By Can A. Dogan – From Supply Chain Quarterly
Companies work hard to reduce inventory and increase order-fill rates, yet many continue to experience erratic, stagnant, or declining inventory performance. The comprehensive approach outlined here can help them achieve the improvements they seek.
The supply chain executive was puzzled. “If I were to combine the promised inventory benefits of all recent performance-improvement projects,” she said, “my company today would be achieving 100 percent customer service levels while maintaining negative inventory. Why is it, then, that year after year, my company’s actual inventory performance is stagnant or declining?”
This executive is far from alone in expressing those concerns. They’re being echoed by finance and supply chain leaders across industries as their companies struggle to achieve material and sustainable improvement in inventory performance.
Inventory performance is a result of all the management and control activities related to inventory. Cash tied to inventory is an investment, and inventory performance is about getting the greatest benefit out of this investment. Reduction in inventory, while desirable, is just one of the multiple objectives of inventory-performance management. In general, good inventory performance involves managing a number of factors, including service levels, product availability, and profitable mix of products, versus reductions in inventory that could risk the ability to maintain the right product mix and level of product availability. Typically, better inventory performance results in inventory reductions due to companies’ organized and proactive behaviors related to the planning and management of inventory.
The problem of poor performance stems from the fact that inventory historically has been viewed by supply chain and finance executives as a simple means of ensuring supply continuity. They have largely focused on the three traditional “legs” of inventory management: inventory deployment (how much to allocate, which inventory at which place); replenishment (quantity, how much to order when); and control (counting and accuracy). But more recently, organizations have started to gain a greater appreciation of the role of inventory in driving business performance. Indeed, inventory is best viewed as a means to drive business performance by improving customer service, enhancing revenue, and streamlining operational efficiency.
To obtain the best performance from their inventory investments, global supply chain leaders should establish a holistic inventory-performance framework that takes into account all supply chain and related functions, and they should understand how all these functions collectively drive inventory performance. The purpose of the framework is to identify and analyze the drivers and connections between inventory-performance outcomes and the operational and market activities that impact them. With an inventory-performance mindset, therefore, the objective is to understand all the factors (drivers) affecting inventory, rather than focus only on current inventory levels and imbalances.
Understanding these drivers can help bring inventory strategy down to an actionable level within the organization. With the right governance structure and process, this more holistic approach to inventory management can help finance and supply chain executives direct the transformational changes that will drive the sustainable improvements they seek.
The inventory-performance imperative
There are several important business issues driving the need for companies to achieve better inventory performance. They include:
- Business growth: Entering new and emerging markets increases the rate of product proliferation and supply chain complexity. An accelerating pace of product innovation and shorter product lifecycles are adding to inventory challenges. In addition, growing customer expectations are increasing product complexity and compressing order-response times.
- Cost reduction: Companies are taking several approaches to cost reduction, each with its own set of issues. Efforts to source low-cost materials, for example, tend to lengthen their supply lead times and increase supply variability. Their work to outsource more supply chain services can reduce managers’ visibility of this function. On top of these factors, financial pressure to rapidly reduce inventory investment can provide temporary benefits but can also adversely affect inventory mix and service levels.
- Structural changes: Global supply chain hubs that companies create in order to leverage centralized management models and improve their tax effectiveness often result in key functions like planning and procurement being located far from core manufacturing and distribution activities. The breakdown in process, policy, and technical alignment that can result adversely affects inventory performance.
- Supply risk mitigation: Expanding a supply chain’s geographic reach can increase the risk of supply shortages and breakdowns. The typical lack of end-to-end inventory visibility, together with supply uncertainty, also can prompt redundant inventory hedging throughout the supply chain.
In an attempt to effectively manage inventory around the globe, most companies have invested heavily in process improvements and technology to get the right product to the right location in the right quantity at the right time. Some have leveraged their investments to achieve material and sustainable inventory-performance improvements, including better order-fill and inventory-turn rates. However, most companies have found that their expenditures to improve inventory performance have not netted the projected benefits.
One reason is that globalization has expanded both the supply chain breadth and complexity of most companies, often resulting in inventory investment spread around the globe. A combination of policies, processes, technology, and data coordinated across a wide array of functions and trading partners collectively drives inventory performance. Each additional layer of functional entities that are trying to manage a divided and higher level of inventory adds more variability and bias to the inventory levels. Unfortunately, the challenges associated with coordinating all of this across more functional entities in more locations have resulted in the growth in inventory investment outpacing business growth for many companies.
