ARTICLE | September 21, 2023

Companies in the manufacturing and consumer products industries—like other sectors across the economy—continue to face elevated inventory levels, and higher interest rates mean inventory carrying costs are increasing as well. Having an intentional, clear and analytically driven approach to inventory optimization can help companies better align supply with demand while improving working capital.

Many middle market companies segment their inventory into A, B and C categories based on volume and/or value but fail to take into account the variability of demand. Having a two-dimensional view of inventory (volume/value versus demand variability) enables planners to develop more specific inventory strategies aimed at meeting customer service levels while minimizing carrying costs.

Efforts to optimize inventory may be especially important right now; 48% of firms with inventories saw their supplies increase in the second quarter of 2023, according to the RSM US Middle Market Business Index survey—down from 52% in the prior period. However, 60% of respondents expect inventory levels to increase over the next six months, a concerning statistic given inventory challenges companies have faced recently.

Many organizations understand the importance of aligning supply with demand to free up cash flow while maintaining customer service, but figuring out how to make the necessary changes can be challenging. Three critical strategies can help companies tackle inventory optimization: inventory segmentation, process improvement, and a focus on sales and operations planning.

1. Inventory segmentation

One of the most important strategies that can help companies improve their inventory management is inventory segmentation. Here are some key actions for leadership teams to take:

• Map out the various segments of the company’s inventory. Using a matrix that compares inventory volume characteristics (high, average and low) to demand volatility characteristics (stable, reactive and erratic) can help teams visualize this.
• Determine the strategies that best fit each segment. For instance, some items might make more sense to manufacture to order, while a make-to-stock approach could be a better fit for others.
• Focus replenishment recommendations and policies on groups of SKUs that have similar characteristics.
• Consider working with an external advisor to build targeted inventory strategies based on demand variability and business impact.

2. Process improvement

Once organizations have a clear picture of their various inventory segments, the next step is to focus on improving demand planning. You can only plan for what you know or think will happen, so investing in improved forecasting capabilities can have a short payback period and high return on investment. One of the challenges in the post-pandemic world, however, is that historical sales data is highly skewed due to supply chain disruptions and erratic customer demand patterns.

To address this, many leading firms are working to identify correlations between historic sales and other econometric variables, such as unemployment, fuel prices, or commodities, to name a few.

Key actions here include:

• Establishing a process for updating inventory segmentation on a regular basis and maintaining system planning parameters to account for changes in demand or supply
• Continuously improving physical and cycle counting processes to increase accuracy and efficiency
• Improving the adoption and use of existing technology and inventory systems, while considering incremental investments in warehouse management systems, digital tracking and process improvement in all relevant receive-to-ship processes
• Making sure the procure-to-pay process is aligned with inventory segment strategies

3. Sales and operations planning (S&OP)

Investing in developing or improving an S&OP process is central to maintaining a healthy inventory position. Too often a company’s sales forecast doesn’t align with its financial forecast, and neither forecast aligns with the manufacturing plan or schedule. S&OP is the cross-functional process that begins with developing a consensus-based demand plan that the entire organization aligns around. With that plan in place, teams can then develop a supply plan that will meet customer service expectations while minimizing inventory carrying costs.

There are five steps in the monthly S&OP process:

1. Conduct a product portfolio review to understand the implications of developing, launching or phasing out products.
2. Update the demand plan based on the latest forecast and customer input, and then update production to reflect the new plan.
3. Next, develop the supply plan. This step highlights the importance of maintaining system planning parameters to evaluate inventory and procure materials.
4. Update the financial plan. While an annual budget serves as a guide for decision making, a financial plan updated on a monthly basis drives more informed business decisions by enabling a better understanding of the firm's current position.
5. Conclude with an executive review to update the business plan as necessary to reflect any strategic or tactical changes.

The triple play of inventory segmentation, process improvement and adopting a more rigorous approach to S&OP will ultimately lead to improved customer satisfaction and working capital. Given near record-high inventory-sales ratios and increasing interest rates, there’s no time like the present to improve demand and supply synchronization.

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