Ways Out of the Working Capital Trap: Empowering Self-Financing Growth Through Modern Supply Management

Professional Supply Management

Series Editors: Gerd Kerkhoff Erik Hofmann Wolfgang Stölzle

For further volumes: http://www.springer.com/series/10063

Erik Hofmann · Daniel Maucher · Sabrina Piesker · Philipp Richter

Ways Out of the Working Capital Trap Empowering Self-Financing Growth Through Modern Supply Management

123

Dr. Erik Hofmann Universität St. Gallen Kerkhoff Competence Center of Supply Chain Management Lehrstuhl für Logistikmanagement Dufourstr. 40 a 9000 St. Gallen Switzerland [email protected]

Daniel Maucher Universität St. Gallen Kerkhoff Competence Center of Supply Chain Management Lehrstuhl für Logistikmanagement Dufourstr. 40 9000 St. Gallen Switzerland [email protected]

Sabrina Piesker Kerkhoff Consulting GmbH Grafenberger Allee 125 40237 Düsseldorf Germany [email protected]

Philipp Richter Kerkhoff Consulting GmbH Grafenberger Allee 125 40237 Düsseldorf Germany [email protected]

ISBN 978-3-642-17270-0 e-ISBN 978-3-642-17271-7 DOI 10.1007/978-3-642-17271-7 Springer Heidelberg Dordrecht London New York Library of Congress Control Number: 2011921254 © Springer-Verlag Berlin Heidelberg 2011 This work is subject to copyright. All rights are reserved, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilm or in any other way, and storage in data banks. Duplication of this publication or parts thereof is permitted only under the provisions of the German Copyright Law of September 9, 1965, in its current version, and permission for use must always be obtained from Springer. Violations are liable to prosecution under the German Copyright Law. The use of general descriptive names, registered names, trademarks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. Cover design: eStudio Calamar S.L., Heidelberg Printed on acid-free paper Springer is part of Springer Science+Business Media (www.springer.com)

Series Preface

The trend towards globalization and the increasing division of labor as well as the rapid development of information and communication technology have led to worldwide value networks associated by material flows, information flows, and cash flows. These global supply chains pose major challenges for the stakeholders involved because of their complexity and cross-national major structure. Therefore, supply chain management deals with the task of planning and directing efficient value creation networks taking economic, environmental and social aspects into account. A professional advanced purchasing comprises the integrated management of all processes to supply a company with the required goods from sources outside the company. Thereby, the foremost target is to contribute to the achievement of competitive advantages of one’s own company. By linking the procurement with the supply chain management, company-wide improvements may be achieved and strengthened in a sustainable matter. Nowadays, procurement and supply chain management are part of the key management disciplines and in many companies they are already anchored at the top management level. Procurement and supply chain managers are not longer focused solely on reducing costs, because of this relevance, but contribute to the differentiation of companies and value networks. The confrontation with issues such as risk management, financing, sustainability in the supply chain, and product innovation will increase in the following years due to changing political conditions, oligopolies in supplier markets and further shrinking resources. Despite the great practical relevance of procurement issues, the future challenges mentioned appear not to be adequately addressed from a scientific point of view so far. Furthermore, the connection between procurement and supply chain management has not been explored extensively. The series “Advanced Purchasing & Supply Chain Management” aims to contribute to closing these gaps. The intention is to generate benefits both in respect of sciences and practical matters. The realization of this objective is supported by the “Kerkhoff Competence Center of Supply Chain Management” (KCC) – a jointly initiated platform of excellence by Kerkhoff Consulting and the University of St. Gallen. The goal of the KCC is to create an interface between science and practice. Therefore, trends and challenges in purchasing, procurement and supply chain management are to be analyzed v

vi

Series Preface

and recommendations to be derived for practical issues. Meanwhile, a practicerelevant cognitive process is strived for in terms of procurement and supply chain management. The contributions of the series deal with current issues as well as innovation and excellence approaches in the management of value networks and link theoretical concepts with practical applications. Relevant themes are inter alia the purchase of capital goods, performance measurement in supply chain management and procurement, performance contracting or procurement in the public sector. The authors are researchers from the University of St. Gallen, researchers of other leading international research institutions with a focus on procurement and supply chain management, consultants from Kerkhoff Consulting as well as practical experts. By forming mixed writing teams from academia and industry, a close integration of these areas is ensured. This combination takes the application-oriented aspect of business management into account. The present volume “Ways out of the working capital-trap” opens the series “Advanced Purchasing & Supply Chain Management”. Based on the situation of an increased demand for capital during a period of restrained granting of credit by banks, approaches to identify and strengthen internal financial power are presented from a company’s and a supply chain’s point of view. With the first volume, the authors show the close integration between procurement and supply chain management and their impact on the financing capabilities of companies. Furthermore, specific recommendations for purchasing managers and supply chain managers are given to enhance the financial competitiveness of their company and of partners along the value chain. The authors of the series hope that all readers may enjoy this first volume and receive a number of specific impulses to pursue possible “paths out of the working capital-trap”. We are convinced that the approaches and tools presented make a valuable contribution to this effort. Düsseldorf, Germany St. Gallen, Switzerland St. Gallen, Switzerland September 2010

Gerd Kerkhoff Erik Hofmann Wolfgang Stölzle

Foreword

In recent years increasing competition has led to a continuous focus on core competences within companies. They reduce their own value-added and buy more from outside. With this increase in buying, the impact of purchase on the company’s results rises. Therefore, the purchasing function is playing an increasingly crucial role in a company. As one of the new hubs to ensure the company profits, the purchase has to make use of all levers available and start to operate professionally outside the “traditional” purchasing areas. A continuous outflow of cash results from the company because of the payment of the procured raw materials, goods and services. There is a time gap within most companies between the payment made by customers and the payment for the raw materials. As a consequence, the purchase of raw materials, goods and services has to be financed. The cover of this time gap results in financing costs. The financing for companies has become increasingly difficult due to the 2008/2009 financial crisis and the previously enacted Basel II. As a result of this situation, a disproportionate demand in the first phase of recovery may result in the so-called “working capitaltrap”. The focus of this book is on the impact of the purchase and its levers available to control liquidity. Therefore, the issues of different financing options and optimization on the debitor’s side are not dealt with in depth. As part of the work on this book, four areas were identified to influence liquidity in the supply chain, whereby each of them has to be optimized individually: • Timing and method of payment to the supplier: many companies work with an extension of payment terms. Thereby, it is often overlooked that different financing costs within the supply chain have to be taken into account. • The amount and date of the transfer of goods from suppliers into the company’s own value-added. In this context, the issues of size of delivery, way of delivery, and thus the stock height are mainly concerned. • Optimization of the financing costs in terms of cash flows given to the suppliers: there is a need to create a balance between internal and external financing costs and align with new payment tools. • Reducing purchasing costs: this topic relates to the classical understanding of the activities in purchasing. vii

viii

Foreword

Directly depending on the business objectives, a comprehensive optimum has to be found for these four areas. The purchaser is faced with a continuous increase in complexity. In order to provide the adequate value contribution in this environment, the purchaser has to leave the beaten track and make use of integrated approaches to a complete procurement optimization. This book aims to provide food for thought on this issue and also constitute a guide. The joint work on these issues has repeatedly shown us that by dropping traditional attitudes and approaches the purchase influence can be expanded significantly. In this regard, our special thanks go to Mr Gerd Kerkhoff, the Chairman of the Board of Kerkhoff Consulting, who has provided us and the authors with many new ideas. Furthermore, we would like to thank the authors who have succeeded in describing the various levers of purchase and have thus created a guide for purchasing departments. Vienna, Austria Düsseldorf, Germany September 2010

Tobias Német Oliver Kreienbrink

Contents

1 Call for Action: From Financial and Economic Crisis to Working Capital Trap . . . . . . . . . . . . . . . . 1.1 Effects of the Financial Crisis on the Real Economy 1.2 Looming Credit Squeeze as an Obstacle to Growth 1.3 The Working Capital Trap as a Challenge . . . . .

. . . .

. . . .

. . . .

. . . .

2 Determination of the Internal Financing Power of Corporate Growth via the Self-Financeable Growth Rate . . . . . . . . 2.1 Limits of Growth and Growth Financing of Companies . . 2.2 Financial Growth Potential According to the Self-Financeable Growth Rate Approach . . . . . . . . . . 2.3 Possibilities for the Optimization of the Self-Financeable Growth Rate . . . . . . . . . . . . . . . . . . . . . . . . .

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1 1 3 4

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7 7

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8

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12

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13 13 16

3 Strengthening Internal Financing Power Using Cash-to-Cash Cycle Optimization . . . . . . . . . . . . . . . . . . . . . . . 3.1 Presentation of the Cash-to-Cash Cycle . . . . . . . . . . 3.2 Influence of the Cash-to-Cash Cycle on Corporate Value . 3.3 Possibilities for the Optimization of the Cash-to-Cash Cycle from the Corporate Viewpoint . . . . . . . . . . . . 3.4 Interdependencies of the Cash-to-Cash Cycle from a Supply Chain Viewpoint . . . . . . . . . . . . . . .

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17

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20

4 Measures for Strengthening Internal Financing Power from a Corporate Viewpoint . . . . . . . . . . . . . . . . 4.1 Management of Payment Terms . . . . . . . . . . . . 4.2 Inventory Management . . . . . . . . . . . . . . . . . 4.3 Product Group Management and Supplier Management

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21 21 31 41

5 Measures for Strengthening Internal Financing Power from a Supply Chain Viewpoint . . . . . . . . . . . . . 5.1 Finance-Oriented Supply Chain Sourcing . . . . . . 5.2 Supply Chain-Oriented Supplier Financing . . . . . . 5.2.1 Reverse Factoring . . . . . . . . . . . . . . . 5.2.2 Cross-Company Financing of Capital Goods .

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55 56 59 59 61

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ix

x

Contents

5.3

5.4

5.5

Collaborative Cash-to-Cash Management . . . . . . . . 5.3.1 Collaborative Cash-to-Cash Management with Varying Inventory Carrying Rates . . . . . . 5.3.2 Collaborative Cash-to-Cash Management with Varying Capital Cost Rates . . . . . . . . . Collaborative Cash Pooling and Netting . . . . . . . . . 5.4.1 Cash Pooling and Netting in the Corporate Group as a Starting Point . . . . . . . . . . . . . . . . . 5.4.2 Cash Pooling and Netting in the Supply Chain . . Supply Chain Financing Platforms . . . . . . . . . . . .

6 Case Study: Increasing Internal Financing Power of a Supplier in the Automotive Industry . . . . . . . . 6.1 Company’s Starting Situation . . . . . . . . . . . . . 6.2 Presentation of Measures . . . . . . . . . . . . . . . 6.3 Performance Measurement Using a Working Capital Management Analysis Tool . . . . . . . . . . . . . .

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62

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63

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64 64

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65 68 70

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75 75 76

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77

7 Measuring Procurement Contribution to Corporate Performance using the “Procurement Value Added” . . . . . . . . 7.1 Measuring Procurement Contribution to Corporate Performance 7.2 Presentation of the Procurement Value Added . . . . . . . . . . 7.3 Exemplary Calculation of the Procurement Value Added . . . .

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81 81 81 84

8 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.1 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.2 Outlook . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

87 87 88

Literature . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

91

Chapter 1

Call for Action: From Financial and Economic Crisis to Working Capital Trap

1.1 Effects of the Financial Crisis on the Real Economy The financial crisis was triggered by defaults and delinquent payments on the U.S. real estate market in 2007 and increasingly spread to the real economy during 2008. The reasons for this were a combination of the banks’ restraint in lending, insecure consumers worldwide and homemade problems in some industries, such as existing excess capacities in the car industry. The financial crisis, moreover, coincided with a downswing of the economic cycle. This resulted in a serious decline in global industrial production. In Europe and in the U.S.A., production indices dropped by about 20% points within a few months (Fig. 1.1). This dramatic plunge in economic performance also had its effects on the labor market. The unemployment rate in Europe increased from about 7% to nearly 10%

120.0

115.0

110.0

105.0

100.0

95.0

90.0

EU27 USA

Fig. 1.1 Development of production indices in the EU and the USA (cf. Eurostat 2010a)

E. Hofmann et al., Ways Out of the Working Capital Trap, Professional Supply Management 1, DOI 10.1007/978-3-642-17271-7_1,  C Springer-Verlag Berlin Heidelberg 2011

1

2

1 Call for Action: From Financial and Economic Crisis to Working Capital Trap

and in the U.S.A. from about 4.5% to about 10%.1 Only the raw materials markets showed positive. Before the crisis, raw materials prices had reached top values due to speculation; but as a result of lower demand during the crisis, oil and natural gas prices dipped significantly. The automotive industry was hit especially hard by the economic crisis. The industry’s structural crisis caused by high fuel prices in previous years resulted in a reallocation of demand in favor of small cars. This was even further impacted by companies failing to invest in their vehicle fleet, as well as by a lack of demand on the part of nervous private consumers. Thus, car production worldwide dropped by 0.9% in 2008 and by 10.4% in 2009, the first reductions in production volume since 2001 (Fig. 1.2). Owing to the difficult economic situation, many companies recorded profit reductions or losses, or even had to file for bankruptcy.2 Even large corporations had to instigate insolvency proceedings, for example, General Motors (approx. 243,000 employees), Chrysler (approx. 132,000 employees), Arcandor (approx. 86,000 employees), Quelle (approx. 3,400 employees) and Karmann (3,500 employees). Since business insolvencies are a typical late economic indicator, a wave of insolvencies frequently reaches its crest only 1 year after passing through a crisis. According to a study, administrators in bankruptcy estimate that 8%

60,000,000

6% 50,000,000

4% 2%

40,000,000

0% –2%

30,000,000

–4% 20,000,000

–6% –8%

10,000,000

–10% 0

–12% 2000

2001

2002

2003

Cars sold

2004

2005

2006

2007

2008

2009

Change versus previous year

Fig. 1.2 Development of worldwide car production (cf. Organisation Internationale des Constructeurs d’Automobiles (OICA) 2010)

1 Cf.

Eurostat (2010b). 2009, more than 33,000 companies filed for insolvency in Germany. This is equivalent to an 11% increase on the previous year. Cf. Bürgel Wirtschaftsinformationen (2010). 2 In

1.2

Looming Credit Squeeze as an Obstacle to Growth

3

34% of the petitions in bankruptcy are triggered by the crisis and more than 17% of the insolvencies in small and mid-size companies are exclusively because of the financial crisis.3 A recovery in the industry was seen to emerge in early 2010. In April 2010, industrial production in the EU increased by 7.8% versus April 2009 to reach its 2003 level.4 A recovery was also evident in the car industry. Owing to the increasing demand for cars in Asia, worldwide production is expected to grow by about 500,000 vehicles by the end of 2010. In China alone, car sales are forecast to increase from an estimated 8.3–12.5 million vehicles between 2009 and 2012.5 But the banks’ looming credit squeeze might prove to be an obstacle to growth.

1.2 Looming Credit Squeeze as an Obstacle to Growth At the beginning of the financial and economic crisis, its effects on the banks’ lending attitudes could not be comprehensively assessed. But the first group companies quickly reported difficulties in obtaining high-volume credit. In particular, small and mid-size companies complained about a restrained lending policy by the banks primarily because of the insecurity of financial institutions in view of unpredictable market developments. According to a survey by the ifo Institut in September 2009, 43.7% of the 4,000 companies polled stated that banks were restrictive in awarding credits. In August 2008, only 28.7% of those polled had stated this. These facts are confirmed by statistics and statements from the European Central Bank and the Kiel Institute for the World Economy, who stated that credit volumes in the 16 Euro countries had shrunk greatly in June 2009. Loans granted to businesses went down by 0.7% or 35 billion Euros compared with the previous month. This was the largest reduction since these statistics started to be collected in 2003.6 In 2009, the volume of corporate loans in the Euro zone decreased by approx. 4% versus the previous year.7 Numerous media talked about a credit squeeze. The Verband der Automobilindustrie in Deutschland (Association of the Automotive Industry in Germany) also complained about this condition with regard to automotive suppliers. According to the definition by the Council of Economic Advisers, a credit squeeze designates a situation in which loan supply is lower than would have been expected based on the prevailing interest rates and the economic feasibility of investment projects.8 Additionally, credit applications by small and mid-size businesses

3 Cf.

Euler Hermes Kreditversicherungs-AG (2009, p. 8). Eurostat (2010a). 5 By contrast, the west European market including Germany, Great Britain and France will recover more slowly. It is expected that the 2007 level will only be reached again in 2012. Cf. Mauerer (2010). 6 Cf. Die Welt (2009). 7 Cf. European Central Bank (2010, p. S33). 8 Cf. Council of Economic Advisers (1992, p. 46). 4 Cf.

4

1 Call for Action: From Financial and Economic Crisis to Working Capital Trap

increased by about 32% in volume in the first half of 2009.9 Companies are facing major challenges with this combination of decreasing loan extensions and simultaneously increasing demand. Companies need loans to prefinance emerging growth. To satisfy increasing demand, production capacities are again utilized to a higher extent and formerly empty warehouses are refilled. According to assessments by the Bundesverband der Deutschen Industrie (Federal Association of German Industries), the risk of a sustained credit squeeze for 2010 has not been reduced. In 2010, numerous small and mid-size companies will apply for loans and must disclose their presumably bad balance sheets from 2009.10

1.3 The Working Capital Trap as a Challenge During the 2009 financial and economic crisis, many companies focused on securing their existence. Considering their vastly reduced sales, their main attention was initially directed towards reducing costs. To realize savings within procurement for example, price cuts were negotiated with suppliers, inventory was rolled back and completed volume contracts were extended or cancelled. With low production utilization rates, many companies used short-time work to cut back on personnel costs.11 Such short-term measures helped to reduce some of the costs to secure these companies’ survivals. Yet, the slump in order intake seen in many sectors of the industry frequently caused a considerable drop in cash flow or even losses. As a result, reserves were used up. If that was not enough, the consequence was that outside capital had to be borrowed to keep up business activities. However, financially troubled companies usually have below-average credit standings, which go hand in hand with increased outside financing costs. After having passed through the crisis, many businesses re-experienced higher incoming orders in mid-2010, and sales increases were expected. Car manufacturers were also bearing out this optimism and again communicated solid planning variables. For example, VW confirmed that, despite the crisis, they would stick to their “18 plus” strategy according to which sales are expected to increase from 6.3 million cars to more than 10 million cars by the year 2018.12 However, the beginning of a cyclic economic upswing presents additional problems. Because of the belt-tightening measures taken during the crisis capacities 9 Cf.