In addition to tying up limited financial resources, coordinating policies, processes, technology, and data across multiple organizations can have a number of other effects. These may include:
- Warehousing: Growth in inventory levels and latency increases handling and storage costs.
- Transportation: Inventory-mix problems associated with declining performance increase transportation costs because of redundant product movement and premium freight.
- Obsolescence: Increased inventory latency, combined with shortened product lifecycles, raises the value of inventory written off each year.
- Manufacturing: For many companies, excess inventory (in other words, product availability) may lead to manufacturing plant shutdowns and is a key contributor to unplanned manufacturing plant down time and its considerable associated costs.
The traditional approach
Executives with a proven track record for achieving return on investment will gain the greatest access to financial resources. Conversely, each failed investment, initially justified by a projected improvement in inventory performance, further limits an executive’s access to financial resources. A fundamental challenge relating to inventory performance lies in its disparate governance, control, and accountability. Supply chain executives, working in concert with their finance organization, must expand their span of control and drive inventory performance into the strategies, policies, processes and performance management constructs of all functions that have the potential to impact inventory performance.
Failed approaches to addressing inventory-performance problems usually exhibit at least three of the following four characteristics:
- Inventory reduction (not performance) is viewed as the primary objective.
- Inventory performance is treated simply as an ancillary benefit of disparate performance-improvement projects.
- There is an overemphasis on systems and technology as “the solution.”
- There is a lack of focus on attaining and sustaining inventory-performance targets.
Let’s consider each of these four characteristics and how they undermine inventory performance.
Inventory reduction as the primary objective. Focusing purely on reducing inventory can be detrimental. In fact, increased inventory can drive better business performance—by improving customer service, for example. In addition, inventory reduction and inventory performance are often mistakenly considered to be synonymous. That alone can create problems. However, for most companies, inventory mix often represents a greater challenge than aggregate inventory level. In other words, the problem of not having enough of the right product frequently trumps the problem of having too much inventory. Companies suffering from “inventory-reduction myopathy” (a nearly exclusive focus on inventory reduction) tend to game the system to meet near-term financial targets. Like a dieter focused on dramatic short-term weight loss, these companies not only quickly regain the reduced inventory but also often end up increasing their aggregate inventory in response to an unanticipated drop in customer service levels.
Inventory performance as an ancillary benefit. Companies often treat inventory performance as an ancillary benefit of disparate supply chain improvement projects. But this approach can lead to an inability to relate changes in performance to any one particular project; that, in turn, can result in the double-counting of benefits. Each project, therefore, can (and often does) claim that some of the improvements are directly related to its own effort.
This behavior often relates to a company’s inability to effectively assess and address the variable array of potential inventory drivers. Without this visibility and insight, a company’s ability to control and sustain the apparent improvement, as well as to drive incremental improvement, is compromised.
Overemphasis on systems and technology. The past 20 years have seen explosive growth in the number of supply chain software applications and their capabilities. This increase can outpace the collective knowledge base of the supply chain organization, often limiting their ability to effectively apply and fully leverage their capabilities. Many organizations seeking a “quick fix” tend to overemphasize the role of technology in achieving inventory management objectives. Industries are littered with companies that have de-emphasized critical elements such as processes, policies, people skills, organizational design, data reliability, metrics, analytics, and reporting by focusing primarily on technology enablement. These companies often find themselves weighed down with systems that are, at best, never fully leveraged, and, at worst, simply abandoned over time.
Lack of focus on attaining and sustaining inventory-performance targets. The most common characteristic of failed inventory-improvement efforts is a lack of three things: effective performance targeting, recognition of goal attainment, and ongoing measurement and tracking. Too often, target setting is inflated by unrealistic expectations or, conversely, is suppressed by those concerned with being held accountable for achieving the targets. Baseline (current) inventory performance, against which future performance is to be evaluated, is often poorly defined, without adequately accounting for inventory trending or performance events such as macroeconomic influences on industry or promotional and pricing efforts to remove inventory.
Effective monetization and timing of performance improvement also represents an unmet challenge for many organizations. Without appropriate performance goals, a performance management framework to assess goal attainment and sustainment, and a recognition and incentive structure for stakeholders, organizations will lack the critical tools required for establishing, achieving, and sustaining improvements in inventory performance.
