Do you need to improve your working capital? Carrying out a detailed inventory review can generate surprising working capital benefits. Here’s how to do it…
Most FDs will be well aware of the improvements that can be made to working capital by refocusing their efforts around cash, debtors and creditors. However, a sustainable reduction in inventory can also unlock significant working capital – while delivering other associated business benefits, such as lower transport and warehouse costs, in the process.
The biggest benefits will be felt by businesses that overstock the wrong products and don’t always have the right products to meet customer demand; those that have a surplus of obsolete or marked-down stock on hand; those which experience stock-outs and back orders on popular products; those that stock a large number of products to meet the needs of few customers; or those that have a number of customers that place small or irregular orders.
For organisations where inventory is a significant contributor to working capital, a structured and detailed approach to reviewing inventory is vital to avoid compromising levels of customer service. Our approach comprises the following three key steps.
THREE STEPS TO IMPROVING YOUR INVENTORY EFFICIENCY
1. Inventory analysis at SKU level
An in-depth analysis of current raw material, work in progress and finished goods inventory at SKU (stock keeping unit) level is an essential first step to drive inventory efficiencies. This analysis helps businesses understand the value and level of inventory, as well as the coverage costs for each SKU against historical and future demand.
It is critical that this analysis is carried out at SKU level – not at the more aggregate category level. A category level analysis can be flawed as individual SKU under or overstocking issues can remain hidden among category averages.
2. Identifying key drivers for inefficiency
The inventory analysis at SKU level is the base reference from which to pinpoint the causes of inefficiencies and to start identifying solutions. To do this the key drivers for individual under or overstocking issues need to be identified:
• Key driver: Product proliferation
Product proliferation is a common factor behind large imbalances in inventory coverage. As such the inventory value and coverage for each SKU should be overlaid against its gross margin contribution. This provides the basis to justify product rationalisation.
Dealing with product proliferation issues:
- Identify those SKUs that contribute the lowest gross margin contribution in value per annum.
- Compare gross margin contribution against average inventory value, cover and cost.
- Establish all SKUs and customers with a high inventory cover relative to demand and contribution.
- Establish robust metrics and processes to deal with new product introduction, product promotions and de-listings.
The greater the number of SKUs, the more complex and costlier it is to sell, plan, track, manufacture, ship and deliver those units.
• Key driver: Customer proliferation
Having too many customers with unique products can result in excessive inventory costs, so it is important to evaluate the net impact of each customer on both the business and the inventory.
Dealing with customer proliferation issues:
- Analyse customer sales history to understand the order frequency, the number and range of SKUs purchased and the average order size.
- Identify those customers with the lowest gross margin contribution and highest conversion and distribution cost.
• Key driver: Internal planning systems and processes
Robust demand, supply and inventory planning processes are key. However, we often find that the planning function is underinvested and not aligned to the needs of the business. Often, a realignment of people skills, systems and processes to the business model is necessary.
More effective demand and inventory planning enables enhanced communication with suppliers. This aids the negotiation and implementation of consigned or vendor, managed inventory as part of the inventory reduction solution.
• Key driver: Sourcing model/supply chain
The sourcing model and supply chain have a significant impact on inventory, not all of them positive. For example, supply-chain efficiencies often drive companies to overseas suppliers with longer lead times.
Dealing with sourcing model/supplier issues:
- Identify the inventory items that are overstocked because of supplier location, lead time, minimum order size or replenishment frequency.
- For suppliers with long lead times, robust inventory planning will be needed, in particular for SKUs with low/high volatility or seasonal demand.
- Align sourcing and inventory planning to reduce coverage costs.
- Work with customers to provide accurate demand forecasts.
• Key driver: Production processes
Vertically integrated manufacturing companies face a major challenge in supply chain management: driving economies of scale in production while maximising inventory efficiency. For some businesses this may be straightforward. However, complications arise in cases of high product proliferation and low order volumes.
To balance these conflicting requirements:
- Improve the planning process.
- Improve the efficiency and responsiveness of production.
- Differentiate service level by product and sales channel.
- Determine target inventory levels as a result of the desired service level.
3. Pulling it all together
Once the SKU inventory analysis is complete and the key drivers for inefficiencies have been identified, finance directors and CFOs should prioritise solutions that will maximise inventory efficiencies and reduce working capital.
It is common for organisations to encounter significant push-back at this stage, eg, sales teams may not want to let go of products for fear of losing customers and sourcing professionals who have painstakingly built up an overseas sourcing model may feel threatened.
Therefore, independent advisers are often better placed to demonstrate the true impact that inventory inefficiencies have on the business, and to support management teams in the implementation of the necessary changes.