Seven Challenges of Inventory Management

Inventory is a necessary evil in modern supply chains. Identifying and

maintaining the right amount of inventory is one of the biggest challenges that
supply chain managers face. Inventory sits as a trade-off between customer
satisfaction and material availability vis-à-vis increasing inventory holding costs
and working capital. With the globalization of organizations, Indian companies
are matching their international peers in terms of sophistication and maturity of
supply chains. However, maturity of supply chains and the supporting technology
does not complete eliminate the aforesaid trade-off completely.

It is essential to look at inventory as “good inventory” and “bad inventory”. “Good

inventory” is the key to good customer service and positive cash flows while bad
inventory, too much of the wrong items, clog warehouses and distribution
centers.

IBM in partnership with IW Custom Research undertook a value chain

survey, the results of which have been published in early 2008. This article draws
from the report and IBM’s vast experience in handling inventory related strategic
and operational projects across industries.

The article highlights the top 7 challenges that are critical but not obvious,
to retain a balanced inventory in the supply chain, preventing unproductive
working capital and lost sales opportunities.

1. Infrequent Parameter Reviews

The parameters that are used for managing inventory - such as safety
stock quantity, replenishment order quantity, reorder point in a Continuous
Review policy, or review period in a Periodic Review policy - use factors such as
service levels, demands, and supplier replenishment lead times as inputs for
their calculation. However rapidly changing markets, competitors, and product life
cycles have made review periods that worked in calmer times unsuitable for
today’s speed of business execution. Failure to monitor the environment and
update these inputs on a frequent and detailed basis is a recipe for inefficient
inventory investment.

Companies set these parameters on a one-time basis, often at the start of

a new process improvement initiative or an ERP implementation. However,
failure to monitor the values fixed to the parameters and the parameters
themselves, leads to their ineffectiveness in the long-term.
Parameter updates are only made when the resultant impacts of these
misalignments become evident as large inventory excesses or frequent stock-out
occurrences. The untracked accumulation of excess inventory leads to inventory
write-downs and lost working capital.

Solution: Periodic review of the key planning parameters is required for

ensuring proper inventory management. Tools and applications are effective
enablers of such reviews.
IBM’S proprietary application for inventory management and
rationalization – Dynamic Inventory Optimization Solution or DIOS, provides for
simulation engines that determine safety stocks’ optimal levels and expected
service levels. The solution also has IBM-patented adaptive methods for safety
stock calculation.

2. Days of Supply

When faced with unpredictable demand and pressures to ensure supply

availability, a seemingly logical approach is to declare a quantity of supply to be
held at all times for each SKU. Typically, this quantity is expressed in terms of
'days of supply', or 'days coverage'. The approach reasons that if it takes on
average two weeks to receive replenishment from the an order is placed, then
adding a safety cushion and calculating average daily consumption will be fine.

Many inventory managers concede that by taking this approach, they may
be giving up inventory reduction (and cost saving) opportunities in order to
'guarantee' availability. However, this approach isn’t completely suitable to
determine an efficient supply quantity. This approach fails in three areas: first, it
does not take into account the daily, seasonal, and lifecycle variations in demand
that may be inherent for each SKU; second, it does not take into account
variations in supplier replenishment lead time; and third, it does not seek a cost-
efficient balance between inventory held as safety stock and inventory being
replenished (cycle stock).

Solution: Monitor and understand the variations in demand and supplier

lead times, and frequently recalculate safety and cycle stock for each stock
keeping unit.
The IBM/IW Custom Research Value Chain Survey showed that sharing
real-time demand and inventory data and continuous replenishment programs for
customers help in facing this challenge. Other programs like collaborative
demand planning, forecasting and replenishment also offer great support.
Respondents using collaborative forecasting reported an average monthly
forecast error of 10 while the average for the larger surveyed group was 15.
 3. Volume-based Classification Method

With tens, and in some cases hundreds of SKUs to manage, some

classification and prioritization is a required first step. However, classification
based only on quantity sold is not the most optimal way. What may seem intuitive
may not be the most effective approach for managing inventory at the lowest
overall cost. With the advent of ERP systems and other high-computation
enablers, it is now possible for a more fine-grained approach to material
classification beyond simple methods like FSN.
Imagine instead an approach that classifies SKUs by the relative
magnitude of value and costs required to order and hold them in stock. For
example, SKUs with a similar ratio of value and ordering costs to holding costs
would be grouped together and ordered with a similar frequency. This approach
seeks to minimize the overall costs - ordering plus holding plus transportation,
etc. - by addressing the manner in which SKUs are grouped.

Solution: Consider alternative classification techniques that incorporate

multiple costs and parameters to optimize inventory investment.
In an earlier DIOS-based engagement, using the ratio of ordering costs to
handling costs for material classification led to the number of orders/year
reducing from 230,000 to 70,000.

4. Top-down Forecasting

High-level forecasts generated by sales teams are vital for effective

demand and supply planning. In many cases, the method for generating the
forecast is set by company division or product type. Thus, a single method of
forecasting is cascaded down to product lines and perhaps even to the individual
SKU/location level. Although an aggregate forecast approach is necessary for
manufacturing and procurement capacity planning and for supplier negotiations,
it is not the most effective means for optimizing the investment in inventory.
Such top-down approaches do not account for the local variations in
demand that can be significant at the individual SKU level. Even within a single
product type, some SKUs are relatively new in their lifecycle, others are soon to
be retired; some are affected by seasonality, others are not, but may be very
sporadic in both time and relative quantity between sales. Since these forecasts
will be used for setting the inventory parameters that are needed in the future,
only an approach that takes into account the anomalies of demand for individual
SKUs at the stocking point will be effective.

