As an operative or tactical buyer, your role isn’t just about finding the best suppliers or negotiating prices—it’s also about managing a critical financial aspect of procurement: operative capital. This blog post unpacks what operative capital means, why it matters, and how you can positively influence it in your day-to-day work. Let’s dive in!
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What is Operative Capital?
Simply put, operative capital (also called working capital) refers to the funds a company needs to keep its supply chain running smoothly. It covers the money tied up in:
- Inventory
- Accounts payable
- Accounts receivable
For buyers, the focus is often on inventory and accounts payable—essentially, the money tied up in the products your company buys and how quickly you’re required to pay for them.
Think of operative capital as the fuel that keeps your business humming. Too little, and the engine sputters. Too much, and you risk inefficiency and missed opportunities for investment elsewhere.
Breaking Down Operative Capital: Inventory, Accounts Payable, and Accounts Receivable
Operative capital is the financial lifeline that ensures a company’s supply chain functions seamlessly. To truly understand how it works, let’s dive deeper into the key components: Inventory, Accounts Payable, and Accounts Receivable, with relatable examples for each.
1. Inventory: The Heart of Operative Capital
What it is: Inventory represents the stock a company holds at any point in time—whether it’s raw materials, work-in-progress (WIP), or finished goods waiting to be sold.
How it ties up capital: Every unit of inventory sitting in a warehouse represents money that’s tied up. The more inventory you hold, the more operative capital is required to maintain it.
Examples:
- Retailer: A clothing store with racks full of seasonal items. The longer these items remain unsold, the more money is tied up in unsold stock.
- Manufacturer: A factory producing furniture might hold large amounts of raw wood and partially assembled chairs. These represent inventory that isn’t generating revenue yet but still ties up capital.
- E-commerce: An online seller with a warehouse stocked with electronics might experience capital strain if sales slow and inventory turnover drops.
Buyer’s Influence on Inventory:
As a buyer, you can influence inventory levels by optimizing order quantities and lead times. For instance, instead of ordering a year’s worth of material upfront, work with suppliers to deliver in smaller, more frequent shipments.
2. Accounts Payable: The Leverage You Have with Suppliers
What it is: Accounts payable refers to the money your company owes its suppliers for goods or services it has received but not yet paid for.
How it ties up capital: While it’s technically not tying up your capital, the terms of payment influence when cash leaves your company. Shorter payment terms (e.g., Net 30) require quicker payment, which increases the demand for operative capital.
Examples:
- Net 30 Payment Terms: Your company orders $100,000 worth of raw materials with an agreement to pay within 30 days. After day 30, you’ll need that cash on hand.
- Extended Terms: Negotiating Net 60 terms instead means you don’t need to pay for two months, effectively freeing up cash for other uses in the interim.
- Advance Payments: Some suppliers require partial payment upfront, which immediately ties up operative capital before you even receive the goods.
Buyer’s Influence on Accounts Payable:
As a tactical buyer, you can negotiate extended payment terms with suppliers. This gives your company more time to generate revenue from the purchased goods before needing to pay for them.
3. Accounts Receivable: The Waiting Game for Customer Payments
What it is: Accounts receivable is the money your customers owe your company for goods or services they’ve received but haven’t paid for yet.
How it ties up capital: Until your customers pay, your company’s cash flow is constrained. The longer the payment terms offered to customers, the more operative capital is tied up.
Examples:
- Retailer: A B2B wholesaler sells $50,000 worth of products to a retailer on Net 90 terms. The wholesaler must wait three months to get paid, during which it needs to finance its operations with other capital.
- Manufacturer: A furniture company delivers a large order to a hotel chain but agrees to a 60-day payment window. During those 60 days, the furniture company’s operative capital is tied up.
- Service Provider: A logistics company invoices a client for transportation services but must wait 45 days for payment, while still needing to pay its drivers and fuel suppliers immediately.
Buyer’s Role in Accounts Receivable:
While buyers don’t directly control customer payment terms, their choices—like selecting suppliers who offer favorable terms—can help balance cash flow. Additionally, buyers can ensure smooth coordination with suppliers to avoid delays in delivery, which can delay invoicing customers.
Connecting the Dots
Operative capital sits at the intersection of these three elements:
- Inventory ties up cash while goods are waiting to be sold or used.
- Accounts Payable determines how much breathing room you have to pay suppliers.
- Accounts Receivable affects how quickly you can get paid by your customers.
By managing these elements strategically, buyers can significantly influence the company’s need for operative capital. Whether it’s reducing excess inventory, negotiating better payment terms, or ensuring smooth supply chain operations, every decision counts.
Remember: Operative capital is all about balance. Too much tied up in inventory, short payment terms, or delayed customer payments can create cash flow issues. On the flip side, optimizing these elements ensures your company can grow sustainably without unnecessary financial strain.
The Cost of Operative Capital and WACC
Here’s where the cost of capital comes into play. Money isn’t free—it comes with a cost, whether it’s equity from shareholders or debt from lenders. This is measured by something called the Weighted Average Cost of Capital (WACC), which we’ve covered in a previous blog post.
