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White Paper

Inventory Rationalization and Right Sizing Strategies

With the global recession in full swing, most companies in the commercial space are scrambling to avoid further degradation of their companies value by delivering profitable business performance despite significantly lower sales volumes. For many companies this battle has already been lost and the subject is more one of survival, as is the case for the American auto industry. When examining the crucial factors that are influencing operations performance during these tough economic times, inventory exposure is a topic raised frequently . Many companies did not anticipate the full impact of the recession and paid dearly in the form of excess inventory in all stages of the supply chain. The impact of inventory on cash flow can be devastating, resulting in everything from payable extensions to missed payrolls and loan defaults. Still, despite the lean six sigma purists who preach that inventory represents waste, inventory does play an important strategic role in buffering against demand variations and potentially harmful supply disruptions. Therefore, the key challenge is selecting the appropriate inventory management strategies and clearly understanding the cost and benefit implications to business performance. The business climate has changed dramatically over the past 20 years along several different dimensions that have significantly increased the challenge in selecting appropriate inventory strategies. To begin with, the internet has enabled the creation of a truly global market place with an unprecedented level of competition on price, availability, and performance. This factor has contributed to other changes including rapid new product introductions and shorter product life cycles. Combined, the level of demand volatility has never been higher and forecast accuracies of less than 60% are not uncommon. In a December 15, 2008 article from AMR Research1 , they described the biggest supply chain risk as being Constant Change. It is no wonder that many companies have undertaken demand planning initiatives to improve forecast accuracy through many means including significant increases in demand collaboration activity. A February 2008 note from AMR Research reported that: Companies that are best at demand forecasting average 15% less inventory, 17% stronger perfect order fulfillment, and 35% shorter cash-to-cash cycle times, while having a tenth of the stockouts of their peers. 2 Even so, properly positioned inventory still plays a vital role in covering the forecast accuracy gap. The bottom line in most markets is that availability trumps even price for comparable items.

Secondary to demand volatility, is the need to evaluate the risk of supply chain disruptions when considering inventory strategies. With the outsourcing movement still in full swing, the supply chain of most companies is more distributed and complex than at any point in history. Numerous industry surveys have validated that companies believe they have less visibility and control over their supply chain today than in past years. On top of this fundamental change, many companies have sought to introduce the concepts of Just-In-Time inventory and Lean manufacturing to help reduce inventory liabilities while also eliminating other forms of waste. The net consequence has been an unparalleled degree of supply chain disruption risk. When a fire struck in 1997 at a single supplier location of Toyota, their automotive manufacturing facilities went idle for 20 days with staggering consequences for product cost and lost revenue. In the same year, raw material and part shortages resulted in Boeing losing $2.6 billion3. The chart below from an IBM Global Business Services white paper4 provides a perspective on the potential profit loss due to supply disruptions lasting 10 days and the potential mitigation that safety stock can yield.

Profit Loss due to Supply Disruptions


23% 22% 21% 20% 19% 18% 17% 16% 15% 14% 13% 12% 11% 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% 0 1 2 3 4 5 6 7

Fixed Cost = 25% Fixed Cost = 50% Fixed Cost = 75%

Profit Loss

10

Safety Stock (days of supply)


SOURCE: IBM Global Business Services, Copyright IBM Corporation 2008

oration 2008
1. Managing the Biggest Supply Chain Risk of All: Constant Change, AMR Research, Noha Tohamy, Fenella Sirkisoon, Wednesday, December 03, 2008. 2. Supply Chain Leadership Matters, AMR Research, Tony Friscia, Monday, February 25, 2008. 3. Just too Much Single-Sourcing Spurs Toyota Purchasing Review, Automotive News, Treece, J.B., March 3, 1997, p.3. 4. Supply Chain Risk Management: A Delicate Balancing Act, White Paper, IBM Global Business Services, February 2008. 2

