According to REL's 2008 Working Capital research (available with registration at www.relconsultancy.com/workingcapital), the opportunity for companies to generate cash by improving inventory is significant. The largest 1,000 companies can generate $315bn in cash by moving to first-quartile performance in this area.  This is separate from opportunities to generate cash from other working capital elements, including trade receivables and trade payables.

Sustainable improvement is the real challenge with regard to inventory performance. In 2007, 45 percent of the companies in the REL survey improved their Days Inventory On-hand (DIO) performance, by reducing DIO. Only 41 percent of those companies improved in two consecutive years, and less than 19 percent in three consecutive years. The 10 companies with the largest gains over the last three years, with improvements in each year, released an aggregate of more than $3bn a year of cash from inventory, an average 15 percent improvement in fiscal year 2007.

Consistent improvement requires a focus on sustainable changes to operational processes rather than tactical efforts to achieve quarter-end or year-end targets. Only with this long-term view of sustainability and addressing root cause issues of inefficiencies in the core operational processes will steady improvement in inventory effectiveness be realized.

Inventory's main purpose is to buffer between supply and demand to enhance service to customers, both internal and external, and allow for efficiencies in production and sourcing. It is driven by two primary variables: uncertainty and time delays. Uncertainty is largely a function of variability in demand and supply and the level of internal communication and synchronization around both. Time delays are a function of distance, speed and capacity.

Most companies, however, make this balancing act more complicated by amplifying these basic variables of uncertainty and time delay.

• Manipulation of customer demand through price promotions, volume discounts and new product introductions without full consideration of the impact of these on efficient utilization of supply chain resources, including inventory.

• Manipulation of employee behavior through sales commission structures, quarterly targets for bonus qualification and functional objectives that are not fully aligned with cross-functional optimization.

• Manipulation of financial behavior to optimize financial reporting while de-optimizing operational efficiency such as quarter end shutdowns, supplier shipment holds and customer shipment expediting.

• Misalignment of functional objectives between procurement, manufacturing, sales, marketing and finance due to the lack of clearly defined trade-offs between inventory investment, product range, product availability, supply chain capability and cost.

The Outlook

In the coming year, companies will be faced with a dual challenge of tight credit markets and volatility in demand. This places inventory planning and optimization in a precarious position of having to reduce inventory levels to provide for corporate liquidity goals while at the same time having to buffer for  higher levels of uncertainty. Companies that make comprehensive demand and supply balancing a top priority through this period of uncertainty will be better positioned to walk this tightrope and will join the ranks of companies consistently improving their inventory efficiency and effectiveness measures.