Posts Tagged ‘Inventory Optimization’

Globalisation 4

In my opinion Logistics industry can be described as wheels of Globalization and key to the market expansion and competitive product availability to the growing global consumers. Dynamic business conditions and confronting economic conditions are driving globalization. Globalization is resulting due to expanding markets, exploding retail market, product proliferation, ever changing needs of customers, economic downturn, cost pressures, technology, cultural integration and government policies around the world. It would be wrong to assume that globalization influences economy and trade only; we are seeing integration in the areas of culture, media, education, research and development, tourism and even climate change.  On political front, we see collaboration and collective approach in addressing daunting challenges we face today.   Globalization will make our societies more creative and prosperous, but also more vulnerable and in transforms economies more competitive.

Let us review some vital statistics (Source: Armstrong & Associates Inc.).  First let us review the region wise Logistics spend vs. 3PL revenue (2012):

Globalisation 1

Obviously Asia Pacific Region heads the chart in all categories if we exclude remaining other countries which were consolidated under other countries.  It would be worth looking into Asia Pacific region by country in order to identify the growth countries.  Top five are highlighted here under:

Globalisation 2

If we look globally, it would be interesting to compare the numbers and easy to identify the globalization impact on different countries:

Globalisation 3

It would be very interesting to analyse 2013 numbers as the world trade is not promising.  World trade is expected to grow by 2.5 percent this year and 4.5 percent in 2014 (source: The World Trade Organisation).  More and more companies are developing agile supply chains and compressing product supply lead time and at the same time reduce the cost of production.  In order  to achieve all these goals, outsourcing supply chains is one of the solutions.  According to CAPGEMINI Consulting 2014 report 72% of the shippers are planning to increase use of outsourced logistics services and whereas the 3PL companies believe that 78% increase in business.  Let us hope economy responds well in 2014!

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In my opinion, optimization means maximising the return at a given risk level or risk is minimised for a given expected return.  The two key elements that dominate the meaning of optimisation are the risk and ROI.  Now Inventory Optimisation means maintaining a certain level of inventory that would eliminate the out-of-stock situation and at the same time the cost of carrying inventory is not detrimental to the bottom line (ROI).  In simple inventory optimisation means balancing demand and supply.

Inventory is the largest single asset that most companies have. Unfortunately, it consumes space, gets damaged, and sometimes becomes obsolete and carrying surplus inventory costs the organisation.  Despite well-documented studies that have proven a 77% correlation between overall manufacturing profitability and inventory turns, manufacturers and traders by and large have acted with ignorance and carried excess inventory to please customers.  Today’s customer thinking is totally different and they suffer from the problem of plenty and the gratification is instant.  They do not have the patience to wait for the product, they don’t mind considering other brands with the same product features and most of the time they may buy the product if they are convinced that the product would meet their expectations.

What level of additional inventory is optimal?

How do you know if you have too much, too little, or just the right amount of merchandise inventory? One way is to compare the value of your current inventory to an “ideal inventory investment.”  The optimal safety and cycle inventory is determined by two factors, supply lead time and predictable demand for a specific time period. In fact, the third factor that could play a critical role is the demand deviation percentage.  Whereas the cycle inventory is expected to cover the demand during supply lead time, the safety stock is expected to cover the deviation in predictable demand and uncertainties in supply lead time.  If we are able to understand and master the technique of identifying these three factors, the inventory balancing is a piece of cake.  But unfortunately, no one is able to crack the code so far.

Safety stock is basically carried to protect against the out-of-stock situation.  Out-of-stock level measurement is industry and segment specific according to Bruce Tompkins.  In the case of manufacturers, the out-of-stock level is assessed at the distribution centre or product level whereas in the case of retailers at the store level or individual buyer level as shown in the below given graphic.

Source: “The Supply Chain Consortium’s report Supply Chain Planning, a True Balancing Act.”

