Working Capital Magic - From Customers to Cash Flow

Data Diving: The Fine Tooth Comb

This is my first post of 2005.  Happy New Year!

It's always great to talk to senior V and C-level executives to get the 30,000 foot level view of the world.  And you just can't get a better feel for the trends and market forces shaping the industry and their impacts on the business.

But the key challenge is to then delve into the details of those business trends and understand how they affect business processes, individuals and the ongoing trajectory of a company's performance.  This is where diving into business data becomes invaluable. 

In my experience, getting and analyzing business data is an art.  Take customer segmentation realted analytics.  Even though there are a host of CRM solutions that help examine different customer based performance activity, the trick is to first figure out what you need to look at.  As an example, we can look at customer segmentation with respect to different working capital processes:

(You can read my previous posting on Customer Segmentation to Manage Working Capital Risk to get a better background on what I'm talking about).

Some key data elements to look at are:

1. Customer payment history over time - DSO by customer, average days late, average time to pay, broken promises to pay, etc...
2. Customer level inventory metrics - Inventory Turns, % of spend attributed to specific customers, if possible, excess & obsolete inventory by customer...
3. Forecast and demand changes/variations over time per customer
4. Customer level credit scoring, both for new and existing accounts
5. Revenue segmentation by customer and customer region, gross margin by customer

and it goes on and on and on...

I also like the Gross Margin Return on Investment calculation that a lot of retailers use to plan and measure their assortments.  One great thing about this is that it gives a great view into which customers and products to protect, which to nurture and grow and which to prune from the portfolio. 

Again, having the right data is key in any type of analysis.  Specific to working capital management, I'd recommend keeping in mind the following:

1. Remember that working capital data is often strewn around the supply chain - account for different data sources, different trading partners, different global regions, etc

2. You have to have a representative sample of historical data to analyze.  For example, if you are aalyzing an A/R portfolio, you need to get at least a year's worth across multiple business lines.  This helps to identify cyclicality in payments, billings, etc..  Also you can slice and dice the data to see the effects on different operating theaters

3. Oftentimes, the important parts of the data analysis is seeing what is not shown.  Although many people might disagree, I think if you're cofortable with your data integrity, you can do some correlation and estimate whether you assumpations about working capital operations is true.  For example, if you were analzying revenues for a CPG (Consumer Packaged Goods) company, you may expect to see a great deal of seasonality in revenues.  However if the data does not point tot his situation, you can then dive into the root causes - maybe deductions are higher due to New Product Introductions, complex promotions, slotting fee hikes, etc...

It's helpful to keep an open mind to possibilities and think outside of the box when really trying to infer business knowledge from a stream of data.

CIOs and Working Capital Management

Just as centralized and line-of-business finance departments are being seens as strategic players in the corporation, the same is also being considered of IT.  I remember during the 90s and through the dot-com boom how IT was driving a lot of the business decisions and corporate initiatives (anyone remember Y2K?).   Unfortunately what happened back than was that the time pressures to bring about innovation was perceived to be so critical, that IT solutions were brought in without having a fully thought out change management plans tied to business drivers.

The end result - tons of expensive shelfware.  Ask yourself how much supply chain software is out there either not implemented or poorly implemented. Or e-commerce applications, ERP upgrades, etc..

So as a reaction, the last few years have seen very little IT spending from wary corporations.  Now, with new initiatives such as Sarbanes-Oxley pushing business-driven compliance requirements, IT and its CIOs are back in the spotlight.

I think CIOs will be next change agents of working capital management initiatives.  This article from Computerworld  about the New IT Leadership Agenda  clearly points to CIOs being the standard bearers of initiatives like Six Sigma, Sarbanes-Oxley, and process change activities.

Some things to consider:

1. IT departments will definitely be judged on feasibility and ROI of any selected software solutions.  This means payback better occur within 6 months or less!

