Recognizing the effects of uncertainty to achieved working capital efficiency

Pulp & Paper, Jul 2002 by Antanies, John

ISSUE FOCUS: INFORMATION TECHNOLOGY

How can information systems help confront uncertainty and increase capital efficiency by balancing inventory, asset utilization, and customer service goals?

IN 2001, DELL COMPUTER CORP. GENERATED $31 billion in revenues, with just $400 million in inventory, turning over its balance sheet inventory 63 times. On average, every component it had on hand was sold 63 times. There was not one single paper company that even broke ten turns per year in 2001, and some of the worst performers are companies who have invested significant capital for enterprise information technology.

We all know the paper industry is capital intensive, but we most often picture that capital tied up in paper machines-we don't really think of the cash tied up in inventory. And fewer still realize the amount of cash tied up with customers who have yet to settle their bills. In this case, we are not talking about fixed capital, but instead working capital. In short, working capital is the amount of money a company uses to run its day-to-day business. For lucky companies like Dell, it often includes a huge stash of cash.

BALANCE IN THE BUSINESS MODEL. Life is a struggle for balance, and especially so in the daily life of a paper company. The paper machine superintendent wants long grade runs to increase efficiency, the salesperson wants high customer service levels, and the finance person wants to reduce working capital.

Dell's success lies in its business model. But that model is less about filling orders directly with customers and more about optimizing its cash operating cycle, part of which is inventory. Basically, inventory turns are the number of times we sell inventory, which consists of finished goods (FGI), work in process (WIP), raw material inventory (RMI), and even spare parts (MRO inventory).

One of the reasons paper companies turn their inventory so infrequently is the huge amount of spare parts carried in storerooms, as well as the large amounts of raw materials. How much wood is in your woodyard? How many caustic cars are in the railyard? How much dust is on the pumps in the storeroom? Ever wonder why Southwest Airlines only flies Boeing 737s? Fewer spare parts, along with easy aircraft substitution and crew training, have a lot to do with it.

The cash operating cycle is very similar to the concept of inventory turns, except it is a measure of how often a company turns over the capital required to run its business. We need cash to pay bills (accounts payable) and cash to maintain inventory. In return, we get cash when we sell products (accounts receivable).

If you look at Figure 1, you will see the dilemma faced by all of us: it is impossible to minimize inventory, maximize asset utilization, and achieve perfect customer service levels-it just cannot be done. Furthermore, attempting to optimize one area while neglecting the impact that optimization process has on the other two leads to suboptimization of the enterprise. And, to make matters worse, uncertainty can corrupt the best of plans.

UNCERTAINTY AND DEMAND MANAGEMENT.

Uncertainty makes life both interesting and challenging. But most of the time, uncertainty creates anxiety.What kind of deductible should we have for our car insurance? How should we invest our hardearned 401k contributions?

Uncertainty also makes life interesting in a mill. Let's take a look at a simple example: demand. Some mills stock inventory so they can respond to customers quickly The amount of inventory held is normally calculated by some statistical formula that often includes some seasonality, and then some kind of safety stock is added. Of course, the more predictable the demand, the more accurate the inventory level will be and the less safety stock required.

The end result of all this math is an inventory position by product. When inventory levels fall below safety stocks, the system creates a production order to replenish the inventory. Ideally, these orders have enough lead time so that they are scheduled the next time the machine is scheduled to run that grade. Obviously, if our machine makes very long grade runs, it will take longer than if we frequently cycle through the grades. Therefore, all else equal, the machine that makes longer grade runs will have to store more inventory.

This even applies to those mills that operate on a make-to-order model, because, most often, orders contain many items, not just one. Suppose a machine made eight different grades and had a customer order for one full truckload consisting of some of each of the eight grades. In order to fill this order, the mill must store each of the first seven products until the final order is wrapped and registered.And what's the result? Inventory, even in a make-to-order environment (more correctly described as WIP inventory).

In the past few years, many software companies have sold demand management planning systems. One chief benefit of these systems is reducing the error between forecasted demand and observed demand. If we can do this, we can indeed have the best of both worlds-low inventory levels and high asset utilization, or paper machine efficiency. At least that's the story. And to some extent, there is a lot of truth to this.