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21 jan 2020

Manu­fact­uring companies: How your position in the value chain affects working capital

– and what to do about it

Thoughts

In a series of four articles, we give our point of view on common working capital related challenges connected to an organization’s position in the value chain. This the second article provides advice and examples on how to tackle challenges in the manufacturing part of the value chain.

Figure 1: Average DPO, DSO, DIS and NOWC % across the value chain

The working capital suffers from a high supply chain complexity

A comparison of working capital performance indicators throughout the value chain (figure 1 above) indicate low performance for AR, AP and inventory for the manufacturing companies.

On average, manufacturing companies have higher number of components per product than processing companies. This leads to a long tail of low volume items being sourced and held in inventory. In product companies with manufacturing, this problem is further exacerbated by a swelling of product portfolios from long product life cycles as well as differentiation of products per customers and segments.

Except driving up inventory, the wide variety of components being sourced weakens the company’s relative buyer power, leading to worse payment terms towards suppliers. Finally, many of the medium sized manufacturing companies in our study sample are suppliers to a few large OEMs with a lot of buyer power, which likely contributes to the high Days sales outstanding found in this category.

Figure 2: NOWC components – Manufacturing companies

Figure 2: NOWC components – Manufacturing companies

Product portfolio management – a long term process affecting working capital

Several traditional improvements related to working capital management can be implemented almost overnight, such as inventory steering, payment terms and dunning processes. However, achieving WCM reductions through reducing the number of stock keeping units (SKU) require foresight and consistent efforts over time. One way to approach this, which drives a lot of other benefit except for working capital improvements, is product portfolio optimization.

Four key considerations when optimizing your product portfolio
  1. Ensure a clear product portfolio strategy and guidelines: Without a clear product portfolio strategy, preferably with actionable guidelines to steer the initiative, too many decisions will require management attention. This will likely stall the process as well as produce an uncoordinated product portfolio.
  2. Get your data in order: A high-quality data model will be required in order to ensure that no critical aspects are overlooked. Key areas to understand include product profitability, product attributes/categorization as well as customer and market attributes. Rather building a static excel model, consider a sustainable BI-solution which can support ongoing product portfolio management and product management work.
  3. Involve and explain benefits for all key stakeholders: Different parts of the organization will have different focus. Upper management may see improvements in working capital and profitability, while for example sales and product management typically are very customer-centric and reluctant towards removing any product. Therefore, early involvement of various parts of the organization will help to surface conflicting opinions to be addressed, thus preventing larger issues at later stages of the initiative.
  4. Establish processes: Ensure that the benefits of the product portfolio initiative are sustained over time by establishing and aligning processes resulting from the initiative.

 

Five product life-cycle management actions improving working capital

Once a clear product portfolio is established, each product and related components can be further optimized by setting up processes related the product life cycle. Key areas with working capital impact which are often overlooked include:

