Why inventory optimization doesn't optimize

Phillip Slater
Tags: inventory management

So, you have finally got hold of that software you have been looking for. The boss has been on your back about inventory and wants your assurance on availability while also reducing the cash investment. You researched the market and decided on a program of inventory optimization. Optimization, surely that is what you need; after all, optimization is the ultimate outcome, is it not? Optimization means that everything is working at maximum efficiency, right? Wrong.

Optimization is probably the most overused word in management today. But, what is optimization? The Concise Oxford Dictionary defines optimization as: “the most favorable condition; the best compromise between opposing tendencies; best or most favorable”1. Before exploring the implications of that definition, let’s go back and understand MRO (maintenance, repair and operations) inventory.

MRO inventory includes:

It is a very wide field.

For all types of inventory, there are only three reasons why you purchase and hold on to inventory:

But if this was all there was, we would all hold only as much inventory as we really need, right? Yes, that’s right, but this is not all there is! You see, sometimes we end up holding excess inventory because there have been changes since we last determined our appropriate holding (yes, we may have calculated the wrong inventory level in the first place, but I’ll let that go for now.)

Some of the changes you might experience that will change your inventory requirements include:

And, this is where optimization comes in. Using the definition of optimization from the Concise Oxford Dictionary, typical optimization programs calculate the “compromise between the opposing tendencies of cost and availability”. This is achieved by recalculating the required holding and safety stock. Sometimes, optimization is presented as identifying excess or potentially excess holdings through a review of slow-moving stock.

The fact that optimization programs base their calculations on “hard data”, such as your usage history, makes the approach particularly appealing. With this kind of solid input, the results must be right – right? Sorry, wrong.

There are two problems with the “data only” approach. First, historical data, no matter how accurate and “clean” it is, only tells us what “has been”. When it comes to your inventory investment, you are more interested in what “could be”.  Second, the data more often refelcts the behaviors of your team rather than the actual demand for your inventory. Who among us can say that our team members don’t take some “just in case” items that distort the usage data?

As a result, you are forced to make assumptions (sometimes implicitly) about the characteristics of both demand and supply for your parts. These assumptions are: that what happened in the past will happen in the future and that you cannot change these outcomes or the behaviors influencing them. This approach forces you to work within constraints that may or may not be real.

This is why optimization doesn’t truly optimize. It only recalculates within a set of assumed constraints; it doesn’t challenge those constraints.

Applying Double Loop Learning to Identify the Real Opportunities
In the 1970s, a Harvard professor named Chris Argyris recognized this phenomena in many fields of management. Professor Argyris called this Single Loop Learning. The problem with Single Loop Learning is that you can never improve beyond your imposed constraints.

To achieve breakthrough improvements in any field, Professor Argyris argues that you need what he calls Double Loop Learning. This also includes the field of inventory reduction.

Double Loop Learning requires that you challenge the constraints and assumptions inherent in your original thinking.

So, how does this apply to your inventory reduction program? Well, rather than just use mathematical techniques to optimize within your constraints, you need to challenge those constraints. This means challenging the assumptions about both supply and demand. Basing your solution on a review that only includes historical data does not do enough to challenge your constraints.

The problem, of course, with MRO inventory is that each and every SKU (stock-keeping unit) may have different supply and demand characteristics and, therefore, different constraints to challenge. Challenging these constraints for each and every SKU under our management is a daunting task. What is needed is a process that helps you to focus on the key inventory items that will truly make a difference to your overall investment without the burden of reviewing thousands of items individually. There is such a process – it is called the Inventory Cash Release Process – and I will describe it shortly.

Once the key items are identified, you need to then systematically challenge the constraints that are part of the Single Loop Learning mind-set that applies to these items. Only by applying the Double Loop Learning approach can you truly identify the opportunities that are available to you both today and tomorrow.

In order to ensure complete sustainability, however, there is one more problem to solve and, fortunately, someone has already done this thinking for us!

Using Systems Thinking to Achieve a Lasting Result
There is another shortcoming with the so-called optimization approach that even Double Loop Learning doesn’t resolve. Consider for a moment the following statement: “The outcome that is achieved from any process is a direct result of the policies, procedures, measures and reporting that manage that process”

This is what is known as Systems Thinking.

