TKMC Case: Just insequence

After the meeting, the plant manager of AA GmbH reports that the OEM plant almost stopped production due to a lack of axles. Due to the importance of this component, the OEM plant has decided to rebuild its own stocks and to have ready-assembled axles in stock. Your plant manager sees this as an opportunity to reduce stocks of finished products himself and thus make a positive contribution to the liquidity of AA GmbH.

Various problems can be decisive here:

• Since the recipient (OEM) does not have its own stock, the dependence on suppliers increases.
• Continuous exchange of information with suppliers necessary, high coordination effort required
• Potential production stop/failure due to wrong order of the products or even worse, not the right time for the delivery of the products

The optimization of the net working capital has been a topic at AA GmbH for quite some time. Therefore, the plant manager of AA GmbH sends you an excerpt of the results of an NWC analysis from the past fiscal year:

• High inventory levels result in low liquidity due to funds tied up in inventory.
• Receivables: Customers don't pay invoices on time - outstanding cash payments.
• Payables: We pay the customer too early compared to what we need to do - cash outflow too early

The plant manager asks you to look at the receivables and payables in addition to the inventories based on these results. He would like to know what measures AA GmbH could take to address these points and thus optimize the NWC.

Liquidity effects arise from the impact of inventories on net working capital.

Net working capital = inventories + accounts receivable + accounts payable.

If inventories go down, the net working capital goes down. Less cash is tied up.

Short-term measures for the next couple of days:

Mid-term measures for the next weeks:

Recommendation:

• In the short term, the AA GmbH should not pay invoices by suppliers and ask for a deferred payment. At the same time, invoices that have not been paid yet should be reminded and outstanding payments requested.
• In the mid-term, the stock should be optimized to have less tied funds.

For this purpose, he sends you the following information:

The plant operates 5 days a week, with one shift per day. One shift is 8 hours.

AA GmbH has only one supplier L for this product. This supplier L has three other suppliers for each component who have different lead times, averaging 3 days, 5 days, and 7 days. Occasionally, our supplier L's suppliers have difficulties and lead times are up to 6 days, 10 days, and 14 days (in the same order as above).

On a monthly average, AA requires 3,600 springs. However, there may be times when the OEM plant is faster and produces up to 1,000 cars per day.

The following formulas can be used to calculate the optimal reorder point:
 

Use the formulas to calculate the safety stock level and the corresponding reorder point for the product "springs".

Lead time demand

= lead time x average daily usage

= 7 days x (3,600 springs/20 days a month) = 1,260 springs

Safety stock

= ((1000 cars x 4) x 14 days) - (180 springs per average day x 7 days)

= 56,000 – 1260 = 54,740 springs

Reorder point = 1,260 springs + 54,740 springs = 56,000 springs

The optimal reorder point is at 56,000 springs.

Additional information: The weighted average cost of capital (WACC) is 8% and one spring costs 10€.

Potential = 60,000 springs - 54,740 springs = 5,260 springs x 10 € / spring = 52,600 €

Capital costs saved = 52,600 € x 0.08 = 4,208 €

Risk: Running out of spring stock leads to non-delivery to the OEM. Very high business risk.

Explanation: Cost of capital is not a real cost, as you can see in the P&L, but rather comparable to opportunity cost. This type of (implicit) cost of capital is very different from the cost of capital such as interest (cost).