How Much Inventory Do You Really Need?
How much inventory do you really need? Companies try to answer in 2 ways: top-down and bottoms-up. In a top-down approach, we define an ‘overall’ target for our business unit, based on a benchmark, or based on last years’ performance. In a bottoms-up approach, we start by calculating per SKU-location what is the required safety stock, cycle stock, anticipation stock, strategic stock, and in-transit or work-in-process. By summing up across locations and across multiple echelons, we also come to the overall target. Do we need both? And how is strategy impacting these calculations?
In my book ‘Supply Chain Strategy and Financial Metrics’, I describe at length how strategy influences the financial targets and why benchmarking should be done in 2 dimensions using so-called orbit charts. To have the lowest price in the market, the operational excellence players need to have the lowest cost, which in turn makes them cut complexity. They will not carry a long tail of products. They focus on the fast moving core which gives scale and efficiency. They may work at minimal margins, but they compensate for that by employing less capital. They have lower inventories and employ less assets, or stated differently, they will have a higher utilization rate. As explained in earlier white papers, customer intimacy players and product leaders add complexity and as a result require more inventory, which from a ROCE perspective is fine, as long as they can drive a higher premium from their customers and show a higher EBIT.
From a target setting perspective, the important conclusion is that as a product leader, I do not necessarily need to be the best in inventory turns. I know the operational excellence player will always have higher turns. As a product leader I need to be the best in gross profit. 2-dimensional benchmarking as explained in the book better reveals these strategic trade-offs. We also refer to an earlier blog for a more in depth discussion on how different strategies require different supply chains, and how these supply chains all require excellence, but with a different focus.
So do we need top-down target setting? The answer is yes, and you need to take control. If you don’t take control and do a proper top-down target setting, your CFO or your board of directors will. They may not account for the strategy and you may land yourself the target of the Operational Excellence player while being a Product Leader. This will cause both chaos and frustration.
Do we need bottoms-up target setting? The answer is yes. If your target for inventory turns is 3 and your actual inventory turns is 3, that does not ensure you have the right inventory balance. You may be carrying too much of some products and not enough of others. Calculating an inventory target per SKU-location is needed to monitor your ‘inventory health’ or your ‘inventory balance’.
How does strategy impact the bottoms-up calculation? As introduced above, the Operational Excellence player will focus on the fast moving core. The Customer Intimacy player, to be able to offer his “Best Total Solution”, will introduce a long tail of products. The long tail is slow moving, so the average inventory turns will go down. The Product Leader is focused on the “best product”. The complexity of the product leader is typically in the product itself. He has a more complex Bill of Material, may have a longer and more difficult production process, may be obliged to work with niche suppliers, will typically have a long tail in the raw material or component inventory. Instead of Make-To-Stock, the product leader is more likely working Make-To-Order. Customers may be willing to wait for his higher specification product. This shifts the inventory challenge from finished product to intermediates, raw materials and components.
Summarizing the impact of strategy on the bottoms-up calculation we may say that regardless of the strategy you will need to calculate safety stocks, lot sizes and the like. For Operational Excellence players it will be simple as they focus on the fast moving core, for Customer Intimacy players we will see a long tail of finished products, and for Product Leaders we will see a shift towards the intermediates, raw materials and components and manage a long tail over there.
So yes, we need both a top-down and a bottoms-up calculation. Make sure to take ownership of your top-down calculation or you may land either incremental or unrealistic targets. The bottoms-up is required to monitor inventory balance and depending on the strategy you may see a long tail on the finished products, or more focus on the intermediates, raw materials and components and a long tail there. Combining both will lead to more realistic targets and a better control.