Management Attention

The extent to which managers emphasize and attend to any specific process, project, or measure will have a large impact on the effort and result of that endeavor. This is very true in capital management. If a manager is only sales or earnings driven, it will follow that operating capital levels will be higher. Conversely, if a manager recognizes the importance of working capital and actively drives and monitors performance, operating capital levels will be lower. In addition, a well‐designed management compensation plan that includes capital utilization (or uses a broad measure such as ROIC that reflects capital) will ensure focus in this important area.

Performance Visibility

Capital management will be improved if managers have appropriate visibility into key performance indicators (KPIs) on a timely basis. Well‐designed performance dashboards provide managers with key process measures and leading indicators of capital performance.

Process Efficiency

Capital requirements are very closely associated with process efficiency. Companies that have well‐established process and quality programs will typically require less capital to support the business. Conversely, a manufacturing process that is not efficient and has a high level of rejected products will result in high inventories (and costs).

Creating Context: Understanding the Importance of Capital Management

When managers and employees fully understand the dynamic impact of capital in creating value, more attention is paid to this driver and related processes. However, organizations with an exclusive focus on sales or earnings growth will often view capital as “free,” with the result of higher than required asset levels.

Accountability

Assigning appropriate accountability for assets such as inventory and receivables is difficult. Out of convenience, many companies look at the functional area responsible for the last step in the related process. For example, manufacturing is often held responsible for inventory, and finance is held responsible for receivables levels since finance people are typically involved in collections. However, most financial measures and other outcomes are the result of a business process that crosses a number of functional areas. For example, inventory levels are certainly a result of manufacturing activities. But they are also a result of the design of products and the product demand forecasts typically furnished by sales or marketing management. Each driver must be disaggregated and assigned to the appropriate process team and leader.

The remainder of this chapter will focus on measuring and improving the management of operating capital. We will explore the other components of capital investment, fixed assets, and intangibles in Chapter 18.

Best Potential DSOs

A significant determiner of a company's actual DSOs is the credit terms extended to customers. There tends to be wide variation in credit terms by industry, country, and competitive situation. Even within a company, it is fairly typical to see a wide range of terms extended to customers for different products, channels, and regions. A useful way to evaluate receivable management is to compare actual DSO to the “best possible DSO” (BPDSO). This computation estimates the DSO level if all customers paid invoices on the contractually agreed date. It is computed by weighting the credit terms for each type of customer, region, or business line by annual sales and is illustrated later in this chapter in the “Best Possible DSO Estimate” table. Companies should also consider the possibility and merits of reducing credit terms to customers, resulting in a reduction to the BPDSO.

Quality

It stands to reason that receivables collections will be affected by the quality of products and services and customer‐facing processes such as billing. The typical customer is not anxious to part with cash in the first place. Obviously, if the product is not performing, the customer will not pay. The same is true for nonconforming or incomplete paperwork. If the invoice does not match the customer purchase order or does not provide required supplemental information, the payment cannot be processed without additional action.

We all recognize that the impact of quality problems goes far beyond slow collections. It reduces customer satisfaction and loyalty, increases costs for both you and your customer and may jeopardize future sales. By examining slow‐paying accounts and identifying underlying reasons, managers can learn a great deal about any customer dissatisfaction and take steps to deal with underlying product or process problems.

Effectiveness of the Revenue Process

The effectiveness of the revenue process is a key driver of accounts receivable. The timeline of the revenue process for a typical company is summarized in Figure 17.3. The process starts long before a product is shipped, when the company is engaged in the product design and preselling activities with the customer. In addition, the setup of the order processing software and product definitions can also facilitate or encumber later stages of the revenue process.

Other activities preceding shipment include order processing and manufacturing and quality control. Imagine the downstream process implications of botching the order entry step by entering an incorrect part number or shipping address. The wrong product will be shipped to the customer, or the product will be shipped to an incorrect location. The ability to reduce defects at this stage in the process can save a great deal of time, money, and customer goodwill.

