Inventory has been a hotly debated topic in many organizations. Since inventory is directly visible in company financials, there is a high degree of sensitivity to excessive inventory levels in the management ranks. Many organizations carefully track inventory turn ratios and benchmark themselves against key competitors. For some organizations a focus on “lean supply chains” with their high inventory turns have proven to be of substantial strategic value.
Whenever the topic of inventory reduction surfaces, a discussion around the following tradeoff is bound to erupt: inventory reduction versus potential negative service level implications. This paper provides a fundamental and systematic approach for inventory optimization bringing these seemingly contradictory forces into unison. We will show a framework that can be applied, discuss two fundamental strategies to be used sequentially to reduce inventory and demonstrate the application of the principles in a case study. Reliance on IT solutions is also discussed.
We briefly address the need of cash generation through inventory sell-offs even if profitability is jeopardized by doing so. For many managers this seems like foolish executive action, but we will shed some light on the rational and demonstrate that in fact this action may represent sound business activity.
The Financial Purpose of Inventory
Engaging in a rational discussion on inventory optimization, we must first clearly define the purpose of inventory. Inventory, just as any other investment in business, must serve the purpose of profit generation, or better yet, profit maximization. Inventory must be put in place in such a way, that the value of placing the inventory exceeds the cost of placing it. Inventory, if strategically placed, can yield additional revenue, profit and cash flow to the organization. In order for inventory to serve this function it must however be put in place using sound analytical methods. ‘Gut feel’ inventory methods are bound to get the organization into trouble and result in heated discussions about the appropriate inventory levels. Many times this approach to inventory management results in executive inventory level edicts as a last resort, ultimately impacting customer service and profitability.
The Operational Purpose of Inventory
Inventory has a simple operational purpose. If supply and demand for a product are not synchronous, inventory can be used to buffer the mismatch between demand and supply. Whenever the demand stream is not synchronized with the supply stream we therefore have the choice between three potential actions:
Option one has potential in markets where demand exceeds supply; backorders are acceptable and won’t have any negative impact on future revenue streams to the organization. While these situations exist, they are rare and bound to be costly further down the road, once customers have been disgruntled by poor availability.
Option two involves utilizing operations management techniques. These techniques allow for the determination of the most profitable inventory position and replenishment methods. Operations management techniques optimize inventory while treating the operational systems and its performance parameters as a given quantity. Therefore, this technique approaches inventory from a “black box” viewpoint, by optimizing inventory given current operational performance.