Management Praxis (2009). further hampers access to liquidity loans, especially considering the increasing use of automated and statistical assessment procedures by banks for reviewing creditworthiness. 11 From November 2008 to May 2009, the number of people on short-time work went from 130,000 to a maximum of 1,533,000. Although 102,000 short-time workers were registered in the annual average for 2008, that figure jumped to 1,143,000 in 2009, with about 20% of these in vehicles construction. Towards the end of the year, the situation somewhat eased with 890,000 short-time workers. Cf. Bundesagentur für Arbeit (2010). 12 Cf. Financial Times Deutschland (2010). 10 This

1.3

The Working Capital Trap as a Challenge

5

that were cut back are now lacking. Investments in new plants and increases in personnel stock are necessary and must be financed. The combination of a company’s increasing liquidity demand through growth and low average inventory levels with simultaneously hampered access to outside capital because of the restrictive lending practices of financial institutions can be described as a “working capital trap”. Figure 1.3 presents the flow from the beginning of the financial and economic crisis up to the “working capital trap” as well as possible ways out of it. Here, an iterative process first determines a company’s internal financing power and subsequently takes measures to strengthen this internal financing power. This book aims to present possibilities for implementing this process of getting out of the trap by following a procedure oriented on practice and solutions (Fig. 1.4). Chapter 2 determines the internal financing power of corporate growth via the self-financeable growth rate (SFGR). Chapter 3 follows with a presentation of strengthening internal financing power by means of optimizing the cash-to-cash cycle. Subsequently, measures are presented to strengthen internal financing power

Financial crisis

Reduction of industrial production

Profit reduction or, respectively, losses for many companies Strengthening internal financing power

Depletion of reserves, reduction of inventories, and relatively lower rating Increased capital demand due to the beginning upswing

"Working Capital Trap"

Way out

Determining internal financing power

Hesitant lending by banks (credit squeeze)

Fig. 1.3 Effects of the financial and economic crisis on companies’ working capital

6

1 Call for Action: From Financial and Economic Crisis to Working Capital Trap

Chapter 1 Call for Action: From Financial and Economic Crisis to the "Working Capital Trap"

Chapter 2 Determination of the Internal Financing Power of Corporate Growth via the Self-Financeable Growth Rate

Chapter 3 Strengthening the Internal Financing Power by Means of Cash-toCash Cycle Optimization

Chapter 4 Measures for Strengthening Internal Financing Power from a Corporate Viewpoint

Chapter 5 Measures for Strengthening Internal Financing Power from a Supply Chain Viewpoint

Chapter 6 Case Study: Increasing Internal Financing Power by the Example of a Supplier in the Automotive Industry

Chapter 7 Measuring the Procurement Contribution on Corporate Performance by Means of "Procurement Value Added"

Chapter 8 Conclusion

Fig. 1.4 Overview of this book’s content

from a corporate point of view (Chap. 4) and from a supply chain point of view (Chap. 5). Using the example of a supplier in the automotive industry, Chap. 6 illustrates and clarifies the presented statements. To measure the procurement contribution for business performance, Chap. 7 presents the “procurement value added” (PVA). Finally, a conclusion as well as an outlook will follow (Chap. 8).

Chapter 2

Determination of the Internal Financing Power of Corporate Growth via the Self-Financeable Growth Rate

2.1 Limits of Growth and Growth Financing of Companies A company can reach its growth limits in different ways. External business factors, such as the saturation of sales markets or the scarcity of a skilled, experienced workforce, but also internal business aspects, such as capacity limits, below-average productivity, lack of capital or organizational inefficiencies can present growth obstacles for a company. These factors will mean that a company’s own growth potential is not fully utilized. Nonetheless, a company’s growth-inhibiting starting position can be fundamentally changed by means of adequate measures for strengthening its financing power. With growth investments, a company assumes that profitability requirements are realized and investment proceeds exceed prorated capital costs. In this case, it is generally aimed at paying for growth investments with internal financing since this generates corporate value. A company’s internal financing is limited by its ability to generate sufficiently high cash flows from its operative business. Any increased outside financing of growth is connected with risks for the lenders and is thereby only reasonable to a certain extent for the company. Aside from general factors of credit standing, a company’s justifiable outside financing rate will depend, inter alia, on the risk and type of investment project to be financed. In particular, excessively outside financed growth stages are considered risky since annuities must be paid irrespective of the development of business results. In this context, the literature talks about the expansion crisis in which excessively outside-financed growth mostly results in a serious financial crisis within a company.1 The limits of outside financing through equity capital are frequently determined by the owners’ financial powers. The question is, on the one hand, whether they have sufficient financial funds and, on the other hand, whether they are willing to invest such funds in the growths of their businesses. Moreover, financing by means of capital increases can result in undesirable shifts in the ownership structure and is connected with costs and organizational expenditures.

1 Cf.

Volkart (2006, p. 704 et seq.).

E. Hofmann et al., Ways Out of the Working Capital Trap, Professional Supply Management 1, DOI 10.1007/978-3-642-17271-7_2,  C Springer-Verlag Berlin Heidelberg 2011

7

8

2

Determination of the Internal Financing Power of Corporate Growth

Based on these theoretical considerations, we can establish that, in many cases, growth should be financed from operatively generated funds. In view of the frequently found situation of the “working capital trap”, the question presents itself as the internal financing power of corporate growth – i.e. which growth rate can be realized with operatively generated funds? Which factors act upon this growth rate as a driving force – leaving out of account any outside financing and divestments? Can this limit be displaced by specific financial management? The following section clarifies these questions by means of the SFGR concept.

2.2 Financial Growth Potential According to the Self-Financeable Growth Rate Approach The following section presents the potentials, fundamentals and structures of the SFGR approach. The SFGR describes a company’s growth rate realizable from operatively generated means without divestment and outside financing.2 This company-specific growth rate essentially depends on three factors: • Time of an operating cash cycle (OCC). • Time of tied-up funds for financing the working capital as well as the operating costs per OCC. • Freely available generated funds per OCC. The OCC comprises the period of time in which financial funds at a company are tied up in stock inventories as well as other working capital before payment is received for the services rendered (Fig. 2.1). The OCC time is calculated from the sum total of days inventory held (age of stocks, DIH) and of days sales outstanding (age of accounts receivable, DSO), which are obtained from different ratios of the balance sheet and the P&L account: Operating Cash Cycle Time [d] = DIH + DSO Goods Receipt of Resources

Outgoing Payment to Suppliers

Sales of Finished Products

Days Inventory Held

Payment Receipt from Customer

Days Sales Outstanding

Suppliers

Customers Operating Cash Cycle Time

Fig. 2.1 Operating cash cycle on the basis of goods and payment flows 2 Cf.

(1)

Churchill and Mullins (2001, p. 135 et seq.).

2.2

According to the Self-Financeable Growth Rate Approach

9

The DIH ratio describes the period of time from the receipt of resources from the supplier until the sale of finished products to the customer and is calculated as follows from corporate ratios: DIH [d] =

Inventories · 365 Days Cost of Goods Sold

(2)

Inventories essentially comprise raw, auxiliary and operating materials, as well as unfinished and finished products that are not yet sold. Cost of goods sold are expenses incurred from the consumption of goods and the utilization of services for manufacturing, expanding or improving an asset, and are shown in the P&L account according to the cost of sales method.3 According to the German Handelsgesetzbuch (HGB – Commercial Code), they comprise direct costs in the materials and manufacturing area and can optionally also comprise all overhead costs in the areas of materials, manufacturing and administration. A reduction of DIH results in a reduction of tied-up capital costs and inventory management costs, but can also lead to higher ordering and out-of-stock costs. DSO comprises the period of time from the sales of finished products until the receipt of payment from the customer. With the help of the balance sheet and P&L account, this ratio results from accounts receivable as well as net sales: DSO [d] =

Accounts Receivable · 365 Days Net Sales

(3)

The DSO ratio essentially depends on stipulated payment terms and the efficiency of accounts receivable management; the faster customers pay their outstanding accounts the smaller the ratio. The payment terms enforceable on the market essentially depend on the sector of the industry, the company’s position of power within that sector and its geographic activity profile. It is problematic that to calculate the OCC time you need to know a company’s cost of goods sold. These are shown in the P&L account according to the cost of sales method. However, the cost of sales method is only absolutely mandatory according to US Generally Accepted Accounting Principles. By contrast, accounting principles according to the HGB and International Financial Reporting Standards allow the cost of sales method and nature of expense method. Accordingly, in practice, net sales instead of cost of goods sold are frequently used as the basis for calculating the DIH to improve external comparability.4 Another problem results from the period under review. Since the calculation of working capital ratios is based on balance sheet and P&L account figures, their calculation merely presents a selective consideration. A higher reporting frequency can increase the informative value of the ratios. However, data from internal accounting must be consulted for this.

3 Cf. 4 Cf.

Handelsgesetzbuch (HGB) (2006, § 255 para. 2). Reason (2004, p. 78).

10

2

Determination of the Internal Financing Power of Corporate Growth

The necessary financial funds per OCC as another determinant of the SFGR are calculated as follows, because of the different tied-up funds for cost of goods sold and other expenses: Tied-up funds manufact. costs =

Cost of Goods Sold Tied − up funds [d] · OCC manufacturing costs [d] Net Sales (4)

Tied-up funds other expenses =

Tied − up funds other expenses [d] Other expenses · OCC [d] Net Sales (5)

The sum of the tied-up funds of cost of goods sold and the tied-up funds of other expenditures per Euro of sales results in the total tied-up funds per OCC. The freely available funds per OCC indicate a company’s absolute financing power in monetary units per Euro of turnover. They are calculated from net sales minus cost of goods sold as well as other expenses. This residual value is equivalent to the profit margin and is available to the company for investments. Figure 2.2 is a schematic presentation of the procedure for calculating the SFGR. The annualized SFGR provides information on the extent a company can grow per year without having to rely on outside financing. If the enterprise grows at a lower rate than the SFGR, more cash is generated than that necessary for growth. But if it grows at a higher rate, it must depend on outside financing to ensure liquidity. To illustrate the mode of calculation, we will look at a company’s data in Fig. 2.3 with balance sheet ratios and duration of tied-up funds of cost of goods sold (time from outgoing payment to the supplier until receipt of payment from the customer – also called cash-to-cash cycle time – see Chap. 3).

Freely available funds per OCC

365

Tied-up funds manufacturing costs per OCC +

=

SFGR per OCC (SFGROCC)

Tied-up funds other expenses per OCC

OCC

(1+SFGROCC)OCCn –1 =

=

Number of OCC per year (OCCn)

Fig. 2.2 Calculation diagram of the annualized SFGR

Annualized SFGR

2.2

According to the Self-Financeable Growth Rate Approach

11

Balance Sheet Ratios Inventories

110,000,000

Accounts Receivable

130,000,000

Net Sales

800,000,000

Cost of Goods Sold

560,000,000

Net Operating Profit After Taxes

28,000,000

Tied - up period, cash [days] Tied - up funds, Cost of Goods Sold

108.2

Fig. 2.3 Basic data for the calculation example

These data can be used to calculate DIH and DSO: DIH =

110, 000, 000 · 365 days = 71.7 days 560, 000, 000

DSO =

130, 000, 000 · 365 days = 59.3 days 800, 000, 000

The sum of DIH and DSO results in a period of 131 days for the OCC. It is assumed that the other expenses (marketing expenses, distribution costs, etc.) extend uniformly over the OCC. They can show tied-up funds of 131 days if the liability is paid off on the first day of the OCC or zero days if payment receipt from the customer and settlement of the liability coincide. Accordingly, to simplify matters, tied-up funds of other expenses are assumed to correspond to half the OCC (i.e. 65.5 days). For further calculation, other expenses are determined from the difference of net sales, on the one hand, and cost of goods sold and net operating profit after taxes, on the other: Other expenses = 800, 000, 000 C – 560, 000, 000 C – 28, 000, 000 C = 212, 000, 000 C By means of formulas 4 and 5, the tied-up funds of cost of goods sold and of other expenses per Euro of sales can be determined as: Tied-up funds manufacturing costs =

Tied-up funds other expenses =

108.2 days 560, 000, 000 · = 0.58 131 days 800, 000, 000

65.5 days 212, 000, 000 · = 0.13 131 days 800, 000, 000

12

2

Determination of the Internal Financing Power of Corporate Growth

0.580 0.035

+

=

0.049 (1.049) 2.786 –1 =

0.130

365

131

=

14.3%

2.786

Fig. 2.4 Example of the calculation of annualized SFGR

The profit margin amounts to 3.5%. Based on Fig. 2.4, an SFGR of 0.049 results. With 2.79 OCCs annually, the company can consequently realize a growth rate of 14.3% by its own efforts. Figure 2.4 shows a summary of the calculation steps of the example. This is retaken up in Chap. 6 to show the effects on the SFGR owing to measures introduced by the purchasing department for optimizing working capital.

2.3 Possibilities for the Optimization of the Self-Financeable Growth Rate The SFGR can be increased by influencing its determinants. Potential measures can be classified into the following categories: • Shortening the OCC, e.g. by lowering the period of inventory lockup, lowering the accounts receivable payment terms or increasing the accounts payable payment terms. • Reducing cost of goods sold and other expenses, e.g. discounts. • Increasing net sales, e.g. through lower sales prices because of reduced purchase prices. From the viewpoint of supply chain management, the period of inventory lockup can be reduced, for example, by the measures described in Chap. 3 in the forecastto-fulfill process. A reduction in cost of goods sold can be realized through the measures indicated in the purchase-to-pay process. The following chapter shows measures for strengthening the internal financing power using cash-to-cash cycle optimization. Chapter 6 illustrates a case study to determine the capability of corporate growth regarding internal financing by means of the SFGR.

Chapter 3

Strengthening Internal Financing Power Using Cash-to-Cash Cycle Optimization

3.1 Presentation of the Cash-to-Cash Cycle The importance of working capital for a company’s success has long been known. Thus, Lough wrote more than 90 years ago: “Sufficient working capital must be provided in order to take care of the normal process of purchasing raw materials and supplies, turning out finished products, selling the products, and waiting for payments to be made. If the original estimates of working capital are insufficient, some emergency measures must be resorted to or the business will come to a dead stop.”1

An increase in corporate value through revenue increases, cost reductions or a reduction in the period of time of tied-up capital results in a better chance of receiving outside financing and strengthening internal financing power. Yet, many companies even today still ignore the active control of working capital through a management approach. Working capital management deals with problems arising from the planning, steering and control of short-term working capital and the liabilities and interrelations existing between them.2 An essential ratio in working capital management is that of net working capital. This is understood as the difference between working capital and short-term liabilities (Fig. 3.1). Working capital includes those things that are not intended to be permanently used for the business operation and comprises inventories, receivables and other assets, securities and liquid funds. Short-term liabilities are obligations that are paid within 1 year. This includes short-term financial liabilities, accounts payable, short-term reserves and other short-term liabilities. Thus, a positive net working capital has one part of the working capital financed with long-term available capital. A negative net working capital means that one part of fixed assets is financed with short-term available capital. Aside from the absolute ratio of net working capital, the cash-to-cash cycle concept (also called the cash conversion cycle concept) presents one possibility for 1 Cf. 2 Cf.

Lough (1917, p. 355). Smith (1974, p. 4 et seq.).

E. Hofmann et al., Ways Out of the Working Capital Trap, Professional Supply Management 1, DOI 10.1007/978-3-642-17271-7_3,  C Springer-Verlag Berlin Heidelberg 2011

13

14

3

Strengthening Internal Financing Power Using Cash-to-Cash Cycle Optimization Balance Sheet

Assets

Liabilities Capital stock

Fixed assets

Long-term outside capital Current assets Inventories Accounts receivable and other assets Securities Liquid funds

Net Working Capital Short-term outside capital Short-term financial liabilities Accounts payable Short-term reserves Other short-term liabilities

Fig. 3.1 Net working capital on the balance sheet

measuring and controlling the effectiveness of working capital management on the basis of relative ratios. The cash-to-cash cycle comprises the period of time from payment outflow for resources to suppliers up to payment inflow for finished products from customers (Fig. 3.2). The cash-to-cash cycle time is the essential ratio of the cash-to-cash cycle concept. Stewart defined the cash-to-cash cycle time as a ratio explaining the average time necessary to convert one dollar invested in raw materials into one dollar received from the customer.3 For service companies, this is the period between payments for resources consumed while rendering a service until the receipt of the customer’s payment for this service.4 As opposed to the OCC time, a calculation Goods Receipt of Resources

Payment Made to Supplier

Sales of Finished Products

Days Inventory Held

Days Sales Outstanding

Supplier

Customer Days Payables Outstanding

Cash-to-Cash Cycle Time

Fig. 3.2 Cash-to-cash cycle time based on the flows of goods and payments

3 Cf. 4 Cf.

Payment Receipt from Customer

Stewart (1995, p. 43). Supply-Chain Council (2006, p. 22).

3.1

Presentation of the Cash-to-Cash Cycle

15

of the cash-to-cash cycle time also takes into account – aside from the DIH and DSO – the days payables outstanding (age of accounts payable, DPO). The cash-to-cash cycle time results as follows: Cash-to-Cash Cycle Time [d] = DIH + DSO − DPO

Sector of the Industry

(6)

DIH [d]

DSO [d]

DPO [d]

C2C [d]

Land–line telephony

11

57

82

–14

Mobile telephony

18

46

65

–1

Travel and recreation

10

24

31

3

Trade and commerce (food and drugs)

31

11

36

6

Oil and natural gas producers

21

54

66

9

Logistics

5

52

36

21

Electricity

18

60

50

28

Gas, water & utilities

24

58

51

31

Media

16

67

51

32

Software & computers

1

76

44

33

Industrial services

6

62

33

35

Trading (other goods)

67

15

43

39

Automotive industry

50

68

60

58

Beverages

56

57

52

61

Food

56

46

40

62

Oil outfitters and service providers

30

84

48

66

Mining

67

48

46

69

Recreational products

72

52

46

78

Construction and raw materials

60

83

62

81

Hardware and accessories

73

66

57

82

Chemistry

67

72

56

83

Paper

66

63

46

83

Electrical engineering

76

77

54

99

Household articles

87

61

49

99

Health system

77

62

40

99

Steel industry

85

60

43

102

Machine building and plant engineering

78

86

61

103

Personal goods

95

59

48

106

Pharmaceuticals and biotechnology

105

75

71

109

Aerospace and defense

102

68

41

129

Tobacco

134

42

33

143

Mean value

54

59

50

63

Fig. 3.3 Cash-to-cash cycle times in 2005 by industry sector (cf. Hofmann 2010, p. 249 et seq.)

