Determining the overall health of a company is far more complex than simply looking at revenues and profits. Equally important, especially for investors, is a measure illustrating the liquidity of their cash flow and operating activity. In other words, should immediate financial action need to be taken to settle debt or resolve a debilitating supply chain disruption, a healthy company should have the working capital on hand to do so. This necessitates crunching the cash conversion cycle to where the company can receive payment on an invoice as quickly as possible from the point of raw material acquisition.
An electronics OEM operating has far more pain points in their cash conversion cycle, many of which are beyond their control, than those in industries of comparable size. One client my company works with, for example, is a primary healthcare equipment provider to a national government. The terms for working with this country require waiting, at minimum, six to nine months for payment from the date the invoice is issued. Factor in the additional time required for buying inventory, assembly through the contract manufacturer, and shipping time on all supply chain levels. It’s not out of the realm of possibility for my client to be waiting over a year for return on their original working capital investment.
Cycle crunching options are limited on the front end as well, especially in today’s market. The Hackett Group recently published an industry-wide survey that found that OEMs in 2018 are pushing the burden of working capital onto suppliers by extending their own payment terms up to 90 days and beyond. The effect in the short term was a 6% increase in days payable outstanding, and a 17% year-on-year increase of OEM cash on hand. This is positive news, but it’s also unsustainable. In such a high demand marketplace where once commoditized components are often entering 52-week allocation periods before even fulfilling a single order, suppliers can only be squeezed so far.
It’s important to remember component suppliers have the same desire to shorten their cash conversion cycles that their customers do. Production capacity for electronic components has largely remained stagnant since 2001, and a ramp up is long overdue — but if the goal is to match capacity with current market demand by 2019 or 2020, these companies will have no choice but to prioritize maximizing their inventory turnover ratio. This obviously favors OEMs who have the working capital to commit to their inventory upfront, leaving those who have come to rely on extended financing by the wayside.
So, if the OEM cash conversion cycle cannot be crunched on the customer side, and squeezing suppliers ultimately results in a market unfavorable to those with working capital deficiencies, that means the best pain point to rectify lies somewhere in the middle, from the moment inventory hits their docks to the moment it is shipped out to the customer.
Here is where the OEM’s focus should be, and upon closer inspection, this is where the OEM has the most control over working capital.
Securely warehousing inventory for an extended length of time accumulates exponential costs. It’s easy to overlook, but every moment it is within the OEM’s possession represents an increase in tied up working capital. Once the expenses associated with packaging, handling, and maintaining proper climate control regulation are all considered, it’s not uncommon to see annual carrying costs as high as 25% of the component’s original cost.
This doesn’t even consider the infrastructure investments required to compete in the electronics market. According to a report published by Credence Research, the market for application-specific integrated circuits is expected to be worth approximately $28 billion by 2025. Benefits from such a trend include drastic improvements to efficiency, greater IP protection, and increased product differentiation in a crowded marketplace. Proper storage of ASICs, however, require highly-specialized equipment capable of regulating humidity at levels suitable for raw die and wafer. Working capital is what makes such purchases possible.
To cut these costs down and free up the working capital it represents, the most important thing is to realize that the economies of scale do not operate in the OEM’s favor. Innovation will always remain a cornerstone of any manufacturer in the electronics industry, but when equal attention is paid to in-house handling and warehousing, both initiatives suffer as a result. The old “divide and conquer” stratagem does not work in manufacturing.
Instead of taking this dual-focus approach, I would recommend OEMs narrow their focus. In fact, I would go as far to say that OEMs should coalesce all their resources around a single goal: innovation in the field they know best. It’s a simple concept, and one that companies such as Amazon and Apple have used to rise to the pinnacle of their respective industries — but it’s also one that requires a degree of humility. It’s difficult to be the best at something, but it’s impossible to be the best at everything.
One quick look around the industry and it’s easy to see that there are supply chain partners who have adopted this mindset. Instead of innovating through the introduction of new products, they have opted to innovate in the areas their OEM customers are lacking. There are supply chain partners who specialize in legacy component procurement, others who specialize in maximizing ROI on excess inventory, and others still who specialize in the proper storage, handling, and fulfillment of critical electronic inventory.
Do not be afraid to seek these specialized partners out, because their success is dependent on fulfilling a defined role better and more efficiently than what a customer could accomplish itself. This flips the economies of scale back in the OEM’s favor, and it can result in substantial savings.
What’s the secret to crunching your cash conversation cycle? It all starts with an honest reflection of your supply chain’s limitations. After that, the rest is easy.