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The persistent gap between supply and demand

Comment
A research study finds that most companies have a long way to go before they can achieve a demand-driven inventory strategy.

In today's rough-and-tumble business environment, distribution-intensive com panies such as retailers and distributors must match supply with demand—not only to gain a competitive advantage but also to survive. Achieving that goal calls for operational approaches (such as carrying buffer inventory) that may sometimes conflict with the tradition al drivers of inventory management: cost control and efficiency.

Today's supply chain executives will have to figure out how to man age the requirements for demand driven inventory while still keeping a tight rein on costs and streamlin ing for efficiency. The task is daunt ing in the face of an extraordinary array of challenges: They are under intense pressure to boost product innovation in order to appeal to a diverse set of stratified markets. Meanwhile, product lifecycles, or "seasons," are getting shorter as the number of products increases. With globalization stretching supply chains, lead times are getting longer. Price sensi tivity and other factors are pushing companies toward outsourcing some aspects of their operations, which requires new processes and approaches to management yet often results in less supply chain visibility. All of these factors, combined with increasing regulation and competition, must be taken into account when each company formulates its distribution and fulfillment strategy.

Article Figures
[Figure 1] Most important inventory management objective
[Figure 1] Most important inventory management objective Enlarge this image
[Figure 2] Primary challenges in matching supply and demand
[Figure 2] Primary challenges in matching supply and demand Enlarge this image
[Figure 3] Top change due to global sourcing
[Figure 3] Top change due to global sourcing Enlarge this image
[Figure 4] Forecast accuracy by time horizon
[Figure 4] Forecast accuracy by time horizon Enlarge this image
[Figure 5] Forecasting policies and forecast accuracy
[Figure 5] Forecasting policies and forecast accuracy Enlarge this image
[Figure 6] Frequency of performance review with partners
[Figure 6] Frequency of performance review with partners Enlarge this image

To better understand how distribution-intensive companies are responding to these challenges, Industry Directions, a market research firm, conducted a study of 190 manufacturers, distributors, and retailers. The respondents represented companies from an array of industries, including electronics, food and beverage, chemicals, automotive, grocery, specialty retail, pharmacy and pharmaceuticals, and other consumer goods, as well as distributors from other industries. These organizations were of various sizes, ranging from companies that reported less than US $200 million in annual revenues to huge corporations that took in more than $1 billion annually.

Industry Directions entered into this study with the hypothesis that distribution-intensive companies must adopt a demand-driven inventory management strategy if they intend to hold a competitive advantage in their respective industries. The questions were, to what degree are these companies succeeding? What obstacles must they overcome? And what tools are at their disposal to help them achieve success? The study revealed that these companies do indeed want to get onto a demand-driven footing. Actually getting there is another matter, however.

A shift from cost to service
Inventory serves many purposes in a company, and managing it well is essential for achieving market success and meeting corporate financial and business goals. Inventory management policies and practices are critical to supporting any company's business strategy, whether that is to offer best-ofbreed products, be first to market with innovations, attain low-cost leadership, or achieve any other major objective.

Most distribution-intensive companies historically have executed a cost-based strategy of pushing inventory out through their distribution networks. Yet, as can be seen in Figure 1, half of the respondents to the Industry Directions survey identified "improve service level" as their most important inventory management objective. In other words, distribution-intensive companies are finding that they must focus on service levels because of the dynamic and competitive nature of the markets they serve, which are often small, diverse, and unpredictable. The notion of long-term planning cycles for building to forecasts and anticipated markdowns is no longer acceptable. Instead, companies have to be nimble enough to adjust production and inventory so they can capitalize on emerging opportunities.

This shift in strategy means that cost reduction, the key marker of inventory efficiency, now runs a distant second to improving service levels. This is not to say that companies are adopting a demand-driven strategy that ignores cost. However, the road to demanddriven inventory management will put tremendous pressure on companies' ability to control costs.

Although relatively few companies are forecasting at the item level right now, an increasing number are adopting this practice. And those that do forecast at the item level are improving their accuracy.

When supply chain executives are tasked with building and maintaining a demand-driven inventory management strategy, most do so by trying to re-engineer a supply chain that has largely been dedicated to driving out cost. This supply chain legacy presents a series of challenges that must be overcome if distributionintensive companies are to become truly demand-driven.

Challenges to overcome
A company's position in the supply chain is likely to influence which challenges it will face when attempting to match supply and demand. Retailers, for example, are located closest to the customer and therefore tend to suffer the most from problems with fulfillment execution. In fact, fulfillment execution was cited as a problem by 35 percent of retailers, but only 18 percent of distributors and 11 percent of manufacturers put it on their lists. Furthest from the customer, manufacturers fight order changes and poor production planning. Order changes rippling through the supply chain were identified by nearly 20 percent of manufacturers as the primary cause of outbound inventory volatility. This sank to 13 percent of distributors and only 8 percent of retailers.

