Wednesday, May 28, 2008

Optimization: Transportation versus Inventory

In talking to a senior executive from a supply chain solutions company I heard an interesting comment last week – that more and more companies are looking at transportation optimization in the face of rising fuel costs. Of course there is a direct link between rising costs (see picture), and the desire to do something about it, but it also got me thinking about what other factors may be driving the interest in transportation optimization.

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Inventory

Traditionally the inventory has been the biggest focal point for supply chain managers. That makes sense as inventory consumes a substantial amount of operating cash flow for retailers. Assuming an inventory turns value of 7 for example, a retailer with $10B in revenues would have locked almost $1.5B of operating cash flow in the inventory. Therefore any reduction in the inventory results in more money available to other functions. However that is a double edged sword: achieve overly enthusiastic reduction in inventory and you will lose sales (and hence revenues) due to stock-outs, but under achievement results in bloated inventory that will eventually require clearance and pull down the margins.

Finding that golden “optimal” level that balances the two sides (service and excess) is hard to establish and harder to maintain as demand patterns evolve and change. Inventory joins the demand with supply – and it is this inherent position that makes it dependent on the supply and demand planning processes. In fact this dependence is very critical. The accuracy, stability and consistency of demand and supply planning processes affects the efficacy of the inventory planning. And that directly impacts the inventory levels and ability to service demand. Inventory planning typically uses demand, supply and lead-time for determining the optimal inventory levels to maintain a specific service level.

All the above makes it almost necessary to review these processes together to have any appreciable impact on the inventories. The combined impact of demand planning, inventory optimization, and supply planning processes can result in huge savings through reduced inventory in the system, lower clearance costs and better financial efficiencies. However it is a large effort and it impacts a large number of users in an enterprise. It also requires good clean master data and large amounts of historical transactional data, both of which need additional effort to obtain. This generally makes it a little more complex and requires a clear consistent strategy to successfully deploy. The rewards are bigger, but so is the effort leading up to it.

Let us also examine how the savings in inventory affect the company financials.

Inventories exist as assets (current assets to be specific) on the balance sheet. Any reduction in inventories therefore reduces the total assets and impacts the asset turnover ratio (see picture). A higher asset turnover ratio basically means that the corporation is able to generate the same revenue by deploying fewer assets than before. Assuming all else remains same, it results into higher ROA (return on assets) that can do wonderful things for a corporation like raise its share price, enable it to pay higher dividends, ability to expand or do any of the other things that spare change can do. Reduced inventories also reduce the inventory carrying costs (hence COGS), but the impact is relatively small because the fixed costs remain the same and only variable costs are reduced.

The financial impact largely makes the corporation more efficient in using the available resources.

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Transportation

Compared to the inventory optimization, transportation is a different story. It is almost an opportunity for the taking. No matter how the replenishment was decided, eventually what has been ordered needs to be moved from the suppliers to the retailer’s warehouses, and from then on to the stores. The transportation optimization just does not depend on other processes like the inventory optimization does. And almost all the data that this solution needs such as routes, rates, lanes, carriers, purchase orders, and weights/volumes of items is deterministic and largely available in the enterprise already. The only exception to this required data may be the volumetric and weights for the items but that too can be obtained in collaboration with suppliers. For an average retailer, shipping costs used to add up to 1.5 to 3% of the revenues (that is, when the oil was still not trading in the stratosphere, it would reasonably be higher now). Assuming a 2% rate, it is still a cool $200M for a $10B retailer. And unlike the inventory savings that indirectly improves ROA, any savings in transportation are immediately visible to the bottom line.

Here is the financial side of the story.

Shipping costs reduce the cost (hence COGS, cost of goods sold). With all else remaining same, it directly impacts the profitability or margin. First and foremost, profitability directly shows up in the bottom line, and provides extra cash for any other priorities. Then improved margin also improves the ROA (see picture) and allows the companies to do all the wonderful things we mentioned above that can be done with spare change.

Finally it looks like addressing inventory improves overall health but requires a broader approach to reviewing the business processes involved in supply and demand planning, but addressing freight costs is a quick solution to a specific problem of runaway fuel costs. And just as fortifying your diet with vitamins will make you stronger and healthier; an impending infection can only be cured with a strong dose of antibiotics. For now, inventory looks more like the vitamins while transportation is the strong dose of antibiotics. Take your pick!

1 comment:

  1. any one give me information about the role of inventory in transportation ???

    ReplyDelete