WACC is an interest rate and essentially tells you how much it costs the business to hold that operative capital. If you can reduce the amount of capital tied up in the supply chain, you directly reduce these costs and contribute to your company’s profitability (from P/L perspective only capital externally provided influence the cost via interests paid).
How Buyers Can Reduce Operative Capital Needs
Reducing the need for operative capital doesn’t require a financial wizard—it requires smart, tactical decisions. Here’s how operative and tactical buyers can make an impact:
1. Improve Payment Terms
Negotiating better payment terms with suppliers can delay when cash leaves your company, freeing up operative capital. For example, moving from Net 30 to Net 60 terms effectively gives your company an extra month of liquidity.
Want to learn more? Check out our online course about payment terms to deepen your understanding and sharpen your negotiation skills.
2. Reduce Lead Times
Shorter lead times mean less inventory sitting in your warehouse, reducing the amount of capital tied up in stock. Work closely with suppliers to explore ways to streamline production and transportation timelines.
When lead times are long, companies often maintain higher inventory levels to avoid running out of stock while waiting for new shipments to arrive. This is called safety stock. Shorter lead times reduce this dependency. Shorter lead times reduce the risk of running out of materials because you can react more quickly to changes in demand. Instead of holding excess stock as insurance, you can rely on your supplier to deliver on time when needed.
3. Optimize Purchase Orders
Balancing order sizes and frequencies is key. Ordering too much ties up capital in excess stock; ordering too little leads to frequent orders, increasing logistics costs. Analyze demand patterns and work with suppliers to find the sweet spot for your assortment.
4. Leverage Logistic Concepts like VMI
Vendor Managed Inventory (VMI) can be a game-changer. In a VMI arrangement, the supplier holds and manages inventory until it’s needed, significantly reducing your company’s inventory burden and operative capital needs.
Bridging Operative and Tactical Buyer Roles
Both operative and tactical buyers play crucial roles in managing operative capital.
- Operative Buyers: Your focus is on the day-to-day. Think carefully about how your ordering decisions affect inventory levels and cash flow. For example, does splitting a bulk order make sense financially, or does it unnecessarily increase logistics costs?
- Tactical Buyers: Your role is more strategic. Negotiating better payment terms and lead times can have a ripple effect, improving cash flow and reducing operative capital needs.
Collaboration between these roles is key. Operative buyers can provide insights from the ground level, while tactical buyers can set strategies that make managing operative capital easier for everyone.
Final Thoughts
Managing operative capital isn’t just a financial exercise—it’s a practical part of procurement that directly impacts your company’s success. By improving payment terms, reducing lead times, optimizing purchase orders, and leveraging concepts like VMI, you can play a pivotal role in reducing costs and driving efficiency.
Remember: Every decision you make as an operative or tactical buyer has a ripple effect on your company’s financial health. Keep learning, stay curious, and always look for ways to make procurement smarter and more efficient.
Difference between operative capital and operating capital
Yes, there is a difference between operative capital and operating capital, though they are related concepts. The terms are sometimes used interchangeably, but they focus on distinct aspects of financial management within a company. Let’s clarify:
Operating Capital
- Definition: Operating capital refers to the funds a company needs for its day-to-day operations. It ensures that a business can meet its regular operational expenses, like:
- Salaries and wages
- Rent and utilities
- Office supplies
- Inventory for ongoing operations
- Purpose: Its main goal is to ensure smooth business continuity and cover all costs required for daily functioning.
- Scope: It’s broader and includes a company’s working capital (current assets minus current liabilities) along with other operational costs.
Operative Capital
- Definition: Operative capital is more specific and often tied to the supply chain and procurement processes. It focuses on the financial resources needed to manage:
- Inventory (raw materials, work-in-progress, finished goods)
- Accounts payable (money owed to suppliers)
- Accounts receivable (money owed by customers)
- Purpose: Its focus is on optimizing financial resources tied up in the procurement and supply chain to improve liquidity and efficiency.
- Scope: It’s narrower than operating capital, specifically addressing the funds involved in the supply chain and related activities.
Key Differences
| Aspect | Operating Capital | Operative Capital |
|---|---|---|
| Focus | Overall business operations | Procurement and supply chain processes |
| Scope | Broader, includes working capital and operational costs | Narrower, limited to inventory, payables, and receivables |
| Examples of Use | Paying salaries, rent, utilities | Funding inventory, managing payment terms, and accounts receivable |
| Objective | Ensures the business runs smoothly | Optimizes cash flow and reduces tied-up capital in supply chain |
Overlap
The two concepts overlap in areas like inventory management and accounts payable, as both play a role in ensuring the business has enough liquidity to meet its needs. However, operative capital zeroes in on optimizing cash flow in the context of supply chain activities, while operating capital looks at the broader picture of keeping the entire business operational.
Another term is Working Capital. Visit Investopedia if you want to learn more about Working capital.
Liked this blog? Don’t forget to check out our online courses and resources at “Learn How to Source” for more insights and practical tools to elevate your procurement skills.