How Does Your Supply Chain Compete?

By John Brockwell, vice president, Global Supply Chain Practice JPMorgan

Global supply chains have their own cycles and intervals. Order lead times, manufacturing cycle times, and transit times directly impact costs, inventory levels and customer service. Often more important than the actual cycle times and transit times is understanding how the rhythm of different operations impact each other. Lean manufacturing principles have a name for this: take time, referring to the maximum time allowed to produce product in order to meet demand. To drive efficiencies in the supply chain, a lean manufacturing company focuses on the flow of product based on customer need and then works backwards through the supply chain to establish the heartbeat of the extended enterprise. The different nodes and links of the supply chain are designed to add value while servicing and complementing both the downstream and upstream flows.

Measuring Performance
In researching the stock of a publicly-traded company, a review of several financial ratios and a comparison with the corporation's performance year-to-year versus its competition provides insight into overall performance. Management efficiency is an important category and a standard measure is the Return on Assets (ROA). Calculate the overall cash conversion cycle of the corporation depicted in the following equation:

Days Working Capital = (Days Inventory Outstanding + Days Sales Outstanding) – Days Payable Outstanding

Where,
Days Inventory Outstanding (DIO) = Inventory / (Revenue / 365)
Days Sales Outstanding (DSO) = (Account Receivables / Revenue) / 365
Days Payable Outstanding (DPO) = (Account Payables / Revenue) / 365

The overall cash conversion cycle (or Days Working Capital) is the number of days of working capital required for a company to operate and serves as the financial rhythm of the company. And while the numbers can be an interesting point of comparison against competition, the real question is how these numbers impact the overall supply chain where the company performs.

Changing Payment Terms Isn't Always a Winning Strategy
The most important thing for a buyer to remember is that their DSO is their supplier's DPO – a change in one impacts the other. For example, it's a common practice for large companies to try to extend payables to improve the cash-to-cash cycle. Some companies will move from using Sight Letters of Credit to Open Account with 30 day payment terms or stretch their Open Account 30 day terms out to 45 or 60 days. Though this will improve the buyer's DPO ratio, it will also affect their suppliers who will have to respond to a ballooning DSO.

Do the suppliers have the working capital to survive the increase? Do the suppliers now need to borrow at higher interest rates to cover the increased working capital requirements? Will this strategy have a negative impact on quality and service as the suppliers look for cost efficiencies in their materials and operations? Will the suppliers need to include their higher costs into the product cost going forward thereby increasing the overall purchase price for the buyer? How does the increase in product cost compare to the savings in working capital for the buying company? A buyer's change in payment terms may cause suppliers to request letters of credit from the buyer to help bridge the additional cost in pre-shipment financing and also to mitigate risk if they foresee the buyer's credit rating being downgraded.

A company wants to get paid as quickly as possible; therefore, a common approach is to drive down the number of days it takes for a company to be paid for their goods resulting in a lower DSO ratio. Question: Why would a high-tech multi-national extend their DSO's in emerging markets, allowing distributors more time to pay? Answer: To increase revenue. A buyer should recognize that typical payment terms vary by geography, industry and overall market conditions.

In Russia, for example, a 30 day term puts the distributor into the situation of having to pay its suppliers for the products before the product can be installed at the end-customer's location and before the distributor will be paid. Customs clearance and in-country logistics can be such a challenge that the goods may take a full 30 days before arriving at the customer location. As the customer pays only after installation, there is little room for the distributor to handle more than one large deal at a time because they need to finance the working capital to fund the transaction. Extending the terms will serve to drive increased revenue and market share.

Recognizing the fact that one company's DSO is another company's DPO allows both companies in the supply chain to work together to develop a sustainable model. One company simply imposing terms on the other may yield a financial benefit in the next quarter's results, but the overall impact may serve to only shift the cost temporarily until the next negotiation on price or, even worse, may challenge the financial health and on-going viability of the other company. The more strategic view is to understand the working capital needs of both parties and to negotiate a mutually beneficial set of terms. In addition, leveraging the power of an Integrated Payables Platform enables a range of trading options from Letters of Credit, Private Label Letters of Credit to Open Account. Establishing programs such as Supply Chain Finance and Order-to-Pay allows suppliers to pull in payments when they need the cash and enables buyers to take advantage of discounts when cash is available.

