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Starting a chain reaction

Reduce supply chain costs, generate additional capital, and increase service levels
with inventory optimization

by Howard Coleman

Recent supply chain management developments have dramatically changed how businesses can compete, supply chain vs. supply chain. A supply chain can be a competitive advantage and a source of business value to a company. For those that have not examined their inventory and supply chain drivers in some time, and have not fully recognized the value of new business intelligence applications, it's time to take a look at how some new innovations can impact profit, service level and working capital improvement.

Many business owners are familiar with the pricing and gross margin analytical software available today that allows companies to drill down into product pricing, customer
statistics, etc. This information aids in the development of what-if scenarios that help predict the results of pricing policy decisions and their impact on gross margin.

Inventory optimization—a subset of these broader analytics—enables more intelligent supply chain decisions that allow businesses to unlock working capital while maintaining or improving desired service levels. In other words, inventory optimization views inventory as a strategic asset, not as a problem.

Inventory optimization software is used to perform a rigorous analysis of inventory, which is then used to identify specific changes to inventory stocking and replenishment processes. This data can then be used to correlate inventory investments to product revenue and profit generation opportunities.

The rationale of inventory optimization
Through inventory optimization analytics, one can drill down to specifics. For example, if it is necessary to provide differing service levels by product, group or location; when adding a branch or two changes the game; or if different markets require different approaches. Stocking strategies become very important, particularly when related to business objectives, specific product attributes (such as fast movers, slow movers, new products, critical products, etc.), demand expectations and supply characteristics.
The challenge of inventory optimization can be even more daunting in multi-location distribution networks, where product is stored at a central point (a CDC or hub) and the DC is the internal supply to the branches (the customer-facing locations), otherwise known as the hub-and-spoke distribution model. The nuts and bolts of inventory optimization involve carefully setting and monitoring the specific drivers of inventory management, which are interrelated and use information gathered from each other:

• Desired service levels. This involves setting and monitoring the desired service level performance of the inventory itself, down to each SKU. Most ERP systems alone don't provide service-level analysis and reporting. Rather, one must peer into demand history, demand variation, GMROI and lost sales.
• Demand forecasting requires an understanding that goes beyond simply having knowledge of recent sales history. It requires an understanding of demand pull and continuous flow concepts and their use to develop appropriate target inventory levels for each product.
• Replenishment order frequency. Replenishment is not just reordering or what it costs to generate a purchase order. Rather, it's how much to order—each time an order is placed. That's where each order costs a company money. More accurately pinpointing an optimum or best order frequency can, by itself, account for significant inventory reductions and service level enhancement.
• Lead time. Anticipating lead time with accuracy goes beyond simply determining a supplier's lead time from past averages; it requires an in-depth assessment of the supplier's overall performance as well as an understanding of its impact on all locations within the distribution network. The goal is to minimize or eliminate self-defeating practices such as over ordering or over transferring inventory in an attempt to compensate for variations in supplier performance.

A hub-and-spoke distribution network can have some major pitfalls because stocking and replenishment strategies are often applied to one echelon without regard to the others. Potential negative consequences include excess inventory in the form of redundant safety stocks (at both hub and spoke); stock-outs at a spoke, even though adequate inventory exists in the distribution network; and a minimal relationship between what is ordered and the actual demand being experienced (due to demand variability).

There is often a split in replenishment approaches, similar to a
sequential approach—one for the DC and one for the spoke. This poses problems:

• Lack of visibility up the demand chain. When a spoke seeks to replenish itself, it's blind to suppliers beyond the DC. The spoke ignores any lead times other than its own—the lead time from the DC. The spoke may also assume that the DC will completely fill its replenishment orders each and every time. Depending on the ERP system, the spoke may not have any visibility into the DC's inventory balances.
• Lack of visibility down the demand chain. Similar to the case above, when the DC seeks to replenish itself, it may be oblivious to customer demands beyond those of individual spokes and/or have no visibility into the spoke's inventory balances.
• Demand distortion. Because the DC and spoke create independent demand forecasts based on their own immediate customers' demands, distortions in demand causing peaks and valleys in inventory levels often result.
• Total distribution network costs. If one or more of the spoke's inventory drivers are modified, the cost implications may be readily apparent at the spoke, but not readily visible to the DC. The impact becomes strictly focused on one single echelon.
• No linkage between safety stocks. Each DC and spoke protect themselves independently, therefore, any desire to optimally balance inventory is made more problematic.

So overall, this lack of cohesiveness is caused by independent decisions as to how inventory will be managed, whether at the DC or at the spoke.

Committing an organization to realizing the benefits of inventory optimization will require a change in thinking. It also requires a solution, or tool, to realize that objective, making inventory optimization something that companies should consider as a source of real supply chain management business value.

Distribution-focused companies must view supply chain management not only as an untapped profit and service level enhancer, but also as a cash saver. By making these concepts a reality, total supply chain costs can be reduced, additional capital generated, and service levels increased in a meaningful way.

Howard Coleman is principal of MCA Associates, a management consulting firm that works with wholesale distribution companies. Reach him at (203) 732-0603 or hcoleman@mcaassociates.com or at www.mcaassociates.com.

This article originally appeared in the Jan./Feb. 2012 issue of Industrial Supply magazine. Copyright 2012, Direct Business Media.

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