On the inbound side, retailers suffer more from order and specification changes, while shortages are manufacturers' number-one issue relative to inbound materials. Similarly, shortages and unrealistic order promising are problems that inhibit distributors from getting the materials they need when they need them. Naturally, all of this inbound and outbound volatility makes matching supply and demand more difficult.

That's evident in two glaring indicators of the struggle to achieve demand-driven inventory. Nearly three-fourths (73 percent) of respondents said they regularly expedite shipments, and 40 percent of those respondents said that their use of expediting is increasing. Meanwhile, 83 percent said they experience overstocks; on a positive note, 52 percent of them also reported that overstocks are decreasing.

Those are just two examples of the fallout from demand becoming less predictable as consumers and other customers shift away from clear or even from cyclical purchasing patterns. No wonder, then, that about one-third of all respondents—regardless of their supply chain role—identified dynamic market demand as their primary challenge. (See Figure 2.)

Inconsistent supply lead times represent another common roadblock to matching supply and demand. Twenty-two percent, or more than one out of five respondents, named the complexity and length of their supply chains as their primary challenge. The rise of global and low-cost-country sourcing is the primary reason for that assessment. As companies have increased their geographic reach, variable lead times have become a common issue across all industry sectors. Moreover, those that focus exclusively on lowcost sourcing may find that logistics, regulatory, and quality issues offset the low per-unit cost of materials. The longer lead times may also hurt competitiveness in some fast-moving markets.

Compliance issues can make inventory management more complex and dynamic for companies that have many customers or are selling and sourcing from many countries. Each customer and each country or region may have specific requirements, which can result in many combinations of special inventory factors, even for a single item. It is such a frequent occurrence that 63 percent of respondents said they must regularly change their inventory policies to comply with regulatory requirements or customers' requests.

Perhaps the most significant effect of global sourcing is that it requires some supply chain redesign. Not surprisingly, the most common change to accommodate global sourcing is longer lead and order times, as seen in Figure 3. Global sourcing has also led nearly 20 percent of respondents to reduce the number of distribution centers (DCs) or warehouses they operate. Meanwhile, to compensate for the smaller number, 13 percent of respondents increased the size of their existing DCs in order to achieve and maintain customer service standards.

Despite the critical implications of global sourcing for demand-driven inventory management, more than 40 percent of respondents said they rarely review their supply networks. The same is true when it comes to reviewing distribution networks and their inventory processes: More than 40 percent rarely examine these.

Given the speed of change in business today, there is obvious risk in continuing to depend on ineffective inventory processes or network designs. Successful companies, in fact, are more likely to review their inventory processes than those that are less successful. Only 20 percent of high-performing companies (those that exceeded goal on half or more of the metrics in this study) reported that they rarely review and redesign their inventory processes.

Forecasting concerns
The difficulties of establishing a demand-driven position can be seen in the relationship between forecasting and inventory management. Forecasting accuracy benefits from a demand-driven system; ideally, in a demand-driven environment distribution-intensive companies would carry lower inventory while hitting higher service marks because they would have an accurate read on demand signals. Yet as shown in Figure 4, less than 40 percent of respondents have achieved a forecast accuracy above 80 percent, even in the shorter time frames where forecasts tend to be more accurate.

For the majority of distribution-intensive companies, this inaccuracy appears to be due in part to the fact that most do not forecast at the item or stockkeeping unit (SKU) level. As shown in Figure 5, only one-third or less of respondents are forecasting by SKU per channel or SKU per customer or location.

Although relatively few companies are forecasting at the item level right now, an increasing number are adopting this practice. And those that do forecast at the item level are improving their accuracy. Forecasting by SKU per channel or SKU per customer or location provides much greater granularity, making it possible to identify specific demand patterns for each individual item for each channel, customer, or location.

Demand forecasts at the product-family level also have led to improvements in accuracy. Given the inherent variability in demand, however, improving this type of forecast generally goes only so far. Companies that forecast at the product-family level need to design in safety stock or buffer inventories to ensure good customer service. The challenge is to set inventory targets that will minimize cost while achieving the desired levels of service.

Organizational issues also affect how well companies coordinate demand planning and inventory targets. With the exception of distributors, most distribution-intensive companies have separate organizations for demand planning and inventory management. For example, two-thirds of the manufacturer respondents stated that they have separate organizations.

