Inventory: A Jekyll and Hyde Story

Stephen DeAngelis

February 15, 2011

Supply chain analyst Bob Ferrari asserts that company executives are of mixed minds when it comes to the subject of inventory [“Inventory- Evil or Good?,” Supply Chain Matters, 18 November 2010]. He writes:

“Most senior financial managers and some CEO’s believe that too much inventory is a detriment to working capital performance. It is just plain, evil. Marketing and sales executives view inventory as an ultimate enabler, and having inventory of a hot selling product is tantamount to ‘candy’ to a child, or exclaims, ‘Give me more!'”

If inventory is evil, it is certainly a necessary evil. “Too much inventory” is certainly not a good thing — perhaps not evil, but certainly not good. But getting inventory “just right” is not an easy matter. Ferrari continues:

“Our community knows all too well that having the right balance and composition of inventory is the real test in the ability to satisfy all stakeholders. A previous mentor of mine, Larry Lapide would often evoke the cholesterol analogy regarding inventory in his presentations to clients. There is good and there is bad cholesterol in our bodies, and the challenge is to optimize good and minimize the bad as much as possible.”

Ferrari goes on to discuss a paradox that was confronted by Walmart. At the end of last year, Walmart “experienced the sixth straight quarter of declining growth in existing U.S. outlets” yet managed to post “a 9 percent increase in profitability.” Some of that profitability came from outside the U.S. (Ferrari reports that “nearly a fourth of overall sales now originate from non-U.S. retail outlets”), but he believes that some of the profitability also resulted from how Walmart dealt with inventory. He explains:

“For those readers unfamiliar with the Wal-Mart situation, there is some history to reflect upon. Wal-Mart suppliers are acutely aware of the relentless focus on supply chain cost, which includes inventory, payables and process efficiencies. The latest initiative is a program directed at purchasing more goods directly from select global suppliers, bypassing intermediaries. Wal-Mart believed that it could gain even more efficiency through direct purchases of standard items. In late 2009, Wal-Mart embarked on an aggressive store re-vamp and inventory reduction program. The intent was to stock only high volume, high demand items while creating a more streamlined, uncluttered look and feel to a Wal-Mart U.S. store. The premise was value at traditional low prices. Gone were the days of stocked pallets placed in main shopping aisles giving the appearance of a cluttered warehouse atmosphere. The new merchandising plan was designed to help customers navigate easier and locate expensive or impulse items in select high-traffic areas.”

That sounds like a good plan. How did it work? Apparently not so well since Walmart “reversed course” at mid-year and “re-assigned certain U.S. management” (the implication being that those individuals who were reassigned were the ones who decided on the new inventory scheme in the first place). The reversal of the decision means that Walmart “is now adding more merchandise variety to stores.” Ferrari continues:

“The Wall Street Journal noted that inventory has grown 7.7 percent compared to a year earlier. By my calculation, in the most recent quarter, days sales of inventory is up to its highest level ever, no doubt in anticipation of an aggressive holiday buying season. [Remember that this was written back in November 2009]”

As I recall, Walmart discovered that even though bargains brought shoppers into their stores they started complaining when they could no longer buy products they were used to buying — even if less expensive alternatives to those items were available. Variety, as the old saying goes, is the spice of life. Ferrari concludes:

“Technology and business process methodologies have come a long way in the ability to optimize merchandising, plan shelf space, analyze and optimize inventory investments based on consumer needs and revenue targets. Management behavior or intuition it seems, has not made the same rate of progress.”

Based on the Walmart experience, it is clear that getting inventory “just right” is no easy matter. How then should one think about “just right” inventory? The challenge, of course, is different depending on whether you are a manufacturer, a distributor, or a retailer. The editorial staff at Supply Chain Digest suggests that for manufacturers, “production scheduling optimization may have bigger impact than improving forecast accuracy.” [“Looking to Reduce Inventories?” 2 November 2010]. It explains:

“The pressure to reduce inventories continues apace, even after the worst of the recession is well behind most companies. Many companies look to improving their forecast accuracy as a key driver of inventory reduction, from the common sense view that better predicting what customers are going to buy will enable companies to better match planned inventories with actual demand. But that might not always represent the lowest hanging inventory fruit for many manufacturers, according to Filippo Focacci, a product manager at IBM ILOG. According to Focacci, there are three main areas in the supply chain that can have a significant impact on overall inventory levels:

  • “Forecast accuracy
  • “Where and at what levels inventory is positioned within a multi-echelon supply chain network
  • “Production planning and scheduling decisions

“… Focacci said that many companies think about factory planning and scheduling in terms of production costs, but often do not fully understand the significant impact manufacturing optimization can have on inventory levels as well – often delivering greater reductions in inventory than might come from improving forecast accuracy can. (To view the full Videocast, go to: Agility in Consumer Goods Demand Driven Manufacturing.)”