2. With the currect risk adverse climate, software costs better be "on-demand" and sold as a service.  Here is where a hosting model for software comes in handy complete with subscription services for pricing.  As an example, Textron chose to deploy working capital solutions from Emagia by using a hosted model - this limits Textron's up front investment and ongoing total costs of ownership (e.g. hardware/software/personnel maintenance and support).  It's a harbinger of the future way that companies will buy and deploy software.

3. Business users and IT will be working much more tightly together than ever before.  Look atteh ramifications of Sarbanes-Oxley: process changes have to go hand in hand with software solutions to ensure compliance. 

4. My prediction is that IT budgets will diminish - but budgets for business units will increase to reflect the need for IT spending on business applications.  However, this clearly means that the business units will ultimately determine whether applications are purchased. In turn, the burden will be in the business units to ensure that the ROI materializes, making the entire transition very fair. And this makes perfect sense for business applications.

Improving Working Capital: Where Should You Focus?

If the Working Capital cycle tied to cash flow is comprised of A/R, Inventory and A/P, where should companies focus their energies to get the biggest bang for their buck?  The obvious answer would be "all of the above".  But the reality of the situation is that this isn't always possible due to limited resources, time and focus.

There's been some research that points to how effectively companies think they are managing the different aspects of their working capital cycles.  Here's what I found to be interesting:

1. When it comes to Accounts Receivable management, companies tend to inherently understand that collecting their cash faster will lead to better working capital.  Pretty much common sense.  However, what's realy interesting is that when asked whether their extended terms were similar to, higher, or lower than their competitors, most companies (95%) replied that they thought they were in the same ballpark.  But, when these same companies were asked if their pricing was the same, higher or lower than their competitors, a much smaller percentage (67%) thought it was the same.  Seems to indicatethat most companies are much more aware of their pricing variations than their trade recevaibles practices.  Which is strange, beacuse although pricing is a direct part of revenue management, A/R is where revenue actually materializes.  You would think that both parts of the quote-to-cash cycle would receive equal attention.

2.  Inventory is a much talked about and (mis) understood subject.  Everybody unstands the need for it, but hates it all the same.  The question is: how much can inventory turns really be improved?  The usual benchmarks for best-in-class reduction in days of supply are around 5-30 days.  In some cases, if companies would prune their product portfolios, the upper end of this range could easily be acheived.

3. Accounts payable is the least glamorous of the working capital management process, but can really add some value.  Every company knows it's a highly manual function, but can reap some tremendous value if properly managed.  I'll be talking about how strategic float management coupled with intelligent discount-taking can really streamline the procure-to-pay cycle.  Typically, companies think that a 20-30 day extension of DPOs is possible if their is enough focus on A/P.  The trick is to do this without risking valuable vendor relationships.

Random Musings About Distributor Programs

I'm happy to say that this is possibly the only blog in America this week that has absolutely no commentary on the election.

Recently, I had an interesting discussion with a electronics company about their Financial Supply Chain.  This particular company deals primarily with Distributors and as a result is highly at their mercy.  The new revenue recognition rules really put the onus on suppliers to ensure that channel stuffing does not occur.  Basically, component suppliers that "sell in" to Distis can't recognize the revenue until the stock is "sold through" to the retailer or end customer. 

This is all put in place in order to prevent the supplier's salespeople from booking phantom orders and simply stuffing the distributors' warehouses, all in an effort to meet their quotas.  Sometimes, this is pure collusion between the supplier and the distributor and the Disti even charges warehouse holding costs to the supplier!

Anyway, I was looking through all the configuration of Disti programs like ship-and-debit, price protection, stock rotation, etc... and was wondering how this affected the whole quote-to-cash cycle.  Although the "sell in" is done on net 30 terms, and even though the Disti pays on time, the revenue can't be recognized until the inventory is sold thru.  In the high tech industry, where product lifecycles are very short and lead to rapid obsolescence, stock rotation programs are also pervasive.