16

3

Strengthening Internal Financing Power Using Cash-to-Cash Cycle Optimization

DPO measures the time interval from the receipt of resources until payment outflow to the supplier and is calculated from the accounts payable as well as the cost of goods sold: DPO [d] =

Accounts Payable · 365 days Cost of Goods Sold

(7)

Similar to the calculation of DIH, net sales are used as the basis of DPO if cost of goods sold are unknown. From the point of view of the individual company, the highest possible value of DPO should be aimed for in contrast to DIH and DSO because of the financing function of the accounts payable. By utilizing the period of time from the receipt of goods until payment outflow, the operative business presents a source of short-term financing.5 However, the utility of the financing function is also confronted with costs that primarily depend on the length of the credit and discount period. Figure 3.3 presents the results of a study investigating cash-to-cash cycle times for various industry sectors. Telephone companies and those in the travel and leisure industries have the shortest cash-to-cash cycle times primarily because of their low ages of their inventories. By contrast, pharmaceuticals and biotechnology, space technology and defense, as well as the tobacco industry have, on average, the longest cash-to-cash cycle times because of the high ages of their inventories.

3.2 Influence of the Cash-to-Cash Cycle on Corporate Value The following section presents the influence of the cash-to-cash cycle on corporate value (Fig. 3.4). With unchanged cost of goods sold and net sales, a reduction in DIH and DSO can be realized by reducing inventory and receivables, whereas the DPO will increase because of an increase in liabilities. These measures result in a reduction in net working capital. Moreover, fixed assets can be reduced by indirect effects, such as the possibility of reducing storage areas or warehouse space because of lower inventories. These two effects cause a reduction in the necessary net operating assets, which – at an unchanged capital cost rate – results in the reduction of a company’s capital costs. On the side of the operating result, cost of goods sold can be minimized by means of additional indirect effects, such as lower inventory carrying costs through lower inventories and improved discount drawing rates because of higher liquidity. Administrative expenditures can also be reduced through optimized supplier and ordering management. These indirect effects bring about an increase in the operating result. Thus, the economic value added (EVA) as a measure of the corporate value can be increased not only by improving the operating result but also by a reduction in capital costs and also has the consequence of increasing internal financing power. 5 Cf.

Schall and Haley (1991, p. 696).

3.3

Possibilities for the Optimization of the Cash-to-Cash Cycle

17

Fig. 3.4 Influence of the cash-to-cash cycle time on corporate value

Furthermore, empirical studies have substantiated the positive connection between a shortening of the cash-to-cash cycle time and the earning power of enterprises.6

3.3 Possibilities for the Optimization of the Cash-to-Cash Cycle from the Corporate Viewpoint For the optimization of the cash-to-cash cycle, the following demonstrates a few possibilities that can be especially influenced by the procurement department of a company. It is here differentiated between the order-to-cash process, the forecastto-fulfill process, the purchase-to-pay process and the credit-to-interest process (Fig. 3.5). The order-to-cash process comprises credit assessment, contract design, billing, payment handling, dunning and collection systems, as well as information processing. The cash-to-cash cycle time can be shortened by a reduction in accounts receivable. This objective can be achieved, for example, by the following measures: 6 Cf.

Deloof (2003, p. 573 et seq.). or Garcia-Teruel and Martinez-Solano (2007, p. 164).

18

3

Strengthening Internal Financing Power Using Cash-to-Cash Cycle Optimization Financial Services Provider/ Bank Bank Loan (Additional Cash)

Payback of Loan (Payment of Interests)

= Order-to-Cash Cycle = Forecast-to-Fulfill Cycle = Purchase-to-Pay Cycle = Credit-to-Interest Cycle

Cash Payment of Credit to Customer (Cash)

Purchase on Credit (Purchases)

Supplier

Liabilities

Value Generation on Target

Sales on Target

Payment of Supplier Credit (Pay)

Receivables

Customer

Sales on Credit (Order)

Inventories (Forecasts)

(Fulfilment) Plan

Source

Make

Deliver

Fig. 3.5 Management processes of the cash-to-cash cycle

• • • •

Acceleration of the billing process, e.g. by e-billing.7 Implementation of a consistent dunning and collection system strategy.8 Sale of receivables via factoring to a financial services provider.9 Use of instruments to avoid losses of receivables outstanding – e.g. operator information, advance payments, risk-minimizing payment terms, etc.10 • Granting discounts for a reduction in the times allowed for payment and the delinquent payment risk.11 However, the influence by a company’s procurement department on the order-tocash process is rather low because of a lack of interfaces.

7 Cf.

Seuring and Goldbach (2002, p. 171). Nicholas et al. (2000, p. 237 et seq.). 9 Cf. Soufani (2002, p. 21 et seq.). 10 Cf. Leijdekker (2002, p. 25 et seq.). 11 Cf. Ouyang et al. (2005, p. 290 et seq.). 8 Cf.

3.3

Possibilities for the Optimization of the Cash-to-Cash Cycle

19

The forecast-to-fulfill process comprises procedures of production and inventory management, as well as materials requirements and ordering quantity planning. Possibilities for a reduction in inventory include: • Outsourcing: Fixed assets and working capital can be reduced by passing on tasks to third-party companies.12 • Vendor-managed inventory: The supplier takes care of the management and control of the procuring company’s stock. Through close ties with the supplier in terms of information, the bullwhip effect13 can be eased and inventory can be reduced.14 • Just-in-time: Delivering the goods at the right time, in the right quantity, to the right location will bring about a synchronization of supply and consumption with the consequence of inventory reductions.15 • Cross docking: Cross docking is the transshipment of goods in distribution systems without intermediate storage to shorten throughput times and avoid storage costs.16 • Optimization of materials requirements planning and order quantities planning for inventory reduction, e.g. by reviewing and adjusting safety stock levels.17 • Optimization of inventory management, e.g. by reducing warehouse levels as well as the variety of parts and variants.18 The purchase-to-pay process comprises all procedures within the context of the creditor management, i.e. the process between purchase and the payment of the supplier. Possible measures for expanding liabilities include: • Optimization or standardization of payment processes: Avoiding payments made either too early or too late. • Optimization of payment terms: Renegotiation of payment terms and Incoterms with existing suppliers and preparation of guidelines for new suppliers as well as preventing down payments. Figure 3.6 presents the average times allowed for the payment and receipt of accounts receivable in Germany.19

12 Cf.

Tayles and Drury (2001, p. 605 et seq.).

13 The bullwhip effect describes fluctuations in stocks of order quantities along a distribution chain.

Reasons for it might be planning uncertainties and lack of information about downstream levels concerning actual demand (cf. Lee et al. 1997, p. 546 et seq.). 14 Cf. Arora et al. (2010, p. 39). 15 Cf. Hutchins (1999, p. 6 et seq.). 16 Cf. Apte and Viswanathan (2000, p. 291 et seq.). 17 Cf. Kelle and Silver (2006, p. 725 et seq.). 18 Cf. Schwartz et al. (2006, p. 1311 et seq.). 19 Cf. Morgan (2004, p. 13 et seq.).

20

3

Strengthening Internal Financing Power Using Cash-to-Cash Cycle Optimization Private customers Business Public authorities B-2-C customers B-2-B

Average time allowed for payment in days

15

30

25

Average receipt of outstanding accounts in days

30

49

40

Average payment delays in days

15

19

15

Fig. 3.6 Average times allowed for the payment and receipt of accounts receivable in Germany in 2009 (cf. Intrum Justitia 2009, p. 20)

• Avoidance of early deliveries or use of contract clauses so that early deliveries have no effect on payment terms; i.e. they would be handled as if they had been delivered at the stipulated date. • Cooperation from internal and external buyers to strengthen negotiating power.20 The credit-to-interest process comprises the steps of liquidity forecast, risk management, administration of payment flows and investment of surplus funds. A few examples such as cash pooling and netting (Sect. 5.4) and reverse factoring (Sect. 5.2.1) will be discussed later.

3.4 Interdependencies of the Cash-to-Cash Cycle from a Supply Chain Viewpoint The reduction in the cash-to-cash cycle of a focal company has consequences for the upstream and downstream companies in the supply chain. A reduction of DSO results in a reduction of DPO of the customers, and an increase in DPO results in an increase in DSO of the suppliers. Thus, a reduction in the cash-to-cash cycle time by means of the optimization of DSO and DPO implies an increase in the cash-to-cash cycle time of the upstream and downstream companies in the supply chain. This phenomenon is known as the “zero sum game”. This disadvantage can be balanced out by a cross-company optimization of the cash-to-cash cycle. Within the scope of “collaborative cash-to-cash management” presented in Sect. 5.3, different inventory carrying costs and capital cost rates within the supply chain can be used to minimize total costs. Before addressing the issue from an inter-organizational perspective, the following section discusses concrete measures for strengthening internal financing power from a corporate viewpoint.

20 Cf.

Schotanus et al. (2005, p. 135 et seq.).

Chapter 4

Measures for Strengthening Internal Financing Power from a Corporate Viewpoint

With the more efficient use of their capital employed, many companies could increase their liquidity and ensure the financing of any upcoming growth. According to a study by Creditreform in 2004, almost every fifth insolvency can be traced back to financial errors.1 Depending on the industrial sectors, it would actually be possible to reduce tied-up capital by 25–40%.2 To realize this objective, we must take a closer look at the management of payment terms (Sect. 4.1), inventory management (Sect. 4.2) and the management of product groups and suppliers (Sect. 4.3).

4.1 Management of Payment Terms The objective of the management of payment terms is to optimize the interacting parameters of liquidity increases and cost savings. Payment terms essentially result from the ratios of discount rate, discount period and net days. The discount rate indicates the percentage of price reduction granted by the supplier on the invoice amount for goods or services if the invoice amount is paid within a defined period of time.3 The discount period describes the period of time between the delivery of the goods and the deadline up to which the invoice can be paid after the deduction of the discount rate. After the expiration of the discount period, the period of time of the supplier credit begins (net days), which ends with the time allowed for payment (Fig. 4.1). From the viewpoint of an individual company, any increase in discount rates or expansion of the time allowed for payment (discount period and net days) principally has a positive effect on liquidity. The discount ratio, which is defined as the quotient of the sum of the discounts granted and the net purchase

1 Cf.

Verband der Vereine Creditreform e.V. (2004, p. 18). Löwer (2010). 3 Cf. Lauer (1998, p. 59). 2 Cf.

E. Hofmann et al., Ways Out of the Working Capital Trap, Professional Supply Management 1, DOI 10.1007/978-3-642-17271-7_4,  C Springer-Verlag Berlin Heidelberg 2011

21

22

4 Measures for Strengthening Internal Financing Power from a Corporate Viewpoint

Fig. 4.1 Functional significance of payment terms

volume, here indicates the average discount rate granted, as shown in formulas 1 and 2: Discount ratio =

Sum of discounts granted · 100% Net purchase volume

Net purchase volume = (Net price rebates) · Quantity

(1) (2)

To be able to present the actual utilization of the discounts granted, the discount utilization ratio is determined. This is the ratio between discount yields and discounts granted. Discount yields are generally recorded by bookkeeping upon the payment of the invoice and are allocated to the goods expenditure account. Discount utilization ratio = =

Sum of the discount amount · 100% Sum of discounts granted Sum of discount amount · 100% Discount ratio · Net purchase volume

(3)

The following example shows the calculation of the discount utilization ratio. At a discount rate of 2% and a net purchasing volume of 10 million C, the sum total of discounts granted is 200,000 C. Since the actual discount yields are only 120,000 C, a discount utilization ratio of 60% results. Example: Discount rate = 2% Net purchasing volume = 10,000,000 C Sum total of discount yield = 120,000 C Discount utilization ratio =

120, 000 · 100% = 60% 0.02 · 10, 000, 000

To strengthen internal financing power, from a corporate viewpoint, the aim is to increase the discount utilization ratio and the discount rates. Moreover, an extension

4.1

Management of Payment Terms

23

Fig. 4.2 Process overview of the optimization of payment terms from a buyer’s viewpoint

of the times allowed for payment versus the supplier results in a reduction of the tied-up capital time and, consequently, a reduction in tied-up capital costs. The payment terms agreed with the supplier here form the basis of these parameters. The optimization of payment terms is an extensive process which, because of its complexity, requires a structured and planned procedure. Figure 4.2 shows the individual steps of the optimization process of payment terms. In larger companies or in group companies with several business units, it must be clarified at the beginning of the process which subsidiaries or branch establishments are to be included in the optimization. The first step includes the collection of all relevant information for an evaluation of the status quo (Fig. 4.3). That information comprises: • Ordering data to indicate at which conditions goods have been ordered from the supplier. • Data on the receipt of goods to show at which payment terms the delivered goods have been invoiced. • Creditor master data to explain the stipulated payment terms for every supplier. • Accounting data to show within which periods of time and at which terms invoices were actually paid. Divergent data regarding payment terms for deliveries and suppliers can be verified by a comparison of the different sources of data, Consolidating the data sources and determining the actual condition via the parameters “used frequently” or “maximum condition” can also help obtain a better overview. The objective is to establish a database that specifies for each supplier one payment term as the starting point.

Fig. 4.3 Optimization process of payment handling – actual analysis of payment terms

24

4 Measures for Strengthening Internal Financing Power from a Corporate Viewpoint

Fig. 4.4 Consideration of the market power of supplying and buying parties

Based on a verified database, a detailed analysis of terms on a product group level can be subsequently performed by showing benchmarking potentials. The times allowed for payment and discount rates are structured depending on the negotiating power of buying and selling companies. Relative to specific product groups, one’s own market position can be assessed first and thereafter the supplier’s position in the market. Figure 4.4 shows which combinations can result within the scope of the offer/demand power matrix.4 Offer and demand power essentially depends on the product group being procured, as well as on the offered or demanded volume. The presented examples (I to V) typically show that, in procurement volume, different product groups exist that can have different characteristics depending on the company: I Low demand power versus very high offering power by the supplier: One example for this is the purchase of products protected under patent law. II Low demand power versus medium offering power: This case is typical for the purchase of computer processors from an oligopolist. III Low offer and low demand power: Product groups with a small share in purchase volume and for which the demand power is low. One example for this is the procurement of office materials. IV Medium demand and low offering power: This situation is based on III, with buyers building up large demand power by bunching volumes versus polypolists. One example for this is the procurement of energy through buyer cooperation. V High demand and low offering power: This combination represents “commodity” products, such as packaging materials for which numerous sellers are on the market and the buyer’s negotiating power is high.

4 Cf.

Cox et al. (2000, p. 18).

4.1

Management of Payment Terms

25

To establish market power constellations, the prevailing power relationships are defined specifically for every company and determined individually for every single supplier or customer. Accordingly, no generally valid presentation can be provided because of the different framework conditions. The multitude of prevailing payment terms is another factor influencing optimization potential. Any large, unsystematic and little regulated multitude of different payment terms indicates a relatively low degree of professionalism in purchasing. However, this problem is frequently underestimated by purchasing departments. The use of ratios, therefore, is indispensable for arriving at an objective evaluation. In practice, the average number of payment terms per supplier or the number of suppliers of the company with more than one payment term is considered. Special attention is paid to the different payment terms of own locations or business units if the same products are procured from the same supplier. Also, it is common that suppliers take advantage of the customer’s weaknesses in information transparency and organization. A classification within the scope of a matrix of time allowed for payment/discount rate is expedient per product group or supplier group (Fig. 4.5): I For every creditor, only one payment term is allocated in the creditor master data. This case represents the ideal condition to be aimed for. II Many discount rates are faced with a few number of payment times allowed. For instance, four different discount rates are considered too many. The number of discount rates should be reduced to counteract this. III A moderate number of discount rates but a multitude of different times allowed for payment. This case stands for product groups where suppliers are billed at one discount rate, but where a great many discount due dates and times allowed for payment exist. This is mostly a result of supplier relations that have existed

Fig. 4.5 The multitude of payment terms

26

4 Measures for Strengthening Internal Financing Power from a Corporate Viewpoint

for a long time but whose payment terms were renegotiated in a disorganized manner. In those cases, the creditor master data were updated only rarely or not at all. IV Since several payment terms are deposited for one creditor who is billed via different payment terms, we call such a case the classical “wild spread growth”. This situation frequently arises in so-called “maverick buying” where goods or services are procured by other departments without calling in the purchasing department.5 This is the opposite of a well-organized payment terms structure and is frequently found with decentralized purchasing organizations. Another objective of the analysis is to identify the critical suppliers and critical product groups that are not being taken into account because of bad cost/benefit ratios. This can concern product groups, for example, for which it is unusual to draw on a discount or grant long payment times. Indicators for the identification of these product groups are, inter alia, high personnel intensity or services having a fee character. Examples of product groups not to be considered further under the aspect of payment terms are rental fees for buildings, insurances or security guard services. In general it is not possible to optimize payment terms if suppliers have a customer–supplier–customer relationship6 (counter-trade transactions), if there has been a valid framework agreement for many years or if specific framework conditions preclude any modification. Such framework conditions exist frequently because of the supplier’s great market power. Examples are suppliers acting as monopolists or oligopolists and suppliers of key products. It is also rarely successful to realize subsequent improvements in payment terms with suppliers involved long-term in capital-intensive R&D projects. As a rule, optimization is potentially possible if the character of the material group includes a discount affinity the negotiation power is considered adequate and organizational strength on the supplier side is inadequate. To identify all relevant suppliers for this project step, an ABC classification of them is necessary based on their purchase volumes. This has the objective of ensuring an adequate cost/benefit ratio of the measures. Protracted negotiations are not worthwhile for C-suppliers; however, for A-suppliers, successful negotiations have the greatest leverage effect on liquidity and earnings. After critical suppliers and product groups offering no optimization potential have been excluded after the analysis phase, the next step is to identify the relevant cases within the scope of a “payment terms strategy” (Fig. 4.6). One standard payment term can be specified for every product group – based on the information of the creditor master data and the analysis described. Two important items must be taken into account in the definition of this payment term. On the one hand, the time from the receipt of invoice to its entry in accounting must be internally 5 Cf. 6 Cf.

