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Best Practices for Reducing Inventory

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December, 2008

Unlocking Working Capital: Best Practices for Reducing Inventory
The macro-economic situation facing manufacturers today is extremely challenging with a perfect storm of volatile fuel prices, reduced consumer spending and challenges in getting credit. Enterprises need to be proactive in this situation and must look for ways to improve cash flow without the need for major new demand generation activities. This document highlights costeffective and practical ways to reduce inventory so that working capital can be released, while also providing caution against doing short term changes that will have a long term negative impact.
Research Brief Aberdeen’s Research Briefs provide a detailed exploration of a key finding from a primary research study, including key performance indicators, Bestin-Class insight, and vendor insight.

Working Capital is King in Times of Economic Uncertainty
In these times of economic uncertainty and global credit crunch, companies need to actively seek out best practices in how to move from working capital optimization theory to practical initiatives that will improve corporate financial performance while maintaining customer satisfaction. Supply chain, procurement and financial professionals have an opportunity to use working capital innovations to create a market advantage for their companies. Cash velocity can be a competitive differentiator and companies need to assess a variety of breakthroughs in working capital management to keep pace with their peers.
“The shortage of working capital to support our business expansion is the main reason why our company has increased its focus on working capital. We are currently evaluating different ways of reducing net working capital requirements, including inventory optimization, reverse auctions and lead-time reduction possibilities." - VP of Logistics, Water Treatment Facility Equipment Manufacturer

Pressures and Actions in Working Capital Optimization
Two-thirds of the 400 survey participants in a 2007 Aberdeen report Working Capital Optimization: Improving Performance with Innovations and New Technologies in Inventory Management and Supply Chain Finance, place a high priority on working capital optimization. These companies are increasing their focus on working capital management because they are being challenged to improve their financial metrics (Figure 1). This pressure is driving companies not only to reconsider their business strategies but also to implement appropriate supporting technology platforms. This combination of a strategy shift with the movement towards better automation is helping companies to improve control over spend, reduce transaction processing costs, optimize inventory strategies, enable better access to financing and make more proactive use of AR/AP balances. These improvements can help companies reduce their net working capital requirements and improve overall financial health.

© 2008 Aberdeen Group. www.aberdeen.com

Telephone: 617 854 5200 Fax: 617 723 7897

Unlocking Working Capital: Best Practices for Reducing Inventory Page 2

Figure 1: Reasons for the Increased Focus on Working Capital Optimization
Financial stakeholder pressure to improve key working capital metrics Current inventory management/deployment practices are not effective enough to meet customer service requirements Current inventory ownership poses too much risk or financial strain Shortage of working capital to support our business expansion or an acquisition strategy Shortage of working capital to support our operational requirements

66% 30% 29% 26% 24%
0% 10% 20% 30% 40% 50% 60% 70%

% of all respondents
Source: Aberdeen Group, June 2007

Companies are facing more challenges in managing working capital due to growth pressures, such as entry into new market segments, geographic expansions, acquisitions or product R&D funding requirements in addition to challenges in acquiring credit to enable the above tasks. Shareholder oversight of corporate performance metrics (both short-term and longterm) is causing organizations to create mandates for change in AR/AP functions, as well as in procurement and supply chain operations, to reduce working capital requirements and increase inventory turns. Figure 2: Current and Future Improvement Focus
Reduce inventory Shorten Days Sales Outstanding (DSO) Increase Days Payable Outstanding (DPOs) More effectively use short-term financing Move inventory off books More effectively invest cash short-term Other
84% 63% 45% 36% 35% 32% 24% 13% 20% 26% 28% 23% 29% 8%

Current improvement focus Future planned focus

0% 20% 40% 60% 80% 100%

% of all respondents
Source: Aberdeen Group, June 2007

© 2008 Aberdeen Group. www.aberdeen.com

Telephone: 617 854 5200 Fax: 617 723 7897

Unlocking Working Capital: Best Practices for Reducing Inventory Page 3

Figure 2 shows that the vast majority of companies today are concentrating on reducing inventory and shortening Days Sales Outstanding (DSOs); innovators are also focusing on many other areas to drive working capital improvements. Given that reducing inventory is the biggest action that companies want to take to improve working capital, it is critical to understand the right approach to doing so rather than haphazardly cutting inventory.