Unrealized Strength of Inventory
Days Inventory Outstanding is the final component of the cash-to-cash cycle and the most closely tied to the physical supply chain. Any given extended supply chain is going to require some level of inventory to fulfill customer service levels, keep manufacturing processes running and buffer variability in the physical world. When strategizing inventory, there are two critical million dollar questions that need to be answered:

• Where should inventory be held or stored in the extended supply chain?
• What is the critical balancing point between necessary inventory and waste that needs elimination?

Tactics in shifting inventory within the supply chain include vendor managed inventory programs, late configuration, and inventory financing. Driving efficiencies in inventory requires a very detailed analysis of the extended supply chain that considers:

• Typical demand patterns
• Inventory carrying rate assumptions
• Service level requirements
• Value of product
• Cost of Lost Sale or Manufacturing Stock Out
• Re-order and safety stock logic / business rules
• Current costs of logistics (origin, destination, international freight, duties, taxes, fees, broker/agent, inland freight and warehousing or consolidation)
• Understanding the sources of variability
• Demand forecast accuracy
• Order lead times
• Transit times
• Number of hand-offs in supply chain

Going for Gold
Management needs to understand all of the different, and possibly, competing activities that contribute to the cash-to-cash equation. Most often, it will be a combination of factors that are at play and not a single silver bullet solution. As an example, to drive efficiencies in an Accounts Receivable process in order to improve Days Sales Outstanding, the view cannot be just internally focused. A company must consider:

• Internal revenue recognition rules, negotiated contracts and payment terms (and policies) including how Incoterms and payment terms interact (e.g. Payment somehow contingent on proof-of-delivery when this official proof is notoriously late or inaccurate, etc.)
• End Customer's view of errors and exceptions in information flow (purchase orders, invoices, bills of ladings, quantities, prices, etc.) which fail their Accounts Payable reconciliation process prior to payment.
• Accounts Receivables policies, processes and technologies used. For example, the buyer may not send a second invoice if payment has not been received within agreed terms or staff may manually re-keying information in multiple applications.
• Physical supply chain breakdowns resulting in delays in shipments, partial shipments, using wrong freight forwarder or level of service to ship the order, etc.

Ideally, a detailed and thorough investigation should be initiated to understand existing customer processes starting with internal activities and working backwards through the supply chain.

Driving efficiencies in the supply chain and the cash-to-cash cycle requires understanding and optimizing the linkages between the different parties in the overall process. In the Olympic Games one of the most exciting track events is the 4x100 meter relay race. The four fastest runners from each country will each run a 100 meter leg of the race and pass the baton off to their teammate. The hand-off must be practiced until it's finely tuned. The runner who is to receive the baton must time their acceleration to match the speed of the incoming runner so that the hand-off is performed in perfect stride and at high speed in the allowed hand-off zone. The slightest bobble of the baton or miscalculated timing of the hand-off can cost the team in a race where a hundredth of a second could mean the difference in medaling. The key to yielding improved financial performance? Understand the hand-offs in your supply chain, establish the best financial rhythm for your business, and go for the gold.

About the Author
John Brockwell has an extensive background in global trade business and process evaluation, logistics planning, and decision support systems. As the Global Supply Chain Management Practice Leader in the Global Trade Services business at JPMorgan, his focus is on finding opportunities for businesses to optimize their international trade by improving costs, cycle times and quality and by minimizing risks. A frequenter speaker on the topic of supply chain optimization and impacts to working capital, John was named one of Supply and Demand Chain Executive magazine's "Pros to Know for 2007".

SOURCE: Global Supply Chain Practice