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A fresh take on inventory as a source of working capital

A three-pronged approach to inventory analysis can help companies free up cash while getting more value from underperforming or unwanted inventory.

Short-term borrowing rates are at their highest level in nearly a decade, threatening economic expansion and adding another variable to an already volatile market. Savvy supply chain professionals should view this uncertainty opportunistically and take advantage of the changing financial environment. How? By using inventory management to improve their companies' working capital. The technical definition of working capital is operating liquidity or, said another way, the access to or possession of cash ... what you could call the lifeblood of every organization.

During the decade-long era of near zero-interest "free money," companies sought to enhance working capital by focusing on pushing accounts payable, factoring accounts receivable, and borrowing against other balance-sheet assets. But with interest rates continuing their upward march, the era of low-cost borrowing is coming to an end, and the aforementioned avenues of working-capital release have been exhausted. It is now time to question the absolute monetary value of inventory necessary to support a business, and to analyze opportunities to wring working capital out of current balances while simultaneously improving other important aspects of the business. 

Through the steps detailed below, not only can supply chain organizations release working capital from inventory, but they also can improve fill-rate performance and forecast accuracy. These steps include:

  • Engaging in an interactive sales and operations planning (S&OP) process, with active involvement by sales representatives and the supply chain organization functioning as a support or "concierge" service to the revenue-generation side of the business;
  • Conducting an inventory-performance analysis at the stock-keeping unit (SKU) level and creating an action plan that includes the formation and validation of set points, order points, days-on-hand targets, and stocking schema; and
  • Developing an action plan at the SKU level for slow-moving, obsolete, and overstocked inventory.

This proposed approach is necessary to mitigate the risk of purchasing unnecessary inventory, which consumes valuable working capital. Of special note is the fact that it can be executed with existing internal human and system resources.

Sales steps up

When it comes time to talk about inventory during the S&OP process the "S," or sales team input, often is conspicuously absent from the dialogue. That's because, historically, operational planning activities have been performed somewhat independently of the needs and desires of the commercial side of the business. As a result, front-end conversions between sales and operations often consist of a cursory approval of a system-generated forecast, and the majority of interactions between order generation and fulfillment are reactionary efforts to understand why certain SKUs are stocked out while others are in excess. 

While historical data—the fuel for most demand management software—can provide directional information, the fact is that markets flex, demand vacillates, and disruptors in the market render past experience misleading when forecasting future demand. For that reason, there is enormous risk in allowing procurement to operate on "auto-pilot"; that is, relying exclusively on system-generated forecasts without adjusting them to reflect reality based on consultation with those who have knowledge of the current market environment. Instead, a "shopping list" of desired SKUs created by the sales team should direct the supply chain organization in regard to what should be stocked. After all, the sales organization, with its constant interaction in the market and access to both quantitative as well as qualitative information, has the best insight into current and future market behaviors. These insights, coupled with macro data provided by marketing organizations, can be extremely valuable in predicting upcoming demand. 

For instance, when there is market volatility, the sales organization's rapid gathering and digestion of market-level data can help procurement ramp up or throttle back purchasing to avoid inventory and fill-rate disruptions. One example of the power of this approach comes from the ethanol market. Semi-custom stainless-steel valves, which cost almost twice as much as standard carbon-steel valves, were manufactured for use in the corrosive environment of ethanol production. When the market for ethanol production unexpectedly crashed in 2006, production inventory for this unique market instantly became unsalable. The rapid identification of this sudden market shift allowed some companies to mitigate the extent of their financial losses by promptly shutting down stainless-steel valve production, thereby preventing manufacturing overruns and reducing the risk of excess and obsolete inventory.

At the same time, the supply chain organization should position itself as a support or "concierge" service to the order-generation side of the business. As sales takes a more active role and corresponding responsibility in the S&OP process, the supply chain team should focus on the fulfillment of sales' predicted demand, and spend less time dwelling on its perception of the forecast's legitimacy. Under this model, forecast accuracy and the correlating product plans would be the responsibility of the sales organization. From a reward standpoint, it is essential that the fulfillment or supply chain organization be recognized based on its achievements relative to the forecast provided to it, rather than on how well the forecast matches actual demand. 

What is unusual about this proposed treatment of the S&OP process is that the "S" organization takes a much greater role in determining inventory. Suggested action steps include, but are not limited to, the following:

  • The sales team will determine what is stocked versus what is made to order based on their understanding of demand predictability and lead-time tolerances.
  • Demand planning will provide data and execute the "plan," but the ultimate stocking decisions will be made within the sales organization. Again, the "S" team creates the "shopping list" of SKUs and required quantities, which will then be executed by the fulfillment team.
  • The sales group will be responsible for the shortfall or excess of inventory. This is based on the concept that members of the "S" team, including both sales and marketing representatives, have the best insight into the market's needs. As long as the order-generation side of the business delivers per the forecast, any forecast misses would be the "S" team's responsibility.
  • The procurement team's performance will be measured based on its performance compared to predicted demand, not actual demand, as that would now be the responsibility of the order-generation side of the business.