Karjalainen et al. (2009, p. 245 et seq.). Lecraw (1989, p. 47 et seq.).

4.1

Management of Payment Terms

27

Fig. 4.6 Optimization process of payment handling – strategy definition

recorded. This period of time can be several days since an invoice passes through several departments during processing and there can also be subsequent approval processes. It would be inefficient to agree on payment terms with suppliers that then cannot be utilized because of internal delays at the company. On the other hand, the executive officers as the decision-makers must determine which strategy is to be pursued in coming years through an optimization of payment terms. Is an increase in the discount sum favored or a later outflow of liquid means? The introduction of an increase in discount rates will limit the possibilities for expanding the time allowed for payment. If the same goods are procured from different sectors (e.g. mechanical engineering and logistics services), it is possible that the payment terms cannot be adjusted to the standard, because of their specificity for an industrial sector. In this case, strategies are to be formulated at the product group level since the new payment terms have long-term validity and the project is sustained by taking all framework conditions into account for the strategy definition. A success factor of the optimization process is that the aimed new payment terms are laid down in writing in the “Allgemeine Geschäftsbedingungen” (General Standard Terms and Conditions) and the “Allgemeine Einkaufsbedingungen” (AEB – General Terms and Conditions of Purchasing). Moreover, all internally involved employees should be adequately informed to ensure coordinated action or appearance on the procurement market. In the strategy phase, workshops can also be organized with the relevant departments (purchasing, controlling, accounting, legal, etc.) to discuss in advance any implementation barriers and increase the acceptance of the new payment terms within the company. The following optimization step is devoted to a written contact with the supplier (Fig. 4.7). All identified A-, B- and C-suppliers are contacted and asked to confirm the new payment terms. For cost/benefit aspects, a standard covering letter is formulated, which is modified for every product group according to the newly requested payment terms. Suppliers with previously agreed payment terms should not be contacted is these terms are equivalent or more advantageous than those requested. The procedure for the covering letter should be according to the plausibility test presented in Fig. 4.8 to exclude non-relevant suppliers from the process.

28

4 Measures for Strengthening Internal Financing Power from a Corporate Viewpoint

Fig. 4.7 Optimization process of payment handling – making contact

Fig. 4.8 Steps of the plausibility test to release the covering letter to suppliers within the scope of payment terms optimization

Suppliers’ answers to the covering letter are recorded in tabular form for analysis. Standardized reminders are sent to suppliers exceeding the advised period for answering. If an answer again fails to come within the set period of time or if the new payment term was not accepted, the next level in the escalation process is used. As a rule, there is no further escalating step for C-suppliers because of the low cost/benefit ratio. Figure 4.9 shows a standard escalation process, which can vary depending on management specifications.

4.1

Management of Payment Terms

29

yes

no

no

no

yes

no

yes

yes

Fig. 4.9 Steps in the escalation process within the scope of payment terms optimization

The next step is a personal contact to initiate negotiations (Fig. 4.10). As explained in the project step “Making contact”, personal contact is required in case of any negative response or a lack of response on the part of suppliers. An explanation of the initiated process steps in terms of harmonization of payment

Fig. 4.10 Optimization process of payment handling – negotiation of new payment terms

30

4 Measures for Strengthening Internal Financing Power from a Corporate Viewpoint

• • •

Fig. 4.11 Optimization process of payment handling – controlling the payment terms

terms and more in-depth collaboration is vital here. The objective of the face-to-face or telephone negotiation is to minimize the number of rejected requests and thereby reduce the number of remaining payment terms. For A-suppliers, it is expedient to conduct negotiations on a personal level. If it is consistent with the planned implementation period, it is conceivable to schedule negotiations together with annual talks. The project manager informs the negotiating purchasing staff at the beginning of the project. B-suppliers – higher in number than A-suppliers – can be informed about the adjustment of payment terms and its intentions by telephone. A predefined and coordinated guideline for this discussion will support the purchasing staff during telephone negotiations. Owing to their low sales volumes and minor strategic significance, there are no negotiations with C-suppliers. To ensure an overview of the course, success rate and status of the optimization project, the analysis of returns and any connected reporting is updated throughout the entire process (Fig. 4.11). This continuous reporting will enable the decisionmakers to intervene in the process in case of increased negative responses. The first part of reporting comprises project-specific ratios, which are to provide an overview of the project and its relevance. The following information is necessary: • • • • • •

Number of suppliers considered in the project; Optimizable volume; Volume of A- and B-suppliers; Volume of suppliers sorted out; Discount sum in the past year; and Target discount sum at the end of the project.

Additionally, procedural ratios for returns and the connected purchase volume are examined to draw conclusions as to the success and progress of the negotiations: • • • •

Number of answers received; Number of accepted payment terms; Number of unchanged payment terms; and Number of payment terms offered.

4.2

Inventory Management

31

Before the analysis and to ensure a uniform presentation of the results, the calculation of the interest effect needs to be clarified (i.e. interest savings due to a lower amount of tied-up capital). In calculating this, it is assumed that the possible discount rates and times allowed for payment are almost entirely utilized. The optimization of the payment process can go hand in hand, as a partial project, with the optimization of payment terms. Based on the figures in formulas (4), (5) and (6), the success of the adjustment of the payment terms can be evaluated as: Improvement of discount yield = Current discount yield − Discount yield before optimization

(4)

Improvement of interest yield = Current interest effect − Interest effect before optimization

(5)

Project success = Improvement of discount yield + Improvement of interest yield

(6)

The calculated success of the measures’s is then compared with the initially specified target figure “nominal project success at the end of the project”. For a more in-depth evaluation of the progress, additional ratios can be defined in agreement with the decision-makers before the adjustment of payment terms. For example, benchmarking can be provided with the payment terms of other companies. Moreover, to be able to modify the escalation process depending on the supplier classification, the ratios can be differentiated according to A-, B- and C-suppliers. The optimization of the payment terms is primarily intended to improve working capital management. One positive side effect of this improvement is a harmonization of existing terms and conditions. In addition to a transparent and structured overview, it is thereby possible to make reference to them as the market standard in subsequent contract negotiations with suppliers. Moreover, the optimization of payment terms provides fundamental and basic mechanisms and structures for the continuous improvement of working capital management. On the one hand, the staff in purchasing is clearly shown the impact of payment terms on working capital; on the other hand, the process provides the basis for the future negotiations of payment terms. Additionally, these measures are helpful to strengthen a company’s internal financing power.

4.2 Inventory Management Another approach for the optimization of corporate working capital is the reduction of capital tied up in the warehouse, which causes opportunity cost and inventory carrying cost. Not only in times of economic upswing but also in times of crises – at the beginning of which inventories typically increase – inventory optimization

32

4 Measures for Strengthening Internal Financing Power from a Corporate Viewpoint

•

•

Fig. 4.12 Optimization process of inventory management – actual analysis of inventory situation

presents a success factor for efficient working capital management and the provision of additional liquidity. Inventories are the largest item in working capital, with an average share of 34%. They also tie up approx. 13% of the sales volume of companies and one half of the logistics costs, meaning that 13–22% of total costs in industrial and trading companies is because of inadequate inventory levels (Fig. 4.12).7 Inventory management is defined as the “classification, planning, steering and control of inventories”.8 It includes warehouse, transport and processing inventories. Decisions derived from corporate strategies on inventory management are called inventory policies. Such decisions include, for example, the locations of warehouses and planning of the warehouse structure. The types of inventory occurring in inventory management can be classified as follows according to the international accounting system (IAS 2.4): • Raw materials: Goods directly flowing into the product to be produced and forming its essential component parts. • Auxiliary materials: Goods also entering into the end product but playing a minor role (e.g. screws, adhesives, etc.). • Consumables: Substances consumed for production and not entering into the end product (e.g. energy sources, lubricants, etc.). • Unfinished products: Products having passed only through one part of the production and further processed in additional production steps. • Finished products: Products ready for sale. Apart from the type of inventory, it is customary to classify warehouses along the flow of materials. The following warehouse types are distinguished:

7 Cf. 8 Cf.

Stölzle et al. (2004, p. 11 et seq.). Stölzle et al. (2004, p. 29).

4.2

• • • •

Inventory Management

33

Procurement warehouse; Production warehouse; Distribution warehouse; and Spare parts warehouse.

The classification of types of inventory and warehouses helps concretize the material flow. Depending on the company considered, the significance of classification or its arrangement can vary. A food trading company, for example, is categorized according to its product classes. Technical warehouse requirements differ, for instance, for long-life goods (e.g. metal products), perishables (e.g. fruit and vegetables) and refrigerated goods (e.g. meats). Also, there are no unfinished products in the trading business because there is no production. A transport company possibly has only a transshipment warehouse and its order and arrangement is determined by the manageability of goods (pallets, boxes, other break-bulk cargo) or by internal processes (e.g. first in-first out or last in-first out). There are various reasons for setting up inventories. Examples for the functions of inventories include: • Cost reduction function: Bundling lot sizes results in degressive procurement costs through the realization of volume rebates or better transport conditions. Furthermore, fixed ordering costs can be reduced by fewer orders. • Security function: Various non-calculable risks, for instance machine failures, delivery difficulties by suppliers or quality defects are balanced out by safety stock levels. Inventories compensate for fluctuations in supply or demand and thereby counteract out-of-stock costs. • Function of reduced delivery periods: Inventories help meet customer requests faster. The storage of finished products as well as intermediate products is conceivable. • Speculation function: Inventories are set up to compensate for fluctuations in market price and exchange rates, for expected price increases or to reduce the effects of possible interruptions of supply. Speculation inventories are especially found with raw materials (e.g. oil, steel, etc.). • Finishing function: The storage of products is here considered a production stage for finishing or maturing (e.g. bananas, wine, beer, cheese). After a review of the types of inventory, warehouses and storage functions, the costs caused by inventories will now be quantified to assess the economic efficiency of inventory management. Different cost items can be distinguished as follows: • Opportunity cost: The capital tied up in inventories is not available to the company for other investments. Costs for it can be calculated by means of so-called calculatory interest. This depends, for example, on the type of capital employed (own or outside capital), the sector of industry and the degree of risk of the enterprise.

34

4 Measures for Strengthening Internal Financing Power from a Corporate Viewpoint

• Warehouse cost: This cost is caused by the use of warehouse infrastructure, technical facilities, personnel and working mediums and depends very much on the type of inventories. Other factors also have an effect, such as the company’s degree of centralization. Several decentralized warehouses generally cause higher costs than one central warehouse. • Cost of insurance: On the one hand, this depends on the value of the stored goods and, on the other, on the risk they present (e.g. explosive products). • Cost of inventory risk: Cost arising from the value loss in case of short product life cycles as well as damage and theft. • Out-of-stock cost: Cost incurred because of the non-availability of goods. This includes cost overrun through short-term procurement activities (spot market purchases, cost overrun of logistics), interrupted production processes and lost contribution margins. The interest area of capital tied up in inventories empirically makes up the largest part of the inventory carrying rate. The inventory carrying rate results from the sum of the individual cost items, without the out-of-stock cost, in relation to the value of inventories; in practice, this amounts to between 16 and 26%.9 Lowered inventories will reduce working capital and thereby the balance sheet total. This has a positive effect on the balance sheet ratios and the valuation of an enterprise. For example, a reduced balance sheet total increases capital turnover and has a positive effect on the company’s return on assets as the following formula shows: Return on total capital employed = Capital turnover · Profit to sales ratio =

Revenue − Cost + Outside capital cost Equity capital + Outside capital

(7)

The security of supply and minimization of out-of-stock cost, on the one hand, and the maximization of the return on capital by a reduction of inventories, on the other, must be carefully weighed. The comprehensive analysis, planning and control of inventories are required to achieve the objective of a holistic optimization of working capital. Moreover, a conflict of objectives results between other functional areas of a company and its inventory management, which tends to aim at ordersynchronous procurement, i.e. small lot sizes with low inventories. Functional areas, such as production and sales, frequently favor more comprehensive lot sizes with high inventories to ensure, for example, the security of supply, optimum utilization of existing production capacities and product range (Fig. 4.13).

9 Cf.

Hartmann (1999, p. 19).

4.2

Inventory Management

35

Fig. 4.13 Goal conflicts in inventory management (cf. Stölzle et al. 2004, p. 33)

•

•

Fig. 4.14 Optimization process of inventory management – ABC–XYZ analysis

Inventories can be differentiated by means of an ABC or XYZ analysis, or by a combined ABC–XYZ analysis. Important findings can be gained from this and strategies can be derived (Fig. 4.14). The ABC analysis classifies articles within an inventory according to volume and value percentages into the categories A, B and C: • A-articles: Low volume percentage of 10–20%, high value percentage of 70–80% of the entire purchase volume.

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4 Measures for Strengthening Internal Financing Power from a Corporate Viewpoint

• B-articles: Medium volume percentage of 20–30%, value percentage from 10 to 20% of the entire purchase volume. • C-articles: High volume percentage from 60 to 70%, low value percentage from 5 to 10% of the entire purchase volume. Strategies and action recommendations can be derived from this classification of inventory management as well as for other divisions and departments. This is exemplarily presented for A- and C-articles: • A-articles: ◦ Conclusion of long-term framework agreements to generate cost benefits. ◦ Demand analyses are necessary to estimate future demand. ◦ The optimum order quantity is determined by taking into account the inventory carrying cost and order handling cost. ◦ Intensive inventory monitoring is required to keep out-of-stock cost low despite minimum inventories. Ideally, just-in-time delivery is to be introduced. Concomitant is a detailed determination of safety stock level and reorder level. • C-articles: ◦ Optimum ordering quantities are determined and procured at the beginning of a planning period to minimize procurement cost. ◦ Inventory monitoring is reduced to ensure an adequate cost/benefit ratio. Statistic fluctuations in demand are balanced out by safety stock levels. ◦ Application of largely standardized processes. ◦ Procurement also through catalogues and e-procurement platforms. Owing to the great monetary potential, inventory management should be primarily focused on A-articles. Only when essential measures for the optimized procurement of A-articles have been implemented and resources used for other projects can activities be extended to B-articles and finally to C-articles. Another important alternative in the consideration of inventory management is the XYZ analysis. Articles are here classified according to the precision of forecasting consumption: • X-articles: Regular consumption, high forecast precision. • Y-articles: Trend and seasonal consumption, medium forecast precision. • Z-articles: Highly irregular consumption, low forecast precision. Forecast precision can be evaluated from empirical values, the results of itemized bills of materials, by determining a coefficient of variation or fluctuation. The greater the consumption spread of an article, the lower the forecasting precision. A combination of ABC and XYZ analyses provides a nine-field matrix that allows detailed and specific inventory management procedures (Fig. 4.15). Accordingly,

4.2

Inventory Management

37

Fig. 4.15 Derivation of classifications and strategies by means of an ABC–XYZ analysis

•

•

Fig. 4.16 Optimization process of inventory management – strategy definition

AX parts are procured synchronous with the order – if possible, just in time. By contrast, CZ parts are held in stock. Following the analysis of the different types of inventories according to value percentage and forecast precision, individual strategies for future demands are formulated in operative job instructions in the form of ordering quantities and dates (Fig. 4.16). Planning the ordering quantity and dates is summarized under the term ordering quantity planning and is used for inventory control.10 To determine the optimum ordering quantity, total costs are considered, which comprise inventory carrying cost and ordering costs. Inventory carrying cost consists of warehouse costs (rent, electricity, depreciation, forklift trucks, shelves, personnel, etc.) and

10 Cf.

Stölzle et al. (2004, p. 82).

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4 Measures for Strengthening Internal Financing Power from a Corporate Viewpoint

Fig. 4.17 Determination of the optimum ordering quantity taking into account inventory carrying cost and ordering costs

the tied-up capital costs caused by inventories.11 On the one hand, ordering costs decrease with the size of the ordering quantity because of the lower percentage of fixed costs of ordering per piece. On the other hand, the inventory carrying cost increases because of the higher inventory. Based on the total cost minimum, the optimum ordering quantity can be identified, which is designated “Andler’s lot size” or “economic order quantity”. Figure 4.17 shows the cost curves for determining the optimum lot size within the scope of a single-stage, uncapacitated industrial production. It can be simply determined as follows:  Qopt =

2 · d · CB CL

(8)

where d consumption rate = quantity units/time unit CB ordering costs = monetary units CL inventory carrying rate = monetary units/(time unit × quantity unit) Extensions of the economic order quantity model are:12 • Economic production lot: The assumption of instantaneous warehouse filling is replaced by a constant production rate. 11 Cf. 12 Cf.

Wannenwetsch (2008, p. 65). Jodlbauer (2008, p. 69 et seq.).

4.2

Inventory Management

39

• Multi-echelon warehouse model: This model describes the inventory for a sequential process over several stocking echelons. • Multi-product warehouse model: This model presents an extension for several products under the assumption that every product has the same cycle time. It is called the economic lot scheduling problem (ELSP). • Stochastic single-product warehouse model: This model takes stochastic demand into account and penalty cost for default in delivery and is very important, especially in practice. • Stochastic multi-product warehouse model: Starting with the ELSP model, a separate approach is presented for every product, taking stochastic influences into account. • Newsboy warehouse model: With the newsboy warehouse model, calculatory penalty cost is taken into account for lost sales as are costs for the disposal or storage of obsolete inventory. A major objective of inventory management is the reduction of procurement time by means of process optimization (Fig. 4.18). Reduced procurement time allows the company to react flexibly to changed framework conditions such as fluctuations in purchasing and prices. Procurement time is determined as the period of time passing between the origin of the demand and the availability of the material at the place of demand. This depends on whether a recurrent or new demand is concerned. Moreover, the number of organizational units plays a role between creating and meeting the demand. To reduce the procurement period, it must be evaluated, inter alia, whether inspections at the incoming goods station are necessary or whether procurement is possible via online platforms or electronic catalogues. The choice of traffic carrier should also be included in the consideration of speeding up procurement logistics processes, possibly by taking higher costs into account.

