Working Capital Management Challenges

June 2016

Shedding light on working capital management challenges and best practices A study of the manufacturing and distribution industry A research report by Bart Kelly

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Working capital management: A study of the manufacturing and distribution industry

Every senior executive faces the working capital challenge: managing cash for today’s obligations while also investing in tomorrow’s growth. Crowe Horwath LLP conducted the Working Capital Study to help manufacturing and distribution leaders make informed decisions when addressing this challenge.

Working capital is a critical gauge of business health, measuring current assets against current liabilities. While negative working capital can create a cash-flow crisis, too much working capital means that a firm’s cash isn’t working hard enough.

The Working Capital Study explores the challenges and opportunities U.S. manufacturers and distributors face as they work to maintain optimum liquidity while planning for the future.

This report highlights best practices and benchmark performances for working capital management. For example, successful working capital management often is built around lean-thinking operation and financial improvement practices.

The lean objective that drives profitability through operational and financial improvement also directs the management of the business at optimum levels of working capital.

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June 2016

The findings from the Working Capital Study provide insights that will help executives minimize working capital while maintaining or improving quality and service to customers. This delicate balance requires cross-functional collaboration, with the following functions proving particularly important: • Operations: Minimizing process wastes, lowering inventories • Supply management: Improving forecasting and fulfillment with customers and suppliers • Finance and legal: Securing favorable procurement and sales terms • Senior executives: Analyzing and communicating the importance of working capital management

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Working capital strategies and effectiveness The Working Capital Study confirms that most executives realize the importance of optimizing working capital – 32 percent rate it “extremely important” to their company’s success over the next two years, and another 50 percent rate it as “very important.”

Despite the importance and potential outcomes from working capital management, more than half of companies have not implemented a working capital strategy (Exhibit 1).

“Working capital management requires ongoing awareness and consistent, standardized practices throughout an organization,” says Bart Kelly, principal at Crowe. “That can only happen if senior leaders identify working capital management as a core objective.

Developing and implementing a strategic plan to optimize working capital is the first step in demonstrating that.”

The vast majority of executives surveyed (88 percent) also believe that improved working capital management would boost their company’s profit margin.

Exhibit 1: Strategic plans to optimize working capital No intent to develop strategic plan

No strategic plan but considering development

7% 9% Strategic plan in development

46% 24%

54% of companies have not implemented a working capital strategy

Numbers may not total 100% due to rounding.

Strategic plan implemented

14%

Strategic plan developed but not yet implemented

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Working capital management: A study of the manufacturing and distribution industry

About two-thirds of executives agree that the approach to managing certain activities (including accounts payable, accounts receivable, capital expenditures, raw materials inventory, and finished goods inventory) meaningfully affects their working capital management. For example, 68 percent report that raw materials inventory management has a measured impact on working capital management in their organizations.

The problem is that a high percentage of manufacturing and distribution executives don’t recognize the impact of these activities; in fact, some stated they see “no impact.” And still other executives don’t see the connection between daily activities in their companies and working capital. Executives may understand the

general relationship between operations and finance, but don’t have access to specific metrics to track the impact of production decisions on the bottom line.

For example, a fear of being out-of-stock may spur managers to order “just-in-case” inventory – wasting working capital.

This situation is driven in part by the fact that many companies lack effective management of raw materials inventory.

For example, only 60 percent of survey respondents effectively manage their raw materials inventory.

This lack of effective management is unfortunate, because improved processes and policies could reduce working capital by an average 28 percent without negatively affecting business performance.

Addressing working capital challenges

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Issues beyond a company’s control can increase the need for working capital: Executives cite economic factors, unreliable customer-demand forecasts, and industry-related factors as their top difficulties (Exhibit 2). But other challenges are directly or indirectly within executive control and provide opportunities to optimize working capital, including:

remains a largely static process that is not updated frequently – meaning that sales plans, production schedules, inventory volumes, research and development project pipelines, and customer lead times often are out of date. Straightforward approaches to implement a better SIOP can deliver more efficient operations, supply chains, and product development.

• Supply-chain lead times. Vendors can deliver supplies on a just-in-time (JIT) basis or assume ownership in strategic areas (and the working capital burden of inventory) until production begins.