According to Bruce Tompkins, average safety stock varies between 10% and 30% of monthly sales by industry and segment. Cycle stock ranges from 85% to more than 190%. This is based on the report, “The Supply Chain Consortium’s report Supply Chain Planning, a True Balancing Act.”  Industry wise the cycle inventory and safety stock levels are shown in the below given graphic:

How Top 25 Supply Chains behave?

When we compare the basic activities of the supply chain (plan, source and supply) of 2009 top 25 supply chains and others we may not notice any significant difference in efficiency levels as shown in the below-given chart.

Source: Kevin O’Marah (APICS) 2009

The critical difference between the top 25 supply chains and the rest of the pack is the leadership traits. As you can see from the above chart, only sourcing efficiencies are better compared to others.  This factor negates inefficiency caused due to deviation in predictable demand to some extent.

How they are different from the rest of the pack?

The leaders in 2009 top 25 supply chains clearly proved to the world how they are different from the rest by demonstrating leadership in the following areas:

  1. Strategy and Change Management;
  2. Customer Management;
  3. New Product design and launch;
  4. Post-Sales Support.

Top Five Techniques to achieve inventory optimisation:

Let us identify top 5 inventory management techniques and compare how the top 25 supply chains have embraced it.

  1. Reduce replenishment cycle time:  This is one of the critical factors in deciding the safety stock.   Shorter lead time for inventory replenishment would lessen the complexity of supply chain.  However, due to global sourcing, this is becoming a great challenge.  Lead time consists of three factors, time taken to place the order, manufacturing time (includes sourcing time) and transit time.  What is critical in establishing the efficient cycle time is the accuracy or certainty?  There is no point having a shorter lead time with huge uncertainty.  It would be easier to plan for longer lead time with minimal uncertainty.
  2. Rank the Inventory: It is necessary to know which part or SKU hurts more if you carry excess inventory.  The best way to rank the inventory is ABC classification. High dollar volume (A), moderate dollar volume (B) and low dollar volume (C). “A” Parts should comprise the top 80% of dollar volume, “B” Parts about 15%, and C Parts about 5%.  The ranking should be based on dollar volume.  The ABC classification system is a tool that will help you employ your inventory control efforts efficiently.
  3. Eliminate Obsolete Stock: Ideal way to identify the obsolete stock is to run FSN analysis periodically.  FSN stands for fast, slow and non-moving items.  The criteria to decide fast, slow and non-moving is specific to industry and product.  In an IT industry if we have a finished product has not shown movement from 21 to 30 days, it is considered as a dead inventory.  Explore the possibility to liquidate non-moving items, review the slow moving items and identify the reasons for sluggish movement and take necessary action.  The red dot/tag sale organised by many organisations is the result of identifying dead inventory.
  4. Understand your customer: Carrying surplus safety inventory is mainly due to lack of understanding about the customer buying patterns.  It is very important to understand the customer and their needs to adjust your supply accordingly and it is fundamental to the inventory management success.
  5. Optimise your SKUs: Product proliferation is one of the reasons for dismal forecasting performance.  The proliferation of SKU numbers is the unfortunate consequence.  One more factor that is contributing to inefficiency is the inefficient management of product lifecycle.  The launch of the new product should be the end of the old product in most cases.  However, customers would prefer to order old products in spite new product with additional features.  This would lead to confusion and inefficiency in planning.

Now compare the five suggestions with the findings of AMR 2009 research and it is a close match.  Strategy and change management is critical to managing your supply chain efficiently.  Supply chain efficiency to a large extent depends upon inventory efficiency.  Understanding the customer and their needs is very critical in positioning your product in the market.  There is no point trying to sell a product that is not an immediate need of the customer.  It is like trying to sell laptops in an economically back word country where customer priorities are different.  Timing is very critical for new product design and launch and at the same time, product life cycle management is also equally important to improve forecasting efficiencies.

