By PATRICK BUCHMANN, ALEXANDER ROOS, UDO JUNG and MARTIN WORTLER
From Boston Consulting Group
Given the rising costs of energy and raw materials, mounting losses in the financial sector, tighter capital markets and ongoing predictions of an economic downturn, many companies are concerned about their ability to generate the funds needed for growth. One potentially powerful source of cash that is often neglected is working capital. By increasing the productivity of their working capital, companies can sharply reduce their dependence on outside funding and better manage the economic storms that blow their way.
Working capital (current assets minus current liabilities) has always been an important measure of a company's liquidity and its ability to support day-to-day operations. But too much working capital usually means that too much money is tied up in accounts receivable and inventory. Typically the knee-jerk reaction to this problem is to apply the "big squeeze" by aggressively collecting receivables, ruthlessly suppressing payments to suppliers and cutting inventory across the board. But that attacks only the symptoms of working-capital issues, not the root causes. A more effective approach is to fundamentally rethink and streamline key processes across the value chain. This can lead to greater reductions in working capital -- as much as 30 to 40 percent -- and to cost savings of 5 to 10 percent. The key is to uncover the underlying causes of excess working capital across the entire value chain.
To address often hidden interdependencies and achieve maximum savings from a working-capital program, companies must analyze the entire value chain, from product design to manufacturing, sales and after-sales support. Companies must also look for ways to simplify processes and eliminate costs, keeping in mind how these changes may affect other areas in the value chain.
Three factors drive working-capital levels: inventory, receivables and payables. In effect, receivables and payables are different ways of financing inventory. Companies need to manage all three simultaneously across the value chain to drive fundamental reductions in asset levels.
A realistic plan with clear priorities is the best approach, since an overly ambitious agenda can stretch internal capabilities and deliver suboptimal results. Instead, companies should concentrate on the most promising actions that won't impair flexibility and performance. These actions will vary depending on the industry and the company's situation, but they should have three overall objectives.
1. REDUCE INVENTORY.
Excess inventory is one of the most overlooked sources of cash, typically accounting for almost half the savings from working-capital management. By streamlining cross-enterprise processes -- as well as processes involving suppliers and customers -- companies can minimize inventory throughout the value chain. For instance, optimizing sourcing and design processes will affect the rest of the value chain, leading to smaller safety stocks, time buffers and batch sizes in both raw-material and work-in-progress inventories. With raw materials, companies can often achieve substantial gains by redefining optimal safety-stock levels and batch sizes.
This requires a thorough analysis of customer demand patterns, customer forecast quality, production throughput time and variability, and supplier lead-times (frequently the most important driver of safety-stock levels). By assessing these factors, companies can often sharply reduce inventory levels throughout the supply chain. Moreover, through more effective sales and delivery planning, they can cut stock buffers by half or more by increasing the reliability of suppliers' delivery dates and by better timing purchases and sales. These improvements can greatly decrease raw-material and work-in-progress inventories, but they require end-to-end process improvements across the value chain, from the supplier to the customer.
2. SPEED UP RECEIVABLES COLLECTION.
Many companies are early payers and late collectors -- a recipe for squandering working capital. Other companies have cash flow problems caused by a mismatch in timing between incurred costs and receipt of customer payments. One way to ensure a steadier flow of cash is to better align incurred costs with customer payments by asking for a down payment and setting up a series of staggered payments to ensure that most receivables have been collected by the time of delivery. All companies should aim to reduce overdue payments and accelerate collection by shortening the dunning cycle and setting up a schedule of escalating payment demands.
Companies should also benchmark their payment terms and conditions against best-practice and international standards and consider renegotiating with their customers. The goal of shortening customers' payment terms, however, must be balanced against the risk of jeopardizing the relationship. Companies should always seek a fair, mutually beneficial and non-confrontational solution.
3. RETHINK PAYMENT TERMS.
If fast-paying companies are at one end of the spectrum, then companies that "lean on the trade" and use unpaid payables as a source of financing are at the other end. Between these two extremes is a more effective, integrated approach to payment renegotiation that takes into account all aspects of the customer-supplier relationship, from price and payment terms to delivery time frames, product acceptance conditions and international trade definitions.
Companies should benchmark terms and conditions against industry best practices and eliminate early payments, except when attractive discounts are offered. When renegotiating payment terms, they should consider the length of their relationship with suppliers as well as competitive loyalties. Moreover, linking suppliers' payment terms to their performance in areas such as delivery accuracy, complaint ratios and order lead-time can improve underlying processes and reduce working capital overall.
By analyzing each component of working capital along the value chain, companies can identify and remove the obstacles that slow cash flow. Done right, working-capital management generates more cash for growth -- along with streamlined processes and lower costs.
Patrick Buchmann is a principal in the Hamburg office of The Boston Consulting Group. Alexander Roos is a partner in the firm's Berlin office. Udo Jung is a senior partner in BCG's Frankfurt office. Martin Wortler is a senior partner in the firm's Dusseldorf office.