Supply Chain and Inventory Management Case Study: Investing to Improve
Over the past 20 years, the distribution-related business functions have grown from being responsible primarily for physical distribution; i.e., warehousing and transportation; to logistics, which encompasses customer service and finished goods inventory planning and management as well as physical distribution. Now, as a result of the emergence of a global customer-driven marketplace and the need to improve material and product flow, it has progressed to supply chain management. As each of these growth steps has occurred, more functions have been brought under the logistics function umbrella: customer service, forecasting, finished goods inventory planning and management, sourcing, supply chain partnerships, and even production planning.
So what’s the difference with supply chain management? Supply chain management seeks first to integrate all of the internal activities necessary to supply product to the customer into a continuous, fast-flowing stream that will decrease costs and improve service by optimizing inventory and increasing its velocity and then, to further optimize supply by integrating directly with the supply chains of others, both suppliers and customers, through supply chain partnerships and information exchange. Sourcing now comes under the supply chain umbrella, also inventory planning and management, and production planning to the extent that it determines the best utilization of available capacity and material. Traditional internal organizational barriers are broken down to assure a smooth flow of information and material.
Note that the objectives of cost reduction and improved service are coequal. To flourish in today’s customer-driven marketplace, a company must offer competitive pricing to its customers, provide excellent service, and show a good return to its shareholders.
Under the supply chain management concept, the product supply areas of the company are reengineered to a business process, rather than functional model. The activities necessary to “Serve the Customer” are brought together in one process. Once the internal integrated supply chain is operating smoothly, the supply chains of others can be brought into the picture through coordinated planning and electronic exchange of information on production, inventory status, and movement of materials and product.
Investing to Improve
From the opening paragraphs, we can see that good supply chain management is partly a matter of balance. Cost versus service versus profitability versus proper utilization of assets. What happens when the pendulum swings too far in one direction? Here was a case where a company had cut to the bone and taken all of the easily achieved benefits, and in the process, caused itself some customer service difficulties. The “low-hanging fruit” was gone. There still were additional cost reductions to be gained in the physical distribution and inventory management areas, but each required an out-of-pocket investment, process changes, and a more intense style of management. As the old adage goes, “sometimes it takes money to make money.”
A process manufacturer of industrial materials had a management objective to manage the company to maximize shareholder value. The principal emphasis was profitability and asset utilization, a good-looking P&L and balance sheet. The company’s products were on the edge of being commodities, plenty of competition and not much product differentiation. The primary means of gaining and holding market share was quality and an ongoing customer engineering support program to get the company’s products engineered into customers’ formulas at design time. This helped assure some stability in sales as the customer would have to reengineer, retest and re-certify his process in order to make formula changes. However, though established customers tended to stay with products already in use, this company’s share of its markets was staying steady or shrinking, not growing. Another interesting characteristic of the company was that it was vertically integrated or had limited sources of raw material in most of the major product lines. This meant that the company often had to enter into long-term contracts with vendors to ensure supply, or in several cases, actually build and operate facilities to capture byproducts from other industries’ processes to obtain material. So in a sense, upstream supply chain integration is already present by the force of circumstance.
In the continuing quest for increased profitability, the company had made drastic cuts in manpower and other aspects of almost every part of the company, including supply chain management. Management was now seeking additional reductions in the supply chain area and a project team was formed to find more ways to reduce costs. The team decided that an outside objective look was needed and retained us to perform a cost/performance benchmark and find cost reduction opportunities.
…sometimes toward the end of a quarter, if inventories looked too high on the balance sheet, production would be stopped.
The first step was to benchmark supply chain costs to see how this company stacked up against other similar companies. The benchmark revealed that because of previous cost reductions, the company was already well below industry cost averages in most areas. The potential for large additional reductions was not there. Distribution administration costs were already down. Some significant dollars could be saved by more intensive management of global transportation costs, and there was some potential for reducing inventories by managing mix more intensively. The question became, “With costs this low, is customer service suffering?”
In some ways, the company had reached the point of diminishing returns in managing to the financial numbers. It was found that sometimes toward the end of a quarter, if inventories looked too high on the balance sheet, production would be stopped. Occasionally, customer production lines had been shut down because of lack of material from this vendor. So far, the client had been protected by its products having been designed into the customers’ products; but, this close relationship and dependency was now in some cases hurting the customer rather than serving him. Over time, the customers could change that if the situation didn’t improve. There was a need to back away from extreme financial management and to make some internal investment in processes, systems and people, and start to put customer service back into balance in the supply chain equation.
When a company is vertically integrated, or has to compete for material in a constrained marketplace, many of the negotiating opportunities in the upstream supply chain don’t exist, so vendor price negotiations and seeking of large-scale, free, value-added services were not serious options. This was an inflexible supply environment. It appeared as well that there was some problem with mix in the company’s finished goods inventories as a result of off-spec materials coming out of the processes. All of the inventory eventually was sold, but it took time to place it, and the margins were poor. So, in some locations, inventory carrying costs were high, turns were low, and overall margins were not as good as they should have been.
There were some inventory opportunities to be obtained by working smarter. To improve the inventory situation would require two things, an investment in improving the production processes to make them more reliable, some of which were already underway, and better inventory and production planning. Contrary to the strong drive toward operating cost reduction, both of these would require investment and possibly increased manpower. The latter would require design of better business processes, an investment in computer software, and probably increased headcount to plan and manage inventories better.
The primary recommendations were to establish effective demand forecasting functions in the divisions; develop documented procedures for forecasting, inventory planning and management, and production planning; implement adequate software tools; and staff to do the job well. It was estimated that these recommendations, coupled with process control improvements already planned, could result in reductions of inventory carrying costs of approximately $1.5 million per year on an investment of approximately $600,000. It was also recommended that the use of optimizer software to evaluate the mix of product planned for production be considered.
In warehousing and transportation, there were also still some savings available. Annual warehousing costs could be reduced by about $300,000 for an investment of approximately $100,000 for network modeling and warehouse redesign. Because of the global nature of the company, there were significant potentials for additional corporation-wide transportation savings, approximately $2.5 million annually, including the company’s share of savings shared with customers in supply chain partnership programs. The costs to realize these savings would be about $300,000 to develop and implement business processes and for negotiation assistance, and there would be ongoing costs of about $120,000 for entry of shipping data and outside freight bill payment services. These activities would provide the data necessary to properly manage freight expenditures.
To improve customer service, the most significant recommendation was to change the inventory management policy so that customers would receive continuous supply. There was a need in the largest division for a moderate investment in improving the customer service operation that would show little direct dollar return, but would improve the ability to serve the customers well. These recommendations included a customer survey to determine true service requirements, implementation of a customer service measurement system, redesign and reorganization of the customer service department, and installation of a state-of-the-art telephone system. The total cost was estimated at $240,000. It was also estimated that one other division had the potential to save approximately $200,000 in ongoing manpower costs by redesigning its customer service process and providing customer service training at a cost of $75,000.
So, although the low-hanging fruit was gone, there were still some supply chain cost reductions to be achieved, but only with an investment. In addition, there were fences to be mended while investing to build a customer service attitude and infrastructure that preserve and expand the customer base. This was a case where too much of a good thing, in this case cost cutting, proved to cause problems from the big picture perspective.