I asked myself whether Inventory Management is the key to the business success. I strongly believe that it is certainly a bigger factor in influencing the business success.  However, the results of 2010 AMR Research 2010 findings were not aligned to my thought process. The biggest average revenue growth registered company did not fare well with regard to their inventory management. However, the most comforting factor is that the leader, Apple Computers showed all-around success. Using the data provided by the AMR Research, I have sorted the data based on inventory turns which are the point of discussion for now and the results are quite interesting:

While analysing and understanding the above table one should consider the industry-specific characteristics.  Inventory carrying patterns differ from industry to industry.  Further, one should not draw conclusions based on the above table because two of the factors in the above-given table are based on 3-year average and whereas inventory turns shown in the table is for the period of assessment.  However, if we go by the average revenue growth factor all growing companies managed reasonable inventory turns specific to their industry.  I have again sorted the data based on 5% and above average growth registered companies and the efficient inventory management is a contributor to the success as shown below:

Let us not forget that the purpose of carrying safety stock is to protect customer service from volatile demand variation during the lead time or delays in receiving a replenishment shipment. Hence, it would be ideal to maintain safety stock considering the variation in demand and lead time.  The greater the variation in demand and/or lead time, the more safety stock will be maintained for the item. This method is known as the “average deviation method.”

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Weight in gym room

Do you know that carrying excess Inventory costs financially?  Well, you may not see the cost of carrying inventory in your Profit and Loss statement, but trust me it hurts you big time financially.  According to one survey conducted by IMR in conjunction with Harding & Associates indicate that almost 45% of the respondents have no inkling of what is Inventory carrying cost and how it is calculated.  Joseph Mazel of IOMA believes that, “The higher the number used to calculate carrying costs, the more potent it is in reducing inventory.”

But what is Inventory Carrying Cost (ICC)?

“Inventory carrying cost (ICC) is the cost of holding one unit of an item in stock for one period of time” – Waters, D.

Inventory is a tangible asset that is intended for sale. For most retailers, wholesalers and distributors, inventory is the largest single asset on their balance sheet. We do come across business leaders who are comfortable in carrying buffer inventory by sacrificing a portion of their profit margin in the form of inventory carrying cost.  Some believe that carrying buffer inventory is a kind insurance to ensure better service levels.  In my opinion carrying right inventory may improve the service levels.  But the trick lies in determining the right inventory.  There is a cost associated with carrying excess inventory and that cost is known as Inventory Carrying Cost.

Why Companies hold Inventory?

The main objective of holding inventory is to maximise the customer satisfaction by avoiding loss of sales due to lack of inventory.  However, there are six basic reasons why companies hold inventory and they are:

  • Globalization;
  • It enables the firm to achieve economies of scale.
  • It balances supply and demand.
  • It enables specialisation in manufacturing.
  • It provides protection from uncertainties in demand and order cycle.
  • It acts as a buffer between critical interfaces within the supply chain.

All the above reasons are compelling business reasons to support the top line revenue growth, to maximise customer satisfaction and at the same time to improve the gross margins.  Inventory holding helps organisations to achieve first two objectives.  In order to achieve the third objective, Inventory carrying should be optimised.  Excess inventory carrying means an additional cost of carrying which shrinks gross margins and cash flows.  It’s the emphasis to improve the bottom line performance and enhance the organisation’s cash flow position.

There are six different types of Inventory we carry.  They are:

  • Cycle Inventory – Average amount of inventory used to satisfy demand between shipments.
  • Safety inventory – Inventory held in case demand exceeds expectations.
  • Seasonal inventory – Inventory built up to counter predictable variability in demand.
  • In-transit Inventory – Inventory in transit between origin and destination.
  • Speculative Inventory – Inventory held for the reasons of speculation.
  • Dead Inventory – Non-moving inventory.

When we see the value of inventory in the balance sheet as an asset it could include all above different types of inventory.

Components of ICC:

Inventory carrying costs influences many decisions in Strategic, Analytic and Operation levels.

Strategic Decisions: Profit Margins, ROI, Make or Buy, Global or local sourcing etc.

Analytical Decisions: Total Cost of Acquisition; BTO (pull) or BTS (push); Where and what amount to store, Annual Operational Budgets etc.

Operational Decision: Lot Size; Price Break even analysis, EOQ, Evaluating promotional deals and lifetime buys etc.

