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The View from Finance: Freeing Up Cash with Inventory Optimization

By Jeff Bodenstab3 May 2016

If you (or your boss) are measured by your company’s Return on Invested Capital (ROIC) or a similar metric, then you want to turn assets into cash. Whether the message comes down from the Chief Financial Officer (CFO) or even private equity investors, either way it’s pretty much the same thing: free up cash from the business. Inventory optimization is one proven way to do it.

Inventory is an untapped, cash-rich asset. Most companies have some form of supply chain systems to manage inventory from production through delivery. But these systems focus on transactions. They control what happens, giving you visibility. But they’re often missing the extra optimization and analytics logic that drives the supply chain to operate more efficiently and throw off more cash.

That missing piece can cost a lot. Home Depot executives, speaking at an analyst meeting, once said that every 1/10th improvement in their inventory turns meant an additional $200 million in cash.

Of course, you need inventory. Inventory is what you make, what you sell. If you slash it too much and don’t have what customers want, when and where they want it, you may lose that sale. Customers have more choices and are less captive than ever. The rule of thumb is that they will switch to another product 50% of the time if yours is not in stock. That’s a gross margin loss on any particular sale, money that does not go to the bottom line.

That’s where inventory optimization comes in. It balances inventory and customer service levels (order fill rates), the percentage of time you deliver goods to customers as ordered and promised – to calculate the optimal mix of where to put your cash. Inventory is like any investment – it requires the right mix of risk and return. The risks are locking up cash in too much inventory or losing revenue because of stock outs. The return is rapid asset turnover into cash.

Inventory optimization calculates inventory and service levels automatically and dynamically to meet business objectives on an ongoing basis, and direct your supply chain accordingly. It lets you specify the aggregate inventory and service level balance that works right for your company – even vary it across products, customers, time intervals and geographies.

Inventory optimization uses advanced logic and analytics to model and understand your forecasted demand. Behind the scenes, millions of SKUs are modeled statistically against variables like volumes, lead times and lot sizes to identify the right stock level and replenishment rate for each product in each location.

It hedges for the daily demand and supply volatility and random behavior across your supply chain, from finished goods assembly to the end consumer or retail shelf. It also can handle challenges like promotions, product phase-in and retirement, expiration and shelf life, end of season closeouts and new product launches – crucial in an age of product proliferation and shorter lifecycles.

A Tweak, Not a Replacement

Inventory optimization software bolts onto your existing management solutions. It provides a new logic to drive those systems. You don’t have tear out and replace your information systems, with all the cost, man hours and lead time that entails. You just apply the new logic on top of the current one. It’s like adding a thermostat or control system to already installed infrastructure. That means inventory optimization goes in fast, in three months or so. You can expect fast payback, too – reductions in working capital employed will recoup your investment in 6-9 months.

You can measure that return on investment – count that new cash – two ways. One is by the amount of cash generated from reducing inventory – a dollar of reduced inventory is a dollar of cash generated.

Another way is by the cash generated from fewer lost sales. Your annual potential profit improvement from fewer lost sales can be calculated as:

Note: Lost Sales Ratio is the percentage of time that a customer or prospect will go to a competing source when goods are not available when desired.

It all adds up to better Return on Working Capital and more day-to-day liquidity, based on significant, sustainable improvements to underlying operational efficiency. So if in spite of substantial investments in ERP and supply chain systems, if you’ve hit a wall in balancing inventory and service levels, then it’s time for Inventory Optimization.

Click below for a case study describing how a private equity firm used inventory optimization to both free up cash and increase profitability at one of their clients.

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