The goal of the above is not to punish the commercial organization. Instead, the purpose is to direct sales representatives to play a more active role in the S&OP process and be an integral part of a solution that achieves an ideal balance of inventory available for sale, without excess or unnecessary product. 

Once the S&OP process has been formalized and a schedule of monthly meetings is being religiously followed, the result should be calibration within all departments (such as purchasing, production, finance, sales, and so forth) of what they believe will happen in the future regarding product demand. The one absolute about forecasts is that they are always wrong, but in the above-described structure everyone shares the same expectation, thus eliminating internal misalignment.

When that alignment has been achieved, a company is in a much stronger position to respond to unexpected market gyrations, as the internal structure is such that there is no question regarding who provides the "marching orders" and who follows. The significance of this cannot be overstated. The resulting organizational efficiencies allow for more immediate action, improving market responsiveness and inventory turns while making the best use of working capital. This improvement in both turns and working-capital utilization occurs because the timely feedback allows the supply chain organization to adjust its production and stocking plans, immediately helping to ensure product availability while mitigating the chances of production or stocking overruns due to changing market preferences.

The right level of inventory

An S&OP team with defined roles and responsibilities that adheres to regularly scheduled meetings is an extremely powerful "committee" that can filter inventory-related issues, including identifying appropriate levels of on-hand inventory. For example, with appropriately directed conversations and data flows, the S&OP team can discuss and determine which SKUs should be stocked as well as their best location, quantity, configuration, and so forth. One way to do this is by coupling historical sales with current market and customer-specific insights to determine which are the key fast-moving SKUs and which are expected to be slower performers. One possible approach to focusing this analysis is detailed below.

While more sophisticated and expensive tools are available, in many companies, simple Microsoft Excel software can be used to perform an "ABC" inventory analysis. Segmenting SKUs into different categories based on frequency of demand is nothing new; what's somewhat novel are the actions that result from this analysis.

As part of the creation of an operational definition for "A," "B," and "C" inventory, desired days on hand (DOH) should be established. DOH measures the average number of days an item is held in inventory before it is sold. These targets are used as measurement guides for stock levels relative to both historical and forecast demand. DOH targets should reflect the lead times, demand volatility, criticality, and other attributes of a particular SKU. In addition to being a measurement tool, DOH targets help guide discussions during the S&OP meeting where the targets are set. 

Oftentimes organizations will be monitored and incented based on an aggregate inventory-turn metric. This is risky, as such an approach potentially masks circumstances where certain SKUs are overstocked and could become excess or obsolete. This inventory "sludge" can accumulate within a company and remain hidden if SKU-by-SKU analyses are not performed. The result is that in order to hit a predetermined inventory turn rate, organizations often will understock certain high-velocity SKUs because, especially in the short term, fast-moving SKUs are the easiest to reduce while they are being used or sold. Although a certain metric may be achieved, the underlying inventory position may not be strong.

By conducting an SKU-level DOH analysis based on both historic as well as forecast demand, using data that can now be provided by the "S" representatives of the S&OP team, the supply chain organization can identify problem-prone inventory. SKUs with DOH levels above the predetermined target can be highlighted and then presented in the S&OP meeting for action. The percentage of "days" in excess of the DOH target directly translates into the potential release of working capital by reducing the inventory balance to target. While the description may seem complicated, the math is actually quite simple.

For example, if a DOH target for a certain SKU is 45 days, and the current DOH calculation based on forecast demand is 60 days with a $50,000 inventory balance, the organization has 15 days (33 percent, or $12,400) of excess inventory. (A critical assumption in the above example is that both the inventory target and the demand forecast are appropriate. In order to prove reliability, monitoring of both forecast accuracy as well as actual inventory turns and stocking levels must be performed and anomalies brought to the S&OP team's attention.) By reducing the balance to the target, more than $12,000 in cash can be released into the business. While this may not appear to be significant, keep in mind that this cash release is for just one SKU. With organizations holding thousands, tens of thousands, or even greater numbers of inventory items, this can be a significant area of opportunity. It therefore should be part of the S&OP process to not only prescribe an actionable plan on how to address certain overstocked SKUs, but also to validate the reasonableness of the set points (inventory target levels), order points (inventory level where replenishment orders are placed), and the overall stocking schema. 

Thanks to the more current and relevant information that the "S" participants can provide to the demand planning and related supply planning process, on-hand inventory balances that are either above or below target can be quickly identified, analyzed, and addressed. The organization can respond to inventory shortfalls by increasing production. It does take time to "spool up" production, however, and the consequences of doing so can potentially be exacerbated in extended and multinational supply chains. But the new S&OP process should provide the maximum amount of response time available given the somewhat imperfect information an organization has to work with. While no forecast is ever perfect, the ability to respond quickly will help a company better handle an unexpected variation.