It would be interesting to compare inventory turns (1/DSI) vs. receivables turns (1/DSO) for component suppliers.  The ratio between DSO and DSI should be a good index for looking at Quote-to-cash cycle velocity.  Tying channel inventory visibility to the quote-to-cash cycle would be pretty helpful for the high velocity demand chains in industries like consumer electronics or semiconductors.

The Last Mile Before the Big Show

I think I'm almost ready for the CFO Working Capital Conference after too many sleepless nights. I wouldn't be surprised if they asked me to check in the bags under my eyes when I board the plane for Boston. Ah... the life of a marketing professional...

By the way, I absolutely love this very informative site on working capital management. Sure, it's low tech, but it really puts the working capital cycle into perspective. I use it for reference from time to time.

Also keep in mind that I'm going to Boston during the height of the World Series. I hear that they already had some riots. Someone also told me that they are thinking of outlawing all alcohol sales in Boston during the Series. Drat! I guess I'll have to stock up on the mini-bottles on the plane.

However, I am looking forward to some great seafood. Legal Seafoods is one of my favorites, but luckily there are some Boston locals in my company who'll probably take us to some new places.

That is, if there's time to eat. Tradeshows are grueling, before, during and after, but the right one can be gold for a company like ours. Might be fodder for another post.

I wonder if they'll let me bring riot-protection gear on board the plane. Think it'll fit in the overhead compartment?

Current Working Capital Management Trends Around the Globe

I'm sure many of you have read CFO magazine's Working Capital Survey. I've been following these trends very closely over the last 4 years, and I've always been surprised by the disparity between North American companies and European companies. However, in this recent article in CFO magazine, it looks like the gap in performance "across the pond" is shrinking.

Maybe this is the way the Europeans are getting back at us for the years of Euro-bashing. (Freedom fries, anyone?).

On a different note, the article talks about Dell's DSO going up! I can't believe the poster child for Cash Cycle Compression is increasing its Cash-to-Cash Cycle. I have to imagine that some of the DSO is coming from B2B trade credit sales along with European sales as quoted in the article. What could be more surprising? Maybe Dell's going to start paying its suppliers for inventory before selling it... Yeah right...

Here's an image I put together that puts some perspective into DSO and cash-to-cash cycles in the electronics manufacturing supply chain. This was based on looking at the 2003 financial performance of leading companies in each sub-vertical (Dell was one of the OEM companies in my analysis). It'd be interesting to see how DSOs have changed for commodity suppliers versus high margin sole-source component suppliers in 2004. I guess we'll have to wait until 2004 Q4 results are announced.

Customer Segmentation to Manage Working Capital Risk

"All animals are equal. Some animals are more equal than others." - Animal Farm by George Orwell

To paraphrase Orwell, I would have to say that all Customers are equal in many respects. But revenue-wise and risk-wise, some Customers are more equal than others. As many of us know, Pareto's law holds quite true for most business situations. I have yet to run into a major company where 80% of revenues did not come from 20% of the customer base.

What this means to me is that the old saying "Treat your customer like a king" really needs to look at the size of the customer's kingdom. Although customer service should still stay paramount, the way you handle the customer from quote-to-cash should be well defined. This is where customer segmentation comes into play for all working capital management and supply chain functions.

From an end-to-end working capital perspective, I would suggest that customers be looked at and segmented along these lines:

1. Revenue and Gross Margin factors: First, look at and divide up your customers in terms of how much they contribute to your revenues and also how much margin they generate for you. High revenue, high margin and low volume customers need to have different strategies applied for doing business than high volume, low margin customers. Also, this detailed segmentation will allow you to apply different pricing procedures to maximize overall revenues. For example, you may typically create different pricing tiers for different custoemr segments. By the way, the retailers use a metric that is useful called GMROI (Gross Margin Return On Investment) ot help do this.

2. Credit Risk: Now this has been done for years. Clearly not all customers have the same level of credit risk. A flexible credit scoring model and access to external bureau data and internal payment history is critical here. After all, if a customer places a sizeable order, but never pays your bill, you may as well have burned the money that you put into building and shipping that product. Credit risk needs to be closely gauged and reviewed on a periodic basis.