“Our company has been expanding rapidly into new markets by acquisitions. Our investors were unhappy with our financial performance in 2005. Since then, we have embarked on an inventory optimization initiative to drive down inventory levels.” - VP of Supply Chain, Medical Devices Company

Inventory Management: Requires Balancing Customer Service with Inventory
Inventory is the lifeblood of supply chains. Properly managed, it drives revenue and efficiency for companies. But as the nature of supply chains changes, so must the policies used to manage inventory. Supply chain inventory practices involve managing the flow and positioning of inventory holistically across multiple stages in the supply chain, including suppliers and downstream partners. As a result of this reexamination, supply chain executives are discovering that many of their preconceptions about managing and positioning inventory are dramatically wrong.

Inventory Misconceptions
• Simplistic inventory policies work well. Companies that use ABCD inventory policies or simple weeks-of-supply rules frequently have 15% to 30% more inventory than they need, as well as lower customer service levels. They hold too little inventory for items with lumpy demand and too much for items with steady demand. Holding all items at all levels in our finished goods network will give us the highest service levels. Companies with multiple tiers of finished goods distribution frequently hold the wrong amount of inventory in the wrong locations and suffer out of stocks despite high inventory investments. Many of these companies should be holding some items just at their hub locations. It is fine for each location or tier in the supply chain to set its own service level targets and replenishment planning frequencies. The lack of synchronized inventory policies across manufacturing stages and distribution tiers builds up unneeded inventory across the supply chain. In addition, firms with highvolume, high-variability environments often have replenishment planning frequencies that are too slow, creating unnecessary stockouts and greater inventory costs. Inventory minimization should be the goal. Companies with strong Lean philosophies often suffer from longer-than-necessary order lead times, high total delivered costs, and service level issues because they hold too little raw material and in-process buffer stock.
Telephone: 617 854 5200 Fax: 617 723 7897

© 2008 Aberdeen Group. www.aberdeen.com

Unlocking Working Capital: Best Practices for Reducing Inventory Page 4

Using purchase orders or release notices for replenishment is efficient. A growing number of companies that used to cut purchase orders or release notices for their suppliers are discovering it is more effective to ask suppliers to take responsibility for maintaining inventory between min / max levels.

These misconceptions around inventory impact both top line revenue and bottom line results. • Top line revenue: 1) revenue loss from stock-outs and late or incomplete orders that are cancelled; 2) customer retention issues because of service failures, long lead times, and flexibility challenges Bottom line results: 1) too much working capital tied up in inventory (also impacts the balance sheet); 2) lost manufacturing productivity and higher warehouse, labor, and transportation costs (e.g., expediting costs) caused by inventory delays or shortages; 3) profit erosion and write-offs from obsolete or declining price inventory

Aberdeen research has identified that Best-in-Class companies do not fall into the traps mentioned above. The key Best-in-Class characteristics are mentioned below.

Best-in-Class Company Performance
In a dedicated study of inventory management practices of organizations, Technology Strategies for Inventory Management: How to Convert Inventory from Cost to a Competitive Advantage, Aberdeen defined Best-in-Class companies in inventory management as companies that have customer service levels 96% and above and that have simultaneously reduced inventory carrying costs. Figure 3 shows, Best-in-Class performers are doing better with respect to reduced-lead time to customers, increased inventory turns, and increased perfect order percentages. These improvements can circumvent some of the challenges that companies are facing with respect to forecasting. Best-in-Class companies are leveraging their inventory as a competitive weapon and using it to hedge demand. They use inventory to optimally position supply when and where it is most needed and most profitable. By performing segmentation of their customer channels and products, these companies are able to attain significantly higher return on assets than their competitors. These companies are able to tie their demand management and sales and operations planning processes closely with the inventory process. They are able to achieve increased supply availability in response to the most profitable demand, resulting in increased customer service levels and market share gains. These companies are able to attain top line revenue increases through inventory management even in situations where the rest of their competitors are facing a flat market.

© 2008 Aberdeen Group. www.aberdeen.com

Telephone: 617 854 5200 Fax: 617 723 7897

Unlocking Working Capital: Best Practices for Reducing Inventory Page 5

Best-in-Class companies are able to analyze their inventory network and policies to add inventory where there are opportunities for winning additional market share and reduce inventory where it is not needed. They do not trim inventories across the board to reduce cost. Through this approach, they are able to increase their overall customer service levels while simultaneously reducing their total inventory carrying costs. Thus these companies are able to improve other key metrics like customer retention, gross margin and inventory turns. Figure 3: Best-in-Class Performance With Respect to Inventory Management
Increased finished goods inventory turns
73% 46% 73% 42% 64% 41% 45% 28% 0% 10% 20% 30% 40% 50% 60% 70% 80%