• •

•

Fig. 4.18 Optimization process of inventory management – implementation and controlling

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4 Measures for Strengthening Internal Financing Power from a Corporate Viewpoint

Fig. 4.19 Determination of optimum cost inventory level, taking into account inventory carrying cost and out-of-stock cost

Furthermore, safety stock levels are newly planned and adjusted within the scope of inventory optimization. Safety stock levels serve to reduce out-of-stock risks due to faulty deliveries, inventory differences, exceeding procurement times and uncertainties in the demand forecast. In contrast to the average inventory, safety stock levels have a significantly lower frequency of inventory turnover. Accordingly, a reduction in safety stock level can make a considerable contribution to reducing the inventory carrying cost. However, delivery dates promised to customers must be taken into account, as well as the readiness to deliver. Accordingly, another objective of inventory management is to define the optimum in which the minimum is provided by the sum of the total of costs of non-availability (lost profit) and inventory costs (Fig. 4.19). Apart from planning the ordering quantities, ordering dates and safety stock levels to ensure optimized inventory management and procurement of future demand, additional measures exist to reduce excess inventories. Examples are: • Reach analysis: The optimum inventory reach and thereby optimum ordering date can be determined by relating the average inventory to the average consumption per period, in combination with the ABC classification for every article.13 • Reduction of process steps: Reducing the levels of scheduling and decisions reduces the potential sources of error and delays. It is to be assumed that, with a higher number of process steps, the flow of information about actual demands

13 Cf.

Bliesener and Kress (2005, p. 189 et seq.).

4.3

Product Group Management and Supplier Management

41

is increasingly interfered with. To counterbalance this, higher safety stock levels are frequently set up.14 • Reduction of warehouse levels: Excessive warehouse levels cause inventories to be frequently stored in places where this is not absolutely required. A reduction in warehouse levels increases the transparency regarding the actual necessity of inventories at individual warehouse levels.15 • Reduction of the diversity of variants: Customized production frequently results in a great diversity of variants. However, few of the offered variants make up a major part of sales. Reducing diversity frequently brings about a massive reduction in inventory.16 • Continuous replenishment: In continuous replenishment, the ordering process is assigned to the supplier. Based on inventory information and demand forecasts, the supplier takes responsibility for the customer’s warehouse stocking. In this case, it is differentiated between vendor-managed inventory and co-managed inventory depending on the supplier’s influence.17 Using inventory management software can support optimum inventory planning on the basis of existing and optimized framework conditions, such as inventory carrying rate, inventory value and safety stock level. This entails investment cost and running cost. However, such an investment is usually paid off after a short time. Furthermore, cross-company approaches such as the just-in-time concept and efficient consumer response can bring about additional inventory reductions. Approaches for crosscompany control are presented in Chap. 5. After the implementation of inventory management measures, a permanent system should be installed to monitor the development of inventories and, if necessary, initiate measures for the achievement of objectives. Analyses and ratios are prepared for this, and the measures taken are documented.

4.3 Product Group Management and Supplier Management Internal product group management and supplier management are closely connected and cannot be considered in isolation within a holistic optimization. Product group and supplier objectives are derived from the purchasing objectives, which, in turn, are based on corporate objectives and customer needs (Fig. 4.20).

14 Cf.

George, M.L. (2003, p. 13 et seq.). Dillon (1990, p. 62). 16 Cf. Swaminathan and Nitsch (2007, p. 324 et seq.). 17 Cf. Angulo et al. (2004, p. 101 et seq.). 15 Cf.

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4 Measures for Strengthening Internal Financing Power from a Corporate Viewpoint

Fig. 4.20 Embedding supplier objectives and materials and product group objectives within the company

The basis for the successful optimization of product group and supplier management is the quality of the available data. Accordingly, this starts with an analysis of the product group structure and inherent information. The “sourcing cube” presented in Fig. 4.21 is used to identify starting points for optimization.

Fig. 4.21 Collection of procurement-relevant data using a sourcing cube

If there is no detailed structure of materials or product groups, first of all it would be necessary to provide transparency and establish a multidimensional structure (Fig. 4.22).

4.3

Product Group Management and Supplier Management

43

• • • • •

Fig. 4.22 Optimization process of product group and supplier management – analysis of product group structure

In practice, there are frequently mixed forms of product group structures that have “historically” grown with the company and sales product range. Common classification criteria for manufacturing works are material properties or manufacturing processes. For the classification according to material properties, the raw material is the focal point. One example is: • Main product group: Steel ◦ Upper product group: Rolled steel 

Lower product group: Structural/sectional steel

One advantage of this type of classification is market transparency since fluctuations in prices – such as for steel – can be directly compared with supplier prices. Another possibility of classification is the distinction based on the production process. This is shown in the following example: • Main product group: Mechanical processing ◦ Upper product group: Rotational processing 

Lower product group: Bolts according to drawing

The strong point of this type of classification is the disclosure of synergies by adequately grouping of equivalent processing steps. This applies especially for the analysis of existing or master suppliers with a broad range of supplied products. Restructuring product groups also requires unambiguous product group encoding using established standards for orientation such as the eCl@ss system (www.eclass.de). Proven in practice is the encoding system according to three types of classification: type of material, application area of the material and manufacturing depth. Every type of classification has a three-digit code (Fig. 4.23).

44

4 Measures for Strengthening Internal Financing Power from a Corporate Viewpoint

Fig. 4.23 Types of classification according to product group codes

Such structuring creates the prerequisite transparency for further analyses in the optimization process of product group and supplier management, and helps detect bundling potentials for cost reduction (Fig. 4.24).18 Moreover, strategic procurement market research is possible on the basis of a product group structure. This means the planned, systematic and methodical determination, interpretation and provision of information used to secure and optimize procurement objectives.19 In practice, procurement market research is frequently confused with a search or exploration of the market. Search and exploration are rather of a short-term and selective character, whereas procurement market research

• • •

Fig. 4.24 Optimization process of product group and supplier management – procurement market research

18 Cf. 19 Cf.

Rüter and Savor (2009, p. 696). Hirschsteiner (2006, p. 242 et seq.).

4.3

Product Group Management and Supplier Management

45

is characterized by the systematic processing of information for a general long-term increase in transparency. The main objectives of procurement market research are to describe the markets and forecast future market developments. Since such market research is time consuming, it should be limited to the main product groups. Data collection, furthermore, distinguishes between primary and secondary research. In primary research, purchasing staff actively collects so far unavailable data through personal interviews. Secondary research relies on pre-existing data (e.g. publications by market participants). Primary research should have a lower priority because of the frequently heavy workload for purchasing staff and its time-consuming nature.20 Sources for secondary research can include trade registers and directories, specialized literature and databases. Additionally, spatial delimitation should be defined to limit research to the necessary procurement territory. The degree of limitation of the procurement market research depends on the defined objectives. In procurement market research, which also aims to search for alternative suppliers and substitution products, a specific country or group of countries is specified as a possible sourcing region. Before the search is extended globally, geographically closer regions should have priority so that transport costs and supply chain complexity can be kept low. Thus, for example, procurement market research in eastern Europe should precede any research in Asia (Fig. 4.25). In defined intervals (e.g. annually), the collected data should be updated since procurement markets are also subject to change.

Fig. 4.25 Spatial delimitation of procurement market research (cf. Kutschker and Schmid 2008, p. 326 et seq.)

Based on the information obtained through the analysis of the product group structure and procurement market research, the next step can be an invitation to tender for the required goods (Fig. 4.26). The materials or product group management can be simplified if standardized tender documents are prepared for the relevant main product groups. Classical tender documents sent by postal service or e-mail comprise different sections.21 They are differently structured depending on the companies and product groups concerned and are generally complex and must

20 Cf.

Large (2000, p. 91 et seq.). study does not deal with the requirements of “e-sourcing auctions”, such as live auctions, multi-price auctions, reverse auctions, single position auctions, multi-position auctions or scorecard auctions since the qualitative requirements differ widely from one bidder to the next.

21 Our

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4 Measures for Strengthening Internal Financing Power from a Corporate Viewpoint

• • • • •

Fig. 4.26 Optimization process of product group management and supplier management – invitation to tender

be carefully processed to avoid subsequent errors. The classical document structure includes the following component parts: • General information: This provides the concrete objective of the invitation to tender and names the defined contact persons. Crucially, this also includes the instructions for filling out the price or bid page to facilitate subsequent evaluation. This first part is completed according to the tender requirements (deadlines and bid forms). • Price and bid page: Here, the supplier is requested to submit its offer and confirm it with its signature. To submit their offer, the contacted suppliers need all of the general information and the scope of the product group, and must include all of the following information: ◦ ◦ ◦ ◦ ◦ ◦

Article number; Name of article; Quantity unit; Delivery quantity (call-off sizes); Delivery dates; and Requested offer price.

This information should be supplemented by the following parameters if possible: ◦ Defined call-off amounts; ◦ Price fixing possibilities; and ◦ Allocation of cost types (production costs, cost of materials, etc.). • Specifications: The purchasing department should closely coordinate with the responsible decision-makers to detail specifications. In the processing industry, for example, these decision-makers are generally engineers from production. An adequate degree of specification comprises such technical data as are necessary for the supplier’s cost-based pricing.

4.3

Product Group Management and Supplier Management

47

• Terms of delivery: These provide a potential supplier with all other information required for a reliable provision of a bid. This includes the general terms of delivery (Incoterms, opening hours of the goods receiving department, quantity of goods, etc.), the price validity of the offer (e.g. fixed for a defined period of time, fixed production costs or price escalator clause for the percentage of the cost of materials), as well as the valid payment terms for all suppliers of a specific product group. Additionally, the person in charge of the project should define the type of packaging to ensure the smoothest possible process handling at the interface of production. If several locations are to be supplied, differentiating delivery criteria and defining geographical regions might also be required so that the suppliers are able to include in their calculations all logistics costs. This part is rounded off by the declaration of the AEB. • Supplier data sheet: For an overview of the profiles of alternative suppliers, a supplier’s disclosure of business and financial data must be filled out. The person in charge of the project can then generate a database about all potential suppliers including relevant information about persons to contact, machine equipment, quality assurance measures, manufacturing processes and references. Well-balanced product group management is the foundation of successful supplier management. Based on systematic materials or product group structure, and in combination with, procurement market research, the prepared tender documents can then be mailed to potential suppliers to obtain improved procurement terms as far as possible. Within the scope of supplier selection, the optimum suppliers for the company are selected based on specified criteria (Fig. 4.27). One primary challenge is the identification of the “right” suppliers to whom the tender documents are to be sent. To prepare a pool of potential suppliers, the staff of the purchasing department might use supplier databases in addition to the already described procurement market research. Examples for such databases are: “Wer liefert was?” (www.wlw.de – ‘Who supplies what’), “Europages” (www.europages.com), Asia International Business & Trade Net (www.asiaBT.com) and “IndustryNet” (www.industrynet.com). From this

• • •

Fig. 4.27 Optimization process of the product group and supplier management – selection of suppliers

Tender procedure

Narrowing down suppliers

Supplier identification

4 Measures for Strengthening Internal Financing Power from a Corporate Viewpoint

Preliminary screening of suppliers

48

Fig. 4.28 Supplier selection process

pool of potential suppliers, a group of relevant suppliers to invite to tender is defined using a supplier selection process (Fig. 4.28). The supplier selection process includes the following steps: • Preliminary screening of suppliers: The supplier pool identified by procurement market research (“long list”) will be reduced by a preliminary screening of the suppliers (“short list”). To carry out this process according to objective criteria, characteristics are defined to evaluate or compare potential suppliers. Two criteria must be met: the characteristic must be measurable and the expenditure of collecting and recording the characteristics must be reasonable in terms of the benefit of the evaluation.22 Because of these requirements, it is suggested to use as a basis any ratings and corporate figures and ratios that can be taken from annual financial statements. All those suppliers that do not reach the predefined target values are removed. Suitable ratios at this stage of the selection process could, for example, be the size of the company, sales volume or product range. • Supplier identification: The pool generated following the preliminary screening of suppliers is composed of potential suppliers, which provide similar products and services as the existing or master suppliers and also have comparable capacities and resources. These suppliers are analyzed more precisely in another step in terms of strategic supplier relations. Certificates and references are suitable for a fast assessment of a supplier’s quality. Suppliers without the required certificates or pertinent references will be excluded from the further process.23

22 Cf. 23 Cf.

Large (2000, p. 145 et seq.). Janker (2004, p. 34 et seq.).

4.3

Product Group Management and Supplier Management

49

• Narrowing down suppliers: For the final narrowing down of the group of suppliers, the purchasing staff should once again query those directly responsible for the materials, goods or services to be purchased. Although all relevant product specifications are included in the tender documents, final confirmation by those involved is advantageous so as not to inadvertently omit any supplier because of missing information. If this procedure is followed, an adequate response rate with concrete offers can generally be expected. In a subsequent step, these will be reviewed and analyzed in substantive, technical and commercial terms.24 First, the bid documents are examined for their legal validity and substantive completeness to ensure the comparability of the bids (Fig. 4.29). Some specialized bidders might not have provided prices for the entire requested supply portfolio. Such partial bids are evaluated as to whether their exclusion from the tender invitation procedure would negatively influence the result. In addition to content examination, the suppliers’ technical information will be recorded. In case of deviations that might affect quality standards, close coordination is required between the buyers involved and the technical staff responsible in production or R&D. The bids’ commercial evaluation must be methodically and systematically conclusive and reliable. All important criteria regarding terms, conditions and performance should be documented. It is important for a reliable statement that prices are related to the same quantity units and that comparable delivery conditions prevail (e.g. Incoterms). Payment terms deviating with regard to the request for tender must also be presented with a calculation. Furthermore, all possible parameters are identified to preclude any unambiguous comparisons. Even if tender documents are always prepared in such a manner, errors can occur in practice. Examples for possible discrepancies are separate presentations in materials and production cost shares,

Fig. 4.29 Optimization process of the product group and supplier management – bid analysis and award strategies

24 Cf.

Hirschsteiner (2006, p. 242 et seq.).

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4 Measures for Strengthening Internal Financing Power from a Corporate Viewpoint

different terms of delivery, customs duties or additional delivery costs in case of several locations and deviating payment terms. Based on this detailed analysis, two different levels are presented: • Articles level: Here, the most financially attractive offer is identified (so-called “cherry picking”) by ranking every article. In this case, the number of different suppliers is neglected. Although this level of presentation is implementable in only rare cases, the resulting information is nonetheless extremely important as a benchmark for price negotiations. • Supplier level: Here, the bid result will be presented per supplier. This reflects the savings scenario if the entire requested volume was awarded to a single supplier. However, since financially attractive offers by alternative suppliers not only provide opportunities but are frequently connected with risks because of the lack of experience, specified award strategies present an expedient solution to spread the risk. Award strategies can be differently designed. Frequently found in practice is the so-called “second source approach” as well as the “geographic diversification approach” and “multi-source approach” according to article groups. With the “second source approach”, a partial volume is transferred from the existing or master supplier to a reasonably priced alternative supplier. This is used to set up a second master supplier, reduce the supply risk and intensify supplier competition. From a strategic point of view, a complete changeover to an alternative supplier is then possible if quality and reliability prove to be competitive. Another award strategy proven in practice is used for several, geographically separate locations. With the “geographic diversification approach”, the calculated procurement volume is divided into different suppliers each supplying different locations. Buyers frequently prefer this strategy for product groups with a critical supply situation. A third award strategy awards the order according to groups of articles. This strategy is mostly used when several specialized suppliers offer similarly good conditions for specific groups of articles. In this case, the best suppliers are identified for every classified group of articles within a product group. The order award according to groups of articles thereby presents an extension of the “second source approach” and can result in a “multi-source approach” in specific product groups. From a strategic point of view, it is sensible to award to several suppliers to spread the risk (e.g. default risks, quality risks, etc.). In an extreme case of “cherry picking”, the best prices result for each individual article; however, the connected coordination and transport costs can bring about a suboptimal overall result. Following the development of the award strategy, potential suppliers are invited to negotiation rounds because only personal negotiations can clarify open questions, optimize terms of offers and finalize agreements (Fig. 4.30). A successful process of negotiations consists of the preparation of negotiations, the actual negotiation, the documentation of results and the evaluation of negotiations.

4.3

Product Group Management and Supplier Management

51

Fig. 4.30 Optimization process of the product group and supplier management – negotiations and results

The preparation of negotiations comprises all steps to be taken prior to the beginning of negotiations.25 These steps can be more or less extensive depending on the scope and relevancy of the pending negotiations. The following points should be ascertained for preparation: • • • • • •

Negotiation power: Assessment of one’s own position and that of the supplier; Availability of information about the negotiation partner; Framework conditions to be discussed; Extent of possible concessions; Upper and lower limits of receivables; Organization of negotiations: Premises or accommodations, team members, distribution of roles, time frame; and • Formulation of objectives. The resulting formulation of objectives must be specific, measurable, attractive and realistic. Moreover, it is necessary to set a due date for the achievement of objectives to be able to compare differently realized objectives.26 The formula for successful negotiations is defined by conducting fourdimensional talks. The competence as a buyer of utilizing the entire fourdimensional space of negotiations (Fig. 4.31) renders it impossible for the partner in negotiations to calculate the negotiations and thereby strengthens the buyer’s negotiating position. The four dimensions in the area of negotiations are as follows: • Atmosphere of the talks: The atmosphere can range from harmonic to conflictoriented. For example, the buyer might provide a cooperative atmosphere to move strategic suppliers to investments in specific technologies or could appear authoritarian, for example to claim damages for defective deliveries. 25 Cf. 26 Cf.

Schmitz et al. (2006, p. 26). Portner (2010, p. 39).

