Create added value

Identify the right service level and create value by optimising tied-up stock capital

In this article, we will clarify how tied-up capital in stocks in particular can be optimised by means of a number of concrete methods and tools which support the short-term tactical decisions and at the same time strengthen the basis for the company’s value added and competitive power.

Create value by optimising tied-up stock capital

Roughly speaking, small stock means less tied-up capital and thus higher return margins on invested capital (all things being equal). However, reality is rarely that simple. Many companies experience the challenges relating to on the one hand delivering the right service level to the company’s customers in terms of delivery time and security and on the other hand avoiding tying up unnecessary capital in the company’s stocks.

Furthermore, with expanding globalisation, both upstream in relation to sourcing and downstream in relation to customers/ markets, the complexity in management increases. A higher number of individual producing units in the value chain result in increased delivery time and thus increase the need for coordinating and balancing value chains in terms of expected sales to the end user. In this connection, stocks are used as a lever to link the value chains and to outbalance variance in demand. The balance is to adjust the stocks optimally to match market requirements, in relation to the need to outbalance unpredicted variance in customer demand and in relation to the total number of stocks in the value chain.

Stock optimisation should always be carried out based on the customer service which has been strategically decided. Delivery time and service level are included (% fulfilment). Two extremes for meeting the delivery time are “make to order” (MTO) or “make to stock” (MTS). In practice, it is usually a combination of these, however, we will not examine this subject any further in this article. One trade-off of these concerns is EOQ in production and transport as well as decisions regarding in what part of the value chain to outbalance variance (optimally as far back in the value chain as the delivery time allows).

The number of stock points in the value chain should be limited to the highest extent possible from a management perspective (the Forrester effect), from a cost perspective and from a capital perspective (reduction of NWC). Opposite this is the need for optimal operations (EOQ) and regular production, i.e. demand for capacity. The higher degree of agility created in production and transport, the better the possibility of producing “just in time”. The requirement for this is flexibility in capacity and small batch sizes.

Optimised stock management is part of realising the value of the chosen sales and operations planning strategy

As described and illustrated in the first article in this series of articles, the level of a company’s economic value added in a given period of time can be expressed by the following formula:

Economic value added

Thus, the two most significant value drivers are the return on invested capital (ROIC) and – if the return is higher than the weighted average cost of capital (WACC) – any additional growth that may be created in the company.

In terms of stock management optimisation in a company, the figure below illustrates different types of stocks and the levers that drive these stocks up, i.e. impact the total stock value.

Create value by optimising tied up stock capital Breakdown of stocks

Based on the above-mentioned reasons for an undesirable level of capital tied up in stock, there are often a number of improvement initiatives in relation to this which can be carried out – resulting in a significant increase in value added, such as:

  • Identification of the “right” service level will, compared to an underestimation, increase turnover and earnings by creating optimal conditions for sales and better utilisation of the capital stock – increased earnings and higher ROIC
  • Better levelling of demand will increase efficiency and reduce costs through the entire supply chain – increased earnings and higher ROIC
  • Management and KPI focus on reduced stocks will release capital and lower stock-related costs – increased liquidity and reduced need for external financing
  • If the stock of seasonal products is increased in time, it will boost sales and reduce waste – stronger growth and reduced costs
  • An optimised supply chain based on the above will also increase the possibility of optimisation relating to sourcing (better supplier contracts) as well as entering into sales agreements – optimise the other working capital items and release additional capital

In conclusion, by making a strategic decision about the right service level and subsequently optimising capital tied up in stock through the entire value chain it is possible to optimise a number of operational conditions which will either generate growth, reduce tied up capital and release liquidity and/or utilise the invested capital more optimally. Every one of these conditions creates value and strengthens the company’s competitive power.

For further information about this process and examples of its use, please contact Morten Søndergaard.

Morten Søndergaard
Morten Søndergaard
+45 2338 0080