Companies labor to eliminate every scrap of inefficiency from the movement of product and data through their supply chains. Why, then, when it comes to the financial side of operations, are they leaving so much money on the table?
There's a certain irony to the fact that money, which drives a business and determines its ultimate success or failure, seems to get less attention from supply chain managers than physical goods. Last year, the Hackett Group reported that the 2,000 largest companies in the U.S. and Europe had more than $1tr in cash unnecessarily tied up in working capital. The culprits, said Hackett, were customers paying too late, suppliers paid too early and inventory moving too slowly through the supply chain.
Things haven't improved since then. On the contrary, 2006 marked the first time in nearly a decade that the 1,000 biggest publicly traded U.S. companies (not counting automakers and financial institutions) failed to reduce working capital levels on a year-to-year basis. A survey by CFO magazine and REL, a sister company of The Hackett Group, found that those companies were shouldering up to $764bn in excess working capital.
"It's difficult to understand why companies are not taking advantage of the opportunity to drive improvements in working capital, as this results in increased levels of cash flow which should be of significant strategic importance," REL president Stephen Payne said at the time. "This is the cheapest source of cash which can be used to enhance shareholder returns or be dedicated to funding strategic initiatives such as paying down debt, building new or additional capacity in low-cost regions or repurchasing shares."
REL blamed the trend on excess inventory, which it called "a hidden downside of offshore manufacturing." Greater distances between production and final distribution mean longer supply lines, and buffer stocks to hedge against disruptions in the chain. Other factors include the poor handling of payables and receivables, and mismanagement of suppliers. Whatever the reasons, one thing is clear: many solutions to the problem of excess working capital lie squarely within the province of supply chain management.
The problem might seem obvious, but the solution isn't. Many companies are failing to make the basic connection between finance and SCM, according to Stephen G. Timme, president of Atlanta-based FinListics Solutions Inc. Top executives continue to view SCM as "a tactical back-room cost-center activity," he says in a recent white paper for Montgomery Research. In addition, SCM professionals don't speak the language of financial management, so they can't articulate its benefits to the corporate suite.
Yet those benefits are compelling. SCM drives basic financial metrics such as revenue growth, percentage cost of goods sold (COGS) and days in inventory (DII), Timme says. It's one thing to tout the general value of lower inventories to senior executives. It's more effective to say that a 10-day reduction in DII can generate $100m in cash flow and add $1 per share to a company's stock price.
The same goes for COGS as a percentage of revenue. Citing one publicly traded appliance manufacturer, Timme argues that an improvement in that metric, from 74.6 percent to a benchmarked competitor's 73.1 percent, would add $205m to first-year cash flow and $1.3bn to market value. This for a company whose total funds from operations are just $905m, with a market value of under $5.7bn.
The Aberdeen Group is another champion of better supply chain finance (SCF) techniques. In a recent benchmark report on the topic, the Boston-based firm reports that more than two-thirds of companies are either investigating or implementing SCF programs. And with dramatic results: "best-in-class" (the top 20 percent) companies experience an average of 13.6 more days payable outstanding than their peers, and obtain trade financing at 2.86 percentage points lower on an annualized basis. Most of all, Aberdeen says, "SCF leaders are creating a lower cost and more financially stable end-to-end supply chain, resulting in a strategic advantage."
Tools that are often grouped in the SCM category can have a strong impact on finance as well. Cadbury Schweppes, the beverage and candy maker, tied stand-alone inventory optimization software to its enterprise resource planning system, giving it better access to forecast and order data. As a result, one division was able to improve inventory service levels by more than a point, to 99.6 percent, Aberdeen reports. In the end, the company reduced inventories by more than $7m - an improvement of better than 12 percent - within the first three months of going live on the system.
The most frequently used SCF techniques by leading companies are the extension of payment terms with suppliers, deployment of electronic invoicing and payment, and participation in early-payment discount programs. Yet, despite their proven effectiveness, such programs remain relatively rare. Only 13 percent of the companies surveyed by Aberdeen were actively using SCF techniques to lower their end-to-end costs.
The case for paying attention to SCF is a strong one. In Aberdeen's latest report on the topic, two-thirds of respondents said they were under pressure from shareholders to improve key metrics related to the use of working capital. Companies also complained that their current policies were not meeting customer-service requirements, were resulting in a shortage of capital needed for acquisitions or expansion, and were creating a financial strain on operations generally.
Respondents don't lack for road maps to improvement, noted Viktoriya Sadlovska, Aberdeen's research analyst on SCF and global trade. Their top four SCM strategies for optimizing working capital include improving forecast accuracy, optimizing inventory routes and storage points, reducing lead times, and collaborating with suppliers and customers. But such goals are easier stated than accomplished. Real solutions often involve a wholesale restructuring of organizations to encourage internal cooperation, along with new technology tools to manage processes related to working capital.