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4 Measures for Strengthening Internal Financing Power from a Corporate Viewpoint

Fig. 4.31 The four-dimensional area of negotiations (cf. Kerkhoff (2008, p. 159)

• Main subject talks: The main thread is used to structure the course of negotiations and can be defined as rigid to flexibly all the way to chaotic. The rigid pursuit of the main thread often seems intolerant, but the chaotic handling of negotiations mostly seem to be aimless. For this reason, it is important for the buyer to weigh carefully how flexibly they want to design this dimension to achieve this objective. • Level of talks: Basically, three levels of talk are distinguished. The first level is the analytic level in which the buyer argues pragmatically and purely objectively. The second level is the selective level in which they argue objectively but at times takes heuristic lines of negotiations. In the third level, the buyer lets emotions guide them. • Handling of talks: This is differentiated between an active leadership style, which is characterized by the buyer’s proactive appearance, and passive leadership in which the buyer assumes an introverted role. In between, there is selective leadership, which changes by adaptation or emotional dependency between the two leadership styles. After the negotiation phase, it is important to document the findings gained. The buyer must take care that the contents of negotiations are converted into concrete measures. This can be, for example, improved payment terms, which are to be filed in the merchandise information system. Securing results is just as important as a successful preparation of negotiations and conducting them since, in the final

4.3

Product Group Management and Supplier Management

53

analysis, its realization serves the negotiated savings or success.27 In practice, standardized and uniformly formulated supplier agreements or framework agreements secure results. After securing results, the detailed processing and evaluation of the negotiation is necessary. Such analysis helps detect errors made and prevent them in the future. An overall evaluation is presented determining in which areas a buyer’s own ideas or objectives were realized and in which there was deviations from them. It is additionally important to discuss the achievement of partial objectives to disclose the connected risks. Finally, successful arguments and counterarguments of the suppliers can be compiled in a catalogue to improve preparation for future negotiations. Successful product group management and supplier management can reduce tied-up capital costs and optimize working capital management. To succeed in this process, it is essential to adjust further strategic measures to it. This requires continuously implemented supplier evaluation, supplier development and supplier auditing.

27 Cf.

Püttjer and Schnierda (2002, p. 167).

Chapter 5

Measures for Strengthening Internal Financing Power from a Supply Chain Viewpoint

The supply chain includes all parties involved in the development, production and delivery of a product to satisfy end customer demands. Collaboration with different supply chain parties is becoming ever more important. The focus shifts from individual companies to the network level.1 Supply chain management has the objective of integrating select cooperation partners in long-term and cooperative win–win relationships into the value added process with its different activities to increase the competitive position of the entire supply chain through the coordination, utilization and improvement of joint capabilities.2 As opposed to the preceding consideration with its unilateral internal company optimization, the integrative approach relies on redesigning strategic partnerships in the supply chain to realize synergies. In particular, predestined are suppliers with long-term commitments to one buyer as well as: • A high place value due to an important procurement volume (A-suppliers); • A key function because of the product they supply (no substitution possible); • Being distinguished by their great innovative power as a partner in the area of product development; or • Their ability to provide support activities because of their location or special competences in the development of new markets (expansion and/or global sourcing). From a corporate point of view, strategic suppliers are thereby supply chain partners that are supportively active in the implementation of corporate strategies and that vitally contribute to corporate performance.3 Owing to increasing competition, shorter product life cycles and fast-changing technologies, the trend towards the increased organization of strategic partnerships is increasing and, thus, is considered

1 Cf.

Cooper et al. (1997, p. 1 et seq.). Christopher (2005, p. 286 et seq.). 3 Cf. Jahns et al. (2006, p. 23). 2 Cf.

E. Hofmann et al., Ways Out of the Working Capital Trap, Professional Supply Management 1, DOI 10.1007/978-3-642-17271-7_5,  C Springer-Verlag Berlin Heidelberg 2011

55

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5 Measures for Strengthening Internal Financing Power

a vital competitive advantage. Such supply chain partnerships can pursue different objectives, such as: • • • • •

Securing long-term low and predictable purchase prices; Quality assurance; Security of supply; Providing innovative leads; and Reducing default risk or securing the supplier’s existence.

The implementation of a supply chain partnership usually requires investments in new technologies and machines, cost-intensive measuring and test instruments, certificates and new personnel (e.g. for R&D to strengthen innovative power). Frequently, the supplier unilaterally bears such investments.4 In the end, these expenses will be reflected in the calculation of the supplier’s sales price and thereby the purchase price for the buyer. Accordingly, the considerations below will focus, from a superior supply chain perspective, on the optimization of the cash-to-cash cycle, i.e. of the capital employed and the connected costs.5 The following section presents the concepts of: • • • • •

“Finance-oriented supply chain sourcing” (Sect. 5.1); “Supply chain-oriented supplier financing” (Sect. 5.2); “Collaborative cash-to-cash management” (Sect. 5.3); “Cash pooling and netting in the supply chain” (Sect. 5.4); and “Supply chain financing platforms” (Sect. 5.5).

5.1 Finance-Oriented Supply Chain Sourcing Supply chain sourcing is characterized by the joint appearance of suppliers and buyers as well as various market operators buying the same goods. Supply chain sourcing is a cross-company procurement concept with vertical and horizontal cooperation for select groups of material in a supply chain. Thus, this concept presents a hybrid solution between the extremes of centralized and decentralized supply chain procurement. The objectives of supply chain sourcing include the optimization of processes and reduction of product costs for the market operators involved.6

4 Cf. Spekman (1988, p. 75 et seq.). Exception: supplier partnerships characterized by great supplier power or lack of a substitution of the supplier (monopoly or oligopoly, respectively). 5 Cf. Hofmann and Elbert (2004, p. 95 et seq.). 6 Cf. Mohr (2010, p. 127 et seq.).

5.1

Finance-Oriented Supply Chain Sourcing

57

Quantities are bundled and jointly procured by prior balancing or matching joint demands. This will provide the following potentials, aside from the obvious price benefits7 : • Access to global suppliers will open up new procurement markets for the smaller operator within the partnership. Global sourcing frequently requires setting up local procurement offices or results in high initial expenditures for establishing a company in different markets. These costs will only be worthwhile for a certain volume and will only pay off over a long period of time. Joint sourcing will reduce these costs for the smaller partner and result in better prices for both sides because of the increase in volume. • The frequently significantly better payment terms for the larger player can be expanded to the smaller player or even improved through the bundling of quantities. For both players, this effect will result in a permanently additional cash flow and interest yield. The buyer can also appear as the sole buyer and subsequently sell the goods onto its supplier. This will enable the buyer to control the improved payment terms and a more favorable purchase price for the supplier. This could be used to support financially troubled suppliers in the following ways: • Extending the payment term for the supplier reduces its cash-to-cash cycle and will result in the short-term in better liquidity. • A matching design of payment terms where the accepted starting materials are set off simultaneously against the delivered articles will decrease the supplier’s liquidity required for the material towards zero. • In extreme cases, the supplier’s times allowed for payment versus the buyer can also exceed the buyer’s time allowed for payment versus the upstream supplier. Supply chain sourcing thereby presents itself as a financing instrument by means of which the buyer can grant its supplier interest-free credit. One prerequisite for this form is the buyer’s corresponding liquidity and prefinancing clout. Furthermore, interest-free credit can be converted to interest-bearing credit by means of a discount on liabilities. The result will be that the buyer generates additional income for the provision of liquidity. Exemplary forms of supply chain sourcing are8 : • Materials provision model: In this case, the supplier transmits its starting material demands to the buyer who passes them on as an order to the upstream supplier. In some cases, the supplier also directly transmits its demand to the upstream supplier. Billing is via the buyer so that the supplier is only paid for its value added activities (Fig. 5.1). 7 Cf. 8 Cf.

Mohr (2010, p. 57 et seq.). Mohr (2010, p. 259 et seq.).

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5 Measures for Strengthening Internal Financing Power

Fig. 5.1 Mode of operation of the materials provision model in supply chain sourcing

• Framework contract model: In this model, the buyer concludes a framework contract with the upstream supplier. Subsequently, the buyer and its authorized suppliers call off their demands from the upstream supplier, with a purchase contract being concluded not only between buyer and upstream supplier but also between supplier and upstream supplier (Fig. 5.2).

Fig. 5.2 Mode of operation of the framework contract model in supply chain sourcing

• Coaching model: In this form of supply chain sourcing, the buyer supports its suppliers by means of information about procurement sources, negotiated price information, product quality tests and audits of upstream suppliers (Fig. 5.3).

Fig. 5.3 Mode of operation of the coaching model in supply chain sourcing

5.2

Supply Chain-Oriented Supplier Financing

59

• Trading model: Here, the buyer appears as the intermediate dealer between the supplier and upstream supplier. The buyer concludes purchase contracts not only with the supplier but also with the upstream supplier and the payment flows also pass via the buyer. However, the goods are delivered directly from the upstream supplier to the supplier (Fig. 5.4).

Fig. 5.4 Mode of operation of the trading model in supply chain sourcing

In practice, the supplier and buyer appear jointly vis-à-vis upstream suppliers, especially in industrial sectors with low value added depth and a resulting high percentage of the cost of materials. In particular, larger buyers with many regional suppliers will gain market power when they aggregate company volumes and appear – over the heads of their suppliers – as buyers vis-à-vis the upstream suppliers. In the automotive industry, savings of over 5% can be realized through the purchase of plastic granulates; in the electronics industry, up to 75% can be saved in purchasing electronic components. Additionally, there are also standardization potentials (e.g. in quality assurance) because less materials testing needs to be carried out.9

5.2 Supply Chain-Oriented Supplier Financing If the buyer is unable or unwilling to accommodate its low-liquidity supplier with better conditions, third parties (banks, factoring companies, etc.) will be tied into the supplier financing to obtain financing benefits or provide short-term liquidity. The following two forms are briefly presented and their advantages and disadvantages described: reverse factoring and cross-company financing of capital goods.

5.2.1 Reverse Factoring In reverse factoring, the buyer is the initiator of the factoring that is to be used for financing a supplier. Via a framework contract with a factor, the buyer determines 9 Cf.

Mohr (2010, p. 292 et seq.).

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5 Measures for Strengthening Internal Financing Power

the order volume, which generally corresponds with the annual purchase volume. The contract also specifies the terms and conditions at which the buyer can finance a liability through the factor. Thus, independent of the actual time allowed for payment, it is possible that the buyer finances the liability through a factor with a time allowed for payment of up to 120 days. In practice, reverse factoring is handled as follows (Fig. 5.5): I. Flow of information and goods: The buyer orders the goods from its supplier, thereby creating a liability vis-à-vis the supplier (I a). The buyer had previously agreed the time allowed for payment and cash discount with the supplier. Delivery is provided on a stipulated date (I b). II. Release notification by the buyer: After the receipt of the invoice, the buyer checks the invoice and releases it. This notification is made to the factor. III. Release notification by the factor: Thereafter, the factor releases the invoice to the supplier for discounting. IV. Payment flow, factor: The factor pays the liability to the supplier after deducting the discount for the stipulated time allowed for payment. V. Payment flow, buyer: The buyer pays the liability with the factor after the individual time allowed for payment with the deduction of the discount, plus financing costs.10 Financing costs for reverse factoring depend on the financed annual volume and the buyer’s credit rating. Some factoring companies keep the cash discount as a discharge of the financing costs; others charge a monthly premium instead. A combination of the retention of discount and a financing charge is also possible. It is accordingly advisable to compare the terms and conditions of different providers when selecting a factoring company. However, compared with the conventional financing of goods purchases, such purchasing credit by a factoring company is rather expensive. If the financing rates from the retention of discounts are projected for the year as a whole, an annual interest rate of 25–54% will result.11 Furthermore, the introduction of reverse factoring will cause, at the beginning, costs for training the employees, tying the factor to the

Fig. 5.5 Mode of operation of reverse factoring in the supply chain

10 Cf. 11 Cf.

Klapper (2006, p. 9). Wittrock (2010, p. 93).

5.2

Supply Chain-Oriented Supplier Financing

61

existing Enterprise resource planning (ERP) system and the integration of the suppliers. Accordingly, it is recommended to take note of the type of design. If reverse factoring is merely used to increase a company’s own liquidity, alternative financing should be considered. However, if reverse factoring is used in combination with collaborative cash-to-cash management (Sect. 5.3) within a supply chain partnership, this can result in a further increase in profitability of the players involved. It should be noted that both parties equally bear the cost of financing and, therefore, savings from the supplier’s reduced cash-to-cash cycle time are distributed depending on the risk carried. This type of supplier financing pursues the following objectives: • If the cost of this financing method exceeds the saved capital costs: Purely liquidity objectives are in the foreground. • If the cost of reverse factoring merely balances out with savings from the reduced capital costs: The objective is to secure the supplier and financing through the buyer’s good credit rating. This is used, for example, for key suppliers. • If the savings exceed the cost of reverse factoring and both partners benefit: Here, the objective is a cross-company cash flow optimization along the supply chain partnership via the buyer’s credit rating.

5.2.2 Cross-Company Financing of Capital Goods In the course of a buyer/supplier relationship, there are investment costs that the supplier frequently bears. This includes, for example, investments in machinery and plants, measuring and test systems and engineering, R&D, licenses and certificates. Investments predominantly allocated to the long-term partnership can occur for different reasons: • Head start in innovation: The supplier must invest, for example, in R&D, modern machinery or in the further education of its employees. • Security of supply: Investments in warehouse capacities, to be able to maintain an agreed level of services. • Quality assurance and green procurement: Procurement of test and measuring instruments, certifications and audits to prove quality. • Optimum cost level: Investments by supplier in new machinery and plants to increase productivity. From a buyer’s point of view, investments can actually be considered necessary; yet, normally the supplier alone must shoulder them. The financial and economic crisis in 2009 showed that this view can result in a higher risk of supplier defaults. Accordingly, it is all the more important in the future to not only build up strategic suppliers but also support them in their investments. This is possible if, similar to supply chain sourcing, the buyer grants its supplier access to its own terms for

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5 Measures for Strengthening Internal Financing Power

intermediate financing. In this case, the buyer’s credit rating determines the supplier’s credit terms. The buyer itself can either appear as the borrower and, with its good credit rating, pass on the favorable lending rates to its supplier or, if the buyer has great financial clout, it can contribute to the investment or prefinance it. Knorr-Bremse, the braking system manufacturer, provides one example for such a model. It implemented, with smaller suppliers and Deutsche Bank, a system for cost reductions through the cross-company financing of capital goods.12 However, economically strained conditions can lead to a credit crunch so that both parties are denied access to loans. Moreover, this model approach requires great trust on both sides and is conceptually not (yet) fully matured. Furthermore, the indirect financing of investments already exists today such that their costs are usually allocated to the cost price.

5.3 Collaborative Cash-to-Cash Management Figure 5.6 shows the necessity of collaborative cash-to-cash management. It is apparent that the supplier’s days sales outstanding (DSOL ) corresponds to the buyer’s days payables outstanding (DPOA ). The sum of the supplier’s and the buyer’s cash-to-cash cycle time remains constant when this time span is changed (zero sum game). The objective of collaborative cash-to-cash management is, accordingly the cross-company optimization of the cash-to-cash cycle within a supply chain partnership to mutually balance strengths and weaknesses and ultimately arrive at a better result for the players involved. Prerequisites for this are trust and the willingness to provide information on financial ratios. In a first step, the corresponding cash-to-cash cycles of the pertinent supply chain partners are ascertained and balanced, as well as their financial ratios, such

Fig. 5.6 Presentation of the cross-company cash-to-cash cycle time 12 Cf.

Leendertse (2009, p. 56).

5.3

Collaborative Cash-to-Cash Management

63

as the weighted average cost of capital and inventory carrying rate. The strengths and weaknesses of both partners are compared to develop a strategy of how to win synergies through more intensive collaboration. The objective is to increase profitability on both sides and maximize cash flow performance. In the following section, two concepts are presented to illustrate the cross-company optimization of the cash-to-cash cycle using different capital and inventory carrying rates. The benefit realized by one supply chain player is passed onto the other player in the form of a price adaptation. This also results in tax effects, which must be examined for the specific case and which might be highly complex in cases of crosscountry collaboration. For example, higher prices for the buyer will result in a higher turnover tax burden. Although these input taxes are refunded as a rule, the resulting tied-up capital until the refund must be kept in mind. Furthermore, corporate taxes must be taken into account since price changes will have a direct effect on revenue and expenses and thereby the taxable operating result.

5.3.1 Collaborative Cash-to-Cash Management with Varying Inventory Carrying Rates If the supplier has a lower inventory carrying rate than its buyer, it might pay to reduce delivery volumes with more frequent deliveries or change to just-in-time delivery, taking the cost of transport into account. Since the supplier can report inventories at cost of goods sold in the balance sheet, whereas the buyer must value the same inventories at the purchase price including the supplier’s margin, the buyer’s tied-up capital costs will consequently be significantly higher. The supplier frequently has a lower inventory carrying rate since its goods are warehoused in large quantities and scaling effects are achieved. From the buyer’s viewpoint, storage at the supplier is thereby at the ultimate aim (Fig. 5.7).13 This is in conflict with the supplier’s interest of realizing its margin as fast as possible. A cooperative agreement is thereby expedient to profit from the supplier’s lower inventory carrying rate. In this case, an optimum ordering quantity results for the buyer, which is lower than that calculated at its own inventory carrying rate (see Sect. 4.2) since the buyer will profit from the supplier’s lower inventory carrying

Fig. 5.7 Effects of the margin and inventory carrying rate on inventory carrying costs 13 Cf.

Randall and Farris (2009, p. 669 et seq.).

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5 Measures for Strengthening Internal Financing Power

rate. As a consequence, delivery frequency and the cost of logistics will increase. To balance out the supplier’s increased costs, on the one hand, and the buyer’s savings realized, on the other, the supplier’s higher costs and a part of the combined savings realized will be allocated to the unit cost. However, this “inventory shift” also affects the cash-to-cash cycles of both players. The buyer’s cycle will be reduced, whereas it is increased for the supplier since deliveries are moved back in time.

