Management Decision

Emerald Article: Working capital management: an urgent need to refocus Maynard E. Rafuse

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To cite this document: Maynard E. Rafuse, (1996),"Working capital management: an urgent need to refocus", Management Decision, Vol. 34 Iss: 2 pp. 59 - 63 Permanent link to this document: http://dx.doi.org/10.1108/00251749610110346 Downloaded on: 22-12-2012 References: This document contains references to 18 other documents Citations: This document has been cited by 3 other documents To copy this document: permissions@emeraldinsight.com This document has been downloaded 5896 times since 2005. *

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Maynard E. Rafuse, (1996),"Working capital management: an urgent need to refocus", Management Decision, Vol. 34 Iss: 2 pp. 59 - 63 http://dx.doi.org/10.1108/00251749610110346 Maynard E. Rafuse, (1996),"Working capital management: an urgent need to refocus", Management Decision, Vol. 34 Iss: 2 pp. 59 - 63 http://dx.doi.org/10.1108/00251749610110346 Maynard E. Rafuse, (1996),"Working capital management: an urgent need to refocus", Management Decision, Vol. 34 Iss: 2 pp. 59 - 63 http://dx.doi.org/10.1108/00251749610110346

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Working capital management: an urgent need to refocus

Maynard E. Rafuse Managing Director, Bennecon Limited, Process Analysis and Stock Management Consultants, London, UK

Argues that attempts to improve working capital by delaying payment to creditors is counter-productive to individuals and to the economy as a whole. Claims that altering debtor and creditor levels for individual tiers within a value system will rarely produce any net benet. Proposes that stock reduction generates systemwide nancial improvements and other important benets. Urges those organizations seeking concentrated working capital reduction strategies to focus on stock management strategies based on lean supply-chain techniques.

Creditor management is essentially a Darwinian situation, the survival of the ttest. Large companies enforce their terms with smaller companies, who in turn enforce their terms with those smaller yet. The apparent intention of many UK companies is to defer payment as long as possible, often well beyond the agreed arrangements. Most purchase agreements will incorporate a single monthly payment, normally end-month following, but often into the second month following or later yet. Actual payment frequently goes well beyond the agreed terms. This article proposes that improvement of working capital by delaying payment to creditors is an inefficient and ultimately damaging practice, both to its practitioners and to the economy as a whole. Stock reduction strategies, drawing on some of the techniques of lean production are far more effective, and the article proposes that those seeking concentrated working capital reduction strategies should focus on stock reduction. A report issued in 1994 by the Forum for Private Business (FPB), a UK small-business trade association, states that on average its respondents debtor accounts were paid more than 50 days beyond the agreed due date[1,2]. The absolute data are shown in Table I. The report indicates that SMEs had average gross debtors of at least 40 billion outstanding. This total was reduced by 20 billion when the SMEs creditors were netted off, leaving a net balance of 20 billion to fund. This net balance was the amount owed to SMEs by non-SMEs and, coincidentally,

Table I Small and medium-sized enterprises debtor levels ( billions) Item Grossa debtors Netb debtors

Management Decision 34/2 [1996] 5963 MCB University Press [ISSN 0025-1747]

Total 40 20 Overdue 20 10 Notes: Small and medium-sized enterprises are taken as those with less than 5 million turnover, VAT registered aTotal debtors bDebtors less creditors

equated almost exactly with the SMEs overdue debtor level. Netting overdue debtors and creditors leaves a net SME overdue balance of 10 billion. Again, this is the overdue balance owed to SMEs by non-SMEs, essentially by large companies with more than 5 million turnover. (The netting process should eliminate all intra-SME transactions.) To summarize this rather convoluted set of data, SMEs are effectively providing 20 billion of net funding to their larger customers. Half of this arises from net late payment of the SMEs debtor accounts. The small supplier often has little redress in this situation, believing strenuous collection effort could jeopardize his volume. The total interest incurred by small businesses to fund 10 billion of late payments by larger companies will be about 1.5-2.0 billion per annum. The SME cost to fund the total net debtor balance of 20 billion will be 3-4 billion per annum. (These estimates are based on average business cycle SME borrowing rates of 15-20 per cent.) These are very large sums indeed. Most of this interest cost will, of course, be offset by interest savings in the larger companies, which is small consolation to the SMEs. However, the annual system oncost would be 300-500 million, based on a typical SME nancing penality of 3-5 per cent. What system-wide nancial or operating benets could conceivably arise from this situation? Somehow smaller companies must pass on their increased borrowing (and administrative) costs, although they frequently seem to perish in the attempt. Working capital starvation is generally credited as a major cause if not the major cause of small business failure in the UK. However, these interest and administrative penalties cannot usually be quantied precisely by the SMEs larger customers. They are subsumed in the complex web of data developed during price negotiations. As a result, these oncosts can often be simply ignored, apparently on the principle that if a phenomenon is not readily apparent in the numbers, it does not exist. However, it is evident that there are signicant penalties arising from this situation. Ultimately these penalties must enter the product cost stream.

