Opportunities for Action in Operations. Working Capital Productivity: The Overlooked Measure of Business Performance Improvement

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1 Opportunities for Action in Operations Working Capital Productivity: The Overlooked Measure of Business Performance Improvement

2 Working Capital Productivity: The Overlooked Measure of Business Performance Improvement More than a decade ago, IBM s then chairman, John Akers, lamented that he could see examples of cycletime reduction and quality improvement throughout IBM but that those gains were not having an impact on the bottom line. Today, many executives are still facing the same issue: they need a simple yet effective measure of overall operational performance. That measure is working capital productivity. We define working capital productivity as the sum of accounts receivable plus all inventories, minus accounts payable, averaged for the year and then divided into net sales. Thus, it is not a driver of improvement, like a focus on efficiency or cost. Rather, it is a measure of the improvement caused by different initiatives. Working capital productivity, in other words, is an indirect indicator of a well-run operation. At a typical manufacturer, for instance, when a customer places an order, distribution ships it and then issues an invoice that the customer pays when it is satisfied. Distribution orders replacement stock from manufacturing, which delivers stock and then adjusts its production schedule. The effect of the customer s order ripples through the entire organization, eventually reaching other organizations, such as suppliers. In the end, each ripple has a positive or negative impact on levels of working capital and, therefore, on working capital productivity. (See Exhibit 1.) Senior executives who focus on being world-class competitors are achieving high levels of working capital

3 Exhibit 1. Working Capital Productivity Reflects a Company s Overall Operational Performance Order cycle Order cycle Order cycle Suppliers Manufacturing Raw materials Work in progress Scheduling cycle Finished goods Distribution Finished goods Customer Payment cycle Billing cycle Delivery cycle Sales, Accounts general, and payable administrative Delivery cycle Accounts receivable Delivery cycle Payment cycle Billing cycle SOURCE: BCG analysis. productivity and saving hundreds of millions of dollars for their companies and shareholders. Increasing working capital productivity has also helped these companies become much more competitive with higher quality, lower costs, and faster response rates. Linking Performance Improvement to Working Capital Productivity When organizations attempt to improve operational performance, they can choose from a wide array of approaches: Six Sigma, total quality management, lean manufacturing, and reengineering, to name a few. But for executives looking at the corporation as a whole, two problems can arise when they opt for any of these approaches. First, they may focus too narrowly on applying just one, making it hard to judge overall performance because they see the results of just that initiative. Second, even when companies use such high-leverage improvement programs, they still find that assessing progress across many different parts of

4 the business can be very difficult. A focus on working capital productivity helps solve both problems. Indeed, almost any performance-improvement effort has an impact on working capital productivity. Take flexible manufacturing or improving customer service. Such initiatives reduce costs and boost overall working capital productivity by shrinking inventories and driving down accounts receivable. Or consider the effect of paying suppliers quickly if they meet enhanced delivery-performance requirements. At first blush, paying suppliers faster would seem to reduce working capital productivity, but companies that do so often receive better service and faster deliveries which drives down inventories and raw materials, and improves working capital productivity. For instance, Wal-Mart is well known for paying its suppliers faster than its competitors do as an incentive to provide frequent and reliable resupply. This allows Wal-Mart to achieve much faster inventory turns and thus higher overall working-capital productivity than its competitors. What s more, responsive service from suppliers means that Wal-Mart has much higher in-store availability than its competitors, leading to more sales per square foot and higher fixed-asset productivity as well. Similarly, there is a correlation between improvements in working capital productivity and improvements in overall labor productivity (defined as sales per employee). The Boston Consulting Group conducted a survey of 500 companies from Europe, Japan, and North America in a variety of industries and found that for every doubling of working capital productivity, labor productivity tends to jump 20 to 60 percent. (See Exhibit 2 for a sample of the data.) Toyota, for example, has improved its working capital productivity fourfold over the past 25 years. During the same period, the automaker s overall labor productivity has improved 200 percent.

5 Exhibit 2. Doubling Working Capital Productivity Coincides with a Jump in Labor Productivity Industry in which working capital productivity doubled Computers Construction equipment Industrial gases Air conditioners Automobiles Average improvement in labor productivity (%) SOURCE: BCG analysis. NOTE: Labor productivity is defined as sales per employee. Of course, this does not mean that focusing on working capital productivity directly drives improvements in labor productivity. Rather, the types of things that companies do to improve working capital productivity (for example, reducing batch sizes or improving quality to cut material in rework) tend to be the things that diminish the need for labor and hence promote labor productivity. Shedding Light on Well-Run Operations To better understand the link between working capital productivity and overall performance, we met with executives of companies that had achieved notable improvements in working capital productivity. In every case, we found that their organizations also were at the forefront of applying continuous improvement principles. Although all the companies had already improved greatly, their executives continued to seek still higher levels of performance, customer satisfaction, and flexibility. Working capital productivity gave these executives a bird s-eye view of their progress in a single calculation.

