Prof. Patrick O. Connelly: Enterprise Supply Chain and Working Capital Optimization a Credit Risk Management (CRM) Perspective
Additionally, in light of global economic turmoil, enterprise executives have sought to better understand the characteristics and process flow of their supply chains and as a consequence, to identify and better manage working capital elements with the objective of achieving a more balanced, and continuous improvement. Significant improvement in working capital elements occurred with focus, but the more elusive goal was that of maintaining a continuous improvement.
Research demonstrates several areas uniquely influenced by Credit Risk Management organizations that contribute materially to the objective of continuous working capital improvement. Working capital is a managerial accounting concept related to enterprise liquidity. With the intent of maintaining a balanced level of current assets and current liabilities, relative each to the other, it provides an indication of the availability of enterprise cash flow necessary to meet short-term debt obligations and normal operating expenses.
Focus on the working capital cycle is generally intended to improve earnings. The traditional elements of the cycle are identified in the chart which follows. Also traditionally, the measure of progress is most often characterized by a combination: 1) working capital ratio, 2) inventory turnover, and 3) collection ratio (DSO).
With observations resulting from analysis, enterprises narrowly target individual areas of concern such as: a) cash conversion cycles, b) inventory management, c) cash management , d) accounts receivable management and e) accounts payable management. Often, unaware that significant improvement in any one area, has a detrimental impact on other areas of enterprise performance. Often, these changes result in overall downgrade in performance of the enterprise. It is for this reason that consideration must be provided for the provision of a concerted effort whereby all impacted organizations participate in the process of supply chain optimization.
In an effort to identify and suggest areas of focus for the team, the following diagram is provided. Distinct from the usual Order-to-Cash Cycle, it is suggested that Credit Risk Management organizations may best contribute through participation in a more extended Cycle, the EC2C Cycle.
As well, the continuing uncertainty of economic growth and the recovery in markets is leading forward-looking enterprises to focus on improving LIQUIDITY, over and above the goal of profit maximization. The focus on working capital optimization has provided yet another opportunity for Credit Risk Professionals to significantly impact the fate of enterprises of every size and market. Their detailed understanding of cash flow and operations, coupled with their analytical expertise in customer and supplier selection and development create an opportune amalgam of skills, seeking only a pallet upon which to execute a solution.
Recent research would suggest operational focus beyond the traditional of a) seeking price concessions from suppliers/providers, and b) providing extended customer payment terms. Resources are being redirected from supply chain infrastructure investment such as: a)Warehousing, b) Transportation, c) Inventory, d) Technology enhancement; towards the objective of improving (reducing) working capital employed. In the short term this seems to have proven successful, BUT to the detriment of supply chain partners. It is clear that in order to SUSTAIN the improvement in performance it will be necessary to implement a solution that a) reduce operating cost, and b) yield returns both to the enterprise and its stakeholders.
These objectives seek to secure continuous performance across the entire supply chain. For many enterprises this requires significant and continuing adaptation to change; change impacting parts or all of the enterprise supply chain necessitates a mode that measures real time (actual/optimum) performance across a broad range of sensed points on a continuous basis. Ideally, and eventually it will be an electronic solution, heuristically resolved (HAL demonstrated the value and risks), in the best interest of the ultimate model objective of optimization. In the meantime we must identify the control points, establish the control mechanics, review, adjust and move forward as need for change is sensed, towards a goal of continuous movement towards optimization.
Despite recently renewed interest, empirical evidence suggests that the objective of reducing working capital on a continuous basis remains elusive.1 In point of fact relatively few enterprises have experienced much success. One noteworthy exception is Walmart’s remarkable and sustained improvement in reducing working capital cycle time (C2C) over the period 1971 through 2011, cut by some 80 days; from 90days at the beginning of the 70’s to 10 days in 2011, while growing (or perhaps catalyzed by growing) revenues by over USD 300 million. 1
According to recent reports, neither U.S. nor European enterprises have been successful in continuously improving the working capital cycle during the period of the global economic crisis and particularly since the turn of the millennium. Improvements noted in this period appear the result of transferring the period of cycle time improvement to suppliers. The possible impediments to a win/win strategy warrant discussion.
