The 2020 Mid-Year Economic Update_long

5 Steps for Aligning Working Capital with Customer Needs

A granular approach to forecast adjustment during a period of revenue decline can help distributors better understand demand shift and adjust for variability.
Young man worker doing stocktaking of product in cardboard box on shelves in warehouse by using digital tablet and pen. Physical inventory count concept

The acronym VUCA, short for volatility, uncertainty, complexity and ambiguity, is a concept that originated with students at the U.S. Army War College. It was used to describe the state of the world after the Cold War. If VUCA is as fitting now as it was then, what does that mean for businesses?

It means we need to accept current conditions and focus on developing new capabilities, rather than wishing for pre-COVID-19 conditions or looking for a silver bullet.

This is especially critical for demand planning teams. They face volatile demand and uncertain signals from customers and suppliers. As states reopen and non-essential businesses restart, these teams should try to fulfill emerging demand without stretching working capital needs.

Rapid Response to Demand Disruptions

First, let’s understand how conditions have affected the demand planning team. In mid-March, revenue went on a free fall and distributors’ inventory stopped moving.

In April, the lockdown cut off demand signals for non-essential businesses. Then, as states started reopening in late May, demand resurfaced at varying degrees. Purchasing teams were tasked with adjusting working capital to align with a double-digit decline in revenue.

In the absence of established processes and purchasing protocols, panic-driven decisions ensued, mostly resulting in across-the-board purchasing cuts rather than more nuanced responses.

As a result, distributors have been scrambling to fulfill customer orders since demand started recovering in June, only to find that their purchasing processes and systems are not agile enough to quickly resume operations as they were.

Upon further research, we identified five critical actions for demand planning teams to balance customer service (product availability) and working capital (inventory) in this new environment. Let’s take a close look at each of these actions.

Segment Demand Disruption

When faced with revenue decline, many distributors hit a pause button and adjusted their forecasts down across the board. Instead of this general measure, we suggest a granular approach that helps you understand demand shifts. For example, one industrial distributor faced an overall decrease in aggregate demand. They observed that, while their cutting tools category was down by 59%, the safety category had jumped 118%, with other categories falling somewhere in between the two.

The distributor measured the change in sales against the same week or month in the prior year. Based on the change, they segmented items into three groups:

  • Surge (sales increasing more than 10%)
  • Slump (sales dropping more than 10%)
  • Static (all other items)

The distributor performed this analysis at both category and location (branch) levels to understand the widespread impact of COVID-19 across states. The purchasing team further divided the three groups to isolate items with extreme demand shifts.

The distributor integrated market segment dynamics and critical customer profiles into their analysis of these items. For instance, the nature of essential versus non-essential business shed light on extreme demand shifts.

Adjust for Demand Variability

Distributors’ ERP systems typically rely on historical demand to make forecasts. However, with abrupt shifts in demand patterns like those identified in the previous step, these models react in the extreme without real-time contextual information.

Continuing with the previous example, the distributor’s system forecasts using the average sales of the past three months. Decreased demand for cutting tools (down 59% and 37% in April and May, respectively) caused the system to forecast very low for this category.

However, the distributor expected this core product to recover quickly as businesses reopened and adjusted for the system’s blind spot.

Instead of relying on the system forecast, the distributor modified their forecasting approach on multiple fronts for managing ‘surge’ and ‘slump’ items (two of the three segments identified in the previous step).

The distributor contacted their top 40 customers (who accounted for 86% of the business) and asked them to segment their end-customer business into two buckets according to essential and non-essential guidelines provided by the federal government.

Then, they contacted strategic suppliers related to ‘surge’ items to ensure supply capacity. They also changed their forecasting bucket from monthly to weekly for the next eight weeks for selected ‘surge’ and ‘slump’ items. This would enable them to follow changing demand closely.

Account for Supply Variability

Many distributors are diligent in collecting and integrating customer information. But they are less inclined to update and include supplier information in their planning.

For instance, they use suppliers’ promised lead time to plan their safety stock, even though distributors have a trove of purchase order information to measure actual lead time. Purchasing systems rely on this information to determine the right amount of buffer stock.

When the pandemic hit, many suppliers stopped operations, shifted to manufacture a select few SKUs, or applied allocation rules in case of surging demand. If distributors don’t account for such supply disruptions, they could see friction in manufacturer-distributor communications and ultimately customers would be disappointed.

On the other hand, if they are integrating recent, relevant data from suppliers, they can catch and adjust for disruption more swiftly.

An HVAC distributor with 27 locations quickly segmented ‘surge’ and ‘slump’ items (by location) and identified 19 corresponding suppliers. They agreed to share weekly demand information by location with those suppliers and updated their system with more realistic lead times every week.

This helped the distributor not only meet core customer needs on ‘surge’ items, but also avoid unnecessary build-up of ‘slump’ items. This quick pivot in working capital deployment also earned the distributor better payment terms since none of their regional competitors approached suppliers systematically.

Align Working Capital to Customer Mix

Distributors traditionally have a ceiling on their working capital that’s been negotiated with lenders. In the current crisis, it’s been easy for firms to fall into the trap of focusing too much on these absolute working capital limits and not enough on opportunities to strategically realign working capital altogether by taking a closer look at customer mix.

An industrial distributor noted two major shifts in its customer mix in April and May. The distributor shipped products to 392 medical, healthcare and hospital customers that had purchased little-to-no product from them in the past.

They also observed a surge (28%) in e-commerce customers’ traffic. Seeing these shifts in their customer portfolio — in terms of new customers and channel mix — the distributor examined the items customers bought to determine additional working capital investment, and further classified the demand mix to understand one-time surge versus recurring demand before making additional inventory investment.

Put on Your Trifocal Lenses

Distributors’ business models are built on the premise of meeting core customer needs by supplying profitable products from strategic suppliers. The three lenses — core customers, strategic suppliers and profitable products — are critical for executives to filter the signal from noise. They are especially critical in a crisis where you lack sufficient time to respond.

Often, distributors build silos across functions, leading to narrow visions among C-level executives and middle managers. As a result, a purchasing team might discontinue an item or product category based on turns or other metrics without considering the mix of customers buying those items. Or the sales team might promise to stock an item without considering its profit profile and supplier base. At challenging times like these, such silo-driven decisions can cost firms both customer loyalty and healthy financial returns.

A building materials distributor has systematically built three critical analytics — item, customer and supplier stratifications — over the years. Throughout this crisis, the distributor used these analytics as an anchor to make critical decisions around redeploying working capital, allocating shortage products, obtaining extended supplier terms, and acquiring new customers across multiple channels.

Trifocal lenses helped the distributor make decisions that were both data-driven and timely. The executives and middle management used the same terminology and made decisions with clarity and confidence.

Distill the Signal from Noise

Managing demand planning (and resulting working capital and customer experience) is a critical deciding factor in terms of how well — and how quickly — distributors recover. Though the road to revenue recovery is ambiguous, effective demand planning helps them make customer-facing decisions more confidently.

Distributors that successfully execute these five steps will have the clarity to distill signal from noise and position themselves to eventually come out of the crisis ahead of their competition. Conversely, firms that wait until the crisis is over to think and act on these opportunities will be too late.

Senthil Gunasekaran is co-founder of ActVantage, which helps distributors drive profitable growth through analytics and talent development. He has more than 18 years of experience helping hundreds of distributors and manufacturers, while co-authoring seven books for the NAW. He also delivers executive education and speaks at industry forums. Prior to ActVantage, Senthil led research and industry projects at Texas A&M’s ID program. Contact Senthil at senthil@actvantage.com or visit actvantage.com.

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