When available, the product is shipped and an invoice is generated and delivered to the customer by post or electronic means. Understanding what happens at the customer's facility to process purchases and payments is essential to speed collections. What process and system does the customer employ to receive the product, test that it works properly, review the transaction, and initiate payment? Does the customer require special paperwork to facilitate processing? How does the customer identify and resolve problems and discrepancies? Does the customer pay on negotiated terms or routinely delay payment to help its own cash flow, often called the cash management lag (CML)?

A best practice is for customer service to contact the customer shortly after delivery to ensure that the customer has received and is satisfied with the product and has everything necessary to pay the invoice. If any issues exist, they are identified early and can be addressed at this time. Unfortunately, many companies wait until the receivable is past due to contact the customer. They may be unaware that there is a problem with the product or paperwork preventing payment. Under even the best of circumstances, this situation results in an unsatisfied customer and delayed payment for 40 days or more.

Revenue Process–Accounts Receivable Dashboard

Depending on the specific facts and circumstances, several of these measures should be selected and combined to create a dashboard for the revenue process and accounts receivable, illustrated in Figure 17.4.

Tools for Assessing and Improving Revenue Process and Accounts Receivable

A number of tools can be employed to help in assessing and improving the revenue process and accounts receivable management.

Accounts Receivable–DSO Drivers Chart. The chart in Figure 17.5 presents a high‐impact visual summary of DSOs. We begin with the best possible DSOs (BPDSOs) of 40 days and then identify the number of days associated with significant factors resulting in an actual DSO of 64 days. In this illustration, three factors account for most of the 24 days: customer cash management lag (CML), revenue linearity, and past‐due collections. Each of these items represents high‐leverage improvement opportunities for managers to address.

Accounts Receivable Aging Schedule. A useful tool for managing accounts receivable, customer satisfaction, and the revenue process is the standard accounts receivable aging report. An example of an accounts receivable aging report is presented in Table 17.6. This report simply details the current accounts receivable balance for each customer by age of invoice. Invoices issued in the past 30 days would be included in the 0–30 days column. Invoices issued in the previous month would be reported in the 31–60 days column, and so on. This report allows the identification of macro payment patterns such as slow‐to‐pay customers, but will also identify specific overdue invoices for review and follow‐up. The report is used by accounts receivable and collections staff but is so rich in information about customers and payment delays that it may also be useful for managers to review from time to time.

Root Cause Analysis: Past Due Collections. A very effective way of assessing key aspects of the revenue process and accounts receivable management is to perform a root cause analysis of any invoice exceeding a certain dollar level and past due for a certain period of time. This also serves as an extremely important tool to identify customer service problems, since an unsatisfied customer will not pay the invoice. Once identified, overdue invoices can be reviewed to determine the root cause for the delay. Overdue receivables generally will fall into one of several root cause categories. For example, key process problems such as invoicing errors or poor quality associated with a particular product may be contributing to overdue receivables. An example of a simple root cause analysis is shown in Table 17.7.

The analysis can then be summarized to provide useful insight into the root cause of problems that can lead to the development of a corrective action plan as shown in Figure 17.6.

Accounts Receivable Roll‐Forward Summary. This tool is a subset of the operating capital budget tool discussed earlier in the chapter. It is a great way to understand and communicate the dynamics of accounts receivable. Accounts receivable represent amounts due from customers for products delivered or services rendered. Receivables are increased by sales and reduced by amounts collected from customers. Sales for each month are taken from the profit and loss (P&L) forecast. Collections will be estimated based on past and projected payment patterns. In the example in Table 17.8, it is estimated that 10% of sales will be collected in the current month, 40% in the next month, and then 30% and 20% in months 2 and 3, respectively.

For example, collections in January of $758 million are estimated as follows:

Assess Effectiveness of Revenue Process. Before embarking on a project to establish measures and improve the revenue process and accounts receivable, many companies first assess the effectiveness of the process by evaluating each segment of the process and identifying high‐leverage improvement opportunities. Using tool kits or best practices surveys for the revenue process, a rating (on a scale of 1 to 5) can be assigned to each stage as illustrated:

This evaluation will set the focus on weak segments of the process, in this case invoicing, follow‐up, and visibility.