6 We also found that the companies shared several other traits. First, they closely tracked their competitors improvements to ensure that their own organizations were turning in better performances. Companies cannot buy a piece of equipment to do this. They must go through the experience of changing processes and of learning by doing. The more organizations focus on learning, the quicker they learn and the further they move ahead of the competition. Improving working capital productivity is an experience-intensive phenomenon, and you create advantage if you accumulate more experience than your competitors do. Second, successful organizations often look to other industries for insights and for opportunities to improve working capital productivity. For example, a leading manufacturer of office products took a lesson from the apparel playbook and learned from the practices of leading clothing manufacturers. These manufacturers managed production using actual retail sales to set schedules, thereby dramatically reducing duplicate and excess inventories. The office products manufacturer began managing the stocks of its products while they were in the big retailers stores, thereby achieving improved levels of service and reduced inventories. Third, companies that are excelling extend their measurement and management of working capital productivity into the organizations of their customers and suppliers. By doing so, they are able to measure the performance of the system as a whole more accurately. For instance, a group of automobile manufacturers and suppliers of automobile seats, upholstery, and fabric teamed up to share data on working capital productivity in order to help make their supply chain more cost-effective, responsive, and competitive.

7 Avoiding Common Pitfalls We have also noticed that focusing on working capital productivity has potential pitfalls. Four areas in particular need to be watched closely. Resources and Management. Because the labor and capital savings from an increase in working capital productivity are predictable and large, management needs to ensure that the improvement effort is funded and managed appropriately. If it is attempted on a shoestring budget or without total commitment from management, the needed cross-functional changes won t happen, working capital improvements will be slow, and frustrations will be many. Focus and Logic. Plans for working capital improvement still must make good business sense. Good plans focus on systemwide improvements. Plans based on simply extending payables, for example, will help improve working capital productivity in the near term but could hurt a business in the longer term. Goal Setting. Set goals for the rate of improvement rather than for absolute levels of working capital productivity. Rates of improvement are measurements of change. In return for committing resources to operational improvements, you should expect increases of 40 percent in all labor productivity as a result of doubling working capital productivity at a steady year-in, year-out rate. (See Exhibit 3.) Accounting. When comparing your working capital productivity with that of your competitors or of benchmark companies, be aware of the accounting vagaries that can distort such comparisons. For example, make consistent adjustments for differing last-in, first-out and first-in, first-out policies. Add back

8 Exhibit 3. When Working Capital Productivity Improves Consistently, So Does Labor Productivity Example: Manufacturer of consumer durables Labor productivity (index: year 1 = 100) Year % slope Year Year Year ,000 Working capital productivity (index: year 1 = 100) As working capital productivity doubles, labor productivity increases by 40 percent. SOURCE: BCG analysis. NOTE: Labor productivity is defined as sales per employee. progress payments to work in progress. Crosscheck performance based on year-end results with quarterly statements to find those companies that dress the balance sheet at year s end. Be aware that reported improvements could also come from sticking it to suppliers by increasing days payable. Discovering the Missing Link Today, reducing costs, improving quality, and saving time through all parts of an organization are the mantra of executives in every industry. In their pursuit of those goals, however, they tend to overlook working capital productivity because it is an indirect measure. They see it as a narrow financial calculation and miss its link to the overall systemic performance

9 of an organization. As a result, executives forfeit a powerful lens to track improvements across the company. It can be a costly oversight. If you are attempting to dramatically improve operational effectiveness and you are not experiencing a 40 percent improvement in all labor productivity for every doubling of working capital turns, then your investments are not yielding sufficient returns. You are missing opportunities to transfer gains in performance to the bottom line, and you are leaving yourself vulnerable to more resourceful competitors. George Stalk Jr. Harold L. Sirkin George Stalk Jr. is a senior vice president and director in the Toronto office of The Boston Consulting Group. Harold L. Sirkin is a senior vice president and director in the firm s Chicago office and head of BCG s global Operations practice. You may contact the authors by at: To receive future publications in electronic form about this topic or others, please visit our subscription Web site at The Boston Consulting Group, Inc All rights reserved.

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