Peter Senge first described Systems Thinking in his iconic book, “The Fifth Discipline” (published 1992)3. In this book, Senge describes how any outcome results from the inputs and processes that drive the outcome. In the case of MRO inventory, the existence of excess inventory is the direct result of the policies, procedures, measures and reporting applied to managing that inventory.

Questions you might ask yourself regarding policies, procedures, measures and reporting include:

And, this is just the start!

Because traditional optimization is driven only by data and does not include a systems approach, it does not address Systems Thinking. The traditional approach really is just a tool that can be used to recalculate your inventory holding based on your assumed constraints. It cannot help you to address the systematic issues that led to an over investment in inventory.

The Inventory Cash Release Process
So, if inventory optimization is not the answer, what is? Well, a process has been developed that addresses all of these issues and enables companies to achieve a lasting and sustainable inventory reduction. This is called the Inventory Cash Release Process and has the following key features:

  1. It addresses the need to focus on the few SKUs that will make a real difference

  2. It uses all seven of the actions for inventory reduction as a means of applying Double Loop Learning (optimization uses just one)

  3. It addresses the systemic issues by reviewing the policies, procedures, measures and reporting that led to the initial over investment

  4. It is implementation focused so that your team takes ownership and your systems change.

Let’s address each of these one at a time.

1. Focus On The SKUs That Make A Difference
The aim of all inventory optimization is to reduce the investment in inventory. This must be true, because if you have had a stock out, you will have adjusted (doubled?) your stock holding to make sure that this doesn’t happen again. Therefore, to be effective, you need to focus on where the money is.

As Tom Cruise said in the movie Jerry Maguire, “Show me the money”. In my experience, it is universally true that the vast majority of the inventory cash investment is tied up in a minority of inventory items (SKUs). This is known as the Pareto Principle. The Pareto Principle is named after an Italian economist, Vilfredo Pareto, who lived more than a hundred years ago. Figure 1 shows the application of the Pareto Principle in a real inventory example.

In Figure 1, the cumulative dollar value of the inventory investment is on the Y axis and the number of SKUs on the X axis. In this example, you can see that 80 percent of the value held in spares is held in just 12 percent of the SKUs. Therefore, for this organization, they need only concentrate on 300 out of their 2,500 SKUs if they want to make a difference. They can ignore the long tail of SKUs because the value there is minimal. In addition, it takes just as much activity to review low-value items as it does high value items, so why let the tail wag the dog?

 

Figure 1: Pareto Review of Inventory

By using this approach, companies can take the daunting task of reviewing a large number of items and turn it into a manageable task of reviewing just a few hundred. They can do this with the complete assurance that these few hundred items are where their true inventory reduction opportunity is.

2. Use The ‘7 Actions for Inventory Reduction’4
When you free yourself of the constraints of Single Loop Learning, you realize that there are many more levers to pull for inventory reduction than just recalculating your inventory levels. Fortunately, however, there are only seven ways to reduce inventory, so the approach is again quite manageable. The “7 Actions for Inventory Reduction” are:

When combined with the use of the Pareto Principle, you now have an efficient and effective way to review inventory and make a real difference. This approach maximizes results while minimizing effort.

3. Address the Systematic Issues
As mentioned above, there are systematic issues such as policy, procedures, measures and reporting that drive your inventory outcomes. I am sure you have seen the situation where a company has conducted an inventory review, cut their inventory and then seen the reductions they made slowly reverse over the next one to two years. Addressing the systemic issues prevents this.

This is the inventory equivalent of reviewing your maintenance procedures. In maintenance, you can keep fixing breakdowns, but it is usually better to address your policies, procedures, measures and reporting so that you can truly address the problem and achieve a lasting solution. Inventory management is no different. For sustainable inventory reduction, you must review your policies, procedures, measures and reporting to identify and fix the issues that have previously driven your excess investment.