inventory right Sizing StrategieS Product Positioning Considerations


While the decision to carry safety stock has both cost and cash flow implications, these must be balanced against reasonable disruption and demand variation risks. Considerations for inventory positioning involves determining at what stage, location, and quantity should safety stock be maintained. Several factors affect these decisions, which in addition to demand variation and supply disruptions, involve product positioning considerations. As the following chart (adapted from Symphony Consulting5) indicates, inventory management strategies (which directly influence product availability lead-times) should also be based on two different factors which influence the markets response to your products availability. The first of these factors is the relative strategic importance of the product to the companys revenue and margin objectives. The more important the product, the higher the consideration for using properly positioned inventory to achieve customer expectations for availability despite variations in demand and potential supply disruptions. The second factor is the competitive position of the product. If a company is clearly the market leader, consumers become more tolerant of product

availability lead-time and this permits a strategy where inventory can reside at lower levels of the assembly and fabrication process. Contrast this to a company that is competing for market share and availability is central to a consumers purchase decision. In these circumstances, finished goods safety stock that is positioned close to the sell point maybe the only viable strategy for capturing unforecasted sales or buffering against major supply disruptions.

Product Life Cycle Considerations


Another significant consideration in establishing inventory management strategies is the stage of the product life cycle. During the prototype phase, the obsolescence risk is typically high due to ongoing engineering change activity and therefore inventory buffers should be avoided. During the launch and ramp phase when demand volatility is often at its peak, inventory positions are appropriate to ensure that product availability meets market demand and the greatest share of that market is achieved. During steady state or maturity phase of the product, inventory positions should be moderated based on the strategic importance of the product and its overall market position as noted in the prior section.

Quoted Lead-times (Product availability)


Product Positioning Matrix

Competitive Position
Weak: Little Brand or Company Loyalty Impulse Purchase Low Cost of Change Ample Alternate Product Solutions Strong: Company Loyalty Planned Purchase High Cost of Change Limited Alternate Product Solutions

Strategic Value, Revenue, Contribution Margin

Relative Product Importance

Must have inventory and short lead-times to capture business

Some lead-time appropriate. Try to cover transformation lead-time

High

Top priority for compressing LT profile Consider programs to enhance flexibility/availability

Low

The amount of lead-time depends on the product

Stretch lead-times to cover most of the total lead-time

SOURCE: Adapted from Symphony Consulting

5. The Impact of Lead-time on Inventory Exposure, Symphony Consulting Newsletter, Q2 2003.

And finally, during the products decline towards phase out, buffers should be significantly reduced or eliminated. The chart below (adapted from Symphony Consulting6) summarizes these considerations.

But of all the techniques, direct collaboration with key customers offers the best hope for at least ensuring that their expectations for variation are appropriately evaluated. Should variation exceed that expectation, then at least goodwill can more easily be maintained without the loss of customer confidence.

Demand Variation Considerations


Outside the considerations for other factors such as those outlined above, determining how much demand variation should be accounted for in inventory decisions can be quite challenging. Decisions in this area are usually made based on one more of the following techniques. Most prevalent is the use of historical demand variation over the products response lead-time, which is how quickly can a change in supply output be accomplished and maintained. Once this value is determined, there are several other considerations for establishing the inventory and they include decisions on the desired fill rate or service level (the higher the targeted fill rate, the greater the inventory buffer) and the expected delivery lead-time (which helps to establish the stage and location where buffer must be maintained). Unfortunately, the use of historical statistics can be of little use for new products or in a market that is in disarray due to external factors like the current recession. In these cases, a historical analysis of similar products or market events may be the best option. In some cases, the degree of expected demand variation may be dictated by key customers in service agreements. These agreements will often define the limits of demand variation that must be supported within certain time windows.

Supply Disruption Considerations


Supply disruptions include such things as the everyday event of late supplier deliveries, component quality issues, equipment breakdowns, and productivity issues, to more the catastrophic forms such as supplier fires, bankruptcy, and natural disasters. While there is tendency to ignore the later in favor of a hope and pray it never happens approach, there are strategies that can mitigate some of these risks. For example, a popular inventory buffer strategy has strategic partners held accountable for maintaining safety stocks to buffer not only demand variations, but those partners internal supply disruption risks. If these inventories are maintained in the same physical location as the partners manufacturing location, then they share both natural disaster risks and other safety related risks such as fire. Even where dual sourcing is used to mitigate risk, if these sources are in close proximity then less risk reduction is achieved. This was highlighted by Hurricane Katrina which brought the flow of goods passing through New Orleans to a virtual stand-still for weeks.