3. Collections & Accounts Receivable Risk: This is the back end of the transaction. How do you really go after different customers when their accounts go past due? Do you mobilize your collections staff and burn up the phones? Do you send friendly reminder letters or scathing dunning letters? When should you chase them - 15 days past due? 30 days past due? etc? Do you want to avoid pissing off a burgeoning customer that will probably end up buying millions of dollars from you next year? It all really depends on the customer segment. And if you use these tactics judiciously, you can really keep your DSO from ramping up and maximize your working capital efficiency.

4. Inventory Liability Risk: Whether or not you have contractual liability in place regarding inventory with you customer or not, you definitely want to be aware of how much it costs to service a customer, how they react and how reliable they are. You have to look at inventory turns specific to customers, average days supply of inventory, average variation in the demand forecast, the cost of the inventory (inclduing carrying costs, stockout costs and liability costs), etc... The reason for the big inventory buuble in the early 2000s when a bunch of electronics suppliers got stuck holding the bag on millions of dollars worth of inventory was because they failed to clearly understand the viability and reliability of their OEM customers. When the tech bubble burst, clearly dropping demand would force OEMs like Cisco to cancel supply orders. Now many OEMs were hit hard and had to write off tremendous amounts of E&O (Excess & Obsolete) Inventory. But the suppliers had stocked also up and had hard supply pipelined for manufacturing. So because the contracts were so vaguely defined, the suppliers often had to eat the loss for the inventory. And that's huge because most margins for the suppliers were tight, and resell channels for the E&O inventory were little to none. Tying up inventory needlessly really hits your working capital too. Don't even let me get started on channel stuffing...

I'm sure there are a lot more factors to consider when deciding how to treat a specific customer - potential for product development partnerships, potential for acquisition, geographic dispersion, etc...

I'm still looking for the Grand Unified Theory of Working Capital Management which will tie up all of the loose ends.

Are We Ready For A (Working Capital) Relationship?

Although those words can instantly strike fear in any red-blooded, single man's (or woman's) heart, they really do have some bearing on working capital management.

It seems to me that a big part of managing working capital is really about managing relationships. After all, it's all about the cash flow cycle and as a company, you're either trying to collect from customers, paying suppliers or working with the internal and external supply chain to build and ship product. The levers that you push or pull in these relationships really drive the velocity at which cash is pulled in, retained and expended from you company.

For example, let's talk about the quote-to-cash (Q2C) process. The way you conduct transactions with the customer, from the first time you hear about them, to the terms you extend, to order fulfillment, to finally billing and collect from them, is really a complete experience. It's the quality and cycle time of this entire experience, and how your company manages it, that really dictates when and how much of your money will come in. It's pretty easy to predict that if you have higher risk customers that get extended standard terms, you'll probably have a harder time to get them to pay everything they owe you on time. Now, we all know that salespeople can never say "no" to a deal. So when a shady looking deal gets cut with a very slow paying customer, usually your A/R department is stuck holding the bag. They have to then hound the customer, spend a lot of time sorting out the gory details and hopefully convince the customer to pay.

Overall this specific example is not what I call a "high quality" quote-to-cash experience. The really sad part is, even customers that have a high credit rating (e.g. D&B 4A1), still may not pay in time due to many reasons like poor service, administrative errors, and their desire to hold on to the gold as long as possible. So these "low risk" customer can really jack up your DSO (Days Sales Outstanding) because they know that you'll let them get away with paying consistently late. Or the way you have done business with them in the past has some issues that haven't been addressed. Either way, your customers aren't complaining about not paying your bills on time. Its really up to your company to manage that relationship and the overall experience for your customers to collect your money when its due.