  1. Product development: Reduce number of components by standardization of components and modularization in product development. For this, guidelines and policies need to be set to steer engineering towards reducing the number of unique components per product which drives down total number of components, safety stock, suppliers as well as supplier power. Here, it is often not time- and cost-effective to reengineer vast numbers of old products as R&D tends to be a bottleneck and reengineering may require customer approvals. Instead, prioritize based on remaining product lifetime, sales volumes and number of related products to which similar standardizations can be extrapolated.
  2. Sourcing and Minimum Order Quantity (MOQ): For companies with broad product portfolios it is not uncommon to find more than 20% of inventory value being the result of limiting MOQs from components. MOQs often set when these components were projected highrunners and subsequently never renegotiated. It is a good idea to try bracket pricing with varying MOQs or dual sourcing with an alternative supplier with shorter lead-times and lower MOQs at higher prices. Reduced obsolescence and capital cost often cover extra cost incurred in sourcing. For best effect, consider doing this during initial sourcing to minimize use of sourcing resources as well as risk of overstocking during product ramp-up phases. A final comment on MOQs is that, if you can get away with it, the best set-ups are usually achieved through vendor managed inventory (VMI) solutions or stocking agreements where your supplier owns the inventory, likely with some sort of risk sharing. There are also wholesalers specializing in handling C-parts in this way which may be worthwhile looking into.
  3. Product life cycle labeling: As a basis for differentiated handling and steering of products throughout their lifecycle is product lifecycle categorization. By labelling products in relation to their position in the product life cycle (eg. “New product”, “Make to order”, “Phase out”, “Closed”) you can ensure they are handled and steered correctly while reducing manual handling. Once labels are established a set of criteria are devised to automatically make the categorization or prompt a manual review for change of label. These criteria can include date since launch, sales quantity per year, sales value per year, date since last manufacture etc. Based on the established labels steering and handling guidelines for each separate label can now be developed.
  4. Phase out: Product phase-out is one important outcome from the product portfolio optimization. This is often best set up through standardization of contractual obligations towards customers based on a set number of years after last production, combined with short-term pushing of customers towards last-time buys. From our point of view this is most easily agreed on during product development stages, through customer collaboration aiming to share costs and agree on common time plans. Furthermore, outsourcing of manufacturing and inventory to a third party can be used to drive the reduction of number of products in the product portfolio in the short term.
  5. Scrapping: There is commonly a reluctancy towards scrapping old aged or obsolete inventory in many organizations. This can often be partly alleviated by establishing a correct inventory carrying cost, and thereby shining a light on the hidden costs of holding inventory. A data model including bill of materials, linking components with products and their sales will also simplify the act of identifying which items can be scrapped.
Spare parts – an often-overlooked opportunity affecting working capital

For companies manufacturing their own products, a disproportionately large number of slow-moving parts with high obsolescence is usually related to spare parts. Despite this, spare parts often fly under the radar for the simple reason that it commonly comprises less than 15% of inventory value. Here are a few steps worth looking into when reviewing your how you work with spare parts:

  1. Set responsibilities and follow-up: If no one has a separate responsibility for spare parts, this is a warning flag. Make sure your organization have dedicated responsibilities and targets for handling spare parts as well as set OPIs and KPIs that are continuously followed up.
  2. Define spare parts assortment: If not previously done, define which parts and products are to be maintained as spares and for how long, then phase out other products and components.
  3. Separate spare parts from production inventory: In inventory control, differentiation is the name of the game, and since spare parts have different consumption patterns than production inventory they should be controlled and steered differently. Stay away from elaborate demand forecasting here, instead historical consumption is likely your best bet.
  4. Refine assortment and leverage commercially: To get the most out of your spare parts initiative, it may be useful to define principles for bundling and de-bundling spare parts to further reduce the number of SKUs and provide a better platform for pricing. Why sell one cheap screw that covers one replacement need when you can sell a semi-assembled component or kit that covers 20 replacement needs at 50 times the profit?
Original Equipment Manufacturers (OEM) – a good basis for factoring

As mentioned, many of the medium sized manufacturing companies in our study are suppliers to a few large OEMs with a lot of buyer power, which likely contributes to the high DSO found in this category. Along with being a challenge, this also provides a good base for factoring solutions as OEMs are typically large companies with strong credit ratings which will allow for lower interests and simpler administration. However, as mentioned in previous articles, this type of financing set-up often reduces the perceived importance of working capital processes leading to deteriorating performance over time. To tackle this it is advisable to follow up DSO both with and without factoring.

A summary: Challenges and solutions

So, if you are a manufacturing company and want to free working capital and work smarter. What are the best ways to go at it? Our study and experience from our clients have led us to the following conclusion:

Challenges

  • Long tail of products and components
  • Large supplier base
  • Long product life cycles
  • Often high buyer-power customers

What to do?

  • Reduce number of product as well as unique components
  • Review spare parts responsibilities, follow-up, assortment and processes
  • Review limiting MOQs and investigate bracket pricing for different volumes and MOQs
  • Consider factoring for OEM customers
About the study
  • 200 Sweden-based companies with net turnover between 1-10 billion SEK were screened whereof 152 companies were allocated to a step in the value chain, ie: Raw material and processing, Manufacturing, Wholesale and Retail. 48 companies were either service companies or difficult to define.
  • For the selected companies, the operating working capital components were analyzed in relation to revenue. Further, turnover days using revenue, spend and cost of goods sold were calculated.
Get the study

Here is a printable version of the article as a PDF.