We are including still more Feedback that we received on our piece on Measuring Inventory Performance, simply because it has been so good.
In fact, for the first time ever, we have “co-Feedbacks of the Week,” one letter from Bob Belshaw of GE, and another from Trevor Miles of Kinaxis.
You will find these great letters, plus more on this topic, and one letter on Lean 2.0, below.
Feedbacks of the Week – On Measuring Inventory Performance:
I am very much looking forward to your continued discussion on metrics that represent or incorporate both the physical and financial supply chain. In my time at GE in the Trade Finance business, I have been extremely excited as I learned about the levers of working capital that are controlled by the supply chain...DIO, DPO and in some ways DSO (had spent my previous time in the supply chain software world).
The impact of decisions made around inventory policies, including strategies like JIT, VIM, timing of title change and the newly packaged financial products that target supply chain finance require significant thought and discussions. I have spoken at 20+ conferences (low-cost sourcing, multiple university settings, supplier, procurement, physical supply chain conferences, etc.) in the last three years on the integration of the physical and financial supply chain. In my discussions with attendees, University Professors, and industry analysts (AMR, Aberdeen, Marsh, etc.), I have been surprised at the lack of understanding of working capital as it relates to common supply chain strategies. I have come to believe that the power of using the CFO metrics is that the organization begins to find a language to communicate in, that is understood in the C levels and on Wall Street. I believe the going back to the DuPont Model in the 1960's that there has always been an academic understanding of the supply chain impact on the balance and income statement, but I do not believe that has gotten to senior leaders in our supply chain and procurement organizations. But, I do think that it is changing as I am finding more and more senior supply chain and procurement executives are being assigned working capital goals and that these goals are part of the goals that the CFO has communicated to Wall Street (Kraft, Bristol Myers Squibb, etc.).
I have attempted in my presentations to highlight the impact on working capital using two major supply chain themes for setting the stage - VMI and Global Sourcing (low-cost sourcing). I have found that the implications of time associated with global sourcing has been the number one driver of awareness around working capital in supply chain organizations...add a weaker supplier that cannot own the inventory for 40 days on a boat, 30 days in a warehouse and handle terms of 60 days and a strong buyer organization begins to feel the impact on their working capital.
I believe the financial metrics of DIO, DPO, etc., produce a strong basis for comparison and a strong common language. They are not necessarily great for benchmarking as stand alone numbers without the association of industry, geography, role and size. I find that these numbers many times highlight the power of channel masters in pushing terms out, or forcing title change for their advantage. But in my way of thinking, the key thing is that we now have metrics that are relevant within our organization and they support the goals of the C-level executive and Wall Street, something that I think is incredibly important for understanding where to go next. I think your discussion on the retail supply chain is a case in point...less inventory may save costs, but it may also reduce revenue.
Thanks for your articles - always great reading and thought provoking.
Senior Vice President
GE Trade Services
Interesting post, and timely, given the increased focus on inventory as a way to reduce supply chain costs. The points you make about the inadequacies of Inventory Turns and DIO are valid, though I have to ask, quite what is it that we need to measure?
While I agree that Purchasing isn’t strictly part of the supply chain if the supply chain is restricted, as you do in the article, to the storage and movement of inventory, I am not sure how the contracts set up by Purchasing are any different in concept from the equipment manufacturing decided to purchase. Both are decisions made with long-term consequences for the efficient and effective storage and movement of inventory through the supply chain. Very few companies have single source procurement processes, so as much as a company can make a decision of which manufacturing site/line to use to satisfy certain demand, based upon capacity availability, throughput, customer delivery expectations, cost and a number of other variables, which have a direct effect on the effectiveness and efficiency, so too they can decide which supplier to use.
So, while DIO might be a broad measure, I do not consider it to be a blunt measure.
For example, Manufacturing may issue planned purchases with quantities and dates, but Purchasing will often consolidate orders in order to achieve a minimum order quantity or to get a full truck load in order to reduce the transportation costs. The consequence may be excess inventory, but overall reduced costs, or simply contract compliance. This situation is made more complex in some industries, such as automotive, which have flex limits on the quantities ordered in a period. Order too much and you have to pay a penalty. Order too little and you have to pay a penalty. These are real constraints, as real as any capacity constraints, and should not be ignored when making supply chain decisions. However, too often the contract terms are decided by Purchasing based purely on a piece price objective and little consideration for supply chain efficiency and effectiveness. In defence of Purchasing/Procurement, market conditions can change quite a lot over the course of a products life cycle, making the contract terms very inefficient in the new conditions, even though they may have been perfectly reasonable under the market conditions prevailing at the time of negotiating the contract terms.
I would argue that we cannot preclude these consequences from an overall evaluation of the supply chain efficiency and effectiveness. Without a doubt, I think it is necessary to drill down to greater detail to understand the root cause when a KPI such as DIO changes a lot or is not consistent with benchmark values. Though admittedly, I do not have an answer for the situation you bring up when Cisco wrote off $2B in inventory. Finance can wreck havoc on these metrics. Of course, while snapshots of these metrics are useful, it is at least as important to understand how they change over time. In the Cisco case, the historical inventories could have been discounted to reflect the adjusted values, in which case the trends would be re-established.
