The case for inventory optimization
Narendra Mulani -- Logistics Management, 2/1/2009
When it comes to supply chain management, no company excels in everything. Of course, no company should aspire to be tops in every supply chain management category, because the required effort and expense would be unjustifiable. Instead, most organizations correctly focus on identifying and optimizing those supply chain capabilities with the greatest potential to help maximize efficiency, growth, and profitability.
The above reality—the need for tradeoffs—is inescapable. Yet it is surprising how many businesses have not made “inventory optimization” a top priority. A large number, in fact, perceive their inventory management competencies to be satisfactory and have chosen to pursue excellence in other supply chain processes, such as sourcing/procurement, manufacturing, and transportation. This is not wrong, but Accenture has frequently observed that companies underestimate the value that high performance in inventory management provides.
One reason is limited visibility of the influence of inventory practices and policies across the supply chain. For example, if the information needed to establish minimum safety stock levels is routinely unavailable, inaccurate, or incomplete, the negative effect on costs, service, and flexibility may also be difficult to discern.
Even more common, however, is that companies don’t fully consider the range of benefits associated with superior inventory management. They probably know that reducing stock levels can free up working capital and improve cash flow—often by as much as 30 percent. But this alone may not be sufficient to build an ironclad business case. Other potential improvements must also be acknowledged:
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Lower carrying costs: Less inventory reduces expenses associated with warehousing, insurance, damage, shrinkage, administration, and taxes.
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Improved asset utilization: Reducing inventory frees up assets such as warehouse space and material handling equipment.
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Higher customer service levels: Improvements in defined customer service levels have been known to reach 10 percent. Increased customer loyalty naturally follows.
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Reduced operating costs: Decreased warehousing, labor, and freight costs improve the bottom line.
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Improved supplier relationships: Smoother, more predicable order flows are a boon to suppliers, and may even save money by allowing suppliers to manufacture and ship more efficiently.
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Increased revenue and gross margin: Inventory optimization programs can raise sales volumes by reducing stockouts. Sales volumes may also be buoyed by improvements in product mix realized by better aligning service and cost to serve.
Given these benefits, inventory optimization could be one of the few initiatives that belongs at, or near, the top of every company’s to-do list. A detailed diagnostic and cost-benefit analysis are needed to know for sure. But if even the most general symptoms are present, a closer look is probably warranted.
For example, it is relatively easy to know if frequent stockouts are an ongoing problem: Below-target service levels combined with above-target inventory levels are a sure sign of inventory-optimization opportunities. Companies with highly complex or decentralized supply chain networks also tend to be good inventory-optimization candidates because aggregating demand by synchronizing and coordinating information flows can significantly reduce inventory buffers.
Long supply chains are another red flag: Global sourcing tempts some companies to maintain higher inventory levels to protect against increased lead-time variability. Other companies, however, underestimate globally sourced inventory requirements and thus encounter service failures and lost business. Either way, failure to properly consider the inventory impacts of offshore sourcing can result in costly implementation of the wrong sourcing network.
Improved accounting for lead time variability can help keep safety stocks realistic and minimize the tendency to order large quantities. A final harbinger is numerous products or product lines. The more products a company offers the more slow-moving products it’s likely to have. Inventory optimization programs focus most intently at the SKU level, thus helping to minimize slow-moving product stocks, while ensuring availability of fast-moving products.
Making it happen
The mission of this article is not to describe the specifics of an inventory optimization project, but rather to emphasize the importance of investigating such an initiative. Still, most companies can expect an inventory optimization program to begin by identifying the minimal level at which stock should be replenished and the amount of stock needed to stay within a cost-effective ordering frequency.
This is typically done at the local level—for a single production tier or distribution node—and may escalate to include every SKU within each production tier or distribution node. Either way, this first step of setting safety stock levels would take into account all the factors that affect inventory levels and inventory turns, including lead time, lead time variability, supply quantity variability, demand and demand variability. With this information in hand, an organization is positioned to make practical decisions about optimal replenishment parameters and optimal inventory placement.
As shown in the graphic, an inventory optimization initiative may begin and end as a pilot study for a single distribution node, encompass all SKUs throughout the production and distribution network, and even continue on an ongoing basis to accommodate changing variables. The key, however, is setting the stage: understanding the myriad potential benefits and taking steps to assess their applicability.
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