Inventory optimisation is key for improved cash conversion cycle

There are large differences in the working capital performance of Dutch manufacturing companies, according to a new benchmark. Inventory management is the explanatory factor for poor performance – the supply chain domain accounts for more than half of the discrepancy between cash conversion cycle leaders and underperformers. 

The benchmark, conducted by M3 Consultancy, a Netherlands based supply chain consultancy, studied the cash conversion cycle (CCC) of nearly 200 manufacturing companies in the Netherlands. The cash conversion cycle is a common metric used to understand how efficient a company’s procure to pay process (P2P) is, and looks at the amount of days between payment of raw materials and collecting the invoices for the finished goods (this could therefore be negative, if suppliers are paid after the invoice from a customer is received). 

The results show that there are large variations in the CCC performance of companies. The average cash conversion cycle for the companies taken under scrutiny was 68 days, yet a large share of those scored either well above or below the median. The worst performers have a CCC of over 100 days, far from the best performers, which enjoy a negative CCC. 

Deeper analysis shows that the performance gap between best and worst performers is mainly driven by inventory levels. More than 60% of the gap – 84 days of the average 135 day discrepancy in CCC terms – is explained for by the Days Inventory Outstanding (DIO), which indicates how many days a company needs to turn its inventory into sales on average.

Days Payable Outstanding (DPO), the period which highlights how long it takes a company to pay its invoices from trade suppliers, accounts for 18% of the gap, while Days Sales Outstanding (DSO), a metric for the average number of days that a company takes to collect revenue after a sale has been made, accounts for the remaining 20%.

Reflecting on the results, Marco Heimensem, a Manager at M3, says: “The results show that most CFOs have mastered the financial side of the equation – credits and debt management. But managing their inventory remains a challenge, they struggle with the complexity.” Based on the analysis, he points out that it is clear that the largest potential for working capital improvement in the industry lies in more effective inventory management.

Structurally lowering inventories in the production landscape is however notoriously hard, Heimensem points out. Foremost is that finished goods inventory and service are tightly linked with customer demand estimates and service quality targets. “Lowering inventory arbitrarily can result in unintentional pressure on customer service levels.” On top of this comes that sales teams are primarily driven by selling products, whilst having a tendency to favour speed and service level, often not, or insufficiently, taking into account the impact on inventory and thus working capital. 

Procurement practices also play a role in too high inventories. When negotiating sourcing agreements, procurement can opt for bulk with lower prices, yet at the same time these are provided for with longer material chains, with as a result more material in transit. “The impact on working capital is often overlooked, as it propels cash ‘locked in’ transit mode,” states Heimensem. 

A similar development is visible at manufacturing facilities. In their bid to optimise unit costs, production departments aim to deliver large batches, which, given not all products are dispersed at the same rate throughout the supply chain, results in high inventory levels. Heimensem: “Raw material and WIP levels often result from manufacturing practices, which aim to optimise different KPI’s without taking into account the amount of inventory generated.” 

Inventory management optimisation

Cracking the inventory code requires a complex interplay of methods, KPIs and behaviour, says Heimensem. “Successfully managing inventory requires an aligned approach across the primary value chain, while a rigid governance is needed to orchestrate the entire process towards the desired outcome.” One of the quick-wins commonly found is reducing the hidden unused overflowing stock. Many companies typically keep redundant products in their storage, such as products no longer for sale, and flawed items. “Get rid of these products and inventory cost will decrease immediately”, the M3 consultant says.

When striving for a structural improvement for inventory management, companies are advised to develop a model in which they not solely take sales, production and purchase into account; inventory management needs to become an essential part of the whole process. “Each department needs to incorporate the working capital (inventory) impact into their decision-making process. For example, the sales department needs to differentiate the delivery time and service level per product/customer. For determining a certain product’s delivery time, one needs to take into account manufacturing lead time, demand, quantities, etc. By passing on inventory cost in the selling price, customers willing to pay for it can be offered a shortened delivery time.” 

Contrary to the dominant thought, the transition does not necessarily imply that performance levels will decrease – “key herein is how the optimal stock model aligns with customer and production strategies and how well the chain of activities is integrated into operations,” concludes Heimensem.