As inventory carrying costs encompasses several critical decisions, it is necessary to determine what cost should be included in inventory carrying costs. Generally,  ICC is reflected in a percentage of the value of an item.  It contains several components.  The ratio of such components may vary depending on the organisation,  product involved and location.  The components of ICC would typically include the following:

The general thumb rules used for Inventory Carrying cost would be 25% per annum.  However, one has to customise the formula based on various factors.  The dominating factor of Inventory carrying cost is the cost of money, followed by local taxes, Warehouse costs, Obsolescence, and Pilferage etc.  Supply Chain Manager all over the world is concerned about carrying additional inventory. Inventory carrying is directly linked to gross profit of an organisation and profits would go up when inventory carrying is reduced and the profits diminish when inventory carrying goes up.

As mentioned in one of my articles, it is very easy to convert cash into Inventory.  However, it is very challenging to convert Inventory into Cash even though it is considered as a tangible asset.  There are several ways one can optimise inventory levels. I have already written an article on Managing Inventory, hence I am not going to spend time on how to optimise inventory.

Industry wise Inventory Carrying pattern:

Inventory carrying varies industry to industry. I was involved in a research supervision while I was teaching, based on the data collected by a student, I would like to compare the inventory carrying trends of Retail, IT/High Tech, and Automotive industries.  All of them are considered as growing industries.  The average data pertains to year 2000 to 2005.  By analysing the gross profits and inventory turns, the numbers reveal great opportunity for improving inventory carrying in Automotive, IT/High Tech and Retail.  The data pertains to the global players and they have the clout to dictate terms to their suppliers and manage better inventory turns.  The below-given data may be used for reference purposes only.

TO: Turnover; GP: Gross Profit.

Optimising the supply chain and inventory management delivers the benefit of freeing up working capital that could be used for business expansion activities.  When we reduce inventory, we are not only freeing up invested capital but also creating opportunities to reduce expenses and improve profitability and maximise cash flows.  We announce productivity numbers, we announce sales achievements, we announce profit margins periodically and we seldom come across Inventory Performance announcements.

Inventory needs our attention! Inventory reduction improves profit margins, maximises cash flows and reduces operations cost.  Let us just do it!

Cartoon Source: ReadyToManage


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We all worry about Inventory Control and Inventory carrying costs. Let us ask one fundamental question, why we carry inventory at all? There could be many reasons for that but some very important are:

1. It enables the firm to achieve economy of scale.
2. It balances supply and demand.
3. It enables specialization in manufacturing.
4. It provides protection from uncertainties in demand and order cycle.
5. It acts as buffer between critical interfaces within the supply chain.

Even though there are five reasons given, I see only two reasons and they are, to meet uncertain demand and to save costs. The very important reason why we carry inventory at different levels in supply Chain is due to uncertain demand. We carry inventory in anticipation of customer order. That is a fair assumption, but the issue that bothers me is lack of efficiency in demand forecasting. I agree no one is good at creating forecasts accurately. But you can always improve your inaccuracy as you go forward and my question is why we are unable to correct it, is it impossible? No it is not, but it needs some level efficiency to achieve it.

Cartoon Source:http://www.scdigest.com, contributed by Kari McEwen.

The other reason is to achieve economy of scale. Fully justified in case of seasonal demand products such as fire crackers, winter clothing, rain jackets etc. but not sure why should go for mass production for an every day consumed product and suffer from inventory carrying costs?

If some one is able to find answers these two questions, we have cracked the DNA of Inventory Control. In my opinion inventory control is about discipline. Discipline in planning discipline in buying, discipline in selling and discipline in warehousing and managing inventory. If we are able to develop checks and balances to control forecast inaccuracy, we should be infusing discipline into planning activity. If we are able to balance our buying process and do not allow EOQ factor to influence our buying pattern, we would be in a position to control what we buy and buy what we sell. In the name of cost savings, I have witnessed large corporations buying huge quantities and ending up with inventory that bites. As long as one is able to liquidate inventory quickly, it works out well for any organization. Procurement experts should look at establishing collaborative approach with the suppliers and develop solutions to could liquidate non moving inventory and at the same time meet the unplanned demand.

