Inventory management has always been critical to profitability. But, in today's economy, poor inventory management can put a company out of business before anyone even recognizes a problem exists. Everyone is at risk -- from manufacturers of goods that normally make a stop in a warehouse, to companies that buy supplies that go unused and tie up needed cash, to retail stores that lose sales because of stock-outs.
New technologies provide options to help solve this multi-dimensional equation. Many CEOs have been lured to the supply chain management promised land. Vendors with the latest supply chain techniques speak of phenomenal cost savings, efficiency and productivity increases. These sales presentations have become the CEOs' new reality and they expect to implement these improvements quickly in order to make the cost savings hit the P&L as soon as possible. While supply chain gurus have promised to improve productivity and dramatically reduce costs, these results are difficult if not impossible to achieve without flawless execution over a substantial period of time. Unfortunately, there is no magic formula.
The Inventory Triangle
Companies destroy profits every day by having too much inventory of the wrong stuff with high carrying costs, or by loosing customer orders because of stock-outs. Profit enhancing inventory management is hard work and requires numerous behavior changes. It is much easier said than done.
Effective inventory management occurs when three groups consistently communicate, collaborate and execute.
Saturn is a great example of interdepartmental collaboration. As chronicled in Harvard Business Review, Saturn realized its dealers were better at selling cars than inventory management. Sure we've all heard the horror stories about centralized purchasing programs -- never getting what you want and paying more for the product for the betterment of the "whole" company. Saturn mitigated this issue by sharing the inventory risk with dealers. The result was that dealer inventory turn is 7.5 per year versus the industry average of 2.5. This inventory management strategy increased profits.
Sales and Marketing
Sales and marketing is at the top of the inventory triangle because they sell stuff. That's their job. They make promises to customers on product specs, quality, delivery times and prices, including discounts and free add-ons. Sales and marketing frequently forget to talk with operations to ensure that what they promise customers can actually be delivered at the agreed upon price and produce a positive margin.
Again, HBR reports that, in 1995, Volvo had too many green cars in inventory. To move these green cars, sales and marketing offered huge discounts, rebates and other incentives on green cars. But, they didn't inform production and operations about these promotions so they doubled the production of green cars. After all, their data said that green cars were hot sellers. Volvo ended up with the same problem again...tons of green cars.
Today's business and consumer customers have the majority of the power in any buying situation. And, they are extremely educated about their options. Customers now demand the products they want be on the shelf when they want them or delivered to their unique specifications just when they need them. Of course, once a customer problem has been identified there's always a salesperson out there with a solution.
The media, especially TV commercials, have exacerbated this fantasy. Consumers are seen reaching through the grocery store refrigeration cabinet right into the orange grove for a carton of freshly squeezed orange juice. Or they're building a car on the Internet to their every detailed specification and then having it available within the week. While these commercials are inventive and entertaining, they also dramatically raise customers' expectations.
Since operations are responsible for critical sourcing and production decisions, this group is at the base of the inventory triangle.
The ability to customize sourcing strategies is critical and is more than simply evaluating the trade-offs between labor and shipping costs. If a certain SKU (stock keeping unit) has low volume and high variability, offshore outsourcing may be more expensive than manufacturing it close to customer -- even if labor costs are more than $1 an hour. And, don't forget to include delivery time as another moving variable in the equation.
The proliferation of several varieties of the same product makes sourcing and production scheduling even more difficult. Sourcing and production scheduling was much easier when there was only one flavor of Oreo cookies. Also, consider the variability in purchasing trends...more chocolate is usually sold at Christmas and Easter.
To maximize profits from inventory management, production scheduling must be done at the lowest level of detail -- by SKUs rather than by product line or product category. This takes time and solid data but skipping this step is costly. Remember: customers buy specific SKUs, not product categories.
The most costly mistake a company can make is inaccurate inventory records. A recent study published in the California Management Review showed that inaccurate inventory records cost companies, on average, 10 percent of profits per year. A major cause of inaccurate inventory records is return processing.
This can easily happen when online orders are returned in retail stores, or exchanges for size and color are not scanned properly into POS system. The physical inventory count will never match the system totals because of the lack of return processing discipline. If your company's physical inventory counts never agree with the "system," you're leaving money on the table.
Finance is on the foundation on the inventory triangle since this is the department that puts the puzzle pieces together. CFOs are often called to explain why promised results aren't realized even though they have very little to do with the actions that caused the poor results. To maximize effectiveness, finance needs to ensure that sales, marketing and operations understand the effect that their decisions and actions have on profits.
To maximize profits, finance needs to assume four tough but essential inventory management roles:
- Corporate strategy vs. inventory strategy alignment: Inventory management strategy must match the corporate strategy. Sounds obvious, but this frequently doesn't occur. For example, if the corporate strategy is high volume and low margin per item, the inventory strategy must facilitate this. Or, if the corporate strategy is one of large assortments or a limited assortment, the inventory process must match.
- Orchestrating the right level of forecasting detail in each department: Finance folks are always trying to save time -- because time (along with knowledge) is their biggest asset. Saving time is good and high-level planning is useful, but it's critical that the operations and sales do the detail work. This detail work is tedious and no one likes it. Ensuring that everyone sees the link between sales and production detail forecasting is critical since this "number crunching" is traditionally a finance task and is perceived to be less valuable than their "real" jobs. It can be a hard sell unless you can link their efforts to preventing profit drains. Linking effective forecasting to compensation is a very effective change tool.
- Forecasting based upon future trends vs. the past: Today, budgeting and forecasting needs to be based on the future not just past performance. For example, this year's flu vaccine inventory was reportedly based on historical levels plus an increase. It still wasn't enough and this year's flu hit the young harder than the elderly. It's hard to say if this could have been "perfectly" predicted but companies that focus on future trends versus historical numbers increase their profitability odds. Let's remember the Volvo green car example again.
- Quality of Inventory Data: Since operations can only produce goods at the SKU detail level and customers only buy at the SKU level detail (not at the product category level), accurate SKU inventory records, sales forecasting and production schedules are a must. Finance is usually the only group that sees all this information and, because of its analytical skills, can quickly tell when the data doesn't make sense.
This is why technology alone is never the answer. To evaluate the quality of the inventory data from supply chain systems, find out who stays late to make sure the data input for the day is completed on time and accurately. Then watch the game of "it's not my job." But timely data enter is critical for making inventory decisions.
Other key questions to ask are:
- Who's inputting the data?
- Who's interpreting the data?
- Who is accountable for data quality?
Beware of filters! As you know, the way data is interpreted dramatically affects the resulting decision. Filters are created when inventory reports are designed by technology professionals who make data assumptions. Avoiding filters is as easy as insisting on seeing the raw data. The downside is that making sense of the data can be a time-consuming task. At the very least, insist on understanding the assumptions behind calculations on every number. Since business decisions are only as good as the data, this is an essential role for finance to maximize the company's profits.
Again, the perfect inventory level is having the right number of the right products when the customer wants then -- with nothing left over. When the next customer calls, magically it happens again. Unfortunately this is just a myth. Regardless of the automation level of the inventory management process, business judgment is still required as well as effective execution. Key decisions have to be made and flawlessly executed to maximize profits.