Wednesday, February 10, 2010

Net Working Capital - Inventory & business models

In the last post, introducing Net Working Capital (NWC), some of the conclusion were that money tied up in working capital is money not available to grow the company, that different business models need different amounts of working capital, that organizations that need lots of working capital will have to raise it from somewhere and that capital always comes at a price.

Also, we saw that NWC can be measured in days, in what is called the Cash Conversion Cycle (CCC) and that the noncash portion of NWC can be both positive and negative:

Positive NWC:
Negative NWC:
In this post I will focus on inventory and the role it has in different business models, and how different organizations have reduced their working capital by reducing DII, days in inventory.

Keeping an inventory
Businesses with value propositions that directly or indirectly involve physical products generally need to have some form of inventory. This can be divided into raw materials, work-in-process, finished goods, goods for resale and spare parts. Determining the optimal level of inventory requires that the benefits and costs are measured and compared.

DII - Days in inventory
Days in inventory measures the number of days inventory stays in the system. The lower the inventory days, as long as there is enough inventory on hand to meet customer demands, the better. In some businesses such as wholesaling and retailing inventory constitutes a very large percentage of total assets, and a difference in DII can spell the difference between success and failure.

Benefits of holding inventory
The reasons for keeping an inventory of raw materials and components are to meet uncertainties in demand, supply, production, and movements of goods, to get quantity discounts, to give the organization flexibility with the respect to timing the purchase of raw materials, scheduling production facilities and employees. If rising prices, shortages of specific items, or both are forecasted for the future, maintaining a large inventory ensures that the company will have adequate supplies at reasonable costs. Work-in-process inventory give each operation in the production cycle a certain degree of independence and minimize costly delays and idle time. The benefits of having finished goods inventory are to be able to fill orders promptly, minimize lost sales, and avoid shipment delays and damaged reputation due to stock-outs. Spare parts are kept to minimize costly delays and idle time.

Costs of holding inventory
There are a number of inventory-related costs, including ordering costs, carrying costs and stock-out costs.

Ordering costs are all the costs of placing and receiving an order from an external or internal source. When ordering from an external source there are costs such as preparing purchase requisitions, expediting the order, receiving and inspecting the shipment, and handling payment. Costs within a company can be production setup costs such as expenses incurred in getting the plant and equipment ready for a production run.

Carrying costs represent all the costs of holding items in inventory and include storage and handling costs, obsolescence and deterioration costs, insurance costs, taxes, and the cost of the funds invested in inventories. The later in the production process, the more funds have been invested in the inventory and the more working capital is tied up:

Stock-out costs are incurred whenever a business is unable to fill orders because the demand for an item is greater than the amount currently available in inventory. A stock-out in raw materials generates expenses in placing special orders and expediting incoming orders, in addition to the costs or any production delays. When a stock-out in work-in-process occurs, stock-out costs include the costs of rescheduling and speeding production, and may also result in lost production costs if work stoppages occur. A stock-out in finished goods inventory may result in customers deciding to purchase the product from a competitor and in potential long-term losses if customers decide to order from other companies in the future.

Business models using Just-in-Time inventory
With just-in-time inventory management, required inventories are supplied to the manufacturing process at precisely the right time. This reduces the need for inventory, making the production more agile and able to adapt to changing customer needs. The concept, also known as lean manufacturing, was developed Toyota Motor Corporation in the 1950's, and often requires that the supplies are standardized, that the suppliers are highly trustable and close to the manufacturing plant. As there is very little buffer inventory between work stations, the quality and timing must be precise to prevent stock-outs.

Business models reducing product uncertainty
In most business models future sales is uncertain resulting in high inventory of some items and stock-out in other items. To take the apparel industry as an example it is difficult to create hit products on a continuous basis, and predict the demand down to the style, color and size, resulting in inventory of unwanted clothes. Threadless' business model uses an online community to contribute and vote for t-shirt designs, and only produce the ones that becomes highly popular. Threadless t-shirts are run in limited batches with 9 new designs a week, and when sold out reprinting only occurs when there is enough demand for a new batch.

Zara, on the other hand, is a vertically integrated retailer with that can go from design to finished goods in stores in as short as two weeks. Shop managers report back every day to designers on what has and has not sold, information that is used to decide which product lines and colors to keep or alter, and whether new lines should be created. Reducing the time to get the clothes into the shelves and the batches of clothing in small quantities also keeps the costs down by keeping stocks low, and if a design doesn't sell well within a week, it is withdrawn from shops, and further orders are canceled.

Business models where customers pay in advance
Getting paid before producing anything is the main ingredient in the recipe for Negative Net Working Capital, but also for limiting the need for inventory. Dell revolutionized the computer industry when it in the 1980s pioneered the configure-to-order approach, delivering individual PCs configured to customer specifications. It could thus keep a minimal inventory in an industry where components depreciate very rapidly.

The subscription revenue model is another way of getting paid in advance and to get information about the quantity to produce. The subscription-based periodical publishing industry has for a long time been able to have Negative Net Working Capital, keeping inventory to a bare minimum and with large current liabilities for all issues due for the rest of the subscription period.

Business models reducing the need for spare parts
Some business models require an inventory of spare parts to assure customer satisfaction and minimize costs and delays if something needs replacement. Maintaining inventory of spare parts has associated costs. The decision what to keep "just in case" is thus a compromise between inventory cost and the probability and cost of failure. One way to reduce inventory of spare parts is to reduce the number of different types of equipment for which spare parts is needed. To keep its operating model lean Ryanair only fly one model of airplane, a stripped-down Boeing 737, reducing its inventory of spare parts and reducing the need to train its maintenance staff.

Analyzing the need for inventory
So what is it in your business model that requires inventory? What is the reason for having it? What would you need to do to lower or reduce it? What would happen if you reduced it too much and could there be other ways to compensate for stock-out that is more cost effective?

Analyzing the customer
Do some existing customers or market segments result in higher needs for expensive inventory? Do customers appreciate all versions of the products and services or can it be reduced? Do customers realize (and perhaps pay for) the service of getting extra orders or spare parts in short time? Would some customers even be willing to pay more if you held the right inventory? What creates value for them?

Analyzing the value proposition
Would it be possible to configure value propositions to reduce the need for inventory? Would it be possible to create value propositions due to the fact that you keep inventory? What are the level of service commitments you make to your partners and customers? Is it possible to modularize components and products and perform final assembly later in the process? Is it possible to deliver in any other way reducing the days in inventory? Can someone else, such as suppliers, partners or customers keep your inventory? Could you reduce someone else’s costs by holding their inventory and charge for it?

Analyzing resources and activities
What are the activities that need expensive inventory? Can the activities be made more lean without disrupting operations? Can better information on how much will be needed control production? Is there an inventory policy on what products or components to keep in inventory? Can it be bought instead of manufactured?

Analyzing suppliers and partners
Can suppliers and partners be the ones that keeps inventory? Would other suppliers or partners be willing to do it? What if we change specifications? What if we change batch sizes from supplier or internal processes? Do we keep inventory due to uncertain delivery from suppliers? Could this be changed? What if we configure the value network in a different way? Could we get quantity rebates? Are we being fooled by quantity rebates? Could we negotiate lower minimal order sizes?

Every dollar freed from inventories contributes to the cash flow of the company. But the reduction of Net Working Capital not only generates cash, it also forces companies to produce and deliver faster and run their businesses more efficiently.

Further reading:


  1. Thank you for highlighting blogs that focuses on such important matters.

  2. Very informative article here. It's important that any business has a good amount of working capital, but those with a larger business are going to have a larger amount of working capital then a small business would have, right? Thanks for sharing this!