Supply chain management has always been a challenge, but during and after difficult economic times, especially those experienced during the last three years, the stakes are even higher. Consequently, the pressure is on to find ways to increase margins and profitability and, at the same time, reduce costs. That’s why top executives are striving to achieve the right balance when it comes to working capital, inventory, customer service, lead times required to fulfill orders, operating costs and quality. The wrong balance is certain to have a long-lasting effect that could lead to undesirable outcomes.
For example, when faced with tough supply chain choices, even knowledgeable and competent top executives often jump to the wrong conclusion. One of the biggest mistakes is to think that a simplified enterprise resource plan (ERP) will solve an organization’s supply chain problems. While ERP solutions have provided considerable value for execution level data tracking and financial management, they typically fall short in providing effective supply chain management planning.
Value in the Supply Chain
It is surprising that some companies do not see the true value that comes from their supply chain operations, yet this can be a strong competitive advantage in a global marketplace. Value in the supply chain can be found in three critical areas: inventory and order management, optimal capital deployment, and effective operations planning and execution. Solving these problems requires a level of complexity that some can find daunting. The easy and often simplistic answer is to turn to a company’s ERP system to provide the solution, however ERP systems are not designed to address the many possible tradeoffs inherent in the supply chain specifically to maximize value. Clearly an alternative strategy is required, and it is best developed through implementation of supply chain optimization.
The whole point of supply chain optimization is to uncover value hidden in the supply chain that could make a considerable difference in reducing margins and, of course, increasing profits. When properly implemented, optimization tools improve profitability by examining the potential for the following:
- More enhanced use of excess capacity accomplished through an analytical reevaluation of manufacturing capacity, inventory, and the supply chain. An examination of this nature can enable companies to target capacity and its usage in both short- and long-term.
- Improving manufacturing product mix to determine and set production amounts and timing, which can achieve maximum throughput of higher margin products.
- Analyzing purchasing habits while taking advantage of pricing fluctuations. This can be accomplished through use of a system that offers strategic and tactical metrics enabling the company to adjust even during times of price volatility.
The goal of any analysis of inventory’s impact on the company’s balance sheet and the profit and loss statement is inventory reduction, but not to the extent that it jeopardizes the company’s customer relations. The relevant point is that inventory reduction translates to cost reduction and, just as important, reduction of indirect costs that are not necessarily reflected in the COGS (cost of goods sold), such as warehousing and labor. Cutting these indirect costs is an often overlooked result of proper supply chain optimization.
FIFO and ABC Customer Stratification – A Second Look
Let’s start with the most common inventory valuation method that has become, for the most part, the standard of inventory management – first in/first out (FIFO). This system is as simple as it gets: first order in is the first order out. However, this business practice is overused as the default method of assigning inventory to orders. In most ERP systems, inventory is assigned to orders in FIFO sequence, meaning orders are given priority based solely upon the time they are received, not on what matters to the company; e.g. increased profits or strategic importance.
FIFO inventory to order assignment has other drawbacks and these pose potential dilemmas for any company relying on FIFO for its entire inventory assignment process. Consider, for example, a situation likely to arise at a time when inventory is either tight or backlogged. In this scenario, the first order received is from a less critical customer or, even more telling, a customer whose business relationship with the company is less profitable because of a lower margin. If the inventory to order assignment process is in a FIFO based system, that customer will get the material first even if the next order is from a more profitable or higher margin customer. No one wants to make preferred customers wait, not if the company wants to maintain a mutually profitable relationship. Yet the major ERP systems utilize standard FIFO inventory assignment algorithms, which allow minimal flexibility. This is a troubling situation. The good news is that it is also avoidable, and that’s where the optimization comes in.
In this case, advanced analytics assess such important considerations as the customer’s low or high margin and the profitability of each order. Standard inventory assignment algorithms of the ERP are then disconnected to be replaced by an off-line best-in-class decision support tool to achieve significant improvement in order management. The result: increased revenue. This is not to disparage ERPs; their value is not an issue. However, their capacities are limited to the application of standard business rules such as FIFO. They are not necessarily the best solution for all inventory and asset management situations that require more complex optimization processes.
Another process that requires a further analytical examination is ABC customer stratification, a method of defining customers in terms of volume, revenue and profitability. Many companies have relied on ABC for a clearer picture of the costs associated with each customer transaction and their impact on margin and profitability.
While companies have depended on ABC classifications for strategic customer decisions, few have considered going beyond the strategy and actually incorporating and integrating their ABC findings with customer interactions. Executives should be paying closer attention to the ABC analytics provided by inventory and asset managers. This data should then influence the day to day interactions with customers so that revenue can be maximized without negatively impacting margin.
