What to Expect from Inventory Optimization

Seven Easy Estimates Reveal What to Expect from Inventory Optimization

The first step toward successful inventory optimization is getting your internal conversation on the right track by assessing your current situation, understanding the potential benefits, and setting your expectations with confidence. The benefits of multi-echelon inventory optimization (MEIO) have been well established by hundreds of companies of all sizes in industries ranging from consumer products to life sciences, high technology to process and discrete manufacturing. Leading organizations have shown that right-sizing inventory buffers and restructuring where and how inventory is held drives powerful financial benefits and adds tremendous value to the sales, inventory and operations planning (SIOP) process. MEIO provides a knowledge platform for better decision making and lets organizations use inventory as a lever for balancing supply and demand. Supply chain managers seeking to assess the potential financial benefits of an MEIO initiative can start with the high-level process outlined here. Based on our years of experience, this paper presents a good way to get the ball rolling, with seven simple estimates that help explore the impact an MEIO initiative can have on your organization.

Types of Inventory Available for Optimization

Optimizable inventory includes finished goods, work-in-process, raw materials, components and service parts. Inventory buffers that are held as a hedge against uncertainty in demand or supply are a primary source of excess and optimizable inventory. This safety stock can be dramatically reduced through MEIO. Not all inventory is available for optimization. One example is in-transit inventory that resides on boats, trains, trucks and planes. Other forms of inventory not available for optimization include stock that was produced but is not expected to sell, pre-built/promotional inventory that has been pre-positioned to handle business cycles, and pre-ordered inventory. The MEIO conversation starts by calculating what percentage of the supply chains total inventory is optimizable. This lends credibility to real-world benefit estimates.

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Benefit Streams of MEIO

Based on years of actual results achieved by companies worldwide, it’s clear that the benefits of inventory optimization vary across industries and businesses. The financial impacts of MEIO span several one-time and recurring benefit streams:

One-Time Benefit

Inventory Reduction: Optimizable inventory can typically be reduced by 10% to 30% by rightsizing inventory buffers held at all stages, or echelons, of the supply chain. MEIO programs normally reduce overall inventory while meeting or improving service levels.

Recurring Benefits

Increase in Working Capital: As the amount of on-hand inventory drops, it frees up the cost of capital that would otherwise be trapped by that inventory. This is a net recurring benefit equal to your cost of capital multiplied by the value of the eliminated inventory.

Reduction in Logistics Costs: The total logistics burden includes costs for warehousing, insurance, labour and expedited shipping, among others. Eliminating inventory eliminates its associated logistics cost, which can amount to 10% of inventory value.

Reduction in Write-offs: Obsolete inventory is a write-off. Most companies can expect MEIO to save a portion of the cost of goods sold (COGS) of optimizable obsolete inventory. Savings can range from a few percentage points to substantially higher for companies with many new product introductions or high rates of product churn.

Reduction in Stock-outs: Shortages and stock-outs cause both fulfilment delays and permanently lost revenue due to cancelled orders. MEIO can reduce the percentage of permanently lost orders within your optimizable inventory by a significant amount typically a double-digit reduction. Lowering the lost order rate results in higher revenue generation.

Seven Easy Estimates of MEIO Potential

Inventory optimization drives both one-time and recurring benefits. The typical ranges used to estimate these benefits can be narrowed down for your unique supply chain by assessing the key factors below. Give your business a rating of low, medium or high in each of the following areas:

1. Level of Demand Uncertainty

To what degree does your company face highly variable, hard-to-forecast demand? Alternatively, is your demand signal very predictable, or do you consider forecast accuracy not a significant problem?

2. Supply Chain Complexity

A good starting point for assessing complexity is to consider four factors: your supply chain length (replenishment lead time) in days, the number of supply chain stages (echelons), the number of locations holding optimizable inventory, and your annual rate of SKU turnover. Lead times over 50 days typically indicate high complexity.

3. Current State of Inventory Optimization Maturity

Does your organization rely primarily on rules of thumb, such as 30 days of forward coverage for all items? Do you perform single-stage inventory optimization in some parts of the supply chain? Does your company have any experience with MEIO?

4. Presence of Long Lead Times

Comparing yourself to others in your industry, are your lead times of comparable length or longer? Are lead times highly variable or unpredictable?

5. Frequency of Inventory Target Reviews

Do your planners review their inventory targets weekly, monthly, quarterly, or annually?

6. Inventory Write-offs

What percentage of your inventory is lost to obsolescence annually, on average?

7. Permanent Stock-outs

How many lost orders are permanently lost (not made up for later or in a subsequent sales cycle)?

Assessing the Impact

To estimate the MEIO opportunity for your company, organize your potential savings into the benefit streams shown below.

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The combination of a one-time reduction in inventory and multiple streams of recurring benefits reinforces the fact that multi-echelon inventory optimization affects many aspects of supply chain performance and delivers financial benefits above and beyond the freeing up of working capital.

Companies must take an organized approach to estimating and calculating each individual benefit stream. Information you will want to have on hand includes:

1.     Optimizable on-hand inventory (based on the value of inventory on hand and the percentage of inventory available for optimization)

2.     Annual sales for optimizable inventory (this estimate should incorporate your annual inventory turns and gross margin)

3.     Annual sales revenue permanently lost (based on your estimate of the percentage of unfilled orders that are permanently lost)

4.     Annual logistics cost for optimizable inventory (based on your Logistics cost burden as a percentage of the inventory value)

5.     COGS of optimizable unsold inventory (incorporating your estimate of your current obsolescence rate)

How to estimate each benefit stream:

One-Time Inventory Reduction Benefit

Multiply optimizable on-hand inventory by the reduction percentage you expect to achieve (typical inventory reduction ranges from 10% to 30% of total inventory). Refine your estimate using the seven factors listed previously.

Recurring Benefits

Working Capital: The recurring financial impact equals your optimizable on-hand inventory x inventory reduction estimate x your cost of capital.

Logistics Savings: This recurring impact equals your annual logistics cost for optimizable inventory x estimated logistics savings due to MEIO.

Lost Order Recovery: Annual sales revenue lost permanently due to unfilled orders x estimated reduction in lost order rate achieved by MEIO.

Reduction in Obsolescence Cost: COGS of unsold inventory x estimated savings from reduction in obsolete inventory due to MEIO.


Multi-echelon inventory optimization right-sizes inventory buffers and recommends where and how inventory should be held across all tiers of the chain. MEIO initiatives typically reduce inventory by 10% to 30% while improving service levels, resulting in dramatically improved profitability and happier customers. Significant recurring benefits include:

·         Increase in working capital

·         Reduction in logistics cost burden

·         Savings from lower obsolescence

·         Revenue uplift from fewer permanently lost sales orders

Estimating these recurring benefits for your individual business is a powerful place to start the internal conversation. Supply chain teams interested in exploring and refining these benefits can begin by looking at the seven easy estimates we ve outlined in this paper. It s a good first step toward building a solid business case for MEIO.

Article contributed by Logility. The original article can be found at www.logility.com