• Inaccurate sales, inventory, and operations planning (SIOP). Shorter product life cycles and increased demand volatility challenge manufacturers everywhere. Yet SIOP at many firms

• Delinquent receivables. Lax invoicing and receivables policies create cash flow problems. Improved management reduces the strain on working capital.

Frequent use of any of these methods can improve management of working capital. Frequent use of all four can result in world-class working capital management — but only 5 percent of companies have achieved that status.

June 2016

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Exhibit 2: Difficulties affecting working capital management = 1 Not difficult

=2

=3

=4

= 5 Extremely difficult

Issues beyond company control Economic factors

1%

17%

Unreliable customer-demand forecasts

5%

Industry-related factors

4%

33%

17%

38%

16%

11%

30%

31%

12%

Seasonality of business

38%

18%

12%

34%

22%

29%

20%

12%

Challenges within executive control Long supply-chain lead times

7%

Inaccurate SIOP

8%

Delinquent receivables

20%

12%

Inability to transfer transaction data to business analytics

21%

Unfavorable supplier contracts

16%

Expeditious payables

13%

Unfavorable customer contracts

13%

Lack of visibility/ transparency to workingcapital performance Poor ERP system drivers or adherence

Other

Numbers may not total 100% due to rounding.

Numbers may not total 100% due to rounding.

10%

16%

28%

9%

13%

10%

33%

30%

15%

7%

30%

32%

14%

8%

41%

35%

31%

31%

12%

Poor credit management/diligence

31%

26%

14%

7%

16%

29%

14%

Aging or obsolete inventory

20%

31%

29%

12%

19%

45%

31%

14%

Access to financing

46%

17%

35%

29%

24%

39%

29%

60%

7%

14%

7%

14%

7%

11%

28%

4%

14%

13%

21%

8%

9%

7%

8%

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Working capital management: A study of the manufacturing and distribution industry

Improve inventory levels, improve sales The faster a company can turn over its inventory, the faster it frees up cash for other purposes. But two-thirds of

companies turn their inventory monthly at best, and 14 percent have three turns or fewer (Exhibit 3).

Exhibit 3: Annual inventory turn rate Don’t know

3 turns or fewer

More than 24 turns 19-24 turns

13%

14%

3% 5% 11%

4-6 turns

28%

13-18 turns

27% 69% of executives report they turn inventory monthly at best 7-12 turns

Companies frequently fail to implement the following four best practices for working capital although doing so could vastly improve an organization’s working capital management:

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1. Formalizing collaboration with suppliers: 15 percent “frequent” vs. 23 percent “infrequent”

3. Creating business analytics of working-capital factors: 12 percent “frequent” vs. 23 percent “infrequent”

2. Building timely and detailed dashboards of working capital performance: 12 percent “frequent” vs. 28 percent “infrequent”

4. Formally collaborating with customers: 10 percent “frequent” vs. 29 percent “infrequent”

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Crowe Horwath LLP

What’s more, 25.5 percent of a typical company’s total inventory is more than 180 days old. This poses a major risk: The longer inventory sits, the more likely those goods are to become obsolete.

Not surprisingly, almost two-thirds of companies hold obsolete inventory or inventory write-offs worth 1 percent

or more of annual sales. And one in 10 companies holds obsolete inventory worth 4 percent or more of annual sales.

Much of this obsolete inventory and write-off damage is self-inflicted — it’s the result of unsolved problems such as poor scheduling, production, and supplier management (Exhibit 4).

Exhibit 4: Factors responsible for obsolete inventory Volatile market factors

28%

Poor economy

17%

Poor scheduling processes

27%

Poor production processes

15%

Poor suppliermanagement processes

14%

Lack of visibility into work-in-process inventory levels

14%

Poor logistics processes

12%

Lack of visibility into material and components inventory levels

12%

Lack of production visibility

11%

Lack of visibility into finished-goods inventory levels

8%

Other

7%

No problem with obsolete inventory or inventory write-offs

Numbers may not total 100% due to rounding.

Much of obsolete inventory and writeoff damage is the result of unsolved planning and production problems.