5.3.2 Collaborative Cash-to-Cash Management with Varying Capital Cost Rates Based on the situation that the buying company has a lower capital cost rate than its supplier, a reduction in the time allowed for payments and the resulting shortened cash-to-cash cycle time can reduce the supplier’s capital costs. This has a positive effect on the supplier’s financial expenditure and consequently also directly on its P&L account. By contrast, the buyer’s cash-to-cash cycle time is increased because of the earlier payment of the liability and this results in increased financial expenditure. Figure 5.8 illustrates the effects of different capital cost rates along the supply chain. Compensation must be provided to establish a benefit for both supply chain parties. To do this, the buyer’s additionally incurred capital costs and part of the costs saved in combination by the supply chain partnership will be allocated to the unit cost so that, because of the lower purchase price, the supplier has lower material expenditures and its P&L account will be positively influenced. A win–win situation results for both sides by balancing out their pertinent strengths and weaknesses.14 Supplier

Buyer

Weighted average cost of capital (WACC)

20%

5%

Value of delivery

€ 10 million

€ 10 million

Capital cost (30 days)

€ 10 million · 20% · 30/365 = € 164,383

€ 10 million · 5% · 30/365 = € 41,096

Fig. 5.8 Effects of the weighted average cost of capital on capital costs

5.4 Collaborative Cash Pooling and Netting The preceding section addressed, within the scope of collaborative cash-to-cash management, the synergies provided by balancing the different inventory carrying rates and capital cost rates of two neighboring players in the supply chain. Apart

14 Cf.

Hutchison (2009, p. 45 et seq.).

5.4

Collaborative Cash Pooling and Netting

65

from the joint optimization of payment flows, the cross-company utilization of liquidity can also be taken into account. The below presented cash pooling and cash netting can be used for this. Until now, it has been used in practice almost exclusively at a corporate group level, but it is now applied to supply chains. Owing to the complexity of implementation and difficulties in risk management, this form of collaboration has so far rarely been put into practice; however, it has great potential to strengthen the internal financing power of supply chain operators. Cash pooling and netting at the corporate group level is described below as the starting point; the concept is subsequently transferred to the supply chain level.

5.4.1 Cash Pooling and Netting in the Corporate Group as a Starting Point The core function of cash management in the corporate group is to control a company’s inpayments and outpayments so that solvency is permanently ensured.15 In particular, short-term and liquidity-driven financing instruments are dealt with. Cash management comprises the administration of liquid funds and liquidity reserves, the supervision of inflowing and outflowing funds and the organization of ongoing monetary transactions. As companies grow and organizational forms become more complex, the short-term control of the flow of funds will take an ever more important role in financial management.16 In a group company, different financial internal relationships exist. They consist of supplies and services which, in turn, bring about corresponding intragroup accounts receivable and accounts payable items with the individual companies. The globalization of company locations results in wide ramifications and the internationalization of corresponding bank systems. One consequence is the increase in transfer times with group companies.17 Transaction costs for major groups are also increasing because of the unnecessary tie-up of liquid funds at the level of individual group subsidiaries. The large number of internal asset transfers and the resulting increased costs can be reduced by different cash management instruments. This includes cash netting and cash pooling, which will be dealt with in more detail below.18 Even today, financial information is still predominantly paper-based. Owing to the repeated recording of data, costs will increase as well as possibly the error potential. One invoice can cost more than 10 C and requires high labor expenditures.19 For cash netting, the sum totals of intragroup receivables and liabilities between

15 Cf.

Foster Back (1997, p. 85). Hofacker (1997, p. 270). 17 Cf. Herold (1994, p. 16). 18 Other instruments are money market activities, currency hedges and liquidity planning, which are not further considered here. 19 Cf. Hansen (2004, p. 94). 16 Cf.

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5 Measures for Strengthening Internal Financing Power

the group companies are first compiled by the accounting department.20 A clearing matrix is used to determine the net receivables, which will be passed onto the subsidiaries involved.21 At a specified date, a central coordination office balances the net sums. This is differentiated between the bilateral and multilateral forms. According to Schulte, bilateral netting is understood as the offsetting of payment obligations between two companies of a group only to subsequently charge or credit the balance.22 By contrast, with multilateral netting, one business unit as the central clearing agency will record the data of the developing receivables and liabilities of the group companies participating in the netting. Cash pooling is considered the most important instrument for simplifying and increasing the efficiency of the daily scheduling of liquidity. Owing to the concentration of different deposited monetary holdings, credit interest and debit interest are optimized. Thus, any high interest current account credit can be foregone in the short-term. The prerequisite for increasing liquidity in the entire group is the suitable control of the flow of information between decentralized group companies and the central administrative agency. This is differentiated between effective pooling or zero balancing and notional pooling. Effective pooling is called genuine cash pooling since real monetary flows move between one central bank account and the subsidiaries’ sub-accounts. Existing liquidity can be effectively controlled; therefore, it is possible to permanently balance the accounts up to specified target figures. Owing to these real monetary flows, it is inevitable that the parties mutually grant each other loans. Interest can, however, only be credited or charged to the principal account (Fig. 5.9).

Fig. 5.9 Master accounts and sub-accounts for effective pooling 20 Cf.

Foster Back (1997, p. 66). Bereuter (1995, p. 82). 22 Cf. Schulte (2006, p. 329). 21 Cf.

5.4

Collaborative Cash Pooling and Netting

67

Notional pooling is also called non-genuine cash pooling because it has only fictitious monetary flows. The corresponding group units accordingly keep their liquidity. The bank in charge will settle the balances of the different accounts daily and then prepare a total balance. Thus, fictitious total liquidity is collected on a so-called “shadow account”. This forms the basis for calculating credit and debit interest. On a prorated basis, the interest will be distributed to the corresponding account balances of the different accounts. Credit balances mean that interest is increased and debit balances reduce interest charges (Fig. 5.10). At the group level, central cash management can result in a reduction of the interest burden and an increase in liquidity.23 Financing costs of groups can consequently be minimized. Yet, central cash management also has its drawbacks. Foreign subsidiaries might oppose the central financial management for fear of losing autonomy. Establishing such central cash management requires increased coordination. The costs of administration and information will consequently increase. In the EU, legal framework conditions concerning cash pooling are not yet harmonized. But there are certain basic rules. The relationship between the bank and the companies involved should be balanced; the cash pool should be organized as transparently as possible; and credit limits must always be adjusted to the needs of the corresponding members.

Fig. 5.10 Mode of operation of the notional account 23 Cf.

Ehringer et al. (2004, p. 69 et seq.).

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5 Measures for Strengthening Internal Financing Power

5.4.2 Cash Pooling and Netting in the Supply Chain Financial flows have so far only been considered at the group level (CP&NK ). This results in the number of financial flows being reduced by cash pooling and netting. The object of the investigation can consequently also be related to the supply chain level. This is differentiated between the different levels. Supply chain level 1 relates to the upstream and downstream processes of the value added chain of the group. This supply chain includes the group with its production companies (PG) and its sales companies (VG), the direct suppliers (L) and direct buyers (A). Also, logistics services providers and financial companies take various roles in the supply chain and must also be integrated into the model.24 On that basis, the object of the investigation will be expanded. By including all companies participating in the value added activities, the entire supply chain (supply chain level N) is considered. Figure 5.11 is a graphic presentation of the entire supply chain and possible financial flows within the indicated levels.

Fig. 5.11 Differentiation of various supply chain levels

24 Cf.

Hofmann (2005, p. 207).

5.4

Collaborative Cash Pooling and Netting

69

Fig. 5.12 Intragroup pooling and netting in supply chain level 1

There are different approaches to the investigation of the financial flows of the different supply chain levels.25 A group that has already introduced cash pooling and netting at the group level also has the opportunity to integrate different suppliers into this network. Financial flows with the supplier are handled directly via the group’s cash pooling and netting department. This will change the payment flows in supply chain level 1 (Fig. 5.12). However, it is also conceivable to have an independent service provider (CP&Nsc ) handling the payment flows (Fig. 5.13). It is also possible that a supplier (L) takes over and coordinates cash pooling and netting.

Fig. 5.13 External pooling and netting for the group in supply chain level 1

25 For reasons of clarity, the following statements only refer to the procurement side. However,

described cash management approaches can also be applied to the distribution side.

the

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5 Measures for Strengthening Internal Financing Power

The applicability of cash netting and pooling on the supply chain will be analyzed in the following section. This is to determine whether the principles and flows of these instruments can also be applied to the supply chain level. In case of cash netting at the supply chain level, the mutual payments of the players involved will be offset by each other and only the balance paid in each case. Necessary cash inventories and transaction costs can thereby be reduced in the supply chain section considered. Cash netting is especially interesting for networks that trade products among each other and render mutual services (so-called “counter trade relations”). Although such structures are principally possible, country-specific regulations and laws must be complied with. Cash pooling will combine in a “master account” the supply chain players’ accounts considered relevant. On the one hand, the transparency of payment flows in the supply chain will be increased and, on the other, the negotiation area will expand vis-à-vis network-internal parties. When looking at “fictitious” cash pooling, the account balances remain with the individual network members so that there can be no physical monetary flows. The prerequisite for this is the concentration of the capital of the considered supply chain section in joint companies. Further cost reduction potentials are developed not only by spreading exchange rate and currency risks but also by reducing payment flows through combined payments to third parties that are connected with several group companies.26 Cash pooling and netting has so far only been used to a limited extent in practice at the supply chain level. However, the basic principles of both instruments suggest possible areas for development. This is where supply chain financing platforms come in.

5.5 Supply Chain Financing Platforms Today, a cross-company view of financial flows is ever more important. This results from the increasingly widespread value orientation and increasing liquidity pressure. This is where supply chain finance (SCF) comes into play.27 Its objective is to increase the corporate value of individual supply chain players and thereby increase the competitiveness of the supply chain as a whole. It is assumed that performance or service flows are already largely optimized cross-company and that companies primarily concentrate on improving financial flows. The concept of the supply chain financing platform can be compared with reverse factoring.28 A buyer finances a certain purchase volume via a third party. The buyer has also taken the initiative in this case. The difference is, however, that not only the buyer but its supplier as well participates in the formulation or structuring. A specialized financial services provider is available in the background as the financing 26 Cf.

Fassbender (2004, p. 29). Hofmann (2005, p. 204). 28 Such concepts are subsumed under the term “trade financing”. 27 Cf.

5.5

Supply Chain Financing Platforms

71

institution. As opposed to the concept of reverse factoring, however, the introduction of a financing platform is considered a long-term project. Apart from improving the buyer’s working capital, it safeguards and optimizes the cash-to-cash cycle of strategic suppliers by offering alternative financing. Based on the supplier’s viewpoint, where outstanding receivables vis-à-vis the buyer are financed through factoring or a loan from the supplier’s key relationship bank, the following starting base results. By using the supply chain financing platform, many individual invoices by different suppliers that were financed by different banks or factoring companies will be processed via a single platform.29 Owing to its credit rating, the buyer (and initiator) determines the conditions and bears the risk.30 With a bundled volume, the passage of risk to the buyer and the established transparency regarding partnerships, payment flows and goods flows provides a comfortable situation for the financing platform as a third party. As opposed to the former situation, this new condition will benefit the service provider who is willing to offer financing at better terms. An example of the flow via a supply chain financing platform is presented in Fig. 5.14. The prerequisite for SCF is a transaction platform offered either by a bank or by an independent provider. The mode of operation is as follows: 1. Buyer’s payable invoices are set daily on the platform. 2. Supplier can inspect its outstanding receivables on a daily basis and demand early payment of the amount against the payment of a margin. 3. The financial services provider verifies the receivables. 4. The financial services provider remits to the supplier the amount minus a margin. 5. When due, the buyer pays the full amount of the invoice to the financial services provider. With this concept, the platform seems to be a factoring company; however, it demands financing interest at the loan interest level and pays to the supplier the amount of the invoice after the deduction of the financing cost. As an alternative

Fig. 5.14 Mode of operation of a supply chain financing platform

29 In

some cases, the function of the platform coincides with that of the bank (e.g. Citigroup). In other cases (e.g. Global Supply Chain Finance), the platform is an independent operator. 30 With some platforms, the risk is borne by another operator – a specialized insurance.

72

5 Measures for Strengthening Internal Financing Power

to the financing interest, a transaction fee can be charged depending on volume or frequency. With this concept, the supplier has the advantage of being able to control its liquidity situation on its own. Moreover, a reduction in the cash-to-cash cycle results in reduced capital costs and an improvement in cash flow. Upon the concept’s introduction, the buyer incurs costs because of the IT connection of the platform, training of employees, connection of suppliers and provision and processing of data, among other things. The buyer benefits such that strategically valuable suppliers are secured by the platform and savings from supplier’s reduced capital costs can be passed onto the buyer through a reduction in the purchase price. In comparison with factoring, supply chain financing platforms can frequently offer much more favorable terms for financing. However, it must be taken into account that the introduction can take up to 2 years, that it is an investment and that its success depends on the supplier’s involvement. Furthermore, it is possible that suppliers conclude a long-term framework contract with a factoring company so that the concept of a financing platform will be inapplicable. Also, there must be a certain trust relationship between the buyer and supplier to realize such a project. Furthermore, the buyer must have a good credit rating; additionally, stable strategic supplier and product group management must be established and the personnel capacity must exist. Moreover, the use of this financing concept requires a high transaction volume, well-specifiable product groups or materials groups, a high transaction frequency and distinct differences in the financing structures of the players involved. Such combinations are found, for example, with the procurement of higher value consumer goods (e.g. PCs) from a non-OECD country.31 The SCF concept can even achieve a “win–win–win situation”. For example, the buyer’s accounts payable time limit (DPO) can be increased to 75 days and payments made regularly at the end of the month. This improves net working capital. Furthermore, the SCF concept can help build a long-term relationship with a supplier. The platform allows the supplier a permanent examination of amounts and payment due dates. Moreover, the supplier is able to refinance via the buyer’s rating by being able to demand payment earlier (e.g. after 15 days).32 With SCF, suppliers can reduce receivables and thereby improve their liquidity. The buyer is able to realize an accounts payable time limit of 75 days without deteriorating its business relationship with the supplier.33 A major challenge of the SCF project is taking up contact and carrying on negotiations with the supplier. This can take 3–6 months. Figure 5.15 presents the effects on the balance sheets of those involved.

31 OECD:

Organization for Economic Co-operation and Development. Most of the 34 member states are considered economically developed. 32 Cf. PrimeRevenue (2007). 33 As a supplement, so-called back-to-back transactions can also be aimed for with suppliers. With this concept, payment to the supplier is coupled with payment to the customer. By tying the supplier to the contract with the customer, payment can be made without it being reflected in the balance sheet.

5.5

Supply Chain Financing Platforms

73

Fig. 5.15 A win–win–win situation by means of a supply chain financing platform

One prerequisite for the success of financing platforms in supply chains is the cooperativeness of the players involved. In addition to financial arguments, the companies’ attitudes towards changes play an important role. Vital in the evaluation of new financing instruments is an open mind by management, especially the Chief Financial Officer. This is the only way that SCF implementation is possible in practice. The function of banks as the financial intermediaries is jeopardized by a centralization of financial companies. As far as larger banks want to enter into business relations with industrial companies, they should offer different cash management instruments. Numerous financial services providers have already reacted to this market change and offer information systems and services for cash management and SCF. In the area of cash management in supply chains, the companies can realize additional optimization and savings potentials. In practice, however, there is still a certain reservation versus SCF concepts.

Chapter 6

Case Study: Increasing Internal Financing Power of a Supplier in the Automotive Industry

In this chapter, the conceptual statements are illustrated by a practical example. A potential analysis is presented that was carried out by Kerkhoff Consulting for a supplier in the automotive industry. After a description of the starting situation of the company and the identification of the problem areas in procurement, target figures will be defined using benchmarks based on comparable procurement organizations. Subsequently, measures for the achievement of objectives are decided upon and implemented. All data will be aggregated in an analysis tool for the calculation of the corporate value (EVA) and the SFGR so that the success of the project is directly evident (Fig. 6.1).

6.1 Company’s Starting Situation First, a short overview will be provided regarding the framework conditions of purchasing in the automotive supplier industry from the supplier’s point of view. Supply chain partnerships to strategically relevant suppliers are frequently characteristic for this sector. Since new suppliers must first be accepted by the customer and strict quality assurance regulations complied with, any supplier change is generally connected with high financial and temporal expenditure. Furthermore, the negotiation freedom with suppliers is frequently limited after the award of a series, i.e. the production of a vehicle generation. Also, incentives to reduce procurement prices are limited since possible purchasing advantages should be partly passed on to the end customer. Necessary resources are frequently limited, such as personnel with the appropriate skills for global sourcing (purchasing strategy oriented towards international procurement markets) and forward sourcing (supplier’s early integration into the development process). The automotive supplier’s purchasing department also suffers from chronic operative overload. The investigated company is a German mid-size automotive supplier manufacturing different components of drive systems, chasses, vehicle bodies and interiors. The potential analysis in the procurement activities of this company identified the following problem areas: E. Hofmann et al., Ways Out of the Working Capital Trap, Professional Supply Management 1, DOI 10.1007/978-3-642-17271-7_6,  C Springer-Verlag Berlin Heidelberg 2011

75

76

6

Increasing Internal Financing Power of a Supplier

Starting situation: Identification of weak areas in the purchasing process Definition of target figures: Identification of benchmarks Planning and implementation of measures for the achievement of objectives Entering data into the tool for performance measurement

EVA, SFGR

Fig. 6.1 Process steps for measuring the success of optimization measures in purchasing

• In some areas, the purchasing department is considered a mere order processing office. For important procurement processes, the purchasing staff rarely applies its competence to benefit the company. • There is no or inadequate systematic, world market-oriented procurement market research. Savings potentials can thereby be realized to a limited extent only. • The purchasing department’s insufficient capacity in terms of quality and quantity limits the implementation of strategic purchasing activities. • A heterogeneous IT infrastructure and non-harmonized processes prevent any optimum support of buyers. • The distribution of functions between purchasing and the special departments is not unambiguously regulated. • No systematic supplier management exists. Although modern purchasing concepts are available, they are not used consistently. Thus, procurement processes are only partly displayed in the ERP system and collected knowledge about suppliers is not archived at all. • The purchasing department does not have any systematic procurement controlling available and procurement reporting at a parts level is only possible with great expenditure.

