Optimally balancing inventory and service level in three steps

Supply chain problems can have a significant financial impact, causing companies’ inventories to grow faster than their sales and therefore their cash flow to dry up. In view of all the supply chain uncertainty and unpredictability nowadays, balancing inventory and service levels is harder than ever. During a recent Webinar Wednesday, Slimstock explained the three steps companies need to take to find the right balance.

By Marcel te Lindert

Food ingredients company DSM saw its operating cash flow fall by 42% to €216 million in the first half of this year. After investments, there was no cash flow leftover at all, meaning DSM generated no money for additional new investments. In early August, Dutch financial newspaper FD quoted co-CEO Geraldine Matchett as saying that the drop in cash flow was a direct result of the decision to build additional inventories. “Because of the supply chain challenges, we deliberately opted for higher working capital because we prioritized supplying customers over reducing our inventory.”

Striking the right balance

DSM is not the only company where cash flow has declined substantially. The ongoing turbulence is hitting numerous supply chains hard, according to Ciaran Lumsden. “We are seeing supply chain costs rise significantly due to higher transportation costs and raw material prices. In addition, we are seeing cash flow issues as companies have had to invest more than usual in inventory due to volatility,” said the business development manager at Slimstock UK & Ireland. “Everything is about reducing risk. The companies that do that best will be today’s and tomorrow’s winners. And one method of reducing risk is to build extra inventory.”

The necessary inventory level depends on the level of service the company wants to achieve. But striking the right balance between service levels and inventory is more complex than ever. “It’s not just about service levels and working capital, but also about eliminating waste and minimizing costs. Companies might manage to increase service levels while keeping inventory levels low, but that usually comes at a high cost. Those who want to be successful will have to optimize operations across all these aspects.”

Dive deeper into the data

During the webinar, Lumsden explained how companies can find and maintain the right balance in three steps. The first step is about creating visibility in the supply chain. “Let’s take bicycle sales as an example. Anyone who sees the annual growth curve will think that the demand for bicycles is pretty easy to predict. But if you dive deeper into this product category, you realize that forecasting isn’t so simple after all. Yes, the demand for electric bikes is rising rapidly, but the demand for road bikes is stable, while the demand for children’s bikes and exercise bikes is actually declining.”

In other words, it’s no longer sufficient to look at the product category as a whole. If bicycle manufacturers were to base their decision-making on that approach, they would soon be facing shortages of e-bikes, and surpluses of children’s bikes and exercise bikes. “You need to look at your product range at a much more detailed level – preferably at the level of stock keeping units (SKUs). That might not have been possible before, but it is now.”

Look further ahead

If you want to create more visibility, you need to answer three questions. The first relates to the availability of historical data. “We used to say that two years of historical data is sufficient, but – given the volatility in recent years – it’s preferable to have more,” stated Lumsden. “The second question concerns the planning horizon. How far ahead do you want to look? Many companies work with a 12-month horizon, simply because they always have done. But if lead times for parts are increasing, you could ask yourself whether 12 months is long enough. And the third question is about getting hold of market information. What are your competitors doing? Are they going to pass on higher costs or not?”

But more visibility alone is not enough. Once you have more visibility, you face the next challenge: keeping the supply chain under control. “That’s easier said than done. Look at rising inflation; it has a major impact on demand, but you have no control over it. The same goes for Chinese lockdowns affecting ports, the high cost of container transport, and pressure on suppliers’ production capacity due to staff shortages,” Lumsden said. He gave the example of Chinese New Year, which always has a major impact on available production capacity and will fall on 22 January next year. “Some companies are already expecting it to cause problems. Because everything takes longer, you need to act earlier to offset any issues.”

Check your parameters

Companies can do several things to gain more control over the supply chain. Firstly, they can improve collaboration with suppliers by communicating openly and sharing forecasts. “In addition, make sure you have a good planning framework. Ensure parameters such as delivery times and minimum order quantities are correct. We still see companies that set these parameters right at the start, during the implementation of the ERP system, and then never review them again. And lastly, be agile. You know that Chinese New Year is coming up, so make sure you can respond to its impact faster.”

The final step is about maintaining focus. Lumsden gave the example of a tool wholesaler with an assortment of 50,000 items. In recent years, the wholesaler’s inventory levels have risen much faster than sales. “We see that happening at numerous businesses: ever-expanding ranges. Companies are good at introducing new products, but not so good at phasing out obsolete ones. As an extra side effect, more and more manpower is needed to manage that inventory – and that manpower is often not available.”

Dynamic ABC analysis

Lumsden recommended doing ABC analysis much more often than before, not only for products, but perhaps also for customers. “It’s no longer enough to do ABC analysis only once or twice a year. A fast-moving product today could be a slow-mover tomorrow,” said the business development manager. “And think carefully about which tasks to prioritize. Some tasks are urgent and important; you should tackle them first. But some tasks are neither urgent nor important. People tend to like doing these tasks because they are relatively easy to perform, but they add absolutely no value. So stop focusing on them.”