1 Supply Chain Management Review, November,2011, “Why Working Capital Should Matter to You”, Pages 26-33.
Culture and strategic process impairment seem clearly factors. Several areas of dissonance have surfaced during the course of research:
- Changing strategic priorities result in shifting management priorities
- Incomplete or incorrect metrics
- Misaligned incentives
- Failure to assign proper responsibility/authority
- Lack of C-level sponsorship and commitment
- General lack of supply chain management skill in finance
A typical example of the mismatch between traditional objectives/outcomes and the objectives of improved working capital utility and supply chain continuous improvement may be seen in the chart below. Unquestionably the challenge is towards recognizing a longer term objective and as well creating objectives that result in benefit to the enterprise as a whole. If the objective remains short-term profit, the challenge to continuously improve working capital performance will be greatly undermined, and with low potential for success.
Profit-Working Capital Improvement Dysfunction
Generally, success depends in working capital employment and working capital contribution focus success supported by:
- Introduction of necessary skill sets in finance and information and control system support for accountable functions
- Alignment of responsibility and authority
- Aligned metrics and incentives
- Executive management priority
- Refocused priority is a critical success factor.
A continuing perception, and one expressed by most senior executive, is that working capital performance is always a top priority. The results indicate differently. They suggest that focus on working capital is inversely proportional to the state of the economy. During periods of economic stress, working capital focus rises in importance. However, in times of weak demand, constrained credit and heavy competition/substitution, enterprises launch towards solutions that free-up cash…for the period of the crisis. Then, in more suitable economic times, focus shifts back to business as usual.
A 2011 KPMG study reports that C2C cycle times move inversely with economic cycles and improves during times of economic stress and deteriorate during alternating cycles. See dysfunction chart on page 4.
The profit objective cannot be ignored, obviously, and requires strong consideration in any continuity model that intends to maintain going concern status while improving working capital employment across the enterprise. However, in because of the trade-offs associated with a continuing improvement in working capital employed, it is necessary to include profit as a variable among others in the model. It is possible that lower profit enables better price performance expanding volumes, market share, loyalty of both suppliers and customers, creating competitive advantage and in the aggregate enabling a consistent improvement in working capital employed and overall enterprise performance, including enhanced reputational capital.
2 Ernst Young, All Tied Up, Working Capital Management 2013, Executive Summary
A review of the impact of a profit maximization strategy on working capital improvement follows.
- Proper measurement of the cost and performance of a working capital optimization program must flow through the enterprise in a manner consistent with impact at the organizational levels:
Why would there be complaints against such an obviously beneficial program and business model?
Well…This undoubtedly represents a cultural change for an enterprise. The strong profit motive, resident in business for generations promotes profit above all often to the detriment of working capital performance.
III. Projects and processes which have responsibility and authority assigned and are measured regularly, seem to achieve positive outcome more regularly. It is clear from results of research and consulting, that unless directly assigned the promise of success is low. Traditionally, specific operational processes are assigned to organizations executing the process, and support improved working capital management. They include:
- Product/Service forecast-to-fulfill cycle
- Order to Cash cycle
- Inventory purchase to FGI cycle
Alignment of needs of a Working Capital Optimization program is facilitated by the current placement of the authority of existing segments of the enterprise strategic plan. A review of the C2C Cycle on page 2 enables identification of these areas.
Working Capital is a derivative condition resulting partly from optimum management and development of both Accounts Receivables (Portfolio) and Accounts Payable. The objective of this combined exercise represents the best balance in both timing and amounts between potential incoming and outgoing cash flow.
That balance relationship may be diagrammed as follows:
The typical invoice conversion cycle for a term of Net 30 is as follows. Cash flow from this source is the most important and consistent source of capital for an enterprise.
- Supplier evaluation and recommendation
- Customer initial evaluation and portfolio review and development
- Supplier condition and performance review
- Redundancy review
- Endogenous and Exogenous event review and scenario analysis
In the course of these duties CRM duties prepare a base of suppliers and customers, and potentially their sources and customers to operate efficiently and according to agreement as stakeholders in the enterprise supply chain. One of the key responsibilities may be to determine what value each supplier/customer stakeholder brings to the enterprise, and to suggest appropriate action where appropriate.
In order to improve the entire supply chain process, the process flow of an enterprise must be reviewed and coordinated. The ordinary course of process capital follows.
Regarding supplier-side content in the supply chain management process, it is important to understand the impact of provider/supplier management and accounts payable on the outcome.
Though not directly under CRM influence, the accounts payable base represents an opportunity to measure the substance and performance of suppliers, selected as part of a supply chain support process. An initial review of the potential supplier provides an opportunity for CRM to influence the potential chain of product and service to be provided, and relied upon by a purchasing and manufacturing organization. It stands to reason that communication among these groups are imperative to an effective supply chain optimization program. Participation in the ECC provides a perfect opportunity to maintain collective awareness and provide the best opportunity for the enterprise to generate loyalty and value.
