For many businesses, the past year exposed the fragility of their cash flow and working capital. The pandemic, coupled with supply chain disruptions and erratic consumer demand, wreaked havoc on companies facing both internal and external pressures. Meanwhile, investors pressured companies into achieving higher shareholder returns. Companies were rewarded for prioritizing short-term investment success, often to the detriment of their long-term strategy. And inventory was caught in the crosshairs.

Companies aren’t rewarded for maintaining high levels of inventory, from raw materials to work in progress (WIP) to finished goods. Rather than carry high levels of inventory to instill resilience in the supply chain, companies were instead pushed to keep levels low; working capital ratios prosper when inventory falls. These short-term gains, however, can set the stage for ruin when assumptions no longer hold.

To avoid this eventuality, companies can learn to manage their supply chains and, in doing so, improve their overall working capital.

How Did We Get Here?

The Japanese just-in-time (JIT) model adapted from the late 1980s onward seems to be the epicenter for the issues that plague the supply chain today. At its core, JIT is a management philosophy that focuses on people, plants and systems to increase overall efficiency and maintain low levels of inventory along the way. It was developed in response to pressures Toyota faced to remain competitive by reducing waste, improving product quality and increasing production efficiency. 

JIT works if companies appreciate the shift in the dynamic that it brings. Consistency of demand is critical to maintaining tighter inventory levels, where buffers are reduced. Long-term contracts with suppliers provide critical relationships in the overall supply chain network. A Harvard Business Review article from 1986 berated companies for not employing this approach. The article argued for increased adoption of the successful business philosophy. More and more companies started to follow suit.

However, the philosophical aspects of JIT and its nuances were lost as more and more Western companies removed pieces of it to adapt to their business models. CEOs and CFOs failed to study and understand why it worked so well in Japan, and the trade-offs necessary to implement it. Instead, companies honed in on reduced inventory as a way to limit waste, passing their inventory risk to suppliers. Doing so had unintended effects, and concentrated the risk on the logistics and distribution sectors of the supply chain and, worse, the vulnerable working class.

The pandemic exposed these flaws in the JIT model. Tight relationships with suppliers can work, so long as you don’t push the burden and risk to the logistics and distribution network. Once the pandemic upset the consistent demand and seasonal cycles the model depends on, companies were left scrambling for inventory (e.g., raw materials, WIP and finished goods).

Borders were jammed up with transports unable to proceed due to shutdowns. What good is JIT inventory if the suppliers can’t guarantee delivery of critical components to manufacturing sites? The chip shortage, for example, continues to delay the manufacturing of cars, electronics and other consumer goods as production can’t keep pace with demand.

Factory closures and border restrictions during the pandemic caused delays in delivery of JIT materials, and triggered a ripple effect that grew until supply chains started to unravel. A prime example is the fiasco at the ports of Los Angeles and Long Beach, which still have over 100 containerships waiting to unload. Inventory remains stuck in transit on the water.

Focusing on Inventory

This past year showed a deterioration in working capital in the retail and manufacturing industries as days inventory on hand (DOH) increased. Inventory levels should be a leading indicator of overall cash flow. Delays in any aspect of the inventory limit a company’s ability to profit.

The JIT model deserves a hard look when evaluating working capital. While managing working capital should start with inventory management, it shouldn’t just rely on top-line cuts to “make estimates for Wall Street.”

As business-management guru Peter Drucker once famously said, “If you can’t measure it, you can’t improve it.” Therefore, instead of upending your supply chain with a top-line cut on inventory, focus on reduction through a comprehensive continuous-improvement program that allows you to concentrate on factors you can control. For example, you can control demand planning through demand fulfillment, using simple digital transformation models.

Digital transformation has democratized regression analysis and forecasting such that you only need to feed in historical data sets as a baseline. Once the analytical models run, they can be evaluated using visualization tools to determine the best fit for the data and then provide a reasonable forecast for the future. Without such digital transformation, planning groups are flying blind to understand their true demand and prepare an efficient demand fulfillment strategy for the limited supply. They must take orders from managers that want to constantly build inventory and squirrel it away — all leading to higher working capital.

Digital transformation also provides insight tools into which accounts are most profitable, and which are the lowest cost to serve. Analytics can test price elasticity to determine a customer’s sensitivity to price and test future price-increase potential. Each of these measures can easily be distilled into continuous monitoring through a health check dashboard to show the overall state of the supply chain. 

Start with qualitative diagnostics. It’s important to have a fact-based and validated assessment of the inventory management process. Cover pain points and bottlenecks in the end-to-end sequence of business events. Perform a gap analysis to hone in on the problematic areas. Lastly, perform a quantitative measurement. This measurement is data-driven and focused on performance. Evaluate key performance indicators and benchmark components of the supply chain against peers, so that you know where to apply time and effort to bring factors back under control. Only then can you create fit-for-purpose solutions that address the enterprise-wide supply chain.

Patrick Long is a director in the Process & Technology practice of Opportune LLP.