To sum up, the recommended steps for performing the "ABC" inventory analysis described above include, but are not limited to, the following:

  1. Set an operational definition for ABC ... D inventory and determine objectives. The objectives should contemplate inventory-turn goals, fill-rate goals, cash availability, and other critical variables. These objectives can then be used as measurement tools for actual inventory performance.
  2. Know what data you have to work with. Understand the availability of SKU-level data, such as stocking locations, historical usage, preset order and line points, descriptions, ability to track past customers, and any other attribute that may provide valuable insight into a specific item.
  3. Sort data by sales revenue to identify SKUs based on their operational definition. This exercise identifies those SKUs that provide the greatest contribution to top-line revenue and, as such, are generally the most critical to the organization's success. Investigating these inventory items will determine whether the item is over- or understocked, offering an opportunity to either release working capital or improve or mitigate risk regarding fill-rate performance.
  4. Determine the value of inventory on hand by SKU.
  5. Calculate days on hand by SKU, and determine the appropriate levels.
  6. Identify "problem" SKUs. These are SKUs that are either over- or understocked based on the aforementioned goals.
  7. Develop an SKU-level action plan to get balances into line with targets. Again, the benefit of this exercise is to confirm current balances, release working capital if inventory levels are too high, or improve delivery performance if balances are too low.

The ability to perform these steps in a relatively short period of time and react to the market and/or stocking variation is significant and a direct benefit of the realignment of the S&OP team and its processes. These steps will ensure that SKU-level inventory balances are appropriately set, with variations from goal identified and rectified. As previously noted, they also will engage the "S" side of the business in more of the stocking decisions, lifting forecast accuracy and fill rates due to the "S" team's critical insight, and thus improving visibility as well as accuracy.

Turn trouble into treasure 

Before any action can be taken regarding slow-moving, obsolete, and/or overstocked inventory, it is necessary to develop an operational definition of what slow-moving, obsolete, and/or overstock inventory actually is. This designation historically has been based on such characteristics as number of days on hand, discontinued SKUs, or some other company-specific consideration. Agreement on how problem-prone inventory is both identified and valued is essential to avoid internal arguments over what is and is not an SKU that should be analyzed. For instance, an organization may define slow-moving inventory as SKU-level balances with over 90 DOH based on rolling, six-month historical demand. In addition, if there is a custom-stocked SKU for a customer that cancels the relationship, then it may be part of the inventory policy to immediately write down those on-hand balances.

Once "problem" SKUs have been identified, an action plan should be developed to maximize the use of these items from both a working-capital investment and customer-usefulness standpoint. The reason for this is that every dollar of unnecessary inventory can be converted into a dollar of free cash flow. One area of potential confusion within an organization is the difference between the generation of profit and the generation of free cash flow. It is important to confirm understanding, as there are times when consuming or repurposing problem SKUs will be profit-neutral or may even involve an inventory write-down expense yet will still be the right decision due to the cash-flow release. For example, expenses may be added to an income statement via an inventory write-off in order to make the SKU salable and eligible to be converted into cash. This appears as a "hit," or additional expense, on the profit and loss (P&L) statement, which may raise questions or opposition.

It is therefore often easier in some respects to address slower-moving inventory when certain profit objectives have been achieved and there is more willingness to make incremental inventory write-downs. While this is not technically appropriate from an accounting standpoint, it may be politically easier to have these discussions at times when metrics have been significantly overdriven or have fallen short of target.

While from a P&L standpoint it requires a simple journal entry to create a financial reserve whenever the market value of inventory is less than what is listed on an organization's balance sheet, the conversion of troubled SKUs into cash has more of a creative aspect. Here again, the sales department's representatives on the S&OP team can provide valuable recommendations on how to convert the inventory into cash. Each organization will have nuances associated with its inventory that will influence its decisions, and therefore not every option will be right for every company, but the following are a few of the many ways to release working capital embedded in slow-moving, obsolete, or otherwise stranded inventory:

  • Return to vendor
  • Reach out to previous consumers who have purchased the SKU in the past to see if there is a desire for additional units
  • If the SKU in question is for a component, re-engineer products to utilize on-hand inventory
  • Include as a component of a "basket" (multiple SKU) offering
  • Introduce to new markets and/or customer categories
  • Up-sell in place of another component or inventory item if appropriate
  • Convert/modify into a faster-moving or on-order SKU, even if some additional cost may be necessary
  • Provide incremental incentives to internal sales team members
  • Discount the price
  • Dispose of the item

Note that price concessions and disposal are listed last, as they are the least-desirable options. While they may at times be the "easiest" or the default options, it is essential to avoid simply writing down inventory to abide by financial reporting requirements, and to instead work at maximizing the working capital released for each eligible SKU.

Companies that pursue and abide by the action items detailed above, on a continuous and consistent basis, will be better able to position their organizations from the standpoints of both financial flexibility, due to the effective utilization of working capital, and customer experience, in the form of higher fill rates and improved response. 

Tim Buhl, CPA is an instructor for the Grainger Center for Supply Chain Management in the Wisconsin School of Business at University of Wisconsin-Madison. The Nelson Institute for Environmental Studies and the School of Business work together to prepare students for careers within circularity.

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