Solution
Paragraphs highlighted in green indicate diagrams or tables that can be shared in the “Case exhibits” section.
Paragraphs highlighted in blue can be verbally communicated to the interviewee.
Paragraphs highlighted in orange indicate hints for you how to guide the interviewee through the case.
I. Client situation
What problems could arise in relation with the just-in-sequence-delivery from your point of view?
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
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.
II. Effect of of reduction in inventories on the liquidity of AA GmbH
Explain briefly what effect a reduction in inventories would have on the liquidity of AA GmbH.
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.
Diagram 1 shows the relation between inventories, accounts receivable, accounts payable and the net working capital.
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 not 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.
III. Measures to optimize the net working capital
Develop suitable measures to address the problems uncovered in the NWC analysis. Please differentiate the measures with regard to the time frame and assess the potential of each measure.
If the candidate is stuck, you can share table 1 & 2.
Short-term measures for the next couple of days:
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Inventories
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- Very short-term (a few days) measures not possible, as physical goods cannot be liquidated in the short term and may be necessary for existing orders
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Very low potential
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Receivables
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- Open invoices from customers: Send reminders, or if already significantly overdue, sell receivables to a refinancing company.
- Grant customers discounts for early payment (long-term effect on P&L and cash position, however, negative).
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Medium-to high potential
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Payables
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- Don’t pay the supplier or ask the supplier to postpone for a few days
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High potential, since the plant manager is not dependent on anyone else for the measure to be successful
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Mid-term measures for the next weeks:
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Inventories
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- Reduce any residual inventories (raw product, half and partly finished products and finished products)
- Reduction through optimization of order point and quantity at supplier, reduction through mitigation of the 7 types of waste (transport, inventory, motion, waiting, over-production, over-engineering, defects)
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High potential, as 1) can be optimized independently and low dependence on other parties and 2) the "7 types of waste" provide a broad approach
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Receivables
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- Standardization/negotiation of payment terms/targets
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Medium, since the administrative work is done centrally, we can assume that there already is a certain degree of optimization
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Payables
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- Standardization/negotiation of payment terms/targets
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Medium, since the administrative work is done centrally, we can assume that there already is a certain degree of optimization
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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, stock should be optimized to have less tied funds.
IV. Inventory optimization
The plant manager is impressed by your structured and weighted list of measures and decides to involve you in the development of further NWC potentials. He wants you to analyze the stock levels of the ready-to-install springs by calculating the safety stock level and the corresponding reorder point. 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".
Important:
- The respondent must choose the longest lead time (7 days) for the calculation, because the supply chain is always only as fast as the slowest chain element.
- Each axle has 2 springs, and since each car requires two axles (front and rear), a car requires 4 springs.
- The respondent must estimate the number of days in a month. We assume that an average month has 20 working days.
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.
V. Cash savings
The plant manager is surprised by the figures, as the current safety stock of 60,000 springs is much larger. He would like to know from you how high the savings potential is in terms of capital costs if the safety stock is reduced accordingly.
Calculate the potential savings in terms of the cost of capital in this case. In doing so, please also address possible countervailing risks and explain how the cost of capital affects the P&L.
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).
The operations manager thanks you for your calculations. However, he explains that these small savings do not justify a reduction in the safety stock, as the contractual penalties for non-delivery to the OEM represent too high a business risk. Nevertheless, because of the good work, he would like to include you in future projects for NWC optimization.
