Bridging the Reality Gap

While manufacturers try to avoid it like the plague, excess and obsolete inventory can often result due to unexpected demand or product configuration changes. However, in this age of outsourcing, the new challenge emerging is how to accurately determine the inventory liability between the original equipment manufacturer (OEM) and their contract manufacturer in an environment of rapid changes.

Before delving into this topic, it's important to understand the concept of inventory liability. Historically, inventory was always thought of as an asset given that it's a valuable item of property that factors into an organization's financial standing. However, while it's technically still an asset from an accounting perspective, many organizations now view it as a liability because they have become more and more sensitive to the financial risks associated with having the inventory on-hand. Neither the OEM nor the contract manufacturer wants to take ownership of the excess inventory when demand suddenly drops, which is why it has become such a delicate issue in today's climate. As a result, inventory is now driving behavior and forcing companies to become more demand-driven.

One of the poster children of this new reality is Dell, which has based its business model on the concept that inventory is a liability. While the company ships 20 million products per quarter, it never keeps more than three days of inventory on hand. A main driver of this is frequent demand changes and rapidly evolving products that quickly become obsolete — thus creating a liability if you're stuck with them. As a result of efficiently managing inventory liability, Dell is delivering superior business performance when compared to its less agile competition. According to AMR Research, "Dell is everyone's favorite example of modern supply chain best practices because it has built a $40 billion business that is fundamentally make-to-order — the exact opposite of 1920's era Ford Motor Co." As further validation of its 21st-century supply chain model, AMR claims, "Dell is the world's best example of a Demand-Driven Supply Network."

Another good example is Wal-Mart. As a retailer, Wal-Mart doesn't own its products, but rather sells the products of its suppliers. So Wal-Mart considers actually "owning" inventory to be a liability. As a result, it focuses its "best practice efforts" on providing a highly responsive supply chain so it can maintain a minimal amount of inventory on-site while still being responsive to customer demand. It is forward-thinking companies like these that have realized the importance of aligning their supply and demand chains as closely as possible that have reduced their excess and obsolete inventory, improved service levels and ultimately will increase profitability.

The Challenge

Minimizing inventory within supply chains characterized by short product life cycles, volatile demand and frequent product changes has always presented a manufacturing challenge. Traditionally, even vertically integrated manufacturers have been challenged to communicate the impact of frequent forecast or product changes to their plants and suppliers. As a result, supply chain plans are often executing to an out-of-date forecast, which can result in excess and obsolete inventory.

In today's age of outsourcing, this challenge is only exacerbated by the fact that more and more companies have extended supply chains with plants and partners located across the globe, where demand planning may be performed by the OEM in one location while supply planning is being managed by the contract manufacturer in another. This makes the synchronization of demand and supply (an already difficult problem) even more challenging, with the additional dimension that information concerning supply and demand decisions must be clearly understood by both the contract manufacturer and the OEM. In order to provide a cost effective supply, the contract manufacturer needs to be able to make supply orders based on a forecast, particularly for long-lead time components; however the need to respond to frequent forecast changes can quickly result in excess inventory, which might be either the consequence of poor supply planning or inaccurate forecasts. As a result, it's increasingly difficult to calculate ownership of inventory, which is the heart of the inventory liability problem.

Achieving a fair allocation of inventory liability creates a considerable strain on the relationship between OEMs and contract manufacturers. The OEM is looking for maximum demand flexibility at the lowest possible cost, while the contract manufacturer must profitably manage the cost while still providing the flexibility to rapidly respond to the inevitable demand or product changes. According to AMR Research, "Companies must manage their inventory risk in a more innovative way. They need visibility and assessment tools that can measure and report the risk."

Managing Inventory Liability

A new approach to managing inventory liability that both enables manufacturers to reduce inventory liability and also alleviates the stress in an outsourced relationship is currently emerging. Response management technologies are providing the ability to respond to the impact of changes in demand, supply and product configuration on inventory liability across the extended OEM/contract manufacturer supply chain.

A response management system extracts enterprise resource planning (ERP), supply chain and manufacturing service agreement data from both the contract manufacturer and the OEM. It then enters it into an integrated system to provide real-time insight to anticipate potential problems, review multiple action alternatives and respond to the constant changes in their supply and demand chains. As a result, OEMs and contract manufacturers can respond to any changes in the supply chain and communicate the impact of changes to their outsourcing partners immediately, thus reducing their inventory liability. Providing the ability to determine the "what-if" impact on inventory liability resulting from forecast changes, changes in supply policies (e.g. lot sizes, safety stock levels) and product changes not only can avoid costly changes but can also ensure that the OEM and contract manufacturer mutually understand the impact of a business decision.

Case In Point

In the high-tech consumer electronics industry, where products tend to have a short lifecycle and demand is volatile, a response management system can be used to manage new product introductions and align them with the end-of-life of older products. This is particularly challenging given the predominance of outsource OEM/contract manufacturing relationships in consumer high-tech electronics. However, a response management system can be used by high-tech electronic companies to simulate what would happen if they were to introduce a new product before actually doing so in order to evaluate the inventory liability associated with different effectivity dates and determine the best time to introduce new products and make old products obsolete. As a result, they are able to lower their labor costs, reduce inventory liability and ultimately improve the bottom line.

The Result

As exemplified by demand-driven pioneers such as Dell and Wal-Mart, which have mastered real-time information flow, the success of an organization is heavily dependent upon the amount of inventory liability it has. Companies that reduce their inventory liability by becoming a demand-driven organization are in a good position to come out on top in the rapidly evolving global economy.