In a previous article (Lean Working Capital: the gift that keeps on giving) we introduced the concept of a working capital steady state in which all underlying processes operate in harmony, impacting not only Cash Conversion, but also Top-Line and Cost. We called this a company’s SETPOINT.
In the same article, we argued a Setpoint is defined by the company’s underlying processes and inherent supply chain constraints: Predictability, Complexity, Capacity, and Lead-time. This article aims at explaining the Setpoint construct in more detail – using inventory as a practical example, through the eyes of Nordstrom Advisory’s fictional alter ego: Celena Noch. Celena is a representation of our combined experiences, with flavor from some of the real-life Supply Chain hero’s and their struggles we have encountered over the years. If all goes well, she will be a recurring theme in our future articles.
However, before we let Celena take it away, we would like to emphasize a few additional pieces of the Setpoint puzzle, namely:
#1. A SETPOINT is company specific A Setpoint denotes an optimal position a company should sustain given its current conditions and constraints (working capital or other). It represents the best possible performance without any structural changes to existing processes or supply chain set-ups.
#2. A SETPOINT is fact based A Setpoint is calculated based on factual evidence, grounded in the structural set-up of your supply chain – not a subjective construct.
#3. A SETPOINT IS NOT A FIXED VALUE AMOUNT BUT A DEPENDENT VARIABLE A company’s optimal working capital is directly affected by volume and changes to mix. The absolute values can and will change over time, which is why a setpoint is defined as a dependent variable: in case of working capital, typically expressed in days (e.g., Days Sales Outstanding, Days Payables Outstanding, Days Inventory Outstanding).
With that said, we leave the floor to Celena: She had recently started a new job as Supply Chain Director with an Industrial Manufacturer – Bluth Industries. As she moved through the first days on the job, her general appreciation for the company grew. Yes, there were many things she would like to work with and improve, but the overall foundation was solid, and the people she met so far felt competent.
There were only two things troubling her: Celena had realized one of the key financial targets she had inherited was unsubstantiated, with little or no ownership amongst key stakeholders: an overall inventory reduction of 15%. The other troubling thing was the dead body she just found hidden in a broom cupboard. This being a management handbook, and not a murder mystery novel, Celena soon focused her attention on the most pressing and relevant matter. Inventory reduction.
Celena had first learnt about the inventory target in one of her orientation meetings. When asking who came up with this opportunity, Celena was told this was a top-down decree, as part of a larger working capital optimization initiative. Her team had so far not managed to understand how this could or should be realized but had decided to wait for Celena to sort it out. Starting to feel a bit annoyed, Celena rose from her chair too fast and accidently pushed a flowerpot off the table, sending it crashing into a million pieces across the floor. “No worries – I will fix this” she cried out as she rushed out of the room to find something to clean up the mess. “There is a broom cupboard down the corridor” was the last thing Celena heard before exiting the door.
Eventually, back in her office, Celena contemplated her next move. She knew she would not be able to challenge the feasibility of the planned inventory reduction, let alone execute on it, unless she herself first understood what inventory was required to sustain operations.
“Bringing down inventory is easy. Doing it without negative impact on delivery performance, quality and cost is harder” Celena thought as she picked up her phone and started dialing. Well versed in Lean Working Capital methodology, she set out to understand the company’s inventory Setpoint.
“I first need to split this elephant into manageable and bite sized pieces” she thought as she asked her team for a transaction data report of all material movements last 12 months, as well as monthly closing inventory balances for the period. She then grouped the inventories and their related consumption by location and type, divided into relevant performance sub-categories. This helped her get an understanding of what stock keeping strategy should apply for each.
Her next move was to collect and review the Item Master data files, making sure they contained accurate planning and replenishment parameters, reflecting each items’ applied stock keeping strategy requirements. Celena thought of this information as the backbone of supply chain management: “without it we wouldn’t be able to make good decisions” she thought – “rubbish in equals rubbish out...”. Finally content the information was good enough, Celena was ready to simulate the company’s inventory Setpoint.
Celena knew the reduction target was set against last year-end’s inventory closing balance, so that was her starting point for comparison: a DIO of 50 days, equal to $780m. When running her initial analysis, she concluded the Company’s aggregated Setpoint at that point was roughly 10% lower: a DIO of 45 days, equal to $700m (see figure 1).
Figure 1. Simplified SETPOINT analysis overview
“So, there seems to be an opportunity to reduce inventory by 10% without any structural changes” Celena thought as she was studying the data. However, she also realized it was not all about inventory reduction. Some of the Company’s high volume stock items were actually kept dangerously low compared to their Setpoint level, thereby running the risk of stock-out and missed sales opportunities (figure 1: note 1).
The excess inventory could be found in product categories B and C (figure 1: note 2), as well as a large portion of inventory with no movement at all (figure 1: note 3). Celena had seen this many times before: “it is fascinating how often lower volume slow-moving working capital items are allowed to occupy space at the expense of in-demand high-runners” she thought. This would have to be adjusted.
However, she knew from experience it was never that easy. In order to sustainably bring down this inventory to its Setpoint level - without shocking the organization - she would first have to understand what Supply Chain Biases created these extra buffers in the first place. Celena would schedule some root cause analysis work sessions first thing in the morning to look into this, and kickstart a set of incremental improvement activities. She would also review what structural improvements would be relevant, to potentially find a new and improved Setpoint level to aspire.
Celena leaned back into her chair and felt good about the situation. She was on the right path and would soon be ready to have a meaningful discussion with the CEO regarding current and future inventory targets: not only optimizing working capital but also delivery performance and cost. Now she could focus on the other issue at hand…
Celena will be making guest appearances in future articles, where we will follow her daily strive towards a lean and efficient supply chain organization. More on Nordstrom Advisory’s LEAN WORKING CAPITAL and Celena Noch in coming articles - stay tuned.