Drivers of Inventory Levels

Market and Industry. The very nature of certain businesses and industries often determines the level of inventory required. For example, retailers must purchase and hold inventories for resale to consumers. Manufacturing companies must acquire materials, assemble products, and distribute finished goods to their customers. However, service companies, including consulting firms, do not have to hold significant levels of inventory.

Effectiveness of Procurement and Conversion Processes. Inventories as well as manufacturing costs can be reduced by improving procurement and manufacturing or conversion processes. For example, by evaluating and then improving vendor quality and delivery performance, the company can reduce lead times and inventory levels. Over the past 25 years, tremendous improvements have been made by many companies in improving the flow and efficiency of the manufacturing process.

Product Life Cycle Issues. The evolution of a product from conception to full‐scale production and to end of life has significant impact on inventory levels. Two critical phases in the product life cycle are new product introduction and the end of the product's life.

New Product Introduction. Many companies carry high inventory levels associated with problems in the design and introduction of new products. If a new product is transferred to manufacturing before all design issues are resolved, there are likely to be high inventory levels associated with the product. In addition to tying up excess capital, this inventory may be at risk for obsolescence if the design of the product is changed.

End of Life. The company must carefully plan and manage the end of a product's life cycle. If this is not done effectively, the company may carry and ultimately have to write off inventories that are no longer salable to customers.

Design for Manufacturability. Many companies have reduced costs and inventory requirements by designing products that are easier to manufacture. Examples include using common components and requiring fewer complex assembly steps. These types of improvements reduce costs and inventories, improve quality, and prevent delays associated with introducing products to market.

Product Quality. If a company manufactures a quality product, inventory levels will be lower than for a similar product with quality problems. A firm with high‐quality manufacturing processes will require lower levels of material input; less time and inventory in test, repair, and rework; and lower levels of inventory returned from customers.

Breadth of Product Line. The company that offers a broad selection of products will typically require higher inventory levels. Conversely, a firm with limited product alternatives will typically have less inventory. Many firms have reduced inventory levels by limiting product variety to fewer options and choices (e.g. color, size, configurations, and power).

Vertical Integration/Outsourcing. Companies that are highly vertically integrated will carry higher inventory balances than a firm that outsources a substantial part of the manufacturing process to other firms.

Forecasting. In Chapter 15 we discussed that most businesses must anticipate future demand for their products so that products can be ordered or manufactured and be available for customers at the time of purchase. The revenue forecast typically drives procurement and manufacturing schedules and activities. The accuracy of forecasts will have a significant impact on inventory levels. If demand is overestimated, excess inventory will result. Even if the total revenue forecast is accurate, if the mix of products is different than projected, the company may miss sales and build products that were not ordered, leading to an increase in inventory. In Chapter 16, we outlined several measures that can be taken to improve the forecasting process. In addition to improving the forecasting process, managers should also strive to increase flexibility and response times, for example by reducing lead times.

Key Performance Indicators for Supply Chain Management and Inventory

There are a number of performance measures that can be developed and tracked to provide visibility into key drivers of supply chain and inventory management.

Inventory Turns. In Chapter 2, we computed inventory turns and days sales of inventory (DSI) for Roberts Manufacturing Company (RMC), as follows:

Inventory turns measure how much inventory a firm carries compared to sales levels. Factors that will affect this measure include effectiveness of supply chain management and production processes, product quality, breadth of product line, degree of vertical integration, and predictability of sales.

Days Sales of Inventory (DSI). This measure is a derivative of inventory turns and is computed as follows:

This measure is affected by the same factors as inventory turns. The advantage to this measure is that it can be easier for people to relate to the number of days of sales in inventory. As a result, it may be easier to conceptualize the appropriateness (or potential improvement opportunity) of carrying 146 days' worth of sales in inventory than to conceptualize 2.5 inventory turns.

