Inventory investments are often considered a necessary evil required to satisfy customer service requirements and maximize revenue. When managed correctly, inventory can be a strategic asset to drive profitable revenue growth and competitive advantage. The challenge is to establish a sustainable foundation for effective inventory management that rapidly adapts to changing business dynamics and promotes prioritized continuous improvement.

Many companies pursue a “silver bullet” solution by implementing sophisticated inventory optimization software tools, but sometimes find they do not have adequate data accuracy, user skills, process compliance or alignment of goals required to achieve — let alone sustain — desired results. Experience has shown that an 80% perfect solution that is 100% implemented yields better results than a 100% perfect solution that is only 80% implemented. Therefore, a methodical, evolutionary approach to inventory optimization is recommended.

Balancing Service, Cost and Capital

Inventory management priorities typically vary among organizational departments based on functional performance metrics and incentives. Commercial teams tend to focus on service as a driver for revenue growth and prefer an abundance of inventory close to the customer. Finance teams tend to focus on working capital as a lever to fund business investments and prefer minimal inventory. Operations teams tend to be held accountable for costs and seek to manage inventory efficiently — perhaps buying inventory in large quantities to maximize economies of scale or reducing inventory to minimize warehousing costs.

The challenge — and key to success — in navigating these differing priorities is to establish a sustainable balance between service, cost and capital. Any one dimension can be improved in a relatively short time frame, but this is often a recipe for disastrous results (e.g., dramatically reducing inventory levels can erode customer service and sales, while increasing replenishment and fulfillment expediting costs). Balancing two dimensions can be achieved with focused attention on fundamental principles, but does not always yield sustainable results (e.g., stocking every item in every location can increase customer service and decrease delivery costs, but requires a higher inventory investment).

A different mindset and approach are required to balance all three dimensions. Consider the analogy of a three-legged stool, where the goal is to keep the seat level through balancing service, cost and capital. 

Too often, companies try to take a giant leap toward a best practice solution (process or software application) that has recently captured the headlines. While these are often technically correct and may be successfully implemented at other companies, they are of little use if an organization does not embrace the recommendations generated by the solution. As a result, these investments can be lost as people revert to legacy processes that they understand.

Just like with best practice solutions, it is critical to plan and manage inventory based on data-driven analytics and decision support tools. The most effective approach is to leverage simple concepts, calculations and simulation tools that enable interactive what-if analysis and cause-and-effect learning by the user. Complexity is only added to the solution as the organization “demands” additional capability based on challenges or shortcomings identified through experience. The organization is then able to better understand the rationale behind the inventory targets and the unique characteristics of their business that have the greatest impact on inventory productivity.

An Evolutionary Approach

Returning to the stool analogy, the first task is to “level the seat,” then work to “shorten the three legs” — do more with less while maintaining balance. In other words, achieve what is possible in the current environment, then prioritize continuous improvement. The concept is applied using a statistical curve familiar to inventory management practitioners, which illustrates the relationship between desired service and inventory investment.

Here’s a five-step approach:

Calculate the baseline curve. Using a commonly-accepted equation, calculate inventory targets based on current attributes of demand and supply for each item-location combination. This baseline establishes a target for the business based on current capabilities.

Get on the curve. Compare historical performance (service and inventory investment) to the baseline to quantify near-term improvement opportunities to reduce inventory investment and/or increase service. Modify inventory management processes and control metrics to “right-size” inventory investments in alignment with calculated targets. In some instances, increased investments are required to “right-size” the inventory.

Shift the curve. Perform what-if sensitivity analyses to evaluate the effects of changing demand and supply attributes, including lead time reductions, supply reliability improvements, and replenishment frequency increases. This will identify key leverage points to improve inventory productivity and quantify potential benefits.

Shrink the curve. A logical but difficult task is to reduce the number of items sold and the number of stocking locations, but the benefits can be significant. Many items may not justify their inventory investments and should be evaluated for potential elimination. Additionally, consolidating inventory into fewer stocking locations can help reduce overall investment.

Move along the curve. Not all items are of equal strategic value to a company, and therefore should not have the same service level goals. Evaluate (challenge) current service level goals by segmenting products and differentiating objectives for prioritized customers. For each item, determining the point at which the cost of a high service level exceeds the benefit of an incremental sale is key to inventory productivity.

Evolution Before Revolution

It’s easy to realize the importance of optimizing inventory investments in support of achieving company goals. The challenge is to determine how to achieve and sustain results — the balance of service, cost and capital. 

The magnitude of benefits tends to be proportional to the adoption of and organizational alignment around a simple, practical, data-driven approach and the passion for agile continuous improvement. This is enabled by a solid understanding of cause-and-effect relationships and key drivers of inventory productivity. Allowing the organization to “pull” the evolution of solution complexity versus “push” a revolution fosters sustainable results.

Gary Jones is partner at River Rock Advisors.