Connecting Operations and Finance Makes Firms More Efficient

Kevin Shang studies supply chain integration

July 1, 2019
Management, Operations

Common sense says cash flow should influence how much inventory firms buy, and when.

But as firms grow, decision makers in finance and operations communicate less and less, making them less responsive to changing business environments.

Kevin Shang, an operations professor at Duke University's Fuqua School of Business, is trying to change that – both in the classroom and through his research.

“Startups and smaller companies can see a clear connection between operations and finance,” Shang said. “But when firms get to be huge, these two departments naturally separate and it becomes harder to talk to each other.”

Shang’s research focuses on the role of working capital in inventory buying decisions. He has developed formulas that tell firms and supply chains how much working capital to maintain when making inventory and investment decisions.

His latest work, Managing Inventory for Firms with Trade Credit and Deficit Penalty, is forthcoming in the journal Operations Management. Working with Wei Luo of Spain’s IESE Business School, Shang found firms make better inventory decisions when they take financial flow into consideration.

Shang has also updated a classic operations teaching tool to better prepare students for the financial variables they’ll face when working in operations.

“When we teach finance or accounting we talk about working capital, which represents the liquidity of a firm,” he said. “But too often in practice it isn’t clear how important daily operations decisions are to working capital. And the working capital of an entire supply chain can be just as important as the working capital of each firm in the chain.”

To illustrate this in the classroom, Shang took a famous operational simulation called the Beer Game and added a financial component.

Traditionally, the game focuses on the flow of information and materials along four players in a supply chain, that is, from upstream to downstream: manufacturer, distributor, wholesaler and retailer. Students are assigned one role in the chain and must place and fill orders from the next player. As information flows upstream in the form of orders, the material product — beer — flows the other way to fill them.

The game is used to teach students about inventory dynamics, and to illustrate the bullwhip effect — how small changes in demand at the retail end of the supply chain get amplified and cause inefficiencies further up. But the game had no cash component — the students didn’t have to “pay” for the orders — and doesn’t reflect the practice.

“A complete story about the supply chain must include the financial flow,” Shang said. “In the real world, you have to worry about financial liquidity.”

So Shang added a financial variable to the game.

“It’s an extra task,” he said. “If my inventory after ordering is high, my cash after payment will be lower. But the cash level is also influenced by my downstream partners who order from me, so the dynamic becomes complicated.”

What Shang’s version of the game teaches — as supported by his research — is that the optimal inventory control policy is related to working capital: the sum of a system’s cash and the monetary value of its inventory.

A system can be a single firm or an entire supply chain, Shang said.

“Either way, the level of working capital plays a significant role in making effective inventory decisions,” he said. “Your total working capital will tell you how much to order.”

The integration of finance and operations — often referred to as supply chain finance in practice — not only makes firms more efficient, but also strengthens connections along a supply chain, Shang said. But, he added, this efficiency can only happen when a supply chain itself is collaborated between firms and different functional departments of the participating firms are integrated.

For example, as manufacturers rebounded from the 2008 recession, the construction equipment manufacturer Caterpillar realized their suppliers might not be able to handle increased demand because they had scaled back to ride out the downturn.

“Caterpillar helped their suppliers finance to increase liquidity and build capacity so they would be able to satisfy orders when they came,” Shang said. “You can only do that if the supply chain firms are fully collaborated,” Shang said. “If you’re not integrated and you don’t know how much working capital you have, you can’t be as responsive as you need to be to react to the environment."

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