Logistics & Supply Chain

The Right Place, Time and Price

Using Value-based Inventory Management to Improve Financial Performance

24.03.2010 -

Balance Act - In this economy, cash is king, and much emphasis has been placed on inventory reductions. In many cases, management has issued inventory goals that seem impossible to accomplish. Those who did not have good inventory management processes in place are finding it is even more difficult to achieve balance between service, costs and inventory investment.

The silver lining in the current dark cloud is the opportunity it is providing for firms to learn what problems are exposed as the inventory lake is lowered and to use these findings to improve planning and controlling. Often times in supply chain, we are like former Secretary of Defense Donald Rumsfeld, who once said, "We don't know what we don't know." The circumstances today encourage us to go find out.

Supply Chain Value Drivers

Value-based management has the macro goals to maximize profitability and minimize working capital. From a supply-chain perspective, three key drivers are customer service levels, supply chain costs and inventory investment (fig. 1).
The first step in improving inventory management is to understand how inventory impacts the value proposition. In supply chain management, our goal is to have the right product in the right place at the right time for the right price. This goal encompasses both service and costs. In addition, inventory consumes working capital that could be used to pay bills in the short-term or invest in the firm's future. The overall objective of supply chain management is to balance inventory levels across these multiple value drivers.

Inventory And Service Level

Inventory interacts closely with delivery performance and production and distribution costs. The most difficult value driver to quantify is service as defined by delivery performance. The occurrence of a stock-out often results in a highly emotional reaction from the sales function. Of course they want "zero" stock-outs. However, on-time delivery service above 95% is very costly.
In the current economy, many firms are taking more risks in regards to stock-outs, but those risks are often not linked to the variability in demand. When a major turndown occurs, the business needs a structured approach even more. In deciding management's bias toward more or fewer stock-outs, such factors as the expected customer response must be evaluated. In some businesses (e.g. packaged consumer goods), a stock-out results in losing the revenue in the short-term and if repetitive the customer may be lost forever.
In other businesses (e.g. chemical specialties), the customer base may tolerate more stock-outs because the cost of changing to another supplier is high and the industry norm is not 100% service. I worked with such a business to optimize their inventory level and asked they measure both backorders and order cancellations over a 90-day period. While they averaged about 5% backorders there were zero order cancellations during the period. This surprised their marketing and sales functions who had complained continuously of lost sales due to stock-outs.

Inventory And Production Costs

Inventory targets also affect production economies and distribution costs. Manufacturing operations is totally focused on unit cost and wants higher inventories to avoid changeovers and extend production runs. The cost to set-up and changeover should be part of the batch size or run-length decision. Unfortunately, this too often becomes an emotionally charged topic with data regarding the true cost of changes not available.
The least-cost batch size occurs when carrying costs are equal to set-up/changeover costs. A better practice is to include the expected rate of return on capital as a carrying cost instead of the over-night borrowing rate. Capital invested in inventory cannot be used to invest in the firm's future. Some key components of carrying cost are storage costs and risks costs. Risks cost can be significant based on the product's life-cycle and volatility in the marketplace. The range of carrying cost is great (i.e. 15%-30%) and each product group must be evaluated in deciding what value to use.
For continuous flow operations where rate-based scheduling is used, the inventory decision is usually made based on a finance perspective and the agreed upon inventory target becomes a constraint used in the production plan. For example, if the maximum inventory is set at 30 days of supply, when the production plan is developed the projected period ending inventory must not exceed 30 days. Because these plants are usually burdened with significant depreciation expense, the planning objective is to maximize throughput within the inventory constraint. Of course in today's economy the depreciation expense receives less priority than in normal times.

Inventory And Distribution Costs

Transportation cost is by far the highest logistics cost and is steadily increasing. Therefore, maximizing capacity utilization of carrier equipment and minimizing transportation cost per unit is an important goal in supply chain. Firms must routinely monitor volume changes in the network and adjust the container size and unit load accordingly. For example, look for opportunities to increase payloads (e.g. hopper truck to railcar) as volumes increase.
The tradeoff between service as expressed in order fulfillment lead time and transportation costs is a key driver to distribution network decisions. Fewer nodes in the network results in higher payloads and lower transportation cost but places more distance between the supplier and customer. Fewer nodes also results in less total inventory in the distribution network. For example, I worked with a business that succeeded in reducing their regional distribution centers in the U.S. from six to four, resulting in significant savings in transportation and inventory costs. However, part of the customer base had to accept an increase in order fulfillment lead time of up to two days. Price concessions were evaluated but in the end were not necessary to implement the new network design.
Sometimes container capacities have a negative impact on order quantity and inventory decisions. For example, a plant raw material planner was ordering truckload quantities of an item that cost $45/unit. A truckload (about 40,000 pounds) represented an inventory investment of $1.8 million and one year's supply. At 15%, the annual carrying cost averaged $135,000. The additional transportation cost to order less-than-truckload quantities was $90/order, as the vendor was only 90 miles away. When asked why he was ordering this in 40,000-pound quantities, the planner replied, "Because that is what a truck holds." I have seen this logic applied wrongly many times in supply chain management.

Improving the Value by Inventory

The key value drivers must be measured by key performance indicators (KPIs). The baseline data gathered will help in finding the truth and developing future strategies. As Satchel Paige once said, "It's not what you know, it's what you think you know that just isn't so." Once a company begins to measure and monitor performance, the truth surfaces.
I was once asked to help a business implement customer service measures. I suggested to the supply chain manager that performance targets not be set until we gathered baseline data. He insisted on setting a target of 97% on-time delivery (OTD) to customer request date based on an informal system being used that was reporting 98% service level. The first month the actual result was 87% OTD. The supply chain manager was devastated. When asked how they had reported 98% compliance in the past, customer service stated that was based on our committed dates, not on what the customer requested.
Marketing, sales, manufacturing, purchasing, finance and supply chain will have to collaborate to achieve the most value-add from inventory investments. The sales & operations planning (S&OP) process will enable this to occur. Finance is responsible for providing information needed by management to inject their current bias into the process. For example, in today's weaker economy with cash flow being of most importance many leadership teams have called for more inventory reduction.
There is an old axiom that states, "action without vision is a nightmare." This is certainly true in regards to managing inventories. Once leadership has established the vision, the supply chain function must facilitate the development of inventory targets which seek to balance service-cost-inventory goals. They must also take aggregate targets driven by the firm's financial position and translate to item-level targets that will maximize the value-added to the firm. Performance must be measured and actions taken to improve. Inventory management to achieve maximum benefit is a continuous journey, not a destination.