A transformative strategy To achieve material and sustainable improvement in inventory performance, leaders of global companies with complex supply chains need to fundamentally rethink the way in which performance objectives are established, as well as the way they are achieved and measured over time. They should accomplish this transformation from the following three angles:
- Holistic approach: As noted earlier, inventory performance is affected by policies and competencies across functions, including product development, demand management, supply management, and order fulfillment. Best-in-class inventory performance starts with an understanding of how all functions collectively drive results, and of the trade-offs associated with making decisions in functional silos. A simple example of such a trade-off would be a sales organization independently making decisions about promised delivery dates for orders of lower-priority products (or less desirable products from a profitability perspective), which triggers a production batch with a minimum quantity far beyond the current order quantities. Excess products inflate inventory that may not have demand for a long period of time. Ideally, order delivery would be promised for a future date that coincides with the planned production for the item. Such a meaningful production rhythm that is in synch with demand would serve multiple orders of the same product and minimize average inventory levels over time.
- Focus on drivers: Companies should identify and analyze the drivers that define the connections between inventory-performance outcomes and the operational and market activities that impact these outcomes. A driver-based approach improves a company’s ability to focus investment due to a better understanding of the nature and relative sensitivities of operational elements that are driving its inventory performance. Focusing on drivers, moreover, brings inventory strategy down to an actionable level within the organization. In the aggregate, inventory performance is driven by three main levers: cycle-time compression (lead time of supply), demand and supply synchronization, and inventory-ownership offsetting. Typically, the impact of most of the drivers of inventory can be classified under one of these levers. For example, in a project-based manufacturing environment with long lead times, work-in-progress (also known as work-in-process) inventory can be very big—when building customized airplanes, for example. The key drivers of work-in-progress inventory can be supplier lead times, supplier reliability, supplier quality, engineering design changes, and so forth. Some of these drivers can be influenced, managed, and controlled to minimize the negative impacts on inventory performance. Progress payments can also be an interesting driver of inventory (offsetting the inventory ownership). Companies negotiate better progress payment terms and successfully hit their milestones to collect these payments in a timely manner, thereby reducing their work-in-progress inventory levels.
- Effective governance: Investments across functions that are designed to propel improvements should be evaluated and implemented within the context of an established inventory-performance strategy. Effective governance can help prioritize, organize, execute, and evaluate a company’s investments and align them with the broader operational strategy and performance objectives. Where that governance should be located is a difficult decision in most organizations. Ideally this would be a cross-functional project management organization (PMO). For some companies, it may make sense to tie it to a sales and operations planning (S&OP) or integrated business planning (IBP) entity that works across functions.
Inventory-performance management (IPM) is a framework for achieving sustainable benefits by focusing on rapid identification, prioritization, and alignment of a portfolio of initiatives to drive sustainable improvements in inventory performance. By taking a comprehensive, end-to-end look at all drivers of inventory along the supply chain, IPM helps organizations assess their capabilities and align inventory strategy with key business objectives. It extends beyond strategy to encompass the development and establishment of program governance, project execution, monitoring of performance attainment (monitoring the progress made in attaining the benefits of an inventory initiative), and sustainability as well as recognition of performance achievement (after the performance goal has been achieved, allocating that benefit to the right initiative, without double-counting).
Stages to sustainable improvement
IPM, which supports a holistic approach by linking inventory performance to financial, operational, and organizational drivers in an integrated way, involves four stages. The initial stages focus on identifying, quantifying, and validating a holistic strategy. Subsequent stages center on establishing effective program governance, executing initiatives within the context of the defined IPM strategy, and attaining and extending performance benefits.
STAGE 1: Performance baseline and diagnostic
The first stage involves analyzing baseline performance and driver sensitivity in order to quantify improvement targets and prioritize inventory drivers that have the highest impact on performance. To identify potential areas for improvement, companies should undertake a comprehensive review of product development, product lifecycle management, customer contracting, customer order management, demand planning, inventory management (deployment, replenishment, and control), operations planning and scheduling, and procurement and manufacturing. Outputs of Stage 1 should include:
- A detailed data analysis of baseline performance and inventory-driver sensitivities.
- Opportunity “heat maps” illustrating potential areas for improvement across all supply chain functions. Opportunity heat maps provide a way to quickly narrow a company’s focus to the areas with the greatest opportunities for improvement across supply chain functions, from the people, process, technology, and data perspectives. The example in Figure 1 highlights key areas of opportunity, with color coding to indicate the range from high opportunity to no opportunity.
- Key capability gaps subject to subsequent synthesis and the development of recommendations for addressing them. A typical capability gap in demand management is the inability to generate a good baseline forecast, which can have a direct impact on safety-stock levels. This may be due to a lack of “clean” historical data to be used in the forecast, a lack of planning tools, and/or deficient planner skills.
