Alan Milliken isn't very impressed when a consultant shows up and offers to assess a company's inventory and risk management strategy for half a million dollars or so. "It just doesn't look like much of a bargain," says the business process education manager of BASF Corp., in Florham Park, N.J. At least until the price of oil tops $140 a barrel. Then it's a whole new ballgame.

Actually, Milliken has been obsessed with the subject of inventory for some time. He has written extensively about "dysfunctional" inventory-situations where stock is too plentiful, too old, obsolete or unsuitable due to quality problems. "Every business needs a formal process to identify and control those inventories that do not function to support customer service or help to optimize costs," he wrote in a recent newsletter of the American Production and Inventory Control Society (APICS).

In recent months, however, the situation has become even more acute. The reason is greater supply chain instability, driven mostly by the soaring price of oil, but exacerbated by the rush to outsource manufacturing, a growing scarcity of raw materials and rising consumer demand in developing nations. As a result, says Milliken, "we're going to see more true risk assessment and risk management. Not just something you read about in a book."

BASF is leading the way. The practice of inventory swaps, whereby nominal competitors help each other out in regions where their own supplies are lacking, is already well established in the chemical industry, Milliken says. Obviously, that approach is less practical where finished goods are involved. But there are other strategies that apply across the board.

One is the development of contingency plans to cope with supply disruptions. Every decision on where to place inventory represents a calculated risk, Milliken says. No business can afford to keep safety stock at all possible locations.

But risk must be accompanied by planning. Many organizations, says Milliken, "wait until the shortage crisis is upon them. Then they start the firefighting." In the future, "you're going to see companies get smarter and start to move toward advance planning on allocating product that's in short supply."

By some indications, those companies will be starting from an alarmingly low level of expertise. Following a presentation that he gave during a recent webinar, Milliken was shocked at the elementary nature of the questions. Individuals with titles like director of inventory management seemed to lack the most basic knowledge about how to set order points, safety stock and lead times.

They'll have to learn quickly. Even the best-laid plans become obsolete when the price of oil jumps $50 a barrel in a decade. David Simchi-Levi, MIT professor and chief science officer with Sunnyvale, Calif.-based ILOG, notes that companies have had dramatic success over the past 20 years with such techniques as outsourcing to low-cost countries, lean manufacturing, just-in-time fulfillment and rapid delivery. The result has been a remarkable increase in supply chain productivity, and cost savings in the billions of dollars.

But companies can't rest on their achievements. In addition to paying more for fuel, they are under growing pressure today to implement green strategies for sustainability. They must also cope with road, rail and port infrastructure that can't accommodate the projected growth in traffic. And that raises the possibility of supply disruptions during peak shipping seasons.

All of which adds cost to the system. A recent analysis by Simchi-Levi revealed a 40-percent increase in U.S. logistics costs between 2002 and 2006. Inventory volumes rose by about 49 percent in the same period. Fuel prices are the obvious culprit, but the uptick in inventories is also the result of companies boosting safety stocks to offset the risk of longer supply lines, caused by outsourcing to China and other low-cost countries.

In a world where product travels 5,000 miles or more to reach buyers, some increase in inventories closer to markets is probably inevitable. But that doesn't mean that companies should flood their distribution centers with buffer stock. ILOG, for one, offers analytical software that helps companies to strike a balance between transportation and inventory expense. The right equation is constantly changing, however, so the exercise needs to be run on a periodic basis.

Reverse of Outsourcing?

High fuel prices and the greater possibility of supply chain glitches are even causing some companies to revisit their outsourcing strategies. The lure of cheap labor isn't quite so powerful when other elements are factored in.

"Initially, everybody rushed to China for the promise of lower labor costs," says David Johnston, senior vice president of supply chain with JDA Software Group in Scottsdale, Ariz. "They didn't do an analysis regarding the additional logistics cost caused by longer lead times. Now, with heightened awareness because of rising fuel costs, we're at the point where companies truly realize what the cost of going overseas is." The recent discovery of lead in the paint used for toys made in China, along with other cases of tainted products, have served as a particular wake-up call, Johnston says.

The new awareness stems in part from a focus on total landed cost, a calculation that not only looks at the price of labor, but at fuel, transportation, import duties, taxation, unit price and the cost of money as well. The exercise has already prompted some rethinking by supply chain executives. Sharp Corp. has shifted production of flat-screen televisions from Asia to Mexico in order to supply markets in North and South America, according to Simchi-Levi. With the price of TVs falling by an average of 10 percent per month, shipping time is becoming a more critical factor for suppliers. They are less able to support the higher lead times and inventories that come with making product in Asia.

Boosting inventory is only one answer to the problem of coping with longer supply chains. And it might not be the best one. Sridhar Tayur, chief executive officer of Pittsburgh-based SmartOps Corp., says agility can be a less expensive alternative. The idea is to respond more quickly to changes in demand signals. That requires a more integrated supply chain, where information is relayed throughout the tiers and manual processes are avoided wherever possible.

Tayur has seen a tenfold increase over the last three years in companies showing interest in inventory optimization tools. They are looking for the ability to reset inventory targets on a more frequent basis. In the past, companies might have gone through that exercise every six months. New software applications permit weekly runs, with much more specificity as to individual products. The net result, even with stock boosts in selected areas, can be a reduction of up to 24 percent in inventory investment, Tayur claims.

