Hello this is Jim Tompkins, the President and CEO of Tompkins Associates and Tompkins International. I am pleased to welcome you back to the sixth part of our podcast series on New Frontiers for Profitable Growth in Business, Leveraging the Supply Chain Shareholder Value.
Today we continue our discussion by covering the last objective of increasing shareholder value, Capital Efficiency. There is a long list of potential actions that need to be addressed here, but the two most important have to do with reducing working capital and fixed assets. Many value drivers go into reducing working capital and fixed assets, but we will focus on reducing inventory and how to optimize your supply chain network to reduce your fixed assets.
I am pleased to welcome back our own Tompkins Expert on Inventory, Ralph Cox to guide us through this discussion. The focus on inventory reduction is very, very important and the source of free cash flow that is so important to increasing shareholder value.
Jim:
Ralph, we’re going to talk about fixed assets and their relationship to shareholder value next time, but what is “working capital” and why is it called that?
Ralph:
In general, it’s the money needed to sustain the business for the time between purchases and sales. The need may be for something tangible like inventory available for sale or, more generally, any difference in timing between payables and receivables. However, unlike fixed assets, working capital is not depreciable and, in fact, can be used to fund deductable expenses.
Jim:
Great, it sounds a lot like debt. Well, then if we limit our discussion to inventory working capital, what role does it play in shareholder value?
Ralph:
Well, the working capital to fund inventory can be either debt or equity. However, regardless of how it’s funded, while inventory is an asset from a financial perspective, as a practical matter if it can’t be sold, it can be a major liability to the business. In other words, like bank loans, inventory may be viewed as performing or non-performing.
Jim:
Wow, that’s bizarre, a financial asset that’s also a liability! I’d like to keep the asset and get rid of the liability. How in the world can you tell which inventory is which?
Ralph:
Most inventories are not completely one or the other but have aspects of both. For example, active inventory which increases product availability and reduces lead times is clearly an asset to the business, financially, of course, but also operationally.
On the other hand, discontinued products, overstock, inventory which needs rework to make it salable and similar types of inventory can be a major liability regardless of how they are reflected on the balance sheet.
Jim:
If a firm wants to increase shareholder value, what should they be doing?
Ralph:
A simplistic answer would be to hold only the inventory which maximizes revenue while minimizing working capital and annual operating expenses. But, that’s very simplistic and also easier said than done. The real answer has five parts:
forecasting demand accurately,
holding only those SKUs in inventory which cannot be acquired economically in small quantities or cannot be acquired fast enough to meet customer expectations,
basing cycle stock order quantities on expenses so as to minimize them,
basing safety stocks on demand statistics, lead time statistics and customer service levels which optimize incremental working capital and revenue,
using a formal Sales and Operations Planning (S&OP) process to address situational issues and resolve conflicts between priorities
It’s important to understand that inventory is not just working capital. The amount of safety stock impacts sales and the amount of safety and cycle stock impacts operating expenses.
Jim:
That’s impressive. So my inventory policies really impact both sales and volume levels. But if I add more and more inventory, to get more sales, my turnover will decline … how do you know how far to go?
Ralph:
First, while turnover is a simple way to measure inventory financial performance over different volume levels, you can’t take it to the bank. Safety stock is indirectly related to turnover in a smuch as, along with lead time, safety stock policies define when to make or buy move inventory. While on the other hand cycle stock policies define how much to make or buy.
So, in answer to your question … yes, as you increase safety stock levels to reduce lost revenue, turnover does decline. At the same time, the return on the additional investment increases but, as you suggest, only up to a point. In practice, you want to increase customer service levels and add gross margin until the rate of return on the incremental investment reaches your hurdle rate and then stop.
Jim:
Ok, but that sounds like a textbook approach. What do you do in the real world when your supplier doesn’t meet his shipping commitments and you get more customer orders than you were expecting.
Ralph:
A great question … that’s what Sales and Operations Planning (S&OP) processes were developed for – to insure that demand planning and supply management issues are effectively addressed and that everyone is aligned. S&OP meetings are not to identify issues, but rather to make decisions to resolve the issues which have been identified and discussed prior to the meeting.
Although other groups such as product development are often involved, virtually every S&OP process includes demand – that is to say sales, includes supply - either purchasing, manufacturing or both depending on the organization, and include the planning group. If shareholder value is to be maximized, in most organizations they are absolutely critical.
Jim:
I see, that sounds interesting. You used the word “operationally” a few minutes ago. What are the other managerial approaches to inventory?
Ralph:
Well, there are financial approaches to maximizing shareholder value as it relates to working capital. For example, consignment is being used increasingly. Consignment provides immediate access to inventory for when it may be needed, but it’s not paid for until it’s consumed or sold. Working capital is reduced. Shareholder value mayor may not be increased, depending on other considerations in the consignment agreement.
Also, while we discussed that inventory could be funded by debt or equity, accounts payable can be used to fun part of it. If the relationship between turnover and payment terms can be improved, some of the inventory can be funded that way.
Another example of a financial approach to shareholder value increase is postponement, in which you don’t invest any more than necessary in the products in inventory until as late in the sales process as possible.
Jim:
Ralph, these are excellent points on working capital and the role it plays in shareholder value. Thank you for taking the time to be with us today.
Joining us next time will be someone that has been with Tompkins Associates, since there was a Tompkins Associates over 35 years ago, my partner, John Spain as he guides are next discussion on Network Analysis. Look forward to speaking with you again real soon.
