Three Common Pitfalls in Inventory Optimization

How to use a service provider to create a competitive advantage out of working capital


By Mike Valentine

In the depressed world economy of 2008-2009, most companies faced significant profit challenges. In response, companies initiated cost containment and reduction programs with particular emphasis on inventory. As finance executives shone a spotlight on the working capital of the balance sheet, supply chain executives scurried to reduce inventory investment. Thus, efforts at working capital reduction often took the form of inventory reduction initiatives.

Given the prevailing sense of urgency, many companies chose a high-handed approach to reduce inventory through simple rules of thumb. For example, one automaker uniformly slashed its minimum levels for domestic landed inventory of Asia-sourced parts from six weeks to three weeks. Rules of thumb, however, are a risky approach to driving lower inventory levels because they can easily result in stock-outs or, worse yet, lost sales. Informed companies instead pursued a more effective course of action known as inventory optimization.

The Scientific Approach

Inventory optimization is the scientific approach to dynamically planning projected inventory to meet the desired service level. Optimization plans each SKU individually instead of treating all SKUs alike. The result is a more optimal inventory level that may increase an individual SKU but overall reduces the inventory levels within the supply chain.

Algorithms can re-plan inventory as often as daily using the inputs of demand history, forecasts, actual lead time performance and service level goals. This scientific approach to inventory planning is complementary to traditional inventory management processes. Since it is complementary, inventory optimization software enhances, and does not replace, the ERP system handling inventory management. As shown in Figure 1, optimization serves to set better targets while inventory management remains the mechanism to execute to those targets.

Supply chain leaders looking to either start or sustain an inventory optimization initiative should familiarize themselves with the financial benefits as well as common obstacles to success. This article details three common pitfalls associated with inventory optimization projects and discusses an implementation approach to avoid or mitigate these pitfalls.

The Benefits

Inventory optimization can have a positive impact on both the balance sheet and the income statement. Lower inventory levels decrease working capital on the balance sheet, letting assets move into free cash flow. On the income statement, benefits include the reduction in inventory carrying costs as well as labor expenses required to order, receive, put away, cycle count and pick the excess inventory. Companies pursue inventory optimization for the reduction of inventory, but the benefits accrue not only to the financial statements, but also to operations. Inventory optimization enhances operations through increased service levels, increased sales, increased inventory turns and reduced obsolescence.

As today's world economy shows sign of recovery, the trend of attacking working capital is still pertinent. Many industry experts see nothing wrong with the conventional wisdom that inventories will grow again as demand recovers. But if inventory reduction is seen as a prudent measure during an economic downturn, why do so many companies relax inventory discipline when markets strengthen? Companies looking to gain a competitive advantage over industry peers will maintain inventory discipline as demand recovers. Moreover, companies with an inventory optimization capability will be best equipped to use working capital as a competitive weapon against peer companies that are still using rules of thumb to manage inventory.

Three Common Pitfalls

As is the case with many process reengineering projects or IT implementations, inventory optimization projects encounter difficulties both during and after implementation. Some projects stall, and even fail, before implementation is complete. Both the need for upfront investment as well as gaps in the required skills of personnel can contribute to dragging a project under before it is off the ground. Even projects with successful implementations can cease to provide value down the road when employee turnover causes lapses in business processes and knowledge. A successful initiative to establish a long-term capability must address these three pitfalls of upfront investment, skill gaps and employee turnover.

The first pitfall is upfront investment. When building an inventory optimization capability, many companies attempt to install and operate a software solution in-house. This approach requires a significant amount of time and money to select the software and gain executive support for the chosen software vendor. A duration of six to nine months is not unusual to navigate through a vendor selection and executive approval process, yet this lengthy first step has only secured the software partner. The selection of an implementation partner plus the actual implementation can take another six to nine months. If a system integrator is required for the integration of the optimization software with existing ERP package, add another two to three months to select that partner. The lengthy time to implementation can often skew an otherwise healthy business case and result in a longer-than-acceptable payback. It is the dynamics of the traditional in-house software implementation that drives the upfront investment of people and cash; often well ahead of the time when the investment starts to yield value. The most benign effect of upfront investment is a reduction in the business case value, while the most lethal effect can spell death for the project.

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