Regardless of the industry, size, or production characteristics of a company, working capital management is an essential practice in running a business smoothly. Working capital management is the strategy used to manage current liabilities and current assets. Efficient working capital management ensures that the company holds enough liquidity to meet short-term expenses and debt. Without sufficient cash available, the company risks not being able to meet expenses quickly. At the same time, holding more working capital is costly. Therefore, it is crucial for any business to balance its working capital efficiently.
Having a proper production scheduling system in place ensures visibility and clarity over current and future production processes. Consequently, it reduces the level of uncertainty and reports directly into working capital management. Is production scheduling the key to efficient working capital management? Also, does it hold for more volatile production environments like HMLV (high-mix, low-volume) businesses? Let's dig deeper into the components of working capital management and the role of production scheduling.
The importance of working capital management
How efficient a business manages its working capital directly influences the company's growth. Without enough liquidity, the firm risks running out of cash in the short-run. Running out of cash can lead to an abrupt halt of the production processes. This threatens the firm's ability to cater to existing customers and to acquire new orders.
On the contrary, "too much" working capital in the form of short-term assets ties up money that could be invested profitably elsewhere. Thus, more working capital bears the opportunity cost of forgone profits a company could earn from other investment possibilities. Additionally, time and resources spent in the management of working capital require further investment.
Purpose of working capital management
Broadly, you can distinguish three objectives of managing working capital:
- Transaction: Every firm needs to have some cash available to run its day-to-day operations as it's impossible to handle all short-term expenses through online purchases.
- Protection: Any business has cash holding for unanticipated situations. Due to several immutable outer circumstances, the firm might not be able to achieve its expected profits. Suppliers and other short-term liabilities have to be paid regardless of the cash inflows. Cash holding acts as a safeguard against such situations.
- Speculation: Having some "extra" cash or inventory in place can allow businesses to take advantage of upcoming events. Excess liquidity can be used to exploit temporary discounts for raw material. Inventory holdings are needed when a firm wants to take on further orders when demand increases temporarily.
Components of working capital
Among others, the essential elements that make up working capital are
- receivables and payables, and
Cash works as a reserve for the purchase of goods in the short run. It is a best practice to ensure a certain level of liquidity at any point in time. Accounts payable apply to creditors that companies need to pay, e.g., suppliers. Accounts receivables refer to debtors where money will e collected from in the future. Lastly, inventory is the stock available. Inventory breaks down into
- raw material,
- work-in-progress and
- finished goods.
All are an integral part of working capital management and require accurate planning. A manager faces the trade-off of the costs and benefits of holding either kind of inventory. A small inventory stock can significantly disrupt the production cycle while a large inventory stock increases the costs of maintenance, costs of storage and cost of management. With a thorough analysis and a high degree of visibility over the production cycle, a near to the optimal level of inventory brings significant advantages to a company.
Production planning and working capital management
As mentioned previously, working capital plays a vital role in hedging against the risk of unforeseen events. A detailed plan can substantially reduce such risks. Therefore, an accurate production planning schedule is necessary to react quickly to the external environment and to assess the probability of certain events happening. All aspects that can be evaluated by a manager should be part of a production plan to reduce the risk to a minimum.
Application to HMLV businesses (high-mix, low-volume)
As usual, what holds for the vast majority of companies cannot be translated one-to-one to HMLV firms such as job shops. They differ significantly in terms of their production processes, product variety, production volume, tools, and alike. "Change" rather than "routine" is a significant characteristic of an HMLV company. The lack of consistency, quick and frequent changes, and customized production processes are daily challenges that have to be addressed and result not rarely in a chaotic working atmosphere. The manager faces an exceptional level of uncertainty as demand fluctuates greatly, product expectations differ, and delivery dates vary.
As elaborated upon in other blog posts, a proper production schedule can tackle the volatile environment by introducing transparency and a vivid visualization. Furthermore, a production schedule certainly supports the firm's working capital management, especially when thinking about inventory. Again, the aid is limited:
- A job shop cannot benefit from finished goods inventory. Batch sizes of only one are not an exception. A sudden incoming order cannot merely be met by finished goods inventory as the order will most likely be a customer-tailored product that requires a different production.
- Holding a work-in-progress (WIP) inventory is also only partly applicable. It is only feasible if companies can identify those unique sub-processes, that are present in most production lines. Their WIP outcome can then act as a buffer between production processes. This buffer can be used to respond to incoming orders quickly.
- Most importantly, raw material inventory does play a significant role in HMLV businesses. The manager should reap the profits of price changes and quantity discounts and can hedge against the risk of supplier shortages. Still, there are limits to such benefits; unique production processes might even require unique materials.
Thus, companies must adopt the usage of efficient working capital management to the unique characteristics of a job shop. However, generally, small businesses still need proper working capital management to take advantage of the mentioned perks. They might even be more flexible in making changes to existing processes, which can lead to agile working capital management.
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