Behind every strong supply chain is a healthy inventory that carefully balances service with cost: too much stock ties up valuable working capital that could otherwise be used to grow the business, while too little stock compromises service objectives and impairs revenue growth. Striking the right balance is the key to achieving long-term profitable growth and is especially important in Asia where volatile markets and changes in consumer demand continually challenge manufacturers.
The three fundamental drivers influencing inventory targets are service, lead times and volatility. Service levels are dictated by the customer strategy and tend to be inflexible. Lead times are a function of manufacturing processes and transportation, and can be costly to shorten. Improving manufacturing agility to cut manufacturing lead times can be capital intensive. Changing transportation modes from rail to truck to shorten transit times is expensive. However, for most companies, the biggest factor influencing inventory health is persistent market volatility and the challenge of accurately predicting demand. Fortunately, recent developments in controlling the effects of volatility have made this the easiest and most cost-effective of these three drivers to regulate.
The first step towards creating a healthy inventory is to improve forecast accuracy. While customer behavior has always been hard to predict, major demographic shifts underway in Asia are making it even harder. Rapid population growth, migration from rural areas to urban centers and the unprecedented expansion of the middle class are radically changing demand. With markets expected to double in size within 30 years, the concept of using historical sales to predict demand has become increasingly irrelevant. Leading multinational manufacturers have abandoned this approach in Asia and are now looking at current data from within their supply chains to sense demand – and in some cases, even peeking into their distributors’ networks. If products are rapidly shipping from distribution centers or distributor warehouses, then this is a strong indicator that demand is about to rise. The use of current data to sense demand significantly improves forecast accuracy.
The second step towards a healthy inventory is to convert accurate demand predictions into optimal stock targets. Inventory optimization tools use complex mathematics to replace generic stock settings with specific values that respect service, volatility and lead times factors for each item at each warehouse. The use of software tools to determine optimal targets is even more important for distribution networks comprised of more but smaller warehouses, as are common in India. In these networks, the high number of locations and inherent capacity constraints make the mathematics particularly challenging and well suited for automated software tools.
By sensing demand and setting optimal inventory targets, manufacturers earn the right to confidently reduce stock levels without risking service commitments. Achieving this balance provides a measurable financial advantage. Annual reports show that companies that sense demand consistently outperform their peers in terms of revenue growth, cash flow and income from working capital. To illustrate this point, consider the five-year financial performance of 29 multinational consumer packaged goods manufacturers with revenues greater than $5 billion, ten of which implemented demand sensing capabilities (see Figure 1).
Figure 1.
Working Capital: Both groups started with 63 days of inventory, but companies that adopted demand sensing dropped by 5 days compared to only 2 for the peer group. Five days of inventory represents roughly $2 billion of working capital that can be reinvested to grow the businesses.
- Gross Margin Return on Investment: This metric indicates the ability of a company to generate cash from capital invested in inventory. GMROI for companies adopting demand sensing grew by 8% while declining by 10% for the peer group. The result is a relative 18% gain in their ability to make money on inventory.
- Cash Conversion Cycle: As a measure of how fast a company can convert funds invested in materials into cash from the sale of finished goods, the cash conversion cycle is a closely watched financial metric. A decreasing cycle means capital is tied up for less time in the production and sales processes and that management is doing a more effective job using its resources to generate cash. The cash conversion cycle was cut by 70% or 18 days for the group of companies adopting demand sensing, compared to 11 days for the peer group.
- Revenue: At the same time as improving cash flow and the ability to make money, companies that sensed demand also increased sales by 20%, compared to only 11% for the peer group, achieving twice the growth advantage. With turnover as a top priority for many Asian corporations, the demand sensing advantage for revenue growth is particularity relevant.
The benefits are clear. It is time to get healthy by sensing demand and setting optimal inventory targets. Competition is about the survival of the fittest where companies need to improve or be left behind. Which group do you want to be in?
Published July 8, 2014 in Supply Chain Asia