Having separate groups involved in demand planning and inventory is not necessarily a problem. It is only problematic to the degree that the two functional areas are not effectively coordinated. Such a separation can work very well when the processes and communication tools for setting targets and the information flow used to adjust inventory as demand fluctuates are employed effectively.

Paths to improvement
As already noted, the number-one priority for distribution-intensive companies and the cornerstone of demand-driven inventory management is raising customer service levels. However, most companies today are not deriving the benefits of technology that could help them automate or better coordinate their inventory and achieve higher levels of customer service.

Most respondents already use some form of forecasting software, but they do so with varying levels of success. Inventory-optimization software, meanwhile, is growing in popularity. Currently, more than 30 percent of respondents said they believe inventory-optimization software that uses algorithms to account for uncertainty would be the best way to manage their inventory levels. Another 27 percent said that an application that includes an inventory-target calculation would be the most effective mechanism. Some 30 percent said they believe that an application with an inventorytarget calculation would be most effective for managing service levels, while 23 percent preferred an optimizing algorithm.

Although respondents' confidence in technology as an aid for managing inventory has risen, a sizable pocket of companies continue to depend on manual processes. Roughly 60 percent of respondents said they use either "rule of thumb" (predetermined guidelines) or spreadsheets to set customer service levels and inventory targets. Moreover, one in five respondents indicated that an expert using rules of thumb is the most effective way to set customer service levels, while another 27 percent identified spreadsheets as being most effective.

It's true that many companies have used spreadsheets to develop excellent calculations for managing inventory targets. But the continued use of spreadsheets and rules of thumb to set inventory and customer service targets will limit companies' ability to move toward demand-driven inventory management. One reason is that spreadsheets become far more challenging to use at the SKU level. More importantly, spreadsheets are single-user systems that inhibit truly dynamic collaboration, a situation that often results in an uncoordinated, unsynchronized flow of information throughout the supply chain.

Other tools and techniques that companies could be using to greater effect are in the areas of metrics and policy. For example, only about one-third of respondents review their inventory targets monthly or more frequently. Forty-seven percent conduct quarterly or annual reviews of inventory processes, and 15 percent rarely review inventory targets.

For products with relatively stable demand at various locations, infrequent reviews may be adequate. However, we suspect that for many respondents, stable demand is not the reason for infrequent reviews. Rather, business processes and information systems simply are not set up to accommodate anything more frequent. Many do not have a process in place for detecting when inventory targets are not delivering the desired service levels, and they require several months or more to change that situation. It is little wonder that the majority of respondents are burdened with overstocks and expediting.

Companies could also improve demand-driven inventory management by implementing supplier management strategies that can help them cope with supply-side variability. However, less than half of the respondents said they are using strategies such as consignments, vendor-managed inventory (VMI), visibility portals, or metrics-based incentives or penalties with their suppliers. Most who do use these mechanisms said they find them effective; the one exception was incentives or penalties based on key performance indicators (KPIs). The approach with the highest proportion of success was consignment inventory from suppliers.

The only supplier management mechanism that most respondents use is the regular process review, employed by 77 percent. Still, monthly supplier-performance reviews are not as ubiquitous as one might imagine. About one-third of companies reported that they communicate performance levels to contract service providers at least monthly, while only about one-fourth conduct monthly reviews with other types of suppliers, as seen in Figure 6.

The partners that have a more direct impact on company finances—customers and contract service providers—are more likely to undergo frequent performance reviews. Service providers often are under service-level agreements (SLAs) or other contractual terms that tie compensation to meeting certain performance expectations. Yet even in these cases, about one-quarter of respondents rarely review and communicate with partners about their performance.

It can be just as critical to have ongoing communication with materials suppliers. Although four out of five respondents do conduct at least annual reviews with their suppliers, these reviews will have to become more frequent if demand-driven inventory management is to succeed.

The road is not easy
As today's business environment becomes less predictable, the importance of demand-driven inventory management is growing. Companies recognize the potential benefits of a demand-driven inventory strategy, but they have much work ahead of them before they can transform their supply chains and inventory practices in a way that will allow them to take advantage of those benefits.

Clearly, the road that distribution-intensive companies must travel if they are to achieve demanddriven inventory management is not a straight or simple one. The good news is that there is a way to get there. A small number of companies that responded to this survey are showing very positive results from adopting practices such as forecasting and planning at the SKU level, frequent reviews of KPIs, using advanced algorithms to optimize inventory, and sharing key data with trading partners. That path is not an easy one, but signs show that it's a journey that's well worth taking.

Endnote:
"Demand-Driven Inventory Management Strategies: Challenges & Opportunities for Distribution-Intensive Companies," May 2007. Industry Directions Inc. www.industrydirections.com

William Brandel is a principal of the market research firm Industry Directions.

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