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Maynard Rafuse Working capital management: an urgent need to refocus Management Decision 34/2 [1996] 5963

Very close supplier-customer partnerships are an essential characteristic of modern lean value systems. These systems, as so much else, were developed by Toyota and others in Japan over a period of 20-30 years. They entail tightly controlled, preventionbased processes; no duplication of effort or capability; shared continuous improvement; and more technical (and more relevant) aspects such as extensive data sharing, EDI, paperless ordering and delivery systems, automatic payment techniques, etc.[3-6]. There is now a large body of evidence to demonstrate that lean production and distribution are systematically superior to traditional mass production in all essential respects quality, cost and customer service by an order of magnitude. The data in Table II shows the level of performance advantage achieved. The lean approach has been adopted by many of those companies which could be characterized as world-class. Lamming[5] and his colleagues argue persuasively that all signicant product value systems will ultimately adopt the lean approach, particularly in respect of those technical transactional elements most relevant here. A detailed review of the operational characteristics of lean world-class companies is beyond the scope of this article. However, one key characteristic they exhibit is what might be termed an enlightened approach to supplier management. As a simple example, a selection of worldclass UK companies would include such names as Beecham, Glaxo and Welcome (as was) in health care; Sainsbury and Tesco in food retailing; and Boots, Great Universal Stores and Marks & Spencer in general retailing. Recent creditor levels for this group of companies were almost 30 per cent lower (in terms of payment days outstanding) than for comparable large rms in the health, food

Table II World-class (WC) plants Category Productivity index Defects index Space index Capacity utilization(%) Stock index Deliveries/day: From suppliers To customers WC plants 100 1 100 94 100 1.4 2.7 Non-WC plants 45-68 16-170 108-220 84 150-290 0.5 0.8

Note: WC plants = 13; Non-WC plants = 58 Source:[6] [ 60 ]

and retail sectors. Simultaneously the operating margins of these eight world-class companies ranged from 40 per cent to 150 per cent above their sector comparators. For the most part the companies designated as worldclass also had far lower stock levels, particularly Sainsbury, Tesco and Marks & Spencer. These three companies are bywords for excellence in British retailing and also stand up well in international comparisons. It is of course unlikely that there is a direct critical causal relationship between creditor days and margins achieved. Both are outcomes of a wide range of operating factors. However, the substantially lower level of creditors would appear to reect a fundamental difference of approach to supplier management within the world-class companies. Wal-Mart, the US retail discounter, provides another revealing example. Wal-Mart has grown at an extraordinary pace over the past 15 years, to become the largest, most protable retailer in the world[7,8]. In the process, Wal-Mart has revolutionized operating practices in the US retail industry, a quite remarkable achievement. Very close, responsive supplier relationships have been a key strategic element in this development. Wal-Mart expects the highest standards of performance from its suppliers. It provides excellent performance in return, for example better terms, with the average time to pay suppliers just 29 days. This compares to 45 days for K Mart (i.e. 55 per cent higher). Back in 1979 K Mart was much larger than Wal-Mart, with eight times as many stores. Today it is a poor second in every important respect (e.g. over 40 per cent more stock). Clearly there is much more to Wal-Marts success than how quickly suppliers are paid. Nevertheless, responsive supply partnerships, what has been termed shared destiny procurement, is clearly a key element contributing to the success of Wal-Mart and the best lean, world-class companies. Sainsbury, Tesco and Marks & Spencer in the UK display a similar pattern. In essence, suppliers must be treated with the same care and consideration as employees. (No responsible manager would dream of paying his staff 50 days late.) However, shared destiny relationships can quickly founder when a large company embarks on a working capital programme. Extending the supplier payment period is always the easiest option. Outdated and discredited adversarial attitudes soon re-emerge. There is a good deal of evidence to support the view that UK companies are particularly remiss in this area. For example, the level of late payment in the UK is much higher than elsewhere in the EEC, even compared with such supposedly poor performers as Italy, Ireland or France[9] (see Table III).

