This investigation into the management of inventory under working capital constraints was motivated by a distributor of industrial equipment that buys heavy goods from a manufacturer and sells them to various business users. The manufacturer, which has a finite production capacity, ships orders requiring a non-negligible delivery lead time and receives full payment after a fixed number of periods following delivery. Customer demand is random. Once a delivery is made, the customer must pay after a fixed number of periods. The distributor's challenge is to determine an inventory management policy that balances its inventory and shortage costs. The problem is further complicated by a limit imposed on the distributor's working capital requirements (WCR). The distributor's WCR, defined as the quantity being financed (the value of on-hand inventory plus accounts receivable) minus the quantity that is financed by the manufacturer (accounts payable), cannot exceed a maximum value that is set by the distributor's parent company. Throughout its operating cycle, the distributor must ensure adequate customer service in a self-financing fashion—that is, generating sufficient funds through sales to procure additional inventory.
The recent spotlight on micro-retailing is another key motivator for our study. With little or no access to external financing, small, typically family-owned firms must carefully manage their operating cycle, generating sufficient cash from sales to replenish their inventories for business continuity.
Finally, a common practice for banks has been to offer asset-based financing. However, under the current lackluster economic conditions, such asset-based financing has become more difficult to obtain. In this setting, cash flows generated by a firm’s operations have to be explicitly incorporated into the operational decision making process—beyond the common practice of imposing an exogenous budget constraint on activities such as procurement, production, and sales.
With today’s lingering global economic crisis rendering external financing increasingly difficult to secure, explicit consideration of the interactions between material flows and cash flows has taken on added importance. In the literature, however, there is little investigation of the relationship between finance and operations. As a result, these decisions are often made separately without a unifying perspective on how these trade-offs affect the performance of the firm.
The objective of this paper is to construct a model to depict the interactions between material and cash flows as well as to quantify the impact of these interactions on performance. Through this study, we identify some unintended consequences of financial constraints and propose a framework to mitigate their impact while satisfying financial requirements.
The traditional approach for modeling inventory management challenges in the face of demand uncertainty is the newsvendor framework. We will extend this framework by incorporating cash flows that might constrain replenishment decisions. We explicitly consider the lead times within the operating cycle (replenishment lead time, payment period for accounts payable, collection period for accounts receivable).
In addition, instead of setting a known, exogenously determined budgetary constraint, we model the available cash in each period as a function of assets that are updated through the procurement and sales activities.