My favourite supply chain metric is Cash-to-Cash. Of course this brings in DSO and DPO. Undoubtedly, these metrics confound Finance and Supply Chain management even more, but in the end Cash-to-Cash does measure the efficiency and effectiveness with which a company purchases goods to manufacture finished goods which are sold to customers. The contract terms negotiated with customers are as much a constraint on the supply chain as are the contracts negotiated with suppliers. I would go further and say that the issue is that currently these constraints are not considered when planning how to satisfy demand, rather than DSO and DPO being inaccurate measures of the supply chain efficiency and effectiveness.
When planning how to satisfy future demand, and therefore, determining how our company will perform in the future in a period in which Finance will have limited influence, payments terms - both to suppliers and to customers – should be taken into consideration. Yes, Finance can change the past, such as the Cisco situation you refer to in your article, but this can be addressed by recalibrating historical values to take this “interference” into consideration. At the heart of the issue is that most supply chain planning systems do not report these metrics or take them into consideration when making decisions. The focus is on satisfying customer demand with the least lateness, rather than at the highest gross margin.
More On Measuring Inventory Performance:
I agree with your comments on the inadequacy of inventory turns and DIO as measures of inventory performance. As a consultant who advises companies of all sizes on supply chain issues, I find neither of these gross measures provides any actionable information.
The first problem is that they are just numbers with no base to compare them to. What is the perfect number of turns? What is the right number of days outstanding? In your example, inventory turns was calculated as 10. So what? Is that good or bad? If it’s bad, what do I do to make it better? Where do I start?
The second problem is both measures are typically calculated for the entire population of inventory, but all inventory is not created equal. Inventory managers typically stratify inventory into A, B and C categories with A items being defined as the 20% of items that consume 80% of the dollars. The fastest way to improve cash flow is to increase the performance on your high dollar items, your A items. Both inventory turns and Days Inventory Outstanding ignore the difference between A, B and C items.
The most effective measure of inventory I have come across is the Inventory Quality Ratio, or IQR. IQR overcomes both the problems above.
The first problem I mentioned is the lack of a standard to which you can compare your turns or DIO. There is a perfect IQR; it’s 100%. Inventory Quality Ratio is calculated by taking your active inventory value divided by total inventory value. If all your inventory is active, that is you have no excess, no slow moving and no obsolete inventory, then your IQR is 100%. If you calculate your IQR as 40%, then you know exactly how far you have to go to improve inventory performance.
IQR, as implemented in almost every company I know that uses it, is calculated for various segments of inventory. This addresses my second concern with turns and DIO. You can measure the IQR for your A items separate from your B items. You can calculate your IQR by warehouse, by plant, by buyer or many other ways. IQR is both a measure of your entire inventory’s performance and it can also be used to measure any discrete segment of your inventory down to individual part numbers. Having a finer measure of inventory performance allows a company to focus on actions needed to improve that performance.
In many companies, in many industries, I have found IQR to be a better measure than inventory turns or days inventory outstanding because it gives you the information you need to take specific action to decrease inventory and free up working capital.
Doug Howardell, CPIM, PMP
I was very interested to read your article.
It is clear that inventory, logistics and supply chain is going more and more visible. Not only because of the economy, but also because business is not anymore the only adding value for a company.
I'm calculating the Stock turn in the same way you do, but not the DSO. I am using a DSI: Days Sales Inventory.
My calculation excludes pricing initiative and so on, as I'm using the cost of goods sold (COGS).
I use the COGS of the last 3 months, as less is not enough to have a full cycle and more is no more representative of the business evolution.
DSI = (inventory month end*90) / (Cogs M-2 + Cogs M-1 + Cogs M)
Example = 5.000 K€ stock * 90 days (3months) /. 2.000 K€ + 1800K€ + 2150K€ = 75 days of stock.
This is really more related to inventory management.
When I want to also include others action looking on the larger process (and it is all about supply chain), then I also calculate the GMROI.
Director European Supply Chain Development
On Lean 2.0:
In our work to find out why LEAN does not produce the results it should in plants that have volatile demand or complex supply chains, we came across something interesting that we have not seen discussed.
Many ERP systems still rely on planning systems that have their roots in MRP-based, 1980's technologies. These modules (including MPS, MRP and Rough Cut Capacity Planning) use techniques (such as infinite capacity, backward scheduling, time buckets and average setup times) that are built around an inventory-centric view of the world and they are just not equipped to accurately manage time constraints. The fact that ERP vendors are selling planning systems that can't handle time is one of the great con games of all time and if management had even an inkling of how they work, I am sure they would be horrified.
If you stay with me on this, you will see where I am leading. Because these legacy planning systems are so inaccurate, the only way they can work is by planning excess buffers of time and materials at every level. Any company that is trying to implement LEAN on top of a legacy planning system faces a dichotomy. Put very simply, every time that LEAN reduces what it thinks is waste, the planning system thinks there is a problem and so it tries to compensate by recommending additional buffers. Sooner or later, this leads to confusion.
We think that there are only two ways around this problem:
1) Implement a totally manual planning system such as Kanban. This can work in simple scenarios, but is likely to fall apart as mentioned above when there is volatile demand or a complex supply chain.
2) Implement a suitable APS (Advanced Planning & Scheduling) system that uses a scheduling engine to accurately manage time constraints. If implemented correctly, APS systems can be integrated with LEAN, which seems to support your LEAN 2.0 approach.
I would be interested in your feedback.
Suncoast Technology Partners