This past year shined a harsh light on the fragility of businesses concerning cash flow and working capital. The global pandemic coupled with supply chain disruptions and erratic consumer demand wreaked havoc on companies coping to face both internal and external pressures. Meanwhile, investors pressured companies into achieving higher shareholder returns. Companies were rewarded for their behavior associated with short-term investment success, sometimes to the detriment of their long-term strategy. And inventory was caught in the crosshairs.
The New York Times ran an article in June 2021 that epitomized this sentiment entitled, “How the World Ran Out of Everything.” In the article, the authors discuss the plight of consumers facing empty shelves in stores, backlogs in retail, the inability to purchase high-end electronics, and even automobiles—all due to shortages in raw materials, silicon-based chips, or Work in Progress (WIP) to create the finished products.
Companies aren’t rewarded based on maintaining high levels of inventory—from raw materials to WIP to finished goods. Instead, they are seemingly rewarded for the contrary behavior. Rather than carry high levels of inventory to instill resiliency in the supply chain, companies were pushed to keep levels low. Working capital ratios prosper when inventory falls. Short-term gains set the stage for ruin when assumptions no longer hold.
However, despite the dichotomy, companies can learn to manage their supply chain and, in doing so, improve their overall working capital.
The efficiency of the Japanese just in time (JIT) model adapted from the late 1980s onward seems to be the epicenter for the issues that plague the supply chain today. At its core, JIT is a management philosophy that focuses on people, plants, and systems to increase overall efficiency and maintain low levels of inventory along the way. It was developed in response to pressures Toyota faced to remain competitive by reducing waste, improving product quality, and the efficiency of production.
JIT works if companies appreciate the shift in the dynamic that it brings. Consistency of demand is critical to maintaining tighter inventory levels. Buffers are reduced. Long-term contracts with suppliers provide critical relationships in the overall supply chain network. A Harvard Business Review article from 1986, titled “What’s Your Excuse for Not Using JIT?”, berated companies employing this approach. The article argued for increased adoption of the successful business philosophy. More and more companies started to follow suit.
However, the philosophical aspects of JIT and its nuances were lost as more and more Western companies lifted pieces of it to adapt to their business models. CEOs and CFOs failed to study and understand why it worked so well in Japan and the trade-offs created from implementing it. Instead, companies honed in on reduced inventory as a way to limit waste. This pushed their inventory risk to suppliers. Doing so had unintended effects as the risk was concentrated in the supply chain on the logistics, distribution, and vulnerable worker class.
That worked for a while.
The events of the pandemic and supply chain crisis exposed flaws in the model and presented a harsh reality of a failed supply chain. Tight relationships with suppliers work if you don’t push the burden and risk to the logistics and distribution network. Once the pandemic upset the consistent demand and seasonal cycles, companies were left scrambling for inventory (e.g., raw materials, WIP, and finished goods). Borders were jammed up with transports unable to proceed due to shutdowns. What good is JIT inventory if the suppliers cannot guarantee delivery of critical components to manufacturing sites? The chip shortage, for example, is causing issues for the manufacturing of cars, electronics, and other consumer goods as production cannot keep pace with demand. Factory closures during the pandemic and border restrictions caused delays in delivery of JIT materials and it triggered a ripple effect that grew until supply chains started to unravel. A prime example is the fiasco at Los Angeles and Port of Long Beach, which has over 100 container ships waiting to unload. Inventory remains stuck in transit on the water.
This past year showed a deterioration in working capital in retail and manufacturing sectors as Days Inventory On-Hand (DOH) has increased. Inventory levels should be a leading indicator to manage overall cash flow. Delays in any aspect of the inventory—from raw materials to WIP to finished products to any of the distribution in between—only delay the conversion to profit and ultimately cash.
The JIT model deserves a hard look when evaluating working capital. While managing working capital should start with inventory management, it shouldn’t just assume top-line cuts to “make estimates for Wall Street.”
Peter Drucker famously once said, “if you can’t measure it, you can’t improve it.” Therefore, instead of upending your supply chain with a top-line cut on inventory, focus on reduction through a comprehensive continuous improvement program that allows you to concentrate on factors you CAN control. For example, you can control demand planning through demand fulfillment using simple digital transformation models. Gone are the days when only Ph.D. quants understood how to program the models.
Digital transformation has democratized regression analysis and forecasting such that you only need to feed in historical data sets as a baseline. Once the analytical models run, they can be evaluated via visualization tools to determine the best fit for the data and then provide a reasonable forecast for the future. Without such digital transformation, planning groups are flying blind to understand their true demand and prepare an efficient demand fulfillment strategy for the limited supply. They must take orders from managers that want to constantly build inventory and squirrel it away—all leading to higher working capital. Digital transformation also provides tools for insight to discern which accounts are most profitable and whose lowest costs are to serve. Analytics can test price elasticity to determine a customer’s sensitivity to price and test future price increase potential. Each of these measures can easily be distilled into continuous monitoring through a health check dashboard to show the overall state of the supply chain.
Start with qualitative diagnostics. It’s important to have a fact-based and validated assessment of the inventory management process. Cover pain points and bottlenecks in the end-to-end sequence of business events. Perform a gap analysis to hone in on the problematic areas. Lastly, perform a quantitative measurement. This measurement is data-driven and focused on performance. Evaluate key performance indicators (KPIs) and benchmark components of the supply chain against peers so that you know where to apply time and effort to bring factors back under control. Only then can you create fit-for-purpose solutions that address the entire enterprise-wide supply chain.
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