The gradual improvement in payables would include at the very least the following elements:
- Customer analysis and selection
- Supplier/Provider identification and selection
They are equally valuable in the process to maximize working capital. In order to establish customer and provider relationships, the first step is to define a methodology which enables the efficient and effective means to identify the best solution in each case.
Customer identification is often mainly a sales or marketing responsibility given the nature of sales to define those potential customers whose business condition demonstrates that they are best choice to utilize (and purchase) enterprise product.
Similarly, the product marketing team is historically the organizational component responsible for identifying those suppliers/providers that have solutions best suited for the enterprise objectives. It is the very process of seeking optimum business partners in each of these cases that presents clear opportunity for CRP and the credit risk organization.
A critical success factor in this journey involves leveraging the value in and performance of each value driver, beginning with the establishment of a clear strategy, keyed to market opportunities and particularly responding to customer needs.
- Establish a clear strategy keyed to market opportunities, customer needs and enterprise objectives
- Execute with integrated organizational support: a single, integrated, aligned process
- Process capital development: strategy implementation incorporating ALL source/manufacturing/delivery options
- Information symmetry and effectiveness: current, correct information supporting planning, decision process, execution
- Performance measurement towards a organizational target.All operations challenged, responsible for and measured against common goals such as:
- Revenue growth
- Optimum asset utilization
Now, as we consider the components of a successful supply chain optimization strategy, it remains to investigate the organizational interfaces where coordination is critical in order to establish a single chain of command, approval matrix, escalation matrix, policies and procedures to assure that the objective of supply chain optimization is paramount. Most of the areas of CRM impact intersect with other organizational practices, measurement and gain/loss; thus the reason for a single approval authority escalation matrix. The key objective of supply chain maximization may, and most probably will impair a local objective (and quite possible traditional compensation measure). It is important to define and address such issues and establish a mechanism to recognize and address these program challenges before implementation.
Given the sophistication of this type of program, it is likely that any organization accepting the challenge to measure the supply chain at the organizational level will have given this significant thought.
The initial screening of the substance and performance of the potential customer/supplier sets the stage for the selection of one over the others, and if properly delivered, also sets the stage for:
- Strong and growing customer account portfolio
- Consistent flow of product/services at cost-effective rate to drive the selling process
- consistent with the objectives of the enterprise.
In order to guide the CRM organization towards the most opportune areas of the business process, it is important to identify the best opportunities from the current business process. The next diagram provides preliminary guidance.
Profitability : derived from higher revenue growth and lower costs.
- Product Costs
- Direct costs
- Design flexibility
- Collaboration with suppliers
- Manufacturing technology continuous improvement
- Continuous improvement in customer relationships
- Supply Chain added strategic value to customer performance
- Loyalty driver
- Very Customer Reliant
- Assessment and Selection
- Nurturing and Development
- Lower Risk of Loss [Enterprise,Industry,Region, etc.]
- Shift of Service Cost Curve
- CRM direct contribution
- ECC collaboration
- Supply Chain Cost
- Continuous review and improvement of the plan, sourcing, manufacturing, delivery operations
- Largely indirect cost opportunities
Capital Employed: The more efficient use and balance of working capital and fixed capital.
- Faster and more effective conversion, reduction of cash needs in the C2C Cycle
- More efficient use of fixed capital resulting in reduced asset ownership (retained assets work harder to produce value)
Expected results of the shift towards a gradual working capital improvement strategy:
- C2C Cycle time improvement:
- reduction in invoice-to-cash conversion period contributes both TVM and OCC value, reduces the working capital commitment in the C2C Cycle
- Inventory: ordinarily some 50% or more of current assets reduces inventory carrying costs and obsolescence risk frees up working capital liberates upwards of 40% additional cost above the inventory cost
- Asset Intensity:
- Decreased fixed asset levels throughout the supply chain
- Reduced asset funding needs
- Requires plan coordination to promote supply chain flexibility and responsiveness by leveraging external capabilities
- Throughput Efficiency: wrings more value from fixed assets, increases capital productivity
These areas represent the greatest opportunities for CRM to expand their role and the level of support to the enterprise top and bottom line. Further, the extent of knowledge to be gained from the ECC interfaces and subsequent projects and improvement will serve as a tremendous training and education source for solidifying succession competency and contribute to the next level of support from CRM.
In subsequent articles, we will discuss manner of measuring customer and supplier value, thereby assisting in the identification of opportunities in the current and future portfolios held by the enterprise.