Maynard Rafuse Working capital management: an urgent need to refocus Management Decision 34/2 [1996] 5963

Table III Late payment of business debts (average number of days beyond agreed terms) Country 1989 1994 24 19 37 34 18 49

France 28 Germany 18 Italy 34 Ireland 34 Sweden 18 UK 51 Source: Dunn & Bradstreet data quoted in[2]

the relationships between large and small companies which currently prevail. (However, one could no doubt anticipate strong objections from many large companies.) It has often been said that the UK suffers a comparative lack of entrepreneurial smallbusiness people. The issues discussed earlier must be contributing factors for many who conclude that these sterile battles are simply not worth the ghting. The simple proposition on VAT payment rules would change this situation quickly and completely .

Why should this be so? Why do UK managers routinely ignore the terms of the bargains they have struck with their suppliers? Very similar arguments can be advanced in the case of debtors, where aggressive collection action by large companies only succeeds in transferring resources from their smaller customers. No net system benets whatsoever will arise from this process.

Administrative costs and value added

It is clear that the bulk of the effort devoted to managing debtors and creditors throughout the economy is essentially wasted. These administrative processes add no value. An interrm (that is, a transactional) process needs to be examined in the same manner as any other operating process and steps should be taken to drive out the waste elements. Operating parameters necessary to ensure a no waste, right rst time, process must be established initially . Prevention-based controls are then implemented to maintain the process within these limits. This systematic approach to process management is not essentially different from controlling an operation in a factory . Greatly improved transactional systems have been achieved in a number of cases, for example with auto industry suppliers in Japan, the USA and the UK. Many of these buyer-seller relationships will involve: long-term supply contracts; regular, small volume call-offs and deliveries, based on EDI and minimized order instability; incoming inspection eliminated at buyer plants, based on strict process control at vendor plants; similarly, duplicated clerical routines eliminated at buyer plants, such as part counts, receiving slips, invoice matching, price checking, etc; electronic data entry, using barcodes, electronic Kanban, etc., based on shipping plant inputs; vendor billing using EDI links; programmed supplier payments at set, short intervals from delivery (e.g. four weeks maximum) using digital transmission arrangements; requisite process controls on the administrative elements. Several of the major UK retailers have made signicant progress along these lines. There are also a number of programmes in North

Possible solutions
Proposed solutions to the SMEs overdue debtor problems often seem to be highly questionable. In particular, the statutory right to interest on overdue accounts (as proposed for example by the FPB and others) is clearly not the answer. This is a lawyers solution. Most small companies would hesitate to invoke the right for fear of alienating their customers[10]. In any case, suppliers do not want interest, they want their money . They want to be paid what is due to them, when it is due and not have to waste a lot of time and effort on collection. They certainly do not want to have lawyers involved. This would only serve to destroy any lingering shared destiny relationship that might still exist. A much better proposition has been put forward by Professor Colin New of Craneld Universitys School of Management. His proposal is that buyers could only reclaim input VAT on suppliers invoices which are paid within a specied maximum period, say 30 days or end-month following. This approach would quickly level the playing eld, concentrating large (and small) buyers minds, eliminating much wasteful collection effort. A cost penalty of 17.5 per cent would change payment priorities very rapidly . The proposition is, of course, entirely nondiscriminatory as between large and small businesses. By this one means the Government could take a major constructive initiative on behalf of SMEs, eliminating many of the inequalities (not to say iniquities) inherent in

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America to reduce transaction and replenishment costs in the retail industry . These socalled quick response (QR) or efficient consumer response programmes are essentially designed to improve lead-times and customer service, while substantially reducing stocks and transaction costs. They frequently involve direct supplier access to daily retail sales and stock data, coupled to automatic replenishment arrangements. Ambitious targets have been established to drive excess cost out of distribution systems. Apart from the immediate prot potential, it is important to improve the cost position of conventional retailing systems in the face of growing competition from electronic shopping media[1115]. The potential reduction in the traditional cost of debtor and creditor management, at both ends of the supply chain, is apparent. Ultimately it should cost companies little more to manage supplier payments and customer receipts than it does to manage employee payments. The key requirements are to eliminate unneeded or duplicated process steps and to ensure fully digitized processing is implemented at all stages in the transaction systems. Forward-looking nance managers will be well advanced along this path.

Reducing stock is not as simple or readily understandable as increasing creditors or reducing debtors. As a result it can be bypassed by those looking for quick, seemingly easy solutions[18]. However, the benets of stock reduction are real and substantial and not simply a result of shuffling resources around a value system. Stock reduction is where working capital management attention should be concentrated, particularly by senior nance personnel in large companies. In our experience a good proportion of these nance managers will take the view that these arguments are good in theory, but not in the real world. In the event, when cash ow pressures arise, suppliers (and even customers) are invariably the rst to feel the draught. Apart from being ethically questionable, this reects dangerous short-termism. Sustaining such attitudes will surely serve only to undermine the position of nancial managers in the longer term. Ultimately most of the wasteful activity now found in transaction processes will be eliminated. That is the way capitalism works. The thoughtful manager will be pursuing these important opportunities today .

