Inventory Optimization Straddles the Line Between Shortage and Excess

By Al Bredenberg

Companies of all sizes and in all industries are recognizing the value of inventory optimization (IO) for improving gross margin. The potential benefits are substantial. Marisa Brown of the American Productivity and Quality Center (APQC) has written that carrying costs for inventory typically come to 10 percent of the annual value of a company’s inventory, although they can be much higher.

On the other hand, many managers perceive IO as a threat. Those who manage distribution and customer relationships realize that cutting back too much on inventory can cause delays in fulfillment and can push customers toward the competition.

A recent survey by Boston-based research firm Aberdeen Group finds that balancing inventory and service levels doesn’t have to be a win/lose exercise. Best-in-class firms actually improve service levels and financial performance through their use of inventory optimization solutions. Aberdeen Group asserted in the report, “IO by design is the ideal tool to set inventory goals required to hit the service levels that need to be achieved.”

Inventory optimization solutions are meant to help managers match supply volume to customer demand over a large number of stock-keeping units (SKUs). Such solutions are coming from developers of supply chain and enterprise resource planning (ERP) software, such as Logility, JDA, Manhattan Associates, SAP, IBM, and Llamasoft.

IO software tends to be classified into two categories: single-echelon and multi-echelon solutions. Single-echelon solutions are elementary-level applications developed for managing single facilities separately as islands. Multi-echelon solutions are required for more complex situations in which facilities are considered as parts of a network.

One of the problems with a single-echelon solution is that safety stock can only be managed at the individual facility level, which can result in excessive inventory if a company operates multiple facilities. A multi-echelon solution allows safety stock to be managed and optimized over the entire network.

In an interview with ThomasNet News, Bryan Ball, vice president and group director at Aberdeen Group for supply chain and operations practices, explained the value of an IO tool: “It grabs all that inventory information and displays it by part number. Then it pumps it back into this engine, which comes back and says, ‘These things are in bounds and these are out of bounds.’ It makes it easy for the planner or manager to go in and say, ‘We need to do something on this particular part number.’”

While many companies in the distribution business are using IO profitably, Ball noted that for manufacturers, inventory problems can be even more complex. “If I’m a manufacturer,” he said, “I could have many subassemblies and components, as well as several nodes even below that -- different subassemblies at different plants, especially critical components, raw materials coming in the door. I may have four or five nodes of inventory stocktaking throughout my supply chain going all the way back to my suppliers.”

In such complex situations, Ball said that “they’re likely to need a multi-echelon tool, more of a complete solution.”

Speaking with ThomasNet News about the potential benefits of IO, Karin Bursa, vice president at Logility, cited the case of Stanley Black & Decker. “They make a wide variety of electronic tools for consumer and industrial markets, with highly configured manufacturing processes and supply chains.” As a result of IO implementation, “they have seen inventory reductions in the realm of 27 percent, while seeing service levels improve.”

IO has given Stanley Black & Decker the capability to model its inventory under very complex scenarios that would never be possible with simple spreadsheets or rule-of-thumb methods. In one case, Bursa said, the company wanted to know whether it should go over to a supplier in China instead of Latin America. “Originally the procurement executive would have seen the lower cost and gone to the [Chinese] supplier immediately. Instead, though, they were able to very quickly model the benefits of changing from supplier A to supplier B.”

Using IO, “in just a few hours, they came back with a highly credible response. In fact, with the [Chinese] supplier, they would have to hold more inventory,” Bursa said. Costs would have been higher. “That kind of tradeoff comes into play all the time in manufacturing businesses.”

Aberdeen Group’s research found that IO is used for three primary organizational initiatives:

  1. To improve inventory modeling, setting of safety stock, and inventory mix
  2. To improve accuracy of demand forecasting
  3. And to improve inventory replenishment strategies.

The IO solution allows the manager to examine each SKU and compare forecasted demand versus actual demand, and to do the same on the supply side for items received through the supply chain. Service-level targets are set for each SKU, and the appropriate safety stock level is also set. All of this allows for greater predictability around safety stock and service levels.

The Aberdeen Group report noted that “the greatest threat to inventory stocking policies is fear of the unknown, which results in hedging at the planning level to ensure availability.” This often occurs “when inventory targets are set using a ‘rule of thumb’ approach.” IO can also help with more complex decisions, such as where a product should be made and the impact of facility closures at the distribution or manufacturing level.

Ball said that “practically any manufacturing company could benefit from IO” nowadays. Granted, “if I’m a very small job shop or I’m a captive shop and 90 percent of what I make goes to one customer, I might have very few part numbers, so how much difference will it make? But most companies aren’t in that situation,” he asserted. “Small, medium, large companies -- they can all benefit from these tools now. It’s got to where you almost have to have it -- especially if you have multiple manufacturing plants or distribution centers [and] greater than, say, a hundred part numbers. It makes your life a whole lot easier.”


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