Now let's look at the supply chain aspect. Many companies have started to outsource parts or all of their manufacturing and logistics functions. For example, a major disk drive manufacturer which sells into OEMs like Dell and Compaq, has been using an outsourced logistics provider to manage their bonded customer fulfillment warehouses. So based on actual inventory pulls by the OEM, the logistics provider lets the disk drive company know consumption quantities, pulled part numbers, etc... And the disk drive company then bills the customer accordingly. All this is great in theory, and with some new systems in place, things go relatively smoothly. However, what happens when problems occur?

In the supply chain for this company, margins are not as high as they used to be due to pricing pressure from competitors. So costs need to be driven down, a primary candiate being inventory. Since the fulfillment model is based on a VMI (Vendor Manage Inventory) program, the disk drive company is stuck footing the cost of finished goods until the customer pulls parts and pays the bill. As you can guess, any process errors or lags in cycle time of this process caused by missing communication hits the disk drive company with a double whammy. First of all, they've got locked up funds in inventory and secondly they're losing out on interest because they aren't getting paid on time. And how does this all roll up? Who chases down the discrepancies in pull tickets, who manages the logistics provider relationship, who chases down the customer for delinquent or erroneous payments? In many cases, these are handled by different parts of the organization, with little coordination. In these instances, the disk drive company may need to carefully gauge the full Q2C experience, not just within their four walls, but also include their logistics provider and their customers. In this case, outsourcing, although a great strategic decision for the company, adds a level of complexity in the relationship that needs to be closely managed, monitored and most importantly - nurtured.

I guess my point is that these relationships and the experiences with customers within the working capital cycle are not usually addressed in a holistic fashion. For example, your field sales or customer service may manage the "customer relationship". But what about the shipping and the billing and collections? Those experiences are often handled by independent silos (logistics, A/R, etc...) who normally dont interact that much except for when problems come up. Instead, is there a need to have an end-to-end relationship manager that really transcends all of these silos? This relationship manager would then handle the entire customer experience from cradle to grave. And he or she is not coming just from a sales perspective, but also looks at things from a company perspective - revenue, cost, supply chain, finance, product development, etc...

I know this gets complicated for companies with large numbers of customers, but I think the Electronics Contract Manufacturers like Solectron have the right idea. They have Program Managers who are relegated to making sure the end-to-end experience with specific customers go through smoothly and are profitable for the company. They get involved with contract discussions, sourcing, fulfillment scheduling and overall profit and loss. They do the overall coordination of the key quote-to-cash functions amongst the different departments. And they are measured on company wide goals specific to those customer. Now, I do think it's easier to manage the complete relationship in that industry because so much of it is project driven for a relatively small number of customers, although at repeat volumes. But I also think there are certain elements that all companies can take away from that approach that would really go a long way to improving working capital management.

It'd also be great to get an idea Six Sigma-wise of typical quote-to-cash cycle time and process variances for the entire Q2C experience. In fact, statistically speaking, (for all of you SPC fans), I'd be interested in seeing an x-bar, R chart of the various factors. We could look at how the controllability and capability of the entire process changes over time. (Thank you Dr. Deming!). May we should look at the entire cash cycle, including A/R, A/P and inventory. Hmmm... maybe an idea for another post. I'll have to dust off my statistics book and sharpen up my Excel skills. (You can use more advanced programs like Minitab too, but Excel will do a reasonable enough job for what we're looking to do)

Working Capital Management

Welcome to my blog. My name is Lou Mohanty and this is my personal forum to muse about working capital management, cash flow, supply chain management and Six Sigma. 

As many of you know, working capital management is comprised of some key core processes which drive cash flow - accounts receivable, inventory management, accounts payable and treasury operations.

I have expanded the focus of this working capital management blog to include all of the above, with a spotlight on best practices, industry trends, benchmarking metrics and enterpise software.

Working capital management is clearly getting a lot of attention in business today.  I invite all readers to comment on my postings and add to their discussion threads is possible.  Similarly, if you know of any other blogs or articles regarding working capital management, please let me know.