Supply Chain Frontiers issue #48
The liquidity crisis in Europe has cast a spotlight on the need to bridge the divide between finance and supply chain management (SCM). More than ever, these two key disciplines need to collaborate on ways to release some of the cash that is locked into supply chains.
Reducing inventory is probably the most obvious strategy for liberating these financial resources, particularly for companies that maintain high stock levels. In addition to tying up large sums of money in the products stored, inventory adds cost in others forms, such as insurance premiums, investments in storage facilities and related transportation budgets, and obsolescence costs.
Large companies in Europe are very concerned about this cash-equivalent mountain, as it has become more difficult to meet their working capital requirements (WCR). But addressing the problem requires a concerted effort to understand the financial implications of SCM decisions.
When firms resolve to outsource production to low-cost manufacturing centers in countries such as China, for example, the move may enhance their profit and loss (P&L) statements, but the overall impact on the balance sheet could be much less favorable. The longer pipeline and corresponding increase in uncertainty require higher inventory volumes, which eats up precious cash reserves.
Transferring production to remote suppliers also is likely to involve larger lot sizes. These vendors often need to sell big batches of product to make the business profitable. Again, this consumes the buyer’s WCR when it purchases 1,000 units even though the enterprise only needs, say, 30 units. Sourcing domestically might be a better option because it is easier to work with local producers to reduce lot sizes.
Stock-keeping unit (SKU) proliferation is another supply chain issue that can have far-reaching financial implications, and a number of multinational companies are striving to rationalize their product assortments. In positive economic times, the inventory holding and ordering costs associated with multiple SKUs tend to be underestimated.
In April 2012, sports apparel company Adidas announced plans to cut its 46,897 SKUs by 25%. Other successful companies have followed a similar path. Apple’s iPhone offers only 10 SKUs worldwide for the product’s color and memory variants, for example. Compare this to Nokia, which sells 37 different models in Germany alone. Spanish supermarket chain Mercadona boasted a net profit of more than 19% at its 1,500 supermarkets in 2011. The retailer has about 4,000 SKUs per store compared to a typical US supermarket, which sells around 40,000 SKUs.
The product assortment issue is a good illustration of how the lack of a holistic view of the supply chain can rob a company of WCR. Often, the marketing department believes that introducing more SKUs delivers more buying opportunities and hence boosts sales. But the marketers may fail to consider how the wider product selection both decentralizes and increases inventory, and has an adverse effect on the company’s balance sheet. Many senior executives also suffer from this myopic view of operations.
Extending payment periods or shifting inventory to suppliers are tactics that many financial departments adopt in a tight economy. Again, understanding how such actions ripple through the supply chain – working capital is more expensive for small suppliers so their performance declines, for instance – may not be a high priority.
SCM leaders are just as culpable. They might take an outsourcing decision without giving much thought to how such a move constrains WCR. Basic financial concepts, such as “WCR equals cash plus receivables plus inventories minus payables,” need to be an integral part of the SCM decision-making process. Supply chain professionals should appreciate that inventory levels directly affect financial risk.
Firms that understand the impact of SCM decisions on their financial statements can capture huge competitive advantage. That holds true in any commercial environment, but especially in one where there is a scarcity of working capital.
This article was written by Dr. Alejandro Serrano, Professor of Supply Chain Management, Zaragoza Logistics Center, Zaragoza, Spain. He teaches “Finance for Supply Chain Management” as part of ZLC’s masters and executive education programs. Please contact Alejandro Serrano for more information on these programs.