On the technology side, Sadlovska says, companies are exploring tools for inventory optimization (the best in class are twice as likely to be using these, she says), collaboration and visibility. The last is of particular importance. "The best in class were consistently reported to have better visibility, and be using more visibility-related technology," she says.
The other key word is collaboration. Buyers and suppliers alike want to improve their working-capital and cash-flow financing, Aberdeen says. But without a coordinated effort, such plans may cause conflict between supposed partners, as each tries to "shift the pain to the other."
Jonathan Heuser, manager of global supply chain sales with JPMorgan Chase in New York City, argues that inventory ought to be viewed from a financial perspective, just like payables and receivables. "Retailers are purchasing inventory from suppliers," he says. "The cash has to come from somewhere." And the longer a particular piece of merchandise is in inventory, the higher its carrying cost.
Many financial types don't see it that way. Inventory might be a significant item on a balance sheet, says Heuser, "but it's not looked at by finance people in a financial context. What's difficult to do is putting that together - finding some way to marry the financial discipline and analysis that's typically used on the payables and receivables side, and using that same lens to look at inventory."
Even key decisions on payables - indisputably, an aspect of finance - may take place outside the purview of financial managers. Buyers and sellers often negotiate the cost of goods and payment terms without input from the finance department. A company could close on what it thinks are attractive payment terms, unaware that the cost of importing from a chosen country is higher. "Suddenly," says Heuser, "something that started out as negotiating for the lowest cost of goods adds cost."
Heuser urges companies to integrate their SCM and finance efforts, with the understanding that certain metrics, such as inventory management and visibility, can be of benefit to both areas. They should understand the financial cost of an extra day in transit, or an unexpected delay in customs. "Rather than looking at the supply chain as something merely to be milked for cost savings, the better way is to ask, how do we look at our supply chain to reduce our risk?" he says.
The path to internal understanding runs both ways. Supply chain managers must learn how to express the value of what they do from a financial perspective, says Bob Davis, supply chain product manager for SAS Institute Inc., the Cary, N.C.-based software vendor. Companies often speak of "the perfect order" - getting the right product to the right place at the right time - but that term means little to a numbers-cruncher. The supply chain organization should also be conversant in such financial metrics as percentage of COGs and DII. "These are things that point straight back to the balance sheet," Davis says. "In the end, they equate to shareholder value."
Financial metrics can help companies to determine the actual cost of serving a given customer. Most-favored accounts often get breaks that can undercut overall profitability. Depending on their location or particular demands for service, they might be causing their supplier to hold extra inventory - a situation that's invisible to managers fixated on "the perfect order."
As corporate functions, supply chain and finance share one characteristic, Davis says: they both span the entire organization. Consequently, it's tough for one to get a full view of the other.
Activity-based management, which identifies the cost behind each process, can help to create a bridge between the supply chain and the general ledger. For the first time, a company can understand the link between, say, trade spending terms and days of sales outstanding.
A Two-Part Supply Chain
The traditional view of supply chains divides them into three parts - the movement of physical goods, information and money. But Douglas McKibben, vice president of research with the Gartner consultancy, says there are really only two pieces of the puzzle: physical and financial. "Information is essential to both of those," he says. "One of the challenges that banks and customers face is not having sufficient granular information on a timely basis, in a standardized manner, that can be processed effectively."
McKibben, too, sees a disconnect between the finance and supply chain sides of the house. Even when finance is aware of a company's liquidity position in the physical supply chain, it might not see that information until it emerges in the form of receivables and payables. This linear flow of data hinders a company's ability to get a grip on its working capital, and address such up-front issues as interest rates and risk exposure.
The first steps toward a holistic view of supply chain and finance are the dismantling of corporate "silos" and the integration of software applications that reside throughout the organization. "We find many pockets of activities within banks and corporations where they've created their own automation processes and data elements," says McKibben. "The information created is isolated within that group."
The overriding goal is to achieve "a single version of the truth," with shared information drawn from a common technological architecture. And convenience isn't the only motivator. New regulations, including the Sarbanes-Oxley law related to corporate reporting, require the keeping of accurate, detailed financial data. A fractured approach can expose the business to multiple types of risk, McKibben says.
Sean Monahan, vice president of A.T. Kearney Inc. in New York City, believes companies are finally paying attention to their financial supply chains because other means of cutting costs have been exhausted. "They are continuing to lower the water in terms of opportunities for improving financial performance, particularly for public entities," he says. In the past, a business might have looked to reduce fixed capital by spinning off non-core assets, as Coca-Cola did with some bottling and canning operations in the late 1990s. Now, the emphasis is on working capital, particularly in industries such as high-tech, where order-to-cash periods must reflect shorter product lifecycles.