11%

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Working capital management: A study of the manufacturing and distribution industry

“Manufacturers and distributors invest significant cash into their inventories — raw material and components, work-in-process inventory, finished goods — but often hold too much inventory due to fears of unexpected customer demand (buffer inventory) or inefficient production and supplier processes (overstock), or they hold the wrong inventories,” says Kelly. “Improved inventory management can reduce the need for working capital, minimize obsolete inventories, and even boost revenues.”

Indeed, three-quarters of executives say that annual sales would increase if they had the right inventories (Exhibit 5).

There’s a toolbox full of best practices available to better manage inventories, but no single technique is used by a majority of companies, and 4 percent of firms don’t use any of them (Exhibit 6). This is surprising. Even techniques once embraced only by companies using lean thinking for improvement – pull systems, kanbans, quick changeovers – are increasingly common today. Other practices such as lead-time indicators, reorder inventory levels, supplier penalties, and rewards are just manufacturing common sense.

Exhibit 5: Effect of right inventories on annual sales Don’t know No change

More than 10% increase

5%

7% 19%

26% 6-10% increase

44% 1-5% increase

75% of executives say that annual sales would increase if they had the right inventories.

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June 2016

Crowe Horwath LLP

Exhibit 6: Inventory management practices Lean materialmanagement techniques (pull, flow, kanbans)

45%

Detailed inventory analysis (plan for every part)

44%

Segmented stock and reorder inventory levels

41%

Vendor-managed or -owned inventories

35%

Lead-time indicators

34%

Radio frequency identification (RFID) and computerized inventory tracking

32%

Quick changeover of equipment

31%

Production smoothing and level loading

31%

Just-in-time or milk-run supplier deliveries

29%

Periodic stock-keeping unit (SKU) rationalization and portfolio management

20%

Supplier penalties or rewards for on-time performance Other No practices to manage inventories

17%

1%

4%

Surprisingly, no single technique is used by a majority of companies, and 4 percent report they don’t use any of them.

Numbers may not total 100% due to rounding.

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Working capital management: A study of the manufacturing and distribution industry

Managing the cash-to-cash cycle Companies generally balance their incoming cash flow from customers with cash going out to suppliers at about the same rate (Exhibit 7).

This cycle accentuates the need to optimize fluctuations and increases in inventory requirements.

Exhibit 7: Average age of accounts Accounts receivable

Accounts payable

30 days or less

14%

16%

31-60 days

52%

51%

61-90 days

25%

25%

91-120 days

6%

5%

121-150 days

1%

0%

151-180 days

1%

1%

181-365 days

0%

0%

More than 365 days

1%

1%

Many executives report that they hold advantages in contract terms with both customers (accounts receivables) and suppliers (accounts payable) (Exhibit 8).

But companies could still do more to improve their terms and cash positions, evidenced by the 16.1 percent of accounts receivable more than 180 days old.

Exhibit 8: Description of account terms Accounts receivable terms with customers

10

Accounts payable terms with suppliers

Very advantageous for company

12%

Very advantageous for company

11%

Advantageous for company

35%

Advantageous for company

41%

No advantage for company or customers

33%

No advantage for company or suppliers

37%

Advantageous for customers

18%

Advantageous for suppliers

9%

Very advantageous for customers

1%

Very advantageous for suppliers

3%

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Crowe Horwath LLP

“Financial executives need to go beyond the first layer of the reports they receive on their receivables and payables to confirm that balances and activity meet contract terms and corporate expectations,” says Doug Schrock, managing principal of

manufacturing and distribution services at Crowe. “For example, we often see companies exceeding their commitments to suppliers, creating an unnecessary draw on working capital.”

Manage and monitor capital expenditures Most manufacturers and distributors invested more than 2 percent of sales in capital equipment over the past 12 months, and plan to do so again in the next 12 months. About a third of companies invested 6 percent or more of sales in capital equipment.

Capital expenditures represent a sizeable component of working capital for industrial organizations. Yet a majority of companies earn a 20 percent or less return on invested capital (ROIC) (Exhibit 9).

Exhibit 9: Return on invested capital More than 30%

Less than 10%

7% 18% 16% 21-30%

58% 76% of companies earn a 20 percent or less return on invested capital.