That means using the analytics to strategically prioritize customers. It may be an uncomfortable thought for executives sensitive about customer alienation and potential loss of business. Yet, when less profitable customers grab available inventory to the detriment of the higher margin customers, the company’s inventory system has been gamed. You can’t fault the customer, but the company has other options. Treating customers differently through a variety of service level agreements based upon execution of ABC categories can reduce the ongoing problem that occurs in inventory management when all customers are treated as equals.
The standard FIFO order to inventory assignment systems does not allow for this type of prioritization, and one size cannot and should not fit all, not if the company wants to maintain its competitive edge. Once again, the answer is optimization, in this case applying the ABC analysis to customer service levels. One method is to pool inventory by customer groupings; that is, the best customers who have higher margins essential for maintaining and increasing profits should be placed in a category separate from the lower margin business with separate service level targets. The process can help lessen exposure risk while reducing inventory and possibly warehouse space.
There are several different categories for customer prioritization, and the choice depends on the executive’s determination as to the best opportunity for long-term growth:
- Profitability – customer orders offering high margins for the company with increased profit potential.
- Strategic Importance – customers whose continued business is the best fit for the company’s strategic plans.
- Volume – choice based on quantity of business.
Stratification is not a revolutionary idea. Some companies have tried it, but studies have indicated that understanding of the process has not always been conveyed throughout the organization, particularly the choice of the applicable category, and how the customer will be treated differently as a result. That problem can be rectified by the executive who connects the results of ABC stratification to the execution systems so that the strategy of the company may be put into place every transaction.
Turning Theory into Practice
Jay Lang, vice president of commercial finance and strategic development for MachineryLink, the largest combine leasing company in the United States, said his company’s experience proves the value of supply chain optimization. MachineryLink opened for business in 2000 with eight combines. Nine years later, the Kansas City, Mo.-based firm leased more than 260 combines to 700 customers in 31 states and Western Canada, which Lang said is a distance measuring more than 750,000 miles. MachineryLink needed to better control its costs.
“We had to figure out how to minimize the number of machines we needed to satisfy customers while reducing the miles to move those machines,” Lang said.
Another challenge was increasing the hours of use for each combine. Lang said that in 2006, the company was averaging 350 hours per machine and felt it could do much better since “hours equal revenue.”
The company purchased a supply chain management tool designed to optimize its assets and was pleased with the improvements. “I think it’s important before you flip the switch on the tool that you understand and document your business rules and doing that exercise of understanding is what gave us our immediate benefits,” Lang said.
The tool has become a key metric and driver of MachineryLink’s business. Lang projected that the hours of use for each combine this year will exceed 500, an increase of more than 30 percent above the 2006 figure. “Besides the tangible benefits, it’s also given us an intangible one – improved customer service,” the executive said.
Logitech, a global manufacturer of interface devices, also sought to optimize its inventory through use of supply chain optimization including customer ABC stratification. The results were overwhelmingly positive. The company installed an off-line decision support tool that led to what it described as dramatic improvements in customer service and a corresponding increase in sales, including the doubling of revenue from one of the preferred customers and a designation as “Supplier of the Year” by another.
Both companies acknowledge that the complexity of the challenge was responsible for an approach that went well beyond the business rules associated with standard ERP or in-house software. As their case studies graphically illustrate, the use of optimization technologies can maximize supply chain value by implementing more sophisticated approaches to standard practices such as inventory and asset management. A simple algorithm as in some ERP models generally lacks the capacity for accurate analysis of more complex issues, perhaps proving that not everything in today’s complex corporate world can be resolved by the application of standard business rules.
Vision for the Future
Executives who can see the benefits of managing inventory in the channel based upon its advantages for the company can set tone and direction for future growth and success. That vision can lead to uncovering hidden supply chain benefits and leveraging them as a major step toward reducing margins and increasing profits. By responding to the information offered by optimization, companies can reduce their exposure by evaluating the costs of meeting each customer’s needs and crafting the appropriate response.
Fortunately, the metrics are available to develop the best top-level strategies for comprehensive inventory management and capital deployment. That’s why the process is so crucial: it can help assure growth by lessening the risks.
Alan Kosansky, Ph.D., is president and Jim Piermarini, is CEO of Profit Point, (www.profitpt.com) a North Brookfield, MA provider of supply chain optimization systems that offer such services as infrastructure and supply chain planning, scheduling, distribution and warehouse utilization improvement.