Reduced lead-time to customers Increased perfect order %(on-time and complete) to customers Increased customer retention

BIC Overall

Source: Aberdeen Group, April 2007

How are Best-in-Class Companies Managing Their Inventory?
These are some of the differentiating characteristics of Best-in-Class companies: • • • 36% of the Best-in-Class are doing multi-echelon inventory optimization (versus 17% of all companies) 57% of the Best-in-Class have an existing supply chain visibility system (versus 27% of all companies) 52% of the Best-in-Class have a forecasting system that supports customer-level forecasting (versus 27% of all companies)

It is clear from the above that technology plays an important role in inventory management success. Process changes are important, but in order to achieve sustainable benefits, Best-in-Class companies are more likely to supplement process changes with improved technology.

© 2008 Aberdeen Group. www.aberdeen.com

Telephone: 617 854 5200 Fax: 617 723 7897

Unlocking Working Capital: Best Practices for Reducing Inventory Page 6

Case in Point: Inventory Management Strategy for Wholesale Distribution and Slow Moving Parts
NTU (Technische Unie) is a wholesaler, distributing goods for electrical equipment, heating and climate technology, plumbing, sanitary and consumer goods including audio, video, and household-appliances. The catalog for NTU has over 350,000 line items of which there are 82,000 active SKUs. Of these, 10,000 are fast moving products and 72,000 are slow moving products. NTU operates on very short lead-times with customer expectations of delivery within 24 hours of the order. NTU owns two warehouses which are sourced by over 600 suppliers, of which per-day delivery is from more than 200 suppliers. NTU’s replenishment process operates on a daily basis with over 4,000 orders generated. Replenishment cycles are daily based on forecast data, initial inventory, lead-times, and lot sizes. Supply lead-times are an average of 25 days with all suppliers present in the "Euro region." Italy, Germany, and Britain are the primary sourcing countries. The challenge faced by NTU was poor forecast accuracy - especially that of the 72,000 slow-moving SKUs. In addition, the prior system was obsolete and no longer receiving support from a maintenance perspective. NTU implemented a demand, inventory, and replenishment planning solution that is able to support forecasting for intermittent demand and plan inventory based on service level agreements. During implementation, it was identified that overall inventory actually went up before coming down – which was predicted by the software implementers and anticipated by the NTU project team. The underlying cause was that the system optimized the mix of products in such a way that some products had forecast and inventory requirements which were lower than the finished goods inventory needed to achieve NTU’s desired service levels, whereas other products had inventory requirements higher than that and also needed to achieve their service targets. In other words, there was a period of re-balancing of inventory where the products with lower forecasts, based on customer demand, had to be sold out and the inventory “flushed” through the system, while other products had to be expedited in with immediate effect to achieve the target service levels. The effect of this was used positively by the project team at NTU to phase the roll-out of their implementation across their entire supplier base in a way that minimized the impact on cash flow – a lesson which should be shared with other companies looking to implement an inventory optimization solution. Benefits include: • • • Improvement in inventory turns Improvement in customer order fill rate Improvement in forecast accuracy at the product SKU level (even for slow moving parts)
Telephone: 617 854 5200 Fax: 617 723 7897

© 2008 Aberdeen Group. www.aberdeen.com

Unlocking Working Capital: Best Practices for Reducing Inventory Page 7

Case in Point: Micron Optimizes Inventory Using Postponement and Multi-echelon Strategies
Micron is one of the worlds leading providers of advanced semiconductor solutions. Micron’s DRAM and Flash components are used in today’s most advanced computing, networking, and communications products, including computers, workstations, servers, cell phones, wireless devices, digital cameras, and gaming systems. Micron has a complex multi-echelon network of internal manufacturing, geographically dispersed subcontract manufacturers and inventory staging locations. There are primary echelons within their supply chain including wafers, die, components, and memory modules positioned at over 100 locations around the world. Micron's supply chain challenge is to improve service levels and reduce order-to-delivery lead times while decreasing the costs associated with running a complex supply chain, especially working capital attributed to inventory. In order to resolve these challenges Micron is aggressively working to improve visibility into inventory, deploy multi-echelon inventory optimization strategies / tools, and increase the use of postponement in order to service their customers faster and more reliably. Micron has implemented a best-of-breed SCM suite for demand planning and supply planning and an inventory optimization tool that supports multi-echelon planning. The demand planning tool takes multiple forecast inputs from customers, sales, and marketing and is rationalized against a statistical forecast to remove the inherent bias within manually developed forecasts. The resulting demand plan is then fed into the multi-echelon tool which derives the safety stock and pipeline stock required to hit the customers desired service level by location. The targets are more robust as they are based upon forecast accuracy, production lead times, transportation times, and supply variability. The following benefits have been gained in the last two years: • • • Perfect order percentage (on time and complete) to customers increased by 11% For key products, order fulfillment lead time has been reduced from 14 days to three days Customer rating of their performance has improved dramatically
"One of our biggest challenges for our supply chain group is to improve customer service levels - reducing lead-times, increasing postponement, and optimizing inventory are three different business strategies that we are implementing to achieve our goals." ~ Simon Tunmore, Director of Supply Chain, Micron Technologies