Product Lifecycle and inventory Strategy/risk

Proto

Ramp

Steady State

Decline

Demand Risk/Volitility Obsolescence Risk Inventory Strategy

Low Med Little or no buffer

High Low

Med Med Balance considering Market Position/Strategic Importance

High High

+Inv

-Inv

SOURCE: Adapted from Symphony Consulting

6. Flexibility and Inventory: Creating LEAN Solutions for an Outsourced Supply Chain, Symphony Consulting Workshop. 4

Still, this doesnt answer the question, how much buffer inventory is needed to address supply disruption risks. Part of the answer lies in the early sections on product and market position considerations as well as the costs associated with the buffer and its overall influence on availability. The later section of the paper will offer some specific suggestions for evaluating the cost and effectiveness of strategy choices, which should help in the selection process.

The Role of Lean Manufacturing and Just-in-Time Inventory


It would be negligent to ignore the importance of the Lean manufacturing and Just-In-Time inventory principles in a discussion on inventory rationalization. One of the tenants of lean six sigma is the reduction of waste and a focus on the value stream that extends from the customer to every corner of the supporting supply chain. By identifying and eliminating activities that dont contribute to value and are unnecessary for sustaining the supply chain (there is the concept of necessary waste), most companies realize double digit improvements in everything from lead-time and inventory reductions, to quality and cost. Most supply chain practitioners understand the direct relationship between the reduction in lead-time to the benefits in flexibility and inventory reduction. With shorter overall lead-times, less inventory is needed to address the same degree of demand variation. The opportunities for eliminating lead-time latency exist at every stage of the order to delivery cycle, much of which is administrative in nature. Furthermore, significant reductions in administrative and manufacturing/assembly lead-times opens the door to maintaining buffer inventories at the level of raw materials or work-in-process components without sacrificing responsiveness to change. Therefore,the implementation of the lean enterprise should not equate to a no inventory strategy unless both demand and supply is perfectly predictable, or any demand loss is insignificant in achieving the business objectives.

of inventory that results in an unacceptable impact on cost and cash flow. Understanding the tradeoffs and the comparable effectiveness is a critical element in making appropriate inventory decisions for your company. Accomplishing this task requires supply chain visibility, modeling and simulation tools that are capable of emulating the demand and supply dynamics of your supply chain. Often inventory decisions are being made on an individual part or group of parts basis without an effective understanding how much actual flexibility it yields when considering all other parts and part relationships to the end product. With this type of tool, inventory strategy alternatives can be modeled and then tested to determine both their cost and cumulative net effectiveness in addressing a variety of demand scenarios. Considering the volatility of todays marketplace and the impact of either too much or too little inventory, tools of this nature are a wise investment. Often these tools can fulfill more than just modeling and planning functions, but monitoring and alerting as well. Even when inventory targets have been established, companies often lack the visibility into the extended supply chains actual inventory levels to make accurate predictions on the real demand flexibility and revenue benefits. Furthermore, should a significant shift in demand or supply occur which puts the business plan at risk the organization should be alerted in time to either eliminate the business impact or mitigate it to the greatest extent possible. In this fashion, this type of tool also directly contributes to reducing some of the administrative lead-time latency and thereby aids in the goal of reducing the overall level of inventory needed to address demand and supply variations. Therefore it makes sense to invest in tools that fulfill all three basic needs; planning, monitoring, and responding.

Summary
Appropriately rationalizing your companys inventory strategies is of vital importance to business performance. Too much inventory or inventory which is poorly positioned can result in impacts on cost and cash flow that can be potentially fatal in the current business climate. The goal of an appropriate inventory strategy is to ensure that you can maximize your opportunities in the market place with as little inventory as possible. This takes a clear understanding of the various factors that should be considered including product positioning, probable degrees of demand volatility, and appropriate considerations for supply disruption risks. When strategies have been selected, then they should be tested and monitored using supply chain visibility and simulation tools that can provide a realistic assessment of their cost and effectiveness.

evaLuating inventory Strategy CoSt and effeCtiveneSS


So youve appropriately analyzed the factors that justify maintaining buffer inventory levels but you still need to understand the potential tradeoffs between the effectiveness of those strategies and the relative cost and/or risk. Wanting to achieve a 98% fill rate on a strategic product may require a level

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