Slow‐Moving and Obsolete Inventory Levels. It is important to identify and manage excess and obsolete inventory. Excess inventory is the inventory on hand in excess of foreseeable demand over a defined period such as 12 months. Excess inventory results from overestimating demand or from radical changes in demand patterns. Obsolete inventory results from holding inventory that is no longer salable or usable in the ordinary course of business. A useful summary of excess and obsolete inventory is illustrated in Figure 17.8. A good first step in managing excess and obsolete (E&O) inventory is to trend the levels over time. Measuring levels of E&O inventory will provide visibility and identify trends. This measure is complemented by a root cause analysis that provides insight into the underlying causes of E&O inventory. Typical causes include product life cycle issues (end‐of‐life issues, new product introductions) and forecasting errors.

Number of Unique Inventoried Parts. Tracking the number of unique inventoried parts may provide insight into a key driver of inventory management. The company may be able to reduce inventory levels by reducing the number of unique inventoried parts. This objective may take time to achieve and must consider supplier, customer, and manufacturing issues.

Past‐Due Customer Orders. If customer orders are delayed past the requested delivery date, the inventory must be carried until the order can be completed. Perhaps the inventory for an order is completed except for a single integral part that is out of stock. Obviously, past‐due orders are likely to negatively affect customer satisfaction as well.

Supplier Performance. Companies should measure the quality of parts supplied by vendors. Poor quality of incoming parts will delay internal processes and result in higher inventories. Late deliveries from suppliers will also wreak havoc with production schedules, resulting in higher inventories and potential delays in shipments to customers.

Forecast Accuracy. Measuring the accuracy of sales forecasts compared to actual demand levels will help to explain inventory shortages and excesses. It will also provide visibility into a key performance driver and serve to establish accountability for sales projections. Measures of forecast accuracy were presented in Chapter 15.

Cycle Time. A very effective measure of supply chain management and inventories is the amount of time required to produce a unit of inventory. The shorter the cycle time for a product, the less time the product spends in the factory. Reducing cycle times typically leads to lower manufacturing costs, lower inventory balances, and increased flexibility. It can also lead to higher levels of customer satisfaction.

Additional measures for supply chain management are discussed in Chapter 16.

Supply Chain Management and Inventory Dashboard

Several of the measures just discussed can be selected and combined to create a dashboard for supply chain management and inventory. (See Figure 17.9.)

Tools for Understanding and Assessing Inventory and Related Processes

Assess Related Business Process. Similar to the approach suggested for accounts receivable earlier in the chapter, it may be helpful to assess the supply chain and related processes before selecting performance measures. Using tool kits or best practices surveys for the supply chain management process, a rating (on a scale of 1 to 5) will be assigned to each stage as illustrated:

This assessment will focus on attention on weak segments of the process, in this case, product design and new product introduction, forecasting, and management of excess and obsolete inventory.

Improving Visibility: Useful Analytical Reports

In addition to the dashboard and assessment, there are a number of reports and tools that are very useful in identifying trends and providing visibility into key drivers of inventory.

Inventory Trend Schedule by Major Category. Much can be learned by drilling down into the major components of inventory and tracking trends in each over time. It is also useful to compute turnover for each significant category of inventory (see Table 17.9).

This schedule includes outstanding purchase commitments to provide visibility into the inventory that the company has ordered and is contractually obliged to take in the near term. Tracking and managing the purchase commitments and the total inventory commitment provide a leading indicator of future inventory levels.

Inventory Roll‐Forward Summary. Similar to the schedule presented for receivables, the inventory roll‐forward summary shown in Table 17.10 displays the transactions projected for each month that will increase or decrease the inventory balance. Inventory will be increased by purchases, manufacturing labor, and overhead applied to inventory. It will be reduced by cost of goods sold (COGS); including cost of product sold, write‐offs, and so on.

This schedule is a great tool for tracking and communicating the key variables that will affect inventories. It also allows us to understand why inventories are higher or lower than we projected they would be as shown in Table 17.11. Did we purchase more material than projected? If so, inventories will be higher than expected. Did we sell less product, resulting in lower cost of sales relief from inventory? If so, then inventories would also be higher.

Tracking Top 20 to 50 Inventory Items. Focusing attention on the inventory items that have the greatest value can provide insight into inventory performance and allow managers to focus on specific items that account for the lion's share of the inventory value. It is common for the top 20 to 50 line items to account for 50% to 80% of the total inventory value. See the illustration in Chapter 5, Building Analytical Capability.