6.2 Presentation of Measures The measures developed within the scope of the potential analysis relate to the areas of inventory management, the optimization of payment terms and supplier management.

6.3

Working Capital Management Analysis Tool

77

The optimization of inventory management comprises the areas of organization, scheduling and controlling. Organizational measures included a clear regulation of responsibilities for inventory management and the implementation of uniform standards of work organization for scheduling. Further measures were the stock management for all articles, the introduction of uniform material numbers, an interdepartmental definition of scheduling processes and the prevention of double inventory management. Measures in scheduling were the introduction of IT support, taking into account the degree of service and reordering points in ordering policies, differentiation of degrees of services on the basis of reliable supplier evaluations and the implementation of a cross-divisional requirements planning process. Finally, numerous improvement suggestions were developed for controlling inventory management. These included the comprehensive recording and updating of ratios (e.g. the introduction of prognostic methods based on an XYZ classification) and a comprehensive supplier evaluation system. With regard to payment terms, a reduction and standardization of regulations was aimed for. Furthermore, the discount rate was increased as was the percentage of discount agreements in the procurement volume. Additional working capital optimization can be realized through the optimization of payment processes and an extension of the time allowed for payment. Numerous product group-specific optimization potentials were also indicated for supplier management. The following identified items are listed below: • Increasing the rate of invitations to tender and volume bundling with invitations to tender; • Executing company location benchmarks; • Initiating renegotiations and the use of linear performance pricing analyses in negotiations; • Searching for alternative suppliers; • Awarding volume-based framework agreements; • Streamlining product range and standardization of materials; • Introducing e-procurement for specific product groups; • Setting fixed prices for external services; • Conducting supplier workshops to determine cost reduction potentials; • Building up suppliers from low-cost countries and expanding global sourcing; • Optimizing manufacturing processes in terms of lower cost procurement; • Consolidating and expanding the supplier base to intensify competition; and • Conducting price structure analyses on the basis of cost breakdowns.

6.3 Performance Measurement Using a Working Capital Management Analysis Tool To illustrate the influence of measures described in Sects. 6.1 and 6.2 on corporate value or EVA and SFGR, a quantitative evaluation was performed. The data used were based on the potential analysis; however, they were appropriately modified

78 Input Relevant procurement volume Weighted average discount time allowed for payment [days] Weighted average net payment time allowed [days] Weighted average of discount rate Discount drawing quota Inventories Accounts payable Accounts receivable Net sales Cost of goods sold Inventory carrying rate Equity capital interest rate Outside capital interest rate Corporate tax rate Equity capital Outside capital Net operativing profit after taxes Net operating assets (NOA)

6

Increasing Internal Financing Power of a Supplier Pre-Project 60,000,000

Post-Project 57,500,000

14

20

30 2% 52% 110,000,000 35,000,000 130,000,000 800,000,000 560,000,000 8% 8% 11% 30% 150,000,000 200,000,000 28,000,000 300,000,000

35 3% 71% 105,000,000 40,000,000 125,000,000 800,000,000 560,000,000 8% 8% 11% 30% 150,000,000 200,000,000 -

Difference –2,500,000 6 5 1% 19% –5,000,000 5,000,000 –5,000,000 0 0 0% 0% 0% 0% 0 0 -

Fig. 6.2 Input parameters of the working capital management analysis tool for the example of the automotive supplier

based on secrecy agreements. Figure 6.2 shows the input parameters used for performance measurement, which have already been used in Chap. 2. They are divided into “pre-project” data and “post-project” data. The fields that can be influenced by purchasing are highlighted in gray. The amount of invested capital (or net operating assets) can be simply calculated as the sum of net working capital and fixed assets minus short-term (interest-free) liabilities. Figure 6.3 presents the results of calculating the EVA. Apart from the cashto-cash cycle and its individual components, the effects on the EVA and market value added are presented. The increase in the EVA is based on a profit increase with a simultaneous reduction in invested capital. The profit increase results from a reduction of tied-up capital and inventory carrying cost as well as an increase in discount value. In this example, it is possible to increase the EVA by about 112% by implementing the presented measures. The values of the sector-specific best-in-class company are used for comparisons. Figure 6.4 shows the effects of the presented measures on the SFGR. Reducing the cash-to-cash cycle time by 9 days and increasing the profit margin by 0.5% points can increase the SFGR from about 14−8%. With operative generated means, the company can thereby finance significantly higher growth and is accordingly well established for an economic upturn. The significant increase in the EVA and SFGR in this case study clearly shows the leverage by purchasing on corporate performance. A structured procedure is here

6.3

Working Capital Management Analysis Tool

Pre-Project

Post-Project

Difference Absolute

Difference Percentage

Best-in Class

7.8%

7.8%

0

0.0%

-

71.7

68.4

–3.3

–4.5%

23.0

59.3

57.0

–2.3

–3.8%

64.0

131.0

125.5

–5.5

–4.2%

87.0

22.8

26.1

3.3

14.3%

79.0

21.6

24.3

2.7

12.3%

32.3

108.2

99.4

–8.8

–8.1%

8.0

–4.2% –7.3% –4.5% 96.4% –4.5%

-

Weighted average cost of capital (WACC) Days Inventory Hold (DIH) [days] Days Sales Outstanding (DSO) [days] Operating Cash Cycle [days] Days Payables Outstanding (DPO) [days] Weighted average payments, liabilities [days] Cash-to-Cash-Cycle [days] Relevant procurement volume Tied-up capital costs Inventory carrying cost Discount value Tied-up funds Net operativing profit after taxes Net operating assets (NOA) Economic Value Added (EVA)

79

60,000,000 16,048,571 8,800,000 626,398 110,000,000

57,500,000 14,874,286 8,400,000 1,230,268 105,000,000

–2,500,000 –1,174,286 –400,000 603,870 –5,000,000

28,000,000

32,678,156

4,678,156

16.7%

-

300,000,000

295,000,000

–5,000,000

–1.7%

-

9,583,870

5,069,585

112.3%

-

4,514,286 €

Fig. 6.3 Calculation of corporate value on the basis of the implemented measures in the case of the automotive supplier

PreProject

PostProject

Difference Absolute

Difference Percentage

Best-inClass

Tie-up Period Cash [days] Operating Cash Cycle (OCC) Cash to Cash Cycle (C2C) Other expenditures

131.0 108.2 65.5

125.5 99.4 62.7

–5.5 –8.8 –2.8

–4.2% –8.1% –4.2%

87.0 8.0 43.5

Sales Percentages Cost of goods sold Other expenditures Total expenditures Return on sales

70.0% 26.5% 96.5% 3.5%

70.0% 25.9% 95.9% 4.1%

-

0.0% –2.2% –0.6% 16.7%

-

–4.1% –2.2% –3.7%

-

21.2% 4.4% 28.2%

-

Tied-up funds (Cash) per Euro Sales Materials expense 0.578 Other expenditures 0.133 Total expenditures 0.711 Self-Financeable Growth Rate OCC SFG Rate OCCs per year Annual SFG Rate

4.9% 2.79 14.3%

0.555 0.130 0.684 6.0% 2.91 18.4%

Fig. 6.4 Calculation of the SFGR for the automotive supplier

–0.024 –0.003 –0.026 1.0% 0.12 4.0%

-

80

6

Increasing Internal Financing Power of a Supplier

essential. An action catalogue is prepared based on an analysis phase, which has the objective of uncovering weak points in procurement and in which benchmarking is carried out with other successful procurement organizations. The implementation phase is time consuming and uses the methods described in the preceding chapters. Following the conclusion of the project, the EVA and SFGR must be given special attention to ensure sustained high performance and bypass the “working capital trap” at a generous distance. This is the function of controlling. In the course of a continuous improvement process, all parties connected with the purchasing department are asked to report any identified weak points to counteract them with further measures. To develop further optimization potentials and achieve a further improvement in the EVA and SFGR, the automotive supplier can take up measures at the supply chain level (see Chap. 5).

Chapter 7

Measuring Procurement Contribution to Corporate Performance using the “Procurement Value Added”

7.1 Measuring Procurement Contribution to Corporate Performance The preceding chapters presented numerous measures that can be influenced by procurement to strengthen the internal financing power of a company. The question here is how the contribution of procurement can be measured regarding internal financing power. Since corporate performance as a ratio has a greater practical importance than internal financing power and has a direct effect on internal financing power, the following section will present the measurement of the procurement contribution to corporate performance using the PVA. The objectives of measuring the procurement contribution to corporate performance are as follows: • Monetarization of measures, which can be influenced by procurement; • Internal and external benchmarking relative to the sector and related to procurement; • Analysis of the development of the procurement contribution over time; and • Identification of procurement-side optimization potential in the supply chain. The following section presents the PVA as opportunity way of measuring procurement contribution to corporate performance.

7.2 Presentation of the Procurement Value Added The PVA includes all value-specific decision parameters that can be influenced by procurement. These parameters can be divided, on the one hand, into the parameters characterized by procurement results (i.e. materials cost, inventory cost and incidental procurement cost). On the other hand, there are those parameters that can be influenced by the utilized capital: inventory and accounts payable (Fig. 7.1). The results of procurement can be reduced by improved product group management, supplier management and risk management. A reduction of the capital employed is achieved, for example, by lean processes, requirement-specific E. Hofmann et al., Ways Out of the Working Capital Trap, Professional Supply Management 1, DOI 10.1007/978-3-642-17271-7_7,  C Springer-Verlag Berlin Heidelberg 2011

81

82

7 Measuring Procurement Contribution to Corporate Performance Result of procurement

Capital employed

Material cost (raw materials, auxiliaries and consumables, fabricated materials, etc.)

Inventories

Warehouse cost (rent, warehouse personnel, infrastructure, insurances, etc.)

Accounts Receivable

Incidental procurement cost (other overhead, transport and transaction cost, etc.)

Product group management

Supplier management

Global sourcing

Processes

Organization

Risk management

Purchase financing

Procurement controlling

Supply management

Fig. 7.1 Influence of procurement subjects on the result of procurement and capital employed

organization and the optimization of procurement controlling, supply management and procurement financing (terms management). Procurement subjects in the company are implemented on three time levels: • Operative level: The short-term and medium-term implementation of measures in subject areas of procurement (Fig. 7.2). • Strategic level: For every subject area of procurement, a target is introduced and a strategy developed of how this target can be reached. • Visionary level: Future trends are included in planning the measures. Future market developments are taken into account in the configuration of the procurement structure. Since all measures have an effect on the expense side and the yield of the capital employed, a measurement within different periods is performed. Not only shortmedium- and long-term optimizations but also visionary and procurement-side optimizations are made measurable by the PVA on corporate performance. The PVA is composed of the costs operatively saved by procurement in one period and of the reduction in capital cost. The first mentioned corresponds to the result of procurement and comes from changes in the cost of materials, the inventory cost and the incidental procurement cost (e.g. transport and transaction cost). On the capital costs side (procurement cost of capital, PCC), a reduction in inventory and an increase in liabilities make a positive contribution to the PVA. Although the capital costs caused by the inventory are calculated by weighted average cost of capital (WACC), capital yields are calculated by an opportunity cost rate, which tends to correspond to the outside capital cost rate since accounts payable can result in crowding out the short-term outside capital.

7.2

Presentation of the Procurement Value Added

83

Visionary view Strategic level Operative level

Product group management

Supplier management

Global sourcing

Processes

Organization

Supply management

Purchase financing

Procurement controlling

Risk management

Fig. 7.2 Time periods and measures for the optimization of procurement subjects

Since external factors also result in sales changes, which have an immediate effect on those parameters influenced by procurement (cost of materials, inventory cost, incidental procurement cost, inventory and accounts payable), these parameters must be adjusted for externally caused fluctuations. For example, if sales increase by 10%, an increase in the cost of materials by 10% should not provide any negative contribution to the PVA. However, the company’s sales also include a margin which is, inter alia, a performance indicator of marketing and distribution. For this reason, all parameters entering into the PVA are not adjusted for sales but for cost of goods sold (cogs). This adjustment is made by a linear method:   cogsneu − cogsalt − Parameterneu Δ Parameter = Parameter alt · 1 + cogsalt

(16)

The following example is used to illustrate this method. A company that reduces its cost of materials from 100 million C to 90 million C and at the same time increases its cost of goods sold from 200 million C to 210 million C will have an adjusted saved cost of materials of 15 million C. Δ Cost of materials

  cogsnew − cogsold − Cost of materialsnew = Cost of materialsold · 1 + cogsold = 100 Mill.

1+

210 Mill. 200 Mill. 200 Mill.

90 Mill.

= 15 Mill.

84

7 Measuring Procurement Contribution to Corporate Performance

Since, for example, procurement costs generally increase degressively with increasing cost of goods sold, scaling effects are considered a performance of procurement. Thus, the PVA presents a value contribution of procurement to corporate performance and can also be used as a benchmark-capable ratio. Since the PVA is an absolute value, it can be related – for better comparability – to an informative ratio of the company, such as sales or corporate value.

7.3 Exemplary Calculation of the Procurement Value Added The following section presents, by way of example, the calculation of the PVA. This requires the input values in Fig. 7.3 for the current period and the prior period. They can be taken from the annual financial statements and the data from accounting. Assumptions are made if no company data exist. In this case, WACC and the opportunity interest rate are assumed to be constant. The PVA is calculated analogously to the diagram presented in Fig. 7.4. The result of procurement within the meaning of cost reduction follows from the sum

Fig. 7.3 Input values for calculating the PVA

PVA

–

Δ Cost of materials

Result of procurement

Δ PCC

+

–

Δ Inventory cost

Δ Incidental procurement cost

Δ Capital cost

Δ Capital yields

x

x

–Δ Inventories

Fig. 7.4 Concept of the PVA

WACC

– Δ Accounts payable

Opportunity interest rate

7.3

Exemplary Calculation of the Procurement Value Added

85

Fig. 7.5 Calculation of the PVA

of the standardized delta of cost of goods sold, inventory cost and incidental procurement cost. The delta of capital costs ( PCC) is calculated as the difference of “delta capital costs inventory” and “delta capital yields accounts payable”. Owing to the difference from the result of procurement and the delta of capital costs, the PVA is finally calculated as 1.73 million C in this example (Fig. 7.5).

Chapter 8

Conclusion

8.1 Summary The preceding chapters described, based on the problem of the “working capital trap”, the measures that can be influenced by procurement and affect a company’s internal financing power. Aspects from various procurement areas were indicated, which are once again briefly summarized below. The success of optimization measures can be determined with ratios: • The calculation of the SFGR can state whether a company is able to manage planned growth on its own by means of its internal financing power. • The cash-to-cash cycle time indicates the tied-up capital period from the time of payment of the goods until the income generated from selling the goods. A short or optimally negative cash-to-cash cycle is the ultimate objective depending on the sector of the industry and involvements within the supply chain. • The success realized by a reduction in cash-to-cash cycle time can be quantified by the EVA. Procurement can improve internal financing power from the corporate viewpoint by means of different packages of measures: • Optimization of payment terms: ◦ The reduction of work expenditure for accounting entries by reducing the multitude of terms to increase the discount utilization quota. ◦ The increase of the discount quota by reducing net periods allowed for payment and increasing discount rates within the pertinent product groups. ◦ The extension of the time allowed for payment for later realization of payment outflows. • Optimization of inventory management: ◦ Inventory reduction through an optimized ordering system. ◦ Adjustment of the safety stock levels by improved information systems. E. Hofmann et al., Ways Out of the Working Capital Trap, Professional Supply Management 1, DOI 10.1007/978-3-642-17271-7_8,  C Springer-Verlag Berlin Heidelberg 2011

87

88

8

Conclusion

◦ Reduction of inventory cost by the use of alternative storage concepts, such as just-in-time or vendor-managed inventory. • Optimization of product group management and inventory management: ◦ The reduction of procurement prices by effective product group management, e.g. by regular invitations to tender. ◦ The reduction of the out-of-stock cost and administrative cost by optimizing supplier management. ◦ The inclusion of risks to safeguard strategic partnerships. However, any optimization from a corporate viewpoint frequently results in deteriorations with upstream suppliers or downstream customers. From a supply chain point of view, internal financing power can be increased by the following measures: • Financing-oriented supply chain sourcing: Reduction of the entire process and product costs through vertical and horizontal cooperation. • Supply chain-oriented supplier financing: Realization of financing benefits by integrating third parties into supplier financing. • Collaborative cash-to-cash management: Cross-company cash-to-cash cycle optimization by utilizing different inventory carrying rates and capital cost rates in the supply chain. • Collaborative cash pooling and netting: Reduction of financing costs by the crosscompany utilization of liquidity. • Supply chain financing platforms: Strengthening internal financing power by the cross-company optimization of financial structures and financial flows. Finally, the PVA was introduced to assess the contribution of measures influenceable by procurement to corporate performance and thereby towards internal financing power. The concept of the PVA includes all value-specific decision parameters influenceable by procurement, with these parameters aggregated to a ratio.

8.2 Outlook In recent years, the procurement function in companies has steadily increased in importance. Some reasons for this development are the rising share of the cost of materials, the great influence of procurement measures on the profit margin and the high volatility of raw materials prices. The significance of purchase financing and SCF have also increased because of the threatening credit squeeze with simultaneously increasing capital requirements. Although many companies have recognized the challenges in this area, suitable instruments are inadequately used in practice. Our explanations show the problems caused by the “working capital trap” and the possible ways out by strengthening the internal financing power of companies. We present not only internal company measures but also cross-company measures.

8.2

Outlook

89

Apart from the latter, the PVA presents one possibility to measure the procurement contribution to corporate performance. This subject area will yield numerous future functions not only in practice but also for science. In practice, it is especially necessary to transmit the presented measures to the procurement functions in the companies. Apart from external consulting, this especially requires that the degree of professionalism of the procurement department is increased (e.g. through further vocational training). To implement supply chain-wide measures, the willingness for cross-company collaboration is especially necessary, as is transparency and trust between the participating parties. Science also has additional research demands. The presented measures, especially at the supply chain level, must be examined in depth and elaborated, and the benefits in practice must be more emphatically pointed out. Moreover, solutions must be developed for the implementation of the concepts (e.g. for the distribution of results because of measures at the supply chain level).

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