Following Stage 1, a company will have a clear understanding of both the range and value of improvement opportunities.
STAGE 2: Development of an effective inventory-performance strategy
This involves developing a strategy based on the results of the data analytics and the assessment of business practices directly affecting inventory performance. It requires gaining a thorough understanding of past, current, and planned improvement programs, business goals and objectives, budgets, and financial constraints The purpose of this analysis is to yield a portfolio of initiatives that are prioritized on the basis of performance impact, effort, and duration. Outputs should include:
- A portfolio of performance-improvement initiatives and related benefits
- A transformation road map outlining initiatives prioritization, dependencies, and timelines
After developing an appropriate inventory-performance strategy, an organization will be equipped with a multiphase plan for achieving targeted improvements within a defined period of time.
STAGE 3: Governance and program execution Once an inventory-performance strategy and authorization to proceed with that strategy are in place, the next step is to establish a program management and governance structure to facilitate the execution of activities. Outputs should include:
- An IPM governance structure that integrates the execution of inventory initiatives and established linkages to other relevant transformation programs. The purpose of doing so is to make sure initiatives are aligned, new capabilities are leveraged properly, and benefits are tracked and allocated properly.
- A benefits management framework providing a consolidated, global view of project costs across the portfolio.
- Tools and dashboards to consistently manage metrics and monitor risks, actions, and interdependencies across projects.
- Initiative details, including project charters, work plans, staffing models, and a detailed cost/benefits analysis.
- Improvement-initiative definitions, including functional requirements, detailed design- and technology-selection criteria, and assessments.
- Comprehensive plans for both the development and the deployment of the improvement initiative. This should include identifying which entities (internal, external, or both) will provide those services.
Stage 3 represents the costliest and most resource-intensive stage. During this stage, strategy becomes reality and benefits begin accruing.
STAGE 4: Benefits attainment and extension
IPM is not an event, but rather a living ecosystem of principles. For that reason, Stage 4 involves continuous monitoring, analysis, and adjustment. Outputs should include:
- Institutionalized learning. Within the context of IPM, institutional learning must be an ongoing process of evaluating performance-improvement activities and outcomes, as well as continuously analyzing what has worked and what has not.
- Driver visibility. Capabilities pertaining to the analysis of inventory drivers, which were established and applied during Stage 1, must become ingrained within the organization itself and within its management of ongoing operations.
- Benefits management. Inventory-performance benefits, such as synchronized demand and supply, better service levels by each customer segment, and reduced cycle times to impact inventory levels, are achieved over a period of time that usually extends well beyond the implementation of a given operational improvement. There must be a framework for continuous monitoring, analysis, and visualization of performance against targets to sustain improvements.
- Behaviors and incentives. People and change management are critical factors in any improvement project, and therefore are integral to an IPM initiative. Achieving the sustained behavioral change required to ensure long-term success is one of the greatest challenges companies face when implementing an IPM program. Modifying the behaviors of all stakeholders who impact inventory performance typically requires reworking individual performance reviews along with adjustments to personal incentives.
- Portfolio development. Over time, as initiatives in the portfolio are completed and business conditions change, new concepts will emerge and be added. An organization must establish an effective framework for ongoing identification, development, and execution of future IPM programs.
Final thoughts
For most organizations, the expansion of the global economy has made their supply chains broader, deeper, and more complicated, making it more difficult to coordinate all the critical components. In this challenging environment, investments in inventory performance are being squandered. Fortunately, there is a solution: Inventory-performance management’s holistic approach, which links inventory performance to financial, operational, and organizational drivers in an integrated and sustainable manner.
By fundamentally rethinking the way in which inventory-performance objectives are established, achieved, and maintained over time, companies can achieve and sustain significant benefits, including a more consistent approach to inventory management, a more demand-driven strategy, cost reductions, and better service levels. With an understanding of the relationships between different forms of inventory and the key drivers that impact the plan-procure-make-deliver functions, companies can connect them to each other and will be better positioned to use supply chain practices to impact and prevent inventory problems rather than try to cure them through inventory deployment. That is the key to achieving and maintaining world-class inventory performance.
The views expressed herein are those of the author and do not necessarily reflect the views of Ernst & Young LLP.
Can A. Dogan is a Principal and the Supply Chain Planning Platform Leader under the Supply Chain and Operations Service Line of Ernst & Young LLP.