10-20%

The most common practices to manage accounts receivable are: • Early detection and alerts of late payments: 56 percent • Front-end credit review: 54 percent • Responsive escalation process: 41 percent • Accounts receivable segmentation analysis: 37 percent • Stratified terms by customer type: 18 percent • Use of outside collections-service providers: 16 percent • Incremental penalties: 16 percent • Enhanced post-mortem review: 16 percent

Numbers may not total 100% due to rounding.

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Working capital management: A study of the manufacturing and distribution industry

During the Great Recession, many companies shelved their capital expenditure plans. Even as the economy rebounded, capital expenditure hesitation remained.

Younger manufacturing executives now may be purchasing long-term assets for the first

times in their careers, and even seasoned executives may be rusty in evaluating capital expenditures. This is reflected in the limited effort expended by most firms in managing (Exhibit 10) and monitoring (Exhibit 11) capital expenditures.

Exhibit 10: Practices to manage capital expenditures Standardized capital project proposal process

48%

Capital-management team or committee

46%

Tracking all proposals and capital expenditure projects in a single portfolio

36%

Project portfolio segregation (such as by risk or by need)

33%

Standardized capital expenditure proposal input data

33%

Capital expenditure project-stage-gate reviews

24%

Standardized capital expenditure project tracking measures

31%

Standardized capital expenditure post-project tracking metrics (such as ROIC) Other No practices to manage capital expenditures

12

22%

1%

3%

June 2016

Crowe Horwath LLP

Exhibit 11: Metrics to gauge effectiveness of capital expenditures 53%

Payback period

ROIC

43%

Return on assets (ROA)

42%

Net present value (NPV)

34%

Internal rate of return (IRR)

34%

Benefit-to-cost value

33%

Hurdle rates

Other No metrics to gauge capital expenditure effectiveness

20%

0%

4%

Numbers may not total 100% due to rounding.

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Working capital management: A study of the manufacturing and distribution industry

Collaborate with supply-chain partners to minimize working capital Manufacturers typically work with a large number of customers and suppliers and have an opportunity to optimize working capital by focusing on their core supplychain relationships: • 37 percent of suppliers provide 80 percent of purchased materials and components.

• 45 percent of customers account for 80 percent of product sales.

Yet only a small percentage of companies takes full advantage of these opportunities to better manage incoming and outgoing inventories (Exhibit 12). Collaboration with supply-chain partners via shared forecasts (customers) and production schedules (suppliers) improves inventory management.

Enhanced collaboration also can generate other benefits, such as improved capabilities (including knowledge, best practices, and intellectual-property sharing), and capacity (facility and resource sharing).

Exhibit 12: Level of inventory collaboration and coordination = 1 Never

With suppliers

With customers

14

=2

=3

=4

6%

10%

June 2016

= 5 Continuously

11%

36%

13%

35%

41%

13%

22%

Crowe Horwath LLP

14%

A critical success factor in satisfying customers is delivery performance, and half of companies deliver to their customers in two weeks or less (from receipt of order to delivery).

helps to evaluate and understand which customer sales drive the most business success.” Although a dynamic, ongoing assessment of market segmentation in terms of products, lead times, pricing, margin, and terms is critical, even for basic measures, this type of assessment rarely occurs (Exhibit 13).

“In the era of e-commerce, speed is expected,” says Kelly. “This puts tremendous pressure on the business, often resulting in ill-advised downstream practices, such as excessive inventories and overproduction. An upstream perspective — better demand forecasting and collaboration with customers — can reduce the pressure and minimize working capital tied up in inventories. It also

Executives also must extend best practices and analysis upstream through the supply chain. Improved supplier performance — speed, cost, and delivery — has a direct impact on working capital. Only by monitoring and evaluating suppliers vs. performance criteria can vendors be expected to improve (Exhibit 14).

Exhibit 13: Frequency of formal sales segmentation and analysis = 1 Never

=2

=3

=4

= 5 Continuously

Product margin

3% 3%

Product sales

3% 6%

Customer

3% 6%

SKU

Customer location

25%

27%

Numbers may not total 100% due to rounding.

