
- Design working capital management into supply chain processes, so that supply chain managers and operatives at all levels continue to manage it, even when senior management has turned its attention to the next strategic project or priority.
- Raise awareness about inventory, its impact on the supply chain and the enterprise as a whole, and the need to manage it properly. While manufacturing and logistics are natural audiences, those involved in sales and in purchasing also need to know.
- Provide ways to measure inventory performance, so that those directly responsible for working capital performance in different areas can compare their progress against the goals that have been set.
Specifically, the following steps may also apply:
- Manufacture using common components and/or product substitution
- Negotiate quantity discounts on supplies according to monthly quantities delivered to your enterprise, rather than individual orders
- Accelerate replenishment cycles of supplies, and reduce raw materials inventory at any given moment
- Regularly align/realign replenishment levels according to levels of use and rates of stock turn
- Reduce customer delivery lead time and variability
- Pool buffer stock at a reduced number of locations to reduce the total amount of buffer stock
- Postpone product differentiation in the supply chain to continue using common products for as long as possible before delivery, and thence reducing overall buffer stock
- Cull SKUs and product references in favour of a simplified catalogue of products that perform well. “SKU hoarding” afflicts many companies, because it is often easier to create a new SKU than to eliminate an existing one. Yet higher numbers of SKUs lead to lower customer service levels and poorer forecast accuracy, which in turn affects inventory management.
Working Capital in Joint Company Supply Chains
When several companies form one supply chain, working capital becomes a challenge across the entire chain, as well as within each company. One company’s efforts to contain or reduce working capital can affect the performance of another company. For instance, pushing supplier payments for goods received by one enterprise can lead to cash flow problems for the supplier upstream. Collaboration is therefore the best way forward, if the supply chain as a whole is to function well. This becomes all the more important in that in a number of major industries, companies no longer compete with companies, but supply chains with supply chains. Critical success factors are:
- Real-time, end to end visibility of information helps to increase forecast accuracy, reduce safety stocks (and the infamous bullwhip effect), contain costs, and improve cash flow.
- As markets and circumstances change, an entire company in the supply chain may have to react and adapt to supply different volumes or mixes of products. Long lead times in one company can put the entire supply chain out of kilter by causing the creation of buffer stocks and possible stock obsolescence (leading to working capital that cannot be recovered) and must therefore be avoided.
- Together with criteria for transparency and flexibility, supply chain partners must also be confident in one another’s reliability to fulfil accordingly. Inventory bloat is only a step away if doubts set in about a partner’s capability to deliver correctly.
In the same way that departments must collaborate within a single company to reach the right inventory and working capital compromise, so must companies within a larger supply chain. A steering committee composed of active representatives of the different companies can define goals and work to increase overall transparency, flexibility and reliability. If one company has a dominant role in the supply chain, it may be able to introduce a system of bonuses and penalties to encourage the performance from its upstream and downstream partners that optimises working capital management.
Moves to reduce working capital vary from sector to sector. In mining for instance, consultancy firm EY considers that “most mining companies could probably reduce working capital 25%-50% inside 18 months if they tried”. The braking factor is the tardiness of the mining sector in adapting to new economic circumstances, where the earlier “production-at-any-cost” credo no longer holds good. Spare parts inventories are singled out as a major area for improvement in working capital, although also one that is particularly challenging. Will companies and supply chains in industries like mining, and for that matter aerospace and pharmaceuticals, be able to emulate the Dells, General Electrics, Wal-Marts and other negative working capital wizards of the world? Whatever the outcome, there are opportunities for all when it comes to optimisation of working capital to cope with credit crunches, liberate funds for investment elsewhere, or simply look more attractive to investors.
Current assets include cash, AR and inventory.. If we reduce the AR and inventory (which is good), the cash saving should increase. The article seems to ignore the cash portion.
Did I miss anything?
No nothing missed, you are correct.