Notes and references

1 Statistics are taken from the paper published by the FPB[2], a small-business lobbying organization, based on a survey of 18,000 VAT registered small companies with less than 5 million turnover. The data from the detailed survey were tested and analysed by the University of Nottinghams Economics Department to produce the summary report. The output is considered to be sound and, if anything, underestimates the scale of the problem, as not all small businesses were covered. It essentially corroborates earlier studies in this area. 2 Report on Small Firms & Late Payments, Forum for Private Business, Cheshire, 31 March 1994. 3 For further discussion of lean systems see [4-6]. These essential documents originate from the International Motor Vehicle Programme, co-ordinated by MIT during 1985-1990, with substantial UK input. 4 Womack, J.P., Jones, D.T. and Roos, D., The Machine that Changed the World, Rawson Associates, New York, NY, 1990. 5 Lamming, R., Developing lean supply chains, paper presented to the British Production & Inventory Control Society Conference, October 1994. 6 The Second Lean Enterprise Report, Andersen Consulting, Cardiff Business School and University of Cambridge, December 1994. 7 See[8]. This important article provides, inter alia, a potted history and analysis of Wal-Marts rapid and sustained progress.

Stock management
None of the serious deciencies associated with creditor and debtor management applies to stock reduction. This is a wholly benecial process, if managed properly . Most stock is simply physical evidence of wasted time and wasted resources throughout a value system over 80 per cent of the stock in most systems[16,17]. Reducing stock produces major nancial benets by simultaneously improving cash ow, reducing operating cost levels, lowering the asset base and reducing capital (capacity) spending. No other single management action can generate such a high degree of nancial leverage. These savings are not trade-offs. They arise from genuine waste reduction, not simply transfers from one company to another. Of perhaps even greater importance, process quality and customer service are greatly enhanced as waste stock (that is, excess lead-time) is driven out of value systems. The truth of these statements is apparent from Table II. This demonstrates that lean world-class companies are systematically better than their comparators in every important respect and the characteristic which makes a company lean is low stock levels.

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Maynard Rafuse Working capital management: an urgent need to refocus Management Decision 34/2 [1996] 5963

8 Stalk, G., Evan, P. and Schulman, L.E., Competing on capabilities: The new rules of corporate strategy, Harvard Business Review, Vol. 70 No. 2, March-April 1992, pp. 57-69. 9 The data in Table III corroborate our own experience in several European and North American markets. 10 Even today supplier terms frequently incorporate an interest on overdue accounts clause. These are rarely implemented, being either overridden by the buyers terms, or simply ignored by one or other of the parties. 11 For further discussion of these issues see [12]. This describes Heinzs ECR programme in North America. Alternatively see [13] for a description of VF Corporations QR programme in the US jeans market. There are many other descriptions of QR and ECR programmes. For an interesting description of a UK world-class performer see [14, p. 15]. New technology links have been made between suppliers and the Companys distribution network, to create supply chains that are among the most responsive and shortest[sic.] of any retailer in the world. Our analyses conrm that this is no idle boast. Also see[15]. This, despite its title, is an interesting evaluation of rapidly developing electronic competition in retail markets.

12 Perry, D. and Palmatier, G.E., The role of S&OP and demand management in EDI and ECR, 1994 Conference Proceedings of the American Production & Inventory Control Society, pp. 462-7. 13 Weber, J., Just get it to the stores on time, Business Week, 6 March 1995. 14 Marks & Spencer, 1994 Annual Report, Marks & Spencer, London, 23 May 1994. 15 Benjamin, R. and Wigand, R., Electronic markets and virtual value chains on the information superhighway, Sloan Management Review, Winter 1995, pp. 67-72. 16 For further discussion of these issues see[17]. 17 Rafuse, M.E., Value added mapping tools for managing system stock, waste and cycle time, British Production & Inventory Control Society Conference Proceedings, May 1995, pp. 117-28. 18 While many large companies have improved their working capital levels, there appears to be little evidence of any widespread and significant reduction in stocks, despite a great deal of attention to this subject. A survey we made of some 50 large UK companies showed stock levels (in terms of days supply) had not changed to a statistically signicant degree in the ve years to 1993. Virtually all the improvement in working capital thus arose from changes in debtor and creditor levels.

Application questions
1 Have we planned to implement low waste, integrated, digital transaction processes with suppliers and customers? 2 Have we established shared destiny relationships with suppliers? Are these supported throughout the company? 3 Do we comply with the spirit and in the letter of the agreements we have reached with our suppliers? 4 Are our debtor management policies consistent with our broader goals of partnership with our customers?

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