Matthew Bardell, Managing Director, nVentic
Traditionally, Finance is the only function within a company that really focuses on net working capital (NWC) and cashflow. Given how critical these are to the health of a company, this is regrettable.
Within Net Working Capital, payables and receivables seem the most straightforward to manage. Customer collections and supplier payment terms are not always as easy to influence as you would like, but at least it is clear what the goal is and what steps need taking to get there.
Things are not so simple with inventories. The principle is clear enough: you want to minimise cash tied up in inventory without putting sales at risk. But where is that sweet spot? How much inventory is the right amount for your business? How can you tell that you haven’t got, say, twice as much inventory as you ideally should? And why do you have backorders and lost sales despite having months’ worth of inventory on hand and millions written off through obsolescence each year?
This is where we look to our friends in Operations for guidance. And there is usually no shortage of explanations. Sales are increasing so we need more inventory. Sales are decreasing so we’re stuck with extra inventory. The forecast was wrong. We have supply worries so we’ve built up extra inventory.
The thing is, they’re not wrong. But that isn’t to say that you have the right amount of inventory. Understanding the different root causes of inventory imbalances is not the same as being able to quantify or even predict them. Which leaves Finance largely powerless: there seems to be no good way of challenging Operations on the specifics of how much inventory is really needed. And it is a brave CFO who will stick their neck out on this topic given the risks involved in running out of inventory.
For much of the last 20 years the cost of capital has been low. This has meant that companies could afford to have cash tied up in inventory. But inflation in the last couple of years has seen interest rates rising and sales are also faltering in many sectors. It is no longer as cheap or risk-free to hold excess inventories.
How can targets be set? The first consideration might be benchmarking Days Inventory Outstanding (DIO) with relevant peers. This is a crude measure, since different supply chains will require different amounts of inventory, and it is highly unlikely that your peers have optimal inventory levels anyway. But it has the benefit of simplicity and if your DIO seems high relative to your peers this can be a convincing argument that you have room for improvement.
Another broad-brush approach is simply to set continuous improvement targets: try to increase inventory turns each year. This is a reasonable approach if you follow the philosophy that there is always room for improvement.
But both of these outside-in or top-down approaches have the major weakness that you still don’t know how much you really need. You are setting relative targets without knowing if your anchor point is reasonable.
The other risk of such a crude target is that crude measures are taken to hit it. Many organisations know from experience that inventory is very simple to reduce. You just stop producing or buying inventory. But this is taking a chain saw to the problem. While almost all companies have objectively too much inventory in aggregate, they are usually short on some items while being overstocked on others. Drives to reduce inventories that don’t take account of this difference are not sustainable, which explains why so many inventory programs, while successful in the short term, soon see inventories returning to previous levels. This makes companies understandably reluctant to invest in inventory initiatives when in the past benefits have proved short lived.
So what can and should a CFO do to help get inventories in shape? The first step is simply to prioritise it. Support from Finance is not a sufficient cause of inventory optimization but it is a necessary one. While Finance needs the active support of Operations to achieve improvements, it is very rare to see a step change improvement in inventory without the active sponsorship of Finance.
The second step is to insist on robust analytics to quantify how much inventory is really needed. Ample work has been done in the field of inventory science to quantify optimal inventory levels sufficiently precisely, even taking account of the various imprecisions that necessarily factor into the equation in messy real-life situations. And yet the vast majority of organisations are flying blind in this respect. Even Operations are unable to state how far from optimal they are.
And this should not be a top-down target set arbitrarily. This should be a detailed calculation done bottom-up, taking account of the empirical data for all inventories held. Doing it this way ensures that the numbers do take account of your specific supply chain constraints. It also highlights, item by item, where stock is short as well as where it is excess. This means that the conversation between Finance and Operations is enriched by insights into what specific changes need to be made.
Various pragmatic measures can be taken to reduce risk (for example, by feeding high service levels into the optimization calculations) and to mitigate data quality issues. It is also useful to consider that inventory optimization is not a short-term project and that theoretical targets are unlikely to be achievable in full in the first year. But there is huge benefit in having an objective target and detailed diagnostics for the whole organisation to work from.
The third step is to help align organisational incentives with inventory goals. There are trade offs to be made between different metrics, but frequently turnover or cost are given greater weight than measures which influence cashflow. Success is engendering a culture of inventory optimization, rather than seeing inventory reduction as a cyclical concern when levels get too high. This not only reduces cash unnecessarily tied up in inventory, but also makes cashflow easier to predict.
Most companies can reduce inventories by between 20 and 50% while improving or maintaining service levels. Very few CFO’s would turn down that kind of improvement. But to make it happen, Finance needs to step up and take a lead.