Monahan sees opportunities for improving the terms of sale at both ends of the supply chain. On the supplier side, early-payment practices, even with generous discount incentives, make less sense as interest rates rise. At the same time, manufacturers and distributors are looking to expedite their invoicing processes, through the use of automatic funds transfers and shorter payment windows.
One key strategy of manufacturers is to pressure suppliers to make components available on shorter notice. Vendor-managed inventory (VMI) programs are a popular means way of shifting the economic burden of parts management to an upstream partner. Even more effective from a financial standpoint are consigned inventories, whereby the manufacturer doesn't take title to components until they enter the production line.
The best approach is collaboration, with buyers and suppliers joining to reduce working capital in their respective supply chains, through improved forecasting and a deeper understanding of the manufacturing process. But such arrangements still represent "the minority of the cases," says Monahan.
Seeking a Middleman
Sometimes the solution is to introduce yet another partner into the mix. JPMorgan Chase offers to finance transactions by compensating suppliers at a slightly lower price, in exchange for early payment. Then it collects from the buyer, which is able to extend its own payment terms without putting suppliers at risk.
UPS Capital wants to take that concept one step further. Drawing on the resources of its sister company, Atlanta-based UPS Supply Chain Solutions, the company claims the ability to obtain better financing terms from banks than many suppliers can. "Since we are able to control those goods at inventory and provide information relevant to that, we convince [financial institutions] that they can lend on a more secured basis," says Chris Vukas, senior managing director of UPS Capital. Smaller suppliers aren't forced to obtain financing based solely on their own creditworthiness.
Global traders might find it difficult to obtain loans on the basis of inventories that are scattered all over the world. "It's very difficult even for multinational banks to get their hands around the control of that collateral," says Vukas. "So they're lending on the financial strength of that company alone." UPS's intimate knowledge of the supply chain "ecosystem" can motivate banks to offer a better financing rate.
Having launched the program less than two years ago, UPS Capital has signed up some 14 financial institutions and has "about 50" opportunities in the pipeline, Vukas says. But the company doesn't intend to stop there. It wants to work with partners that would be willing temporarily to take title to goods in transit. Suppliers would be paid earlier, but the ultimate buyers wouldn't have to carry on their books inventory that was traveling by sea or air, or sitting in a bonded warehouse. UPS would play one of two roles: either as a provider of information about the inventory's location, to assure banks of its existence, or as an actual source of financing for the original transaction.
The idea remains largely untested, and carries some unanswered questions. "If you have title [to inventory]," asks Heuser, "what guarantee do you have that the theoretical buyer is going to buy it in the end? What if you get stuck with this merchandise?" Whether the intermediary could find another buyer depends on the nature of the goods, he adds.
Less radical options are still available to companies looking to reduce inventory expense. One approach lies in strategic network optimization. As companies expand their markets and sourcing options, they confront a tangle of tariffs and other local regulations. And that can affect one's cost of capital, says John Bermudez, senior director of supply chain management product strategy with Oracle Corp. in Redwood Shores, Calif.
Trade agreements offer both obstacles and opportunities for reducing capital costs. Through supply chain optimization techniques, a company shipping from France to Morocco might discover that moving the goods through Spain saves money because of European Union trading policies. In the process, it will trade off the cost of carrying that extra inventory against the potential tariff savings. "You're starting to see companies get very interested in those types of things," Bermudez says.
Network optimization can also help a company to compare inventory carrying costs between countries, then build the conclusions into a larger risk scenario. They can factor financial considerations into their "what-if" models, to determine how much revenue would be lost in the event of a supply chain failure. The result could cause them to store more inventory within the country of sale, a choice that a traditional profit-and-loss analysis might have rejected out of hand.
Financial metrics are also a crucial part of effective sales and operations planning (S&OP), Bermudez says. Consumer-products makers need to know whether they are committing their limited trade funds to the right merchandise. In planning a special promotion, for example, they should be able to forecast how much of each trade fund is going to be consumed. "When you overspend [the funds]," says Bermudez, "it comes right off your net profit."
A "single-number plan," incorporating metrics for supply chain, finance and sales and marketing, can be tied to point-of-sale data from the retailer, in order to present a real-time picture of how the customer's needs are being met. Bermudez says Oracle intends to develop additional systems for unifying these critical elements of a business. "We're extremely interested in aligning the financial side of the house with the supply chain side," he says. "It makes all the difference in the world."
To access this article online, visit The Digital Edition at www.SupplyChainBrain.com.
Aberdeen Group, www.aberdeen.com
FinListics Solutions, www.finlistics.com
The Hackett Group, www.thehackettgroup.com
A.T. Kearney, www.atkearney.com
JPMorgan Chase, www.jpmorganchase.com
SAS Institute Inc., www.sas.com
UPS Capital, www.capital.ups.com
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