28%

35%

15%

17%

29%

36%

29%

20%

11%

41%

23%

35%

27%

20%

22%

24%

13%

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Working capital management: A study of the manufacturing and distribution industry

Exhibit 14: Frequency of formal supplier evaluations Never

Annually or less frequently

Quarterly

Monthly or more frequently

Quality and reliability

2%

24%

Delivery to schedule

3%

22%

Total cost

3%

25%

Service

3%

26%

24%

26%

20%

Specification compliance

3%

29%

29%

20%

19%

Delivery lead time

3%

28%

Regulatory compliance

9%

Upside and downside flexibility

28%

25%

22%

26%

29%

20%

26%

26%

20%

24%

37%

15%

34%

34%

Ethics and governance

20%

37%

June 2016

16%

18%

29%

21%

25%

29%

24%

Environmental performance

Labor practices

16

Semi-annually

14%

22%

21%

38%

12%

16%

Crowe Horwath LLP

8%

16%

7%

16%

6%

16%

5%

Improving working capital Improved working capital management requires executive time and attention, creation of a detailed strategy, and vigorous implementation of best practices in operations and across the supply chain.

The data and ability to optimize working capital are available in every company, and only require senior leadership’s commitment to begin a journey toward improved financial health.

Working capital study methodology and participants The Working Capital Study was conducted in February and March 2016 with participants including a panel of manufacturing and distribution executives.

The study received 153 valid submissions.

Responses to the Working Capital Study were received from a variety of executive positions (titles), entities (public, private), company sizes (revenues and employees), and industries.

Approximate title Operations or manufacturing director or comparable

22%

Other senior-level executive or VP

18%

VP operations or comparable

14%

President or CEO

11%

Plant-level manager/leader

7%

CFO

7%

Chief Information Officer (CIO)

6%

VP finance or comparable

5%

Chief Operating Officer (COO)

4%

VP information technology or comparable

3%

Chief Marketing Officer (CMO)

2%

VP supply chain or comparable

1%

Chairman

1%

Other

0%

Numbers may not total 100% due to rounding.

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Working capital management: A study of the manufacturing and distribution industry

Approximate annual revenue

Corporate structure Private-equity-owned company

$251 million to $500 million $501 million to $1 billion

7% 8%

$10 million to $50 million

5%

26% 58%

14% $101 million to $250 million

More than $5 billion

15%

$51 million to $100 million

44%

16%

14%

Public company

$1 billion to $5 billion

Approximate employees 50,001 to 100,000 5,001 to 10,000 7%

501 to 1,000

5%

101 to 500 29%

8%

58%

9% More than 100,000 12% 10,001 to 50,000

16% 14%

1,001 to 5,000 Less than 100

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51% Private company

Industries in which company participates Machinery and industrial equipment

15%

Electrical and high tech

14%

Fabricated metal products

14%

Automotive

12%

Consumer packaged goods (except food, beverage, and tobacco)

11%

Construction materials

10%

Chemicals

9%

Food, beverage, and tobacco products

9%

Plastics and rubber

5%

Wholesale and distribution

5%

Life sciences

4%

Primary metals

3%

Textiles and apparel

3%

Wood and paper products

2%

Other

16%

Numbers may not total 100% due to rounding.

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About the Crowe Manufacturing and Distribution Services Group The Crowe M&D services group is one of our largest groups, serving more than 2,000 M&D clients coast to coast. Our clients range from Fortune 500 to midmarket companies with overseas operations, as well as foreign-based companies operating in the United States. With more than 600 industry-experienced professionals serving M&D clients, our equal-sharing partnership model provides clients with the right team of people and solutions without organizational barriers.

About us Crowe Horwath LLP is one of the largest public accounting, consulting, and technology firms in the United States.

Connecting deep industry and specialized knowledge with innovative technology, our dedicated professionals create value for our clients with integrity and objectivity.

We accomplish this by listening to our clients – about their businesses, trends in their industries, and the challenges they face.

We forge each relationship with the intention of delivering exceptional client service while upholding our core values and our industry’s strong professional standards. Crowe invests in tomorrow because we know smart decisions build lasting value for our clients, people, and profession.

Learn more Bart Kelly is a principal with Crowe Horwath LLP and can be reached at +1 404 442 1627 or bart.kelly@crowehorwath.com.

crowehorwath.com/mfg

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This material is for informational purposes only and should not be construed as financial or legal advice. Please seek guidance specific to your organization from qualified advisers in your jurisdiction. © 2016 Crowe Horwath LLP, an independent member of Crowe Horwath International crowehorwath.com/disclosure

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