Being a supply chain professional I have worked closely with many sales teams. Surprisingly, I have seen one similarity across all industries and that is, demand is generated for a product for which the organization is running low on inventory. Is it something to do with customer mindset? Not sure. If we agree with a production plan and create inventory for product “A” and invariably the demand is more for product “B” which was not part of our planning. I am unable to understand the reason behind this pattern. We end up creating back orders, low clear to build ratio and order processing is on allocation instead automated.

I have worked with a great and successful CEO who used to send a very simple message to sales, “sell what is available”. It needs great ability to do that. I strongly believe that Sales teams all over the world have the ability to do that. It is only matter of honing that skill aggressively. The best example is the second hand car sales person. Often we end up buying what he wants to sell.

We do hear about inventory shrinkage, it is an unpardonable blunder. One of the objectives of warehousing is to assure protection of assets. If we are unable to achieve it with the help of world class WMS (warehouse management systems) and with best of breed surveillance techniques, it is shame. If you are unable to handle operational excellence, outsource and drive excellence through KPI monitoring and improving.

Explore the possibility of establishing pull process with regard to buying and by using Vendor Management Inventory (VMI) model and differ the inventory ownership. Collaborating with vendors and sharing consumption pattern in order to prepare the suppliers for the demand onslaught or slump. Explore the possibility of using Cross Dock or JIT models (again a pull process). In order to implement all these concepts, the supply should be abundant, delivery cycle time should be very short and competitive market conditions. All industries may not enjoy the luxury of meeting all the above mentioned criteria. In those circumstances, we should explore conventional inventory control techniques and keep the inventory carrying costs down.

Inventory carrying cost us in $$ and it may not appear in P&L as a direct cost, but it is a fact that it costs us up to 25% per annum as explained in the below given graphic.

Hence, it is essential to control the inventory and add value to the business process by minimizing inventory carrying costs. In order to control inventory we need inventory status update on online basis (inventory visibility). The first step towards inventory optimization is to know your total inventory in supply chain. The second step would be to understand poor inventory management symptoms. They are:

1. Increasing number of back orders;
2. Low Inventory Turns;
3. High Customer Turnover rate;
4. Lost Sales;
5. Periodic lack of sufficient storage space;
6. Inventory Variance;
7. Obsolete inventory.

Some of the suggestions for improving inventory control:

1. Create Inventory Visibility;
2. Introduce aging (FSN) analysis of Inventory if not already in practice;
3. Create accountability and introduce incentives for meeting inventory targets;
4. Implement Cycle Counts every week and ensure stock take once a month;
5. Classify the inventory (A,B, and C) and increase focus on big ticket items;
6. Improve surveillance efficiency to eliminate pilferage;
7. Optimize Ordering Process;
8. Share POS information and consumption patterns with Vendors;
9. Make Vendors jointly responsible for avoiding stock outs and excess inventory;
10. Align supply with Demand;
11. Invest time in reducing supply lead time;
12. Partner with suppliers with great flexibility to adopt to the changing demands;
13. Introduce checks and balances in Forecasting methodology;
14. Develop six month rolling forecast plan and freeze some portion of the plan depending upon supply lead time;
15. Opt for modular production techniques;
16. Deploy excess buffer manufacturing capacity/encourage like minded third party manufacturers;
17. Introduce postponement to address product differentiation;
18. Explore possibility of inventory differing concepts for dependent demand related products;
19. Consider Inventory balancing in a decentralized inventory carrying situation;
20. Consider consignment sales for independent demand products to maximize sales.

We all know these techniques but still end up with huge inventory. The reason behind the debacle is lack of discipline in implementing the best practices and silo approach adopted by majority of organizations. In order to achieve overall success, we need an integrated and collective approach internally and collaborative approach externally.

Cartoon Source:http://www.scdigest.com, contributed by David Armstrong.

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