Jeff Metersky, Vice President, SIOP Practice
Thursday, March 8, 2012
In the current battle-scarred economy, as with any economic downturn, “cash is king.” When sales are stagnant or declining, where is the easy target to generate cash? Inventory, of course. Why not? I see plenty of hype to goad you on. I’m sure you’re probably bombarded with news articles and case studies from software vendors that boast of their success in minimizing inventory and increasing turns in the supply chain. “Lean” and “Six-sigma” experts “preach” that inventory is the “bad cholesterol” that clogs up streamlined operations. I continue to read in the press and, unfortunately, hear from our clients that inventory is “a necessary evil,” and should be avoided at all cost. Beware! This myopic focus on inventory reduction is dangerous.
Inventory is necessary, but is not evil. And if you manage it effectively, it can be a significant dial to turn. Inventory impacts both the balance sheet and the income statement, with both helpful and harmful effects. As a liability, inventories tie up working capital, generate expense to store and handle, and increase the chances of obsolescence. But as an asset, the right inventory improves revenue, helps meet customer expectations, reduces transportation costs, and helps procurement take advantage of economies of scale.
Inventory turns should not be a target you set, but the driver to achieving your enterprise’s goal. The right inventory turn will help you meet customer expectations, minimize your total cost, and maximize your company’s ROI. The wrong inventory turn will create stock outs or service failures, eat away at working capital & operating costs, create obsolescence, and unnecessarily shrink your margins.
The key to succeeding with inventory is not how fast it flows through the system, but how you mix the right products in the right locations to achieve the highest profitability. Instead of focusing solely on turns, you should also look to a set of metrics that allow you to maximize profits. Our favorite is gross margin return on inventory investment (GM ROI). Forget turns which drive the organization to spending inventory dollars on fast-selling, low-margin items — not to mention the creating upward pressure on the transportation budget. Rather, view products by profitability contribution, and thus spend your inventory investment more wisely.
Also, you should differentiate your inventory policies on more than just turn velocity or some variation of simple “ABC” classifications. After all, not all products are created equal. When you are solely focused on simple metrics like turn velocity, you have a tendency to apply blanket approaches to inventory, disregarding differences in variability and value. A recent Aberdeen study found that Best-in-Class companies are more than 3 times as likely to differentiate their inventory policies as compared to Laggards. At a minimum, you should consider velocity, variability and value, but in addition, consider evaluating margin contribution, life-cycle stage (i.e., newly introduced or end-of-life product) and shelf life.
Myopia on inventory velocity – fueled by the hype – is dangerous, even in this economy. Succeeding in this environment requires you to step back and consider the impact of your inventory decisions on profitability. After all, sometimes speed kills.