The article goes on to explain how Focacci reached his conclusions and provides a case study to examine. “The key is doing production planning and inventory optimization together,” Focacci said. “You need less safety stock because you are doing better production planning.” The article concludes:

“The challenge, of course, is how to quantify the likely impact of any or all of the three inventory drivers (forecast accuracy, inventory positioning, improved factory planning). It is not obvious at first to many companies that forecast error may not actually be the best target for inventory reduction.”

Both of the articles cited above were written at the end of last year, but the problem has persisted into 2011 [“Adjusting Inventories Get Harder,” by John Shipman and Paul Vigna, Wall Street Journal, 27 January 2011]. Shipman and Vigna report that “the choppy U.S. economic recovery is testing companies’ skill at finding just the right inventory levels to maximize their profits.” They continue:

“Business inventories, slashed during the recession, had been climbing since June on a year over year basis, according to U.S. Department of Commerce figures. But, amid December’s strong auto and retail sales, the build-up of finished goods may have cooled off when the month’s figures are disclosed, some economists say. The rebound in demand so far has been uneven, and combined with a rapid rise in commodity costs since the third quarter, it’s becoming trickier for manufacturers to balance their production with sales. The stakes are high—produce too much and if demand falls, be forced to pare overstock at margin-killing prices; play it too safe with lean inventories and potentially miss out on additional sales.”

Shipman and Vigna report that Kimberly-Clark cut production too deeply and the company estimates that it lost an estimated “$20 million in profits.” Shipman and Vigna continue:

“The Johnson Redbook Index of retail sales showed January’s sales so far are up 2.5% from a year ago, slightly below the research firm’s estimate of a 2.6% gain. ‘Some retailers said consumers are back in a penny-pinching mood,’ the firm reported this week.”

According to Shipman and Vigna, another company that reduced production too much was Harley-Davidson. Even though its revenues increased by 20% during the fourth quarter of 2010, its dealerships find themselves with “the lowest level of dealer inventory in many years.” Shipman and Vigna continue:

“‘I think customers are being very careful before taking on a load of inventory,’ said John Koraleski, executive vice president of sales and marketing at Union-Pacific Corp. ‘They want to make sure they see that the economic recovery is sustainable and improving, but I still think we do have upside.’ Meanwhile, 3M Co. is building inventories in expectations of a strong first quarter. Inventories were up 19%, CFO Patrick Campbell said on a conference call, and he expects inventory levels to remain high as 3M exports more merchandise overseas.”

Shipman and Vigna report that other companies increasing inventories include Coach Inc. and Monro Muffler Brake Inc. The fact that manufacturers producing everything from handbags to auto parts are increasing inventories should be taken a good signal that the economy is producing. Still increasing inventory can be risky. Business executive and author Michael Hugos reminds us that “inventory” is one of the five essential areas involved in supply chain management (the others being production, location, transportation, and information). [Essentials of Supply Chain Management] He recommends that supply chain managers ask the following questions when making decisions about inventory:

“What inventory should be stocked at each stage in a supply chain? How much inventory should be held as raw materials, semifinished, or finished goods? The primary purpose of inventory is to act as a buffer against uncertainty in the supply chain. However, holding inventory can be expensive, so what are the optimal inventory levels and reorder points?”

Every company will have different answers to those questions. There is no “one size fits all” solution to optimizing inventory. Inventory not only buffers against uncertainty it affects responsiveness as well. Hugos puts it this way:

“If a company’s strategy is to serve a mass market and compete on the basis of price, it had better have a supply chain that is optimized for low cost. If a company’s strategy is to serve a market segment and compete on the basis of customer service and convenience, it had better have a supply chain optimized for responsiveness.”

To state the obvious: Large inventories can improve responsiveness but they also increase costs. Small inventories can reduce costs but risk reducing responsiveness. Best Buy, which ranks 24th on Gartner’s 2010 Supply Chain Top 25, learned back in the late 1990s that “you don’t buy inventory just in case — you buy it just in time.” They learned that lesson one Christmas season when they stocked on up on computers only to see PC sales plummet. David Blanchard, in his book entitled Supply Chain Management: Best Practices, writes of interview he had with Eric Morley, Best Buy’s director of transportation. As a result of this bad experience, Morley indicates that Best Buy focused on inventory optimization. Blanchard writes:

“According to Morley, Best Buy has established four guiding [principles] for supply chain management:

  • “Focus on where the most money is spent or where the most network disruptions occur.
  • “People are the most important asset, so assign the right people to the right tasks.
  • “Implement performance measures because ‘what gets measured gets done.’
  • “Balance overall company objectives against individual functions and activities.

“As a result of it supply chain programs, Best Buy now has high-level collaboration with selected vendors. The company recruits a key vendor in each retail department … to undertake collaborative initiatives designed to deliver breakthrough results.”

Frankly, Best Buy’s “collaborative initiatives” probably have a more profound effect on the company’s inventory optimization than its four guiding principles, which appear to have little to do with inventory optimization. No stakeholder in the supply chain wants to get inventory wrong. As a result, they should be willing to collaborate to get it right. Unfortunately, goals are easier to express than results are to achieve. That is why companies continue to struggle with inventory and see both the good and the evil it entails.