Three Common Pitfalls in Inventory Optimization

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

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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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The second pitfall is a gap in skills. The employees needed to implement and run the new optimization process and system may lack the necessary skills. An organization may have planners who lack the ability to change or to operate the new software. Investment in training may be enough to address the gaps for some personnel. In other cases, the existing staff may simply be the wrong people to operate the future process. Skill gaps can also occur in the IT organization, since implementing a new software solution requires IT staff to have specific knowledge and training in order to install, maintain and upgrade the software. The knowledge required to maintain another software solution can overburden the IT staff already responsible for maintaining multiple ERP, supply chain and other enterprise solutions. Whether it is business or IT personnel, a gap in skills can cause significant delay or even failure.

Whereas the first two pitfalls deal with concerns before and during implementation, the third pitfall comes into play after implementation. Companies that succeed in making the upfront investment and that address skill gaps either through training or obtaining the right people can still encounter issues with sustaining business value in the long term. Future promotions or attrition can expose holes in succession planning that lead to degradation in the use of processes and systems. Without adequate time for handover, job transitions to even qualified successors will suffer. The successor might even have a skill gap that can be easily addressed with training but may lack the support and funds for training because the implementation has been complete for some time. In summary, employee turnover can cause a successfully operating process to degrade in performance and, over time, stop producing the business value it was designed to create.

Use of a Service Provider

How do companies cognizant of the three common pitfalls avoid or overcome these obstacles when pursuing inventory optimization? One approach that mitigates all three pitfalls is to engage an experienced service provider that can bring inventory optimization capabilities in an outsourced arrangement. The software is owned, hosted and maintained by the service provider. This one-stop shop service eliminates the time and costs associated with the in-house approach, where a company must engage multiple partners to assemble all of the pieces required to own, integrate and implement the system.

After implementation, the inventory professionals that operate the software and run the optimization processes also reside at the service provider. The service provider performs the optimization on the relevant demand and inventory data and returns the optimized inventory parameters and replenishment orders. The company's planners review the optimized orders and execute inventory management just as they would on the currently derived parameters.

To avoid the pitfall of upfront investment, the partnership can be structured on a "pay as you go" basis, with payments commencing only after the solution is up and running. The time from cash outlay to value creation is immediate, and the payment is in proportion to the quantity of value creation. In this subscription approach, the company continues to pay for the service as long as business value is being created. The company can decide to stop and shut down the service with little notice and no large sunk costs. The service approach allows for a shorter time to implement by leveraging the installed base and experienced resources at the service provider.

In addition, a service provider brings the skilled functional resources required to operate and host the software and run the daily business process. Utilizing the professionals at the service provider mitigates both the pitfalls of skill gaps and employee turnover. The provider's inventory professionals are typically operating optimization processes for other companies as well, so their market skills are fresh. The company's planners review the optimized output from the service provider and accept parameters to execute upon just as they have in the past. The only difference is the parameters are now improved and optimized. Utilizing the resources of the service provider also means the chance of employee turnover leading to performance degradation is reduced as the service provider's personnel continue to operate the business process and system no matter how many times planners turn over and switch jobs.

In Summary

Inventory optimization provides companies with a scientific approach to dynamically plan inventory to meet desired service levels. Overall, the ability to create and sustain an inventory optimization capability is not a simple task. Common pitfalls include upfront investment, gaps in skills, and employee turnover. Engaging a qualified service provider to provide the inventory optimization resources can be an effective means to avoid these pitfalls. A service provider hosting the software under a "pay as you go" model removes the upfront investment. The fact the service provider's professionals are performing the daily process and using the software alleviates the risks from skill gaps and employee turnover. By using a service provider to overcome these pitfalls, a company increases its ability to create a competitive advantage out of inventory optimization. ¦

About the Author: Mike Valentine is director, supply chain design & innovation at UTi Worldwide, a global logistics provider also specializing in inventory optimization services for its clients' supply chains. He can be reached at [email protected].