Solution: Create forecasts at the SKU stocking level to generate reliable

models of demand variation.
While implementing an ERP for an Indian Pharma major, IBM suggested a
bottom-up approach to forecasting, with inputs from the area sales managers
being aggregated along the hierarchy, after reviews. Any changes at the highest
level of forecasts could be disaggregated to the lower levels through pre-
determined ratios or manual overruns. The suggestion led to reduced forecast
errors and better planning.

5. Misaligned Service Level Measurement

The service level target is a key factor in the determination of inventory

levels. Yet despite its influence, rarely is enough attention paid to how this
measurement is calculated.
Implicit in most service level discussions is that poor service levels result
in lost sales and vice versa. Therefore an effective service level measurement
should reflect customers' performance expectations and buying behavior and
should be agreed to by key internal functions.
For example, a manufacturing organization may track quantities of
product shipped and quantities ordered over a specific time period, so a fill rate
calculation is used for serviceability. However, this calculation provides no
insight into the probability of a stock-out occurrence, or how long it takes until
supply is replenished when that stock-out occurs. One of these approaches is no
better than the other. However it takes a consensus from the manufacturing,
marketing, sales, and sometimes finance teams as to which approach is best
suited for measuring the performance that is most relevant to customers.
In addition understanding the link between service level and customer
satisfaction also opens the door to segmenting the customer base to further
differentiate service levels by customer segment. Our experience shows that the
“squeaky wheel” service level tends to get applied to all customers and items
because rule of thumb policies do not lend themselves to defining and
maintaining segment specific services levels. The result is more inventory than is
really needed to provide the optimal service level.

Solution: Create an approach to service level calculation that can provide

multiple differentiated measurements of serviceability and include all functions in
determining which measurements and values should be used when developing
inventory plans.

6. Failing to address the underlying causes of variability

We have often found that when science is applied to understanding

service levels, supply variability, demand variability, and various stocking
policies, the result, though technically optimal, still holds opportunity for
improvement. This is because variability in both supply and demand can often
be self inflicted or turn out to be easily addressable. Examples are: promotion
practices that create spikes, suppliers with erratic shipping patterns, and ordering
policies that create bottle-necks in shipping and receiving.
The right inventory level for a given level of service is highly sensitive to
the variability around supply and demand. Most inventory stocking policies
assume a normal distribution of variability around these key parameters. Our
experience has shown that a normal distribution is often not the case, and
beyond measuring and accommodating for the variability, taking actions to
address the variability, focusing on the most volatile and expensive fluctuations,
can drive even better inventory productivity.

Solution: understand the sources of high variability on both the demand

and supply sides of your stock and take actions to reduce the variability. While
working on statistics-based forecasting, outliers have to be removed from the
historic data. Similarly, future production planning and inventory management
must factor in promotional plans. Cross-functional teams involved in the planning
process offer a solution to the above. Simultaneously collaboration and
integration among customers and suppliers, as shown by the IBM/IW Custom
Value Chain Survey is important (65.3% of respondents who collaborate, said it
is ‘somewhat effective’ to ‘highly effective’.

7. Failure to align inventory policies

Reduced inventory helps in greater working capital productivity. However,

resistance from sales and marketing, due to the risk to service levels is high. We
have found that an approach that simulates various inventory policies and
parameters can bring transparency to the decisions and their impacts.
Simulations allow companies to compare the impacts of different
parameter choices on expected stock-outs, service level, and inventory costs.
Also, by simulating under different demand and supplier response scenarios, a
firm may be able to anticipate the correct level of inventory to hold to minimize its
exposure to risk. The ability to see how a company’s inventory will fluctuate next
week and months into the future is imperative for reducing the fear around
change and helps to align the organization on priorities.
A time worn and Edelman award winning example of the power of
simulation is the case of IBM’s use of its Supply Chain Analyzer to simulate the
impact of changing our inventory policy to individual retailers in the personal
computer supply chain. Sitting with each retailer and showing them the impact of
our holding the inventory higher up in the supply chain, using their data, allowed
IBM to take two month’s worth of inventory out of its retail channel and reduce
price protection expenses by over $100 million. This is a classic example of
supply chain collaboration facilitated by simulation.

Solution: Invest effort in building organizational alignment around

inventory policies, potentially using simulation capabilities to anticipate the
expected results of your inventory parameter decisions.

Summary
 Over the last decade our supply chain practice at IBM Global Services has
conducted well over 200 supply chain transformation engagements that focused
on improving the effectiveness and efficiency of our clients’ inventories, finished
goods, raw materials, and work in process.

As a result of these engagements and supported by cutting edge

proprietary solutions and tools, we have developed an approach that blends data
analytics, optimization algorithms, and discrete event simulation. This approach
allows us to quickly analyze a given client’s unique inventory management
challenges and evaluate literally thousands of policy parameters, provide
transparency to the organization on the trade-offs involved, and arrive at the right
combination that delivers optimal inventory efficiency. This approach lets us
accurately and efficiently diagnose a clients’ inventory and pinpoint which items
are clogging the arteries and which ones need increase in inventory.

About the authors:

Clifford Patrao is an Associate Partner with IBM India and is the lead for their
Consultancy Services division. He has widespread experience in successfully
leading supply chain transformational engagements across industries. Clifford
can be reached @ clifford.patrao@in.ibm.com

Suresh Chivukula is a consultant in the supply chain area with a focus on

process improvement engagements. Suresh can be reached at
suresh.ch@in.ibm.com