My Turn: Profit From the Inside Out

Is there such a thing as profitable inventory? Absolutely. In the current economic downturn, the opportunity to reduce costs lays in your warehouse.

[From iSource Business, October 2001] Distributors, faced with the uncertainty that a slowing economy brings, are wrestling with the question of how even a moderate downturn will impact them. From reducing  expansion plans and looking for consolidation opportunities to putting off technology investments and generally cutting expenses, many possibilities are being considered as reduced sales and falling profits become a reality in some sectors. However, distributors have a significant and frequently overlooked opportunity to reduce costs and increase working capital  without scaling back operations, without making risky capital investments and without even going outside their own four walls. That opportunity is inventory optimization.

While many distributors are aware that they carry too much inventory  as much as 10 to 30 percent  many are at a loss when it comes to addressing the problem. Every business person knows that what isn't in stock can't be sold. Sloppy, inefficient inventory management can lead to all sorts of headaches for your company, not the least of which include unnecessary carrying costs, lost customers, lost sales and lost profits.

Although technology and other factors have shifted the focus of many distributors to issues related to the entire supply chain, there is still a strong emphasis on the physical aspects of inventory management, such as setting procedures to control physical inventory, determining the true cost of carrying inventory, and running reports from computer systems to measure turns. As undeniably important as these issues are, they are not focused specifically on how to make inventory management a true profit asset for your company.

With the help of technology and strategic inventory planning solutions, distributors can guard against the effects of economic downturns by taking advantage of the cost-reduction and sales-growth opportunities that sit in their own warehouses.

Out With the Old

As we all know, inventory optimization is a process that lets distributors reduce the amount of inventory they carry while improving service levels, ensuring that the right stock is available when and where it's needed, increasing turns, and reducing lost sale opportunities. Inventory optimization is rarely an area that management targets for sustained economic improvement. As long as orders are being filled and operations are running smoothly, companies can be reluctant to fix it. Part of the problem is found in some common misconceptions that many distributors have about inventory management.

One such misconception is that existing enterprise resource planning (ERP) systems can handle inventory management adequately. For small distributors not working in complex environments, this may be true. Most ERP systems do count and track inventory very well, and possibly even provide a basis for replenishment. However, such systems can lack the sophistication required to take inventory management to the next level, as well as the responsiveness necessary to handle rapidly changing market conditions. Nor do they have the depth or strength to evaluate and forecast inventory down to individual products and locations, which is essential if you're going to squeeze out additional costs and increase profits.

A second misconception is that turns are the most important measurement of success. Turns are certainly important, and profitable inventory management can actually increase the number of times distributors turn their inventory. But by focusing on turns exclusively, distributors often forego valuable discount brackets, profitable forward-buying opportunities and economic buying cycles. While capitalizing on these opportunities may appear to have a negative impact on turn rates, it's essential to analyze quickly and consistently the profitability of each buying situation, independent of the impact on turns.

A final misconception is that inventory optimization cannot provide the same profitability increase that a bump in sales will deliver. While sales are obviously important, ongoing inventory optimization practices actually afford the single largest opportunity to have a direct impact on profitability. Optimization of inventory can result in an inventory reduction of 30 percent, while also reducing out-of-stock situations and ensuring that the correct stock is available to satisfy demand. These are benefits that can't be realized by increasing sales.

Getting There

How much profit can be achieved from effective inventory management? By empowering the purchasing and supply management department with intelligent inventory and purchasing tools, the opportunity to realize significant annualized profits and generate additional working capital to help your company achieve critical business objectives is very real. This is true whether your company's objective is to survive an economic slowdown or buy out your biggest competitor.

The following areas are key to achieving your inventory optimization goals. Closely monitoring and reviewing performance in each one will have a significant, positive impact on your inventory management process. Therefore, revising buying procedures, implementing software and tools to increase the sophistication of your process, and generally establishing the right type of inventory management mindset will make your company successful in its inventory management efforts.

  • Lead-time Forecasting

You have your suppliers' promises of delivery and fill rates, and you have their average lead-time. But do you have their actual performance?

It's very hard to profitably sustain a customer service level of 98 percent if your suppliers are servicing you with a fill rate of 87 percent. If you have several stocking locations, that means you are cross-dock shipping, handling merchandise more than once or relying on your supplier to deliver each item to each location, on time. A common purchasing error is over-ordering to compensate for poor supplier performance.

  • Service-Level Analysis

This is your company's image to the marketplace. A multi-location distributor needs to have the correct information on performance of every item at every location.

By monitoring this information, which should include demand history, demand variation, profit margin and lost sales costs, you can establish competitive service levels.

  • Demand Forecasting

Most distributors track customers' consumption history along with demand velocity, lost sales, returns and other essential data. However, demand forecasting is not just about looking at recent or extended sales history. It must also include examining seasonality and life cycles, filtering promotional and spiked demand, reacting to trends, and evaluating item profit margins.

  • Order Frequency

This is probably the most overlooked of the profit opportunities. Correct order frequency analysis alone can reduce inventory by 10 to 15 percent.

The cost of ordering too frequently ripples throughout your organization. When you consider the expense of generating the purchase order, the cost of freight/receiving/put-away, acquisition costs, carrying costs, volume discount levels and supplier minimums, order frequency can have a tremendous impact on your profits. An uninformed buyer will order to sustain service levels or for perceived economic reasons, such as free freight.

  • Replenishment

On the surface, replenishment seems like a simple concept. Buyers should be able to place the order at the most profitable advantage for your business.But there are a number of factors that are often overlooked. For example:

Is this the right time to order?

Have the next potential order points been calculated?

Have potential overstock and out-of-stock projections been evaluated?

Do I have all the information I need about promotions, advertising, product

production changes, etc.?

This is a crucial point. The order is ready to go to your supplier and profit loss or gain is going to be directly impacted. This is the core of the hidden profit opportunity that separates the distributors who have a 20 to 30 percent or greater profit return on inventory from those who fail to capture these profit dollars.

Perhaps most important of all, however, is to firmly establish the principle that you will treat purchasing and inventory management as a profit center. More than just an abstract idea, this mindset establishes your priorities and sends the right message to your customers, suppliers and employees.

Leap of Faith

In times of economic uncertainty, it can be difficult to take the leap of faith required to realize the benefits that opportunities like inventory optimization provide. Companies instinctively work to preserve their capital and protect cash positions, relying on methods that have kept their businesses afloat through more than one potential crisis situation. These attitudes become even stronger when reviewing technology investments. People have been burned before.

So why does an initiative like inventory optimization merit special consideration? Part one of the answer lies in its ability to generate cost reductions and additional working capital for distribution companies. It's not uncommon for distributors to generate five to 10 times return on their investment in inventory optimization in six to 12 months, and initiatives of this type have saved more than a company or two from Chapter 11.

Part two lies in the feasibility of using inventory optimization techniques in the distribution environment. The process doesn't require major changes in your organization, nor should it impose a significant burden on your business. It's just an opportunity waiting to be taken advantage of.

In the world of distribution, inventory represents both your company's greatest cost and its most significant asset. By taking advantage of the opportunities that inventory optimization provides, distributors can start maximizing the return on their biggest investment.