4. Be Implementation Focused
The problem when you buy a “tool” is that usually only one person uses the tool (after all, we can’t all sit around the same computer screen). This means that other people are necessarily excluded from the improvement process and decisions. We all know that this, in turn, reduces the likelihood of ownership and, therefore, minimizes the chance that the change will be permanent.

When you stop to consider the number of people that actually influence your inventory outcomes, the single-tool approach seems wholly inadequate. For most MRO inventory, the people who influence the inventory will include:

With OEM and industrial supplies, you can expand this to include sales people, production planners and regional management. Obviously adopting a single-tool approach is unlikely to engage this entire group in any meaningful way. What is needed is an approach that engages the key decision-makers, the key influencers and those that actually do the work! This will enable you to develop a common understanding of the issues and actions required to produce a sustainable result. When it comes to reviewing and changing the policies, procedures, measures and reporting this approach builds ownership. Ownership maximizes the chance that the changes will last.

Some people will think that involving a range of personnel is excessive, but you should consider what is actually at stake here. The organizations that consider taking action on their MRO inventory will have an investment of many millions of dollars, sometimes tens of millions of dollars. Even if you do not have that level of investment, the money tied up in your inventory is important to your company.

As in the example shown below, the opportunity that is presented may itself run into many millions of dollars (or at least a significant sum). So, ask yourself what other projects you have right now that will produce the type of return that a program of inventory reduction can generate – with no capital investment!. When viewed from this perspective, a program of inventory reduction may be the most financially lucrative initiative that you can undertake.

Case Study: A 42% Reduction Worth More Than $6 Million!
Just to show that this approach really works, consider this example. This organization had suffered the yo-yo effect of optimization. One consulting group after another came and went, each claiming successful outcomes and none delivering a sustainable reduction. They tried optimization software programs, they tried eliminating SKUs, and they tried reviewing slow moving stock. Each time, they only included a small number of the people with influence, they only used single tools and they didn’t address the systems issues.

Because of this approach, each time they only achieved short-term gains and those gains were lost a year or so later when the inevitable impact of their existing policies, procedures, measures and reporting took over.

When they then applied the Inventory Cash Release Process, the result was, however, quite different. Figure 2 shows the inventory reduction achieved and the sustainability of that result. The key feature of this diagram is not just the inventory reduction that occurred (an impressive 42 percent reduction worth $4.6 million) but also the sustained result that has continued over the past few years.

For three years, this company has had a total benefit of well over $6 million (when the cost of holding inventory is taken into account).

This was achieved after they had previously completed traditional optimization and thought that their inventory was at its best or most favourable. After applying theInventory Cash Release Process, this organization is now comfortably in a position where its inventory reduction is both real and sustained.

Figure 2: Inventory Cash Release Net Inventory Reduction

Conclusion
For many organizations, the promise of traditional optimization is hard to ignore. The promise of reducing inventory based on “hard data” of past activity can be very attractive, especially to the analytical mind. But this approach is flawed in its thinking and limited in its application. Anyone that adopts this approach needs to be aware that traditional optimization doesn’t truly optimize. It will, at best, produce limited results through recalculation but these results will be neither complete nor sustainable.

These shortcomings can be addressed, however, through the application of the Inventory Cash Release Process. This process utilizes the principles of both Double Loop Learning and Systems Thinking to ensure that the solution is both complete and sustainable. By taking this approach, you can identify all of the actions for inventory reduction and the requirements for changes that will drive a lasting result, and release cash back into your business.

About the author:
Phillip Slater an inventory reduction specialist and the author of the book “Smart Inventory Solutions: 7 Actions for MRO and Indirect Inventory Reduction” (Industrial Press, 2007). In addition, he is the developer of the Inventory Cash Release System – ICR06, a best-practice approach to inventory management and reduction. For more information, visit www.InitiateAction.com.

References

  1. Concise Oxford Dictionary (1987)

  2. Smith, M. K. (2001) 'Chris Argyris: Theories of action, double-loop learning and organizational learning', the encyclopaedia of informal education, www.infed.org/thinkers/argyris.htm. 

  3. Peter Senge (1992), The Fifth Discipline, Random House

  4. Phillip Slater (2007) Smart Inventory Solutions