Recommended Actions
Aberdeen research finds that the motivations and approaches for improving inventory are very similar across large scale as well as mid-size organizations. However the requirements for software technology that supports these processes is quite different - for mid-size organizations ease of use, packaged nature of apps and price are critical factors as compared to large organizations which may require customization and scalability. Organizations should look into SCM software suites that enable the following capabilities as a strategic investment.
© 2008 Aberdeen Group. www.aberdeen.com Telephone: 617 854 5200 Fax: 617 723 7897

Unlocking Working Capital: Best Practices for Reducing Inventory Page 8

By adopting the following practical approaches, companies can embark on their journey to reduce inventory the right way and unlock working capital: • Identify the attributes of segmentation. Only 9% of Laggards have indicated strong process capabilities in segmenting inventory based on customer service requirements, versus 36% of Best-inClass companies. Companies should implement customer level forecasting and inventory / service segmentation processes. The key attributes based on when segmentation has to be done must be identified as well; for example, volumes, picking volumes, complexity of customization, and lead-times. Analyze forecasts and remove bias. Only 12% of Laggards have indicated strong process capabilities in the ability to analyze demand patterns and create accurate SKU-level forecasts, versus 34% of Best-in-Class companies. Companies should analyze the forecasts from their customers and ensure that forecast bias is removed and the forecast is allocated down to the SKU level based on the individual demand profiles associated with the SKUs. This may require the implementation of demand analysis solutions.

Identify demand echelon. Only 16% of Laggards have indicated strong process capabilities in the ability to determine safety stock targets for inventory at critical nodes in the supply chain, versus 48% of Best-in-Class companies. Companies should look into their distribution and manufacturing processes and identify the echelons where the demand is being placed. If the demand is being placed only at the finished goods distribution level, then safety stocks should be calculated at that echelon. In environments where components, finished goods, and even raw materials are being sold to customers, a multi-echelon optimization may be required. For more information on this or other research topics, please visit www.aberdeen.com. Related Research
Technology Strategies for Closed Loop Working Capital Optimization: Improving Inventory Management; April 2008 Performance with Innovations and New Technologies in Inventory Management Technology Strategies for Inventory and Supply Chain Finance; June 2007 Management September 2006 Author: Nari Viswanathan, Vice President and Principal Analyst, Supply Chain Management and Logistics ([email protected])
Since 1988, Aberdeen's research has been helping corporations worldwide become Best-in-Class. Having benchmarked the performance of more than 644,000 companies, Aberdeen is uniquely positioned to provide organizations with the facts that matter — the facts that enable companies to get ahead and drive results. That's why our research is relied on by more than 2.2 million readers in over 40 countries, 90% of the Fortune 1,000, and 93% of the Technology 500. As a Harte-Hanks Company, Aberdeen plays a key role of putting content in context for the global direct and targeted marketing company. Aberdeen's analytical and independent view of the "customer optimization" process of Harte-Hanks (Information – Opportunity – Insight – Engagement – Interaction) extends the client value and accentuates the strategic role Harte-Hanks brings to the market. For additional information, visit Aberdeen http://www.aberdeen.com or call (617) 723-7890, or to learn more about Harte-Hanks, call (800) 456-9748 or go to http://www.harte-hanks.com. This document is the result of primary research performed by Aberdeen Group. Aberdeen Group's methodologies provide for objective fact-based research and represent the best analysis available at the time of publication. Unless otherwise noted, the entire contents of this publication are copyrighted by Aberdeen Group, Inc. and may not be reproduced, distributed, archived, or transmitted in any form or by any means without prior written consent by Aberdeen Group, Inc.

© 2008 Aberdeen Group. www.aberdeen.com

Telephone: 617 854 5200 Fax: 617 723 7897

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