Optimization is defined as making the “best” of anything. The true meaning is in defining what is the “best.” In the case of inventory, in my opinion, it’s the balance between the improvements in return on assets (ROA) and the loss in sales and customer good will. That careful balance needs to be constantly evaluated in an analytical fashion from one operating period to another.
Besides the obvious issues of having all the necessary data and tools to do the optimization, there are some headwinds that companies often face and struggle with:
- Improving ROA normally means inventory reduction initiatives. These are significantly diminished when the margin of the product is high simply because stock out cost greatly outweighs inventory carrying cost on the high-margin items. Remember … inventory is valued at cost (not selling price), so high-margin items can also be low-cost, making them a bigger contributor to the bottom line. As a first test, balancing stock-out costs with inventory carrying cost helps determine which items should be optimized or reduced.
- Finished Goods Inventory (FGI) optimization will be most important to companies that have thin margins, high sales volumes and longer replenishment times. A small mistake in inventory planning could blow the financial budget or cause sales to drop due to product availability. In today’s global sourcing world, longer replenishment times are the most common.
- Fashion oriented or seasonal products are particularly difficult to plan since the buying season is short and the procurement times are long, requiring an upfront gamble on inventory. Normally, items not sold during the season loose value and are sold at a greatly reduced price to avoid obsolescence, which is a key component in carrying cost.
- If you look at the problem from a pure analytical perspective, reducing the overall replenishment lead time will produce the largest reduction in total inventory – no surprise there. However, there are a few other operational drags on the optimization process.
- The key contributors to higher inventory requirements (real headwinds to optimization) are forecast error, replenishment time and replenishment time variability, and the desired customer service level (how well orders are fulfilled). A good rule to remember is that reducing demand forecast error (the planning side of the equation) produces twice the positive effect as reducing lead time variability (the execution side of the equation).
- Surprisingly, inventory carrying costs are much higher than operational folks think. 15% to 25% are not unusual when all things are considered, such as borrowing rates (not interest rates), warehouse storage costs, taxes, obsolescence and insurance.
- Not to be forgotten are the pressures applied by the sales and marketing team to have more inventory to support their prospective sales opportunities. This head wind can sometimes be managed by more closely tying sales compensation to inventory. Frankly, this is a rarity in most businesses; but if the business is predominately sales forecast-driven, then it becomes more important as a balance against the demand for more inventory by the sales team.
Several common performance metrics can be used to help determine how to do a better job of inventory planning (optimization). These metrics should be viewed in relationship to product segmentation, which includes margins and sales volume.
- Sales / Inventory shows the rate of inventory flow through to customers.
- Days of inventory indicates how much cash is used for stored capacity and should be compared to lead times as well as product demand.
- Total inventory, of course, is a big factor in asset utilization or ROA since inventory is usually one of the largest items on the balance sheet.
- GMROI (gross margin return on investment of inventory) by product. Normally used by retailers, it is an excellent measure of financial leverage of inventory.
All of these headwinds blow in the face of optimizing inventory and determining the overall efficiency of your supply chain. Another important supply chain dynamic to consider is agility. In one of my next posts I will discuss supply chain agility.
This post was written by John Hughes