How your position in the value chain affects your working capital – and what to do about it? - A guide for Raw material & processing companies

In a series of three articles, we will discuss challenges connected to working capital and a company’s position in the value chain. We will also give advice on how to meet these challenges and look at data as well as examples from our client engagements. In this first article we are focusing on raw material and processing companies.

The second and third article in the series analyzes the working capital situation of manufacturing companies and wholesalers. Curious? Read more here and here!

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Good to know about raw material and processing companies

In Sweden, pure raw material companies are fairly few, and a large part of their operations are commonly related to processing. Thus, we have chosen to view Raw material extraction and processing as one part of the value chain.

The reason for reasonable performance

In our data analysis of raw material and processing companies we see that they score better in DIS1, DSO1 and DPO1 than both manufacturing and wholesalers in all those areas. A likely reason for this is a narrower product portfolio and component breadth which leads to reduced supply chain complexity.

Inventory – a large part of the working capital

Finished goods – a sore spot

Unless supplier consolidation and payment term standardization have been overlooked, inventory is usually the place where the most radical improvements can be made in raw material and processing companies. In the analysis we can also see that the inventory makes up the largest proportion of working capital in relation to sales.

Finished goods is normally a sore spot in this part of the value chain. Part of the reason for this is capital-intensive machinery, long setup times and limited production capacity which drives long production runs. This, combined with steep delivery performance expectations from customers, encourages companies to use finished goods to buffer. This is unfortunate since added value in finished goods is usually large compared to raw material and semi-finished goods in these industries.

“Holding semi-finished goods inventory instead of finished goods can combine the shorter lead times of Make-to-stock with the lower inventory of Make-to-order”

Many actions can be taken to meet the challenges in this industry. In our experience, four commonly effective ways are:

1. Reviewing batch sizes and batch sequencing

Quick wins can often be made in finished goods inventory by reviewing batch sizes and batch sequencing in a production planning model. A total cost of ownership view needs to be adopted here, where at least capital cost and other main drivers of inventory carrying costs are considered.

Further, including consumption patterns of the finished goods into this production planning model can often motivate smaller and more frequent batches of high-value stable materials resulting in lower inventory.

For producers of commodities with volatile prices, this can be taken further by also feeding current raw material and finished goods prices into the production scheduling to optimize capacity usage by maximizing production of high-yielding products.

2. Meet lead time requirements by reviewing customer order decoupling points

Traditionally, lead times for processing and raw material companies have been very long but the pressure for shortening lead times is increasing. Again, the simple way of coping with this is through finished goods inventory. However, there is another approach traditionally found in manufacturing companies which can be successfully applied, especially for customer important products with volatile demand. For these products, holding semi-finished goods inventory instead of finished goods can combine the shorter lead times of Make-to-stock with the lower inventory of Make-to-order.

The key here is placing the customer order decoupling point where semi-finished goods can be processed quickly enough to provide acceptable lead times yet far enough back for there to be product differentiation left in the production process, which allows for reductions in safety stock and risk of obsolescence.

Finally, this process of moving the customer order decoupling point can be leveraged further by price differentiating based on customer lead time.

3. Integrate with customers

A third area which can provide a lot of value is integrating with customers to improve quality in forecasts and orders - thus reducing demand variability which is a main driver of safety stock. In this part of the value chain, this often takes the form of stock agreements which has the added benefit of risk-sharing in addition to increased predictability in demand.

However, the risk with stock agreements is that compliance to them tends to be low. This is often due to faulty follow-up and internal processes as well as lack of intervention for non-compliant customers.

4. Supplier financing or not?

A final point on processing companies is that a few suppliers usually account for a large proportion of spend in direct material, which provides ample opportunity for supplier financing at a reasonable cost and administrative burden. However, supply chain financing can be double-edged sword since companies who set them up often lose focus on working capital and end paying more than expected as working capital management processes deteriorate.

A summary: Challenges and solutions

So, if you are a processing company and want to free working capital and work smarter. What are the best ways to go at it? Our study and experience from our clients have led us to the following conclusion: 

Challenges

  • Stock build-up due to large production batches
  • Setting optimal production schedule 
  • High customer demand on delivery performance and shorter lead times resulting in larger safety stock

What to do?

  • Review batch sizes using a total cost of ownership perspective 
  • When chasing lead time reductions evaluate holding semi-finished instead of finished goods inventory
  • Consider customer stock agreements and supply chain financing but ensure compliance to set processes

Need a working capital expert?

Capacent have carried out over 300 working capital projects and have experience from most industries. So if your company is pursuing working capital reductions, do not hesitate to contact Erik Påhlson or Fredrik Hammarström (Erik.pahlson@capacent.se, fredrik.hammarstrom@capacent.se). We would be glad to make sure you get the most out of your initiative and are happy to tie our compensation to achieved results.

About the study

  • 200 Sweden-based companies with net turnover between 1-10 billion SEK were screened whereof 152 companies were allocated to a step in the value chain, ie:  Raw material and processing, Manufacturing, Wholesale and Retail. 48 companies were either service companies or difficult to define.  
  • For the selected companies, the operating working capital components2 were analyzed in relation to revenue. Further, turnover days1 using revenue, spend and cost of goods sold were calculated. 

1) Turnover days refer to:  Days sales outstanding (DSO), Days payables outstanding (DPO) and Days in stock (DIS) 

2) Working capital components refer to: Accounts receivables, Accounts payable, Inventory, Prepaid expenses and accrued income, Accrued expenses and prepaid income