Lean Working Capital – Supply Chain Bias and why organizations set themselves up to fail

In a previous article (Lean Working Capital; incremental steps towards your SETPOINT) we discussed why company functions are often inclined towards solutions favoring themselves, with less focus on the carryover effect on neighboring areas of the supply chain – often resulting in a sub-optimization of the supply chain as a whole. We called this inclination SUPPLY CHAIN BIAS. This article will look at the origin of many Supply Chain Biases, namely the budgeting process.

We have over the years worked with a multitude of companies in a variety of industries, many of them with one thing in common: operational inefficiencies and conflicting targets originating indirectly or directly from their respective budgeting process. To be clear, we are not criticizing budgeting as a concept, but rather the way it is being performed in many organizations.

So, what are these issues, and why should we spend time on this? I am glad you asked. As we see it, a company never performs better than the sum of its functions. As an example, a world class sales organization is nothing without a product or service to match – delivered at-quality, on-time and in-full. In order to achieve and sustain this intra-company balance, a company requires a set of basic building blocks: 1.) a shared direction and approach, 2.) aligned and achievable targets, and 3.) stakeholder trust – where trust is often a result of how well you deliver on the first two.

Trust is key in any supply chain: when it is not there, people start building buffers and putting safety mechanisms in place, creating disturbances to the natural flow of supply and demand. As a direct consequence of these imbalances, we often see build up of wrong and slow-moving working capital – reducing flexibility to meet changes in short term demand, and reduced agility to move quickly and respond to new market situations. In many cases, these disturbances also cause inefficiencies impacting quality, service delivery performance and cost.

This is where the budgeting process comes to play as an early disruptor of trust – by setting unachievable, conflicting and/or disproportionally distributed targets across an organization. Ironically enough, the root cause of this behavior is often -- trust (…or rather lack thereof). A typical scenario we often come across can play out as follows:

  1. A company’s Board or CEO does not trust its organization to push the envelope by themselves, assuming any bottom-up budget proposals to be understated, and therefore demands additional X% top-down increase no matter what is presented.

  2. Sales and Operations managers assume the CEO will increase their budget targets no matter what, and therefore understate their respective estimates as a protective measure, thereby turning their behavior into a self-fulfilling prophecy.

The result is a budget with little ownership and a process which breeds frustration and mistrust, causing several fundamental issues: it can produce unsubstantiated and unrealistic sales targets, driving excess inventories alternatively push the organization towards unprofitable sales and/or customers with poor payment performance; it can push for unfounded cost cutting exercises stretching the organization too thin to function properly; it can also disconnect sales from operations, as each stakeholder is busy protecting and optimizing his/her own agenda – often leading to misaligned or even directly conflicting targets.

In short – lack of trust often leads to a funky budget process where top-down push breeds incentive bias and responding safety- and hedging biases (see figure 1. for visual representation – also read more on Supply Chain Bias in our article: Incremental steps towards your SETPOINT). Examples of real-life budget process outcomes setting their organizations up to fail

Example I – Following a larger acquisition the Company looked to strengthen its Balance Sheet by reducing net debt, of which 50% would come from Working Capital. Operations were handed an aggressive top-down inventory reduction target (in value, not days), allocated to respective Business Unit budgets proportional to their share of sales, not their performance or ability to deliver. At the same time, the Sales organization had been told to organically increase revenues by 5%, which they planned to realize by promising the market shorter delivery lead times, which in turn was to be achieved by increased stock levels of large volume and high value SKUs. NA comment: The inventory reduction target turned out to be impossible to reach without significantly damaging sales delivery performance, especially in light of current sales strategy. Nordstrom Advisory helped the Company find sufficient working capital release elsewhere (a large portion through Approved Payables Finance program) whilst also optimizing inventories to the best of each Business Units’ performance. Example II – A Company division had over a period of time seen its single largest customer (c.35% of sales) go out of business, and with it lost a highly predictable and standardized demand. New customers taken on to replace these lost volumes led to a significant shift in production mix, with a subsequent drop in reported productivity. Shortly thereafter, new productivity targets were pushed top-down, reflecting the levels prior change of customer and production mix. This was in turn translated into a pure headcount reduction exercise, with little or no focus on supply chain or process improvements to support. NA comment: Owner’s and Group Management’s push for top-down savings resulted in cuts deeper than operationally sound, with several negative implications on the business as a whole. Nordstrom Advisory was originally brought in to help design and install a S&OP process but ended up performing a full turnaround of the division (now one of the business units’ top performers).

Figure 1. Indicative overview of how Supply Chain Bias is created and spread in response to faulty budget processes

An alternative could be a truly bottom-up process, starting from a blank sheet of paper, where each stakeholder is trusted to provide an unbiased view on what he/she believes is the true potential given current conditions and constraints (i.e., the company’s SETPOINT1), and what the end-to-end process requirements are to make this a reality.

This view should also include what levers and buttons are available to push and pull to move beyond that SETPOINT – and what structural changes are required to make this happen (including comments on investment requirements, resources, time horizon, etc.). The CEO plays an instrumental role in making this happen, by i.) supporting his/her team to look beyond immediate constraints in cases when and where this is required, ii.) aligning organization towards a set of shared targets while securing required conditions for them to succeed; and iii.) managing Board of Directors or Owners expectations.

But how do you make this happen IRL, and is it worth the effort? Unlike our previous articles, we do not aim at presenting an overall answer or recommendation – simply because this is such a broad topic with consequences reaching far beyond just Working Capital – but would rather see this as a start of a debate:

  • Is this an issue in your organization?

  • Should companies be talking about this more – is this important?

  • How do we move beyond funky budget processes?

  • (Alternatively give examples of how funky budgets and/or biases have created bad outcomes in your organization)

Please leave us a comment in the comment section – either on LinkedIn or directly on our website’s news section. We appreciate your input!

Note 1: SETPOINT in this context refers to much more than just the Working Capital steady state we have discussed in earlier articles. Here in also includes True demand, Optimal cost structure, etc.

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