The greater frequency allows companies to react to constant changes in fuel prices as well as customer demand. They can shift modes and enter into short-term leases for warehouse space, in line with current conditions. Even with the increase in energy cost, Tayur says, John Deere cut its cost of doing business by 8 percent a year, the result of optimizing inventory on a seasonal basis.

The next step is to apply network design strategies to such activities as postponement, where generic product is customized for local markets at the last possible moment. New information technology allows companies to examine multiple scenarios from the standpoint of landed cost. It can also help them to understand the point at which transportation becomes a bigger driver of cost than inventory investment, says Lee Wilwerding, director of total inventory management with i2 Technologies in Dallas.

The Wrong Focus

Just as they once looked only at labor costs, companies can get sidetracked by focusing only on inventory. "Inventory itself is really not the issue," says Harpal Singh, chief executive officer of Supply Chain Consultants in Wilmington, Del. "The issue is how you manage that entire logistics supply chain."

Manufacturers have tended to treat their extended supply chains as "islands of automation," says Singh. Now, with fuel prices on the rise, the logistics function is receiving a fresh look by supply chain managers. "It's almost becoming as important as manufacturing the product."

While some see a consequential rise in inventory levels, Singh takes a different view. So far, he says, "the impact on physical inventory has been relatively marginal." Supply chains tend to have so many structural inefficiencies that companies have been able to reduce costs without adding substantial amounts of product to the system. What Singh does see is a change in where existing inventory rests. In many cases, it's moving closer to the customer, in order to create a more responsive supply chain in uncertain times.

The trick, says Singh, lies in taking a high-level view of inventory optimization across the supply chain, then combine it with manufacturing, logistics and distribution considerations to arrive at an overall cost. A good forecasting tool can then help companies to understand all of the options for moving product to market.

It can also alter traditional assumptions. Wilwerding tells of an automotive customer of i2 that was trying to decide whether to buy aluminum wheels in China or Germany. Procurement managers recommended China, without taking into account the buffer stock that was needed to ensure a continuous supply to the plant in Germany. Having run the i2 optimization software, the company determined that China was in fact cheaper, but not by much. So it set up a spot-buy arrangement with a German manufacturer, to offset the increased risk associated with sourcing the bulk of the product from China.

New software tools can also help companies to differentiate popular items from slower-moving stock, so that the former can be held at regional locations while the latter rests at a centralized point, perhaps the plant warehouse. In this way, the slower stuff becomes easier to obtain when it's needed. "Supply chains don't work uphill," says Wilwerding. "Trying to move from a [regional] DC on the East Coast to one on the West Coast is not going to happen. It's costly and consumes a lot of time."

Customer behavior is yet another consideration. Buying patterns can shift suddenly in a troubled economy, says JDA's Johnston. Companies must be ready to alter their distribution networks accordingly. "As you bring on new customers or lose them, you may want to move those service points around," he says.

The Biggest Factor

For all the talk of customer-centric supply chains, cost is the biggest driver behind companies' embrace of more sophisticated inventory management tools, according to Nari Viswanathan, research director with Boston, Mass.-based Aberdeen Group. That, at least, is the finding of Aberdeen's latest survey on the topic. Customer service ranks second, he says, but return on invested capital is a more important concern for managers faced with rising costs and shrinking margins.

When it comes to actions taken, the number-one response cited by companies in the Aberdeen survey was looking at how much inventory was being held across the network, says Viswanathan. The second most popular technique was working to improve forecast accuracy. The third was new replenishment strategies.

All three areas feed into the larger decision as to where to place manufacturing plants and distribution centers. Companies need to approach the question from multiple angles, looking at components, finished goods and product families. They must prioritize among their customers, deciding which ones are most critical and should therefore receive the highest (and costliest) level of service. By balancing long-term network design with tactical considerations, Viswanathan says, managers can actually reduce inventory levels by a substantial amount.

There are numerous ways of approaching the issue of inventory optimization, says Viswanathan. They include a general rules-based approach, setting blanket inventory targets; the "ABCD" strategy of ranking inventory according to how frequently it sells; and a series of computations, utilizing advanced planning and scheduling tools, for each tier of the supply chain.

But the most effective approach is multi-echelon optimization, whereby companies calculate inventory targets across all supply chain tiers. In the process, they account for real-world variability and the links between multiple echelons, says Viswanathan. Still, such a technique remains untested at many companies, at least in its full-blown version. A number of companies continue to make separate calculations for inventory and customer service at each level of the supply chain.

The higher view may lead to pockets of increased inventory. "Don't hesitate to add inventory as a competitive weapon for certain product lines," says Viswanathan. "Just make sure that customer service levels are high, and overall inventory levels are low."

Inventory Equals Cash

Far-seeing companies are beginning to view inventory in the same way that they have managed cash, says Fred Lizza, chief executive officer of Optiant Inc. While multinationals maintain bank accounts around the world, they manage total cash balances on a global basis, through centralized credit facilities. Similarly, companies are asserting high-level control over total inventories, even as they allow for day-to-day management at the local level.

One user of Optiant's software, a large consumer products company, is deploying the application to manage inventory that is actually owned by partners elsewhere in the supply chain. The information it derives from the tool allows the company to assert influence over product held by both retailers and suppliers. Lizza expects to see such arrangements work themselves into future supplier-buyer contracts.

Global inventory management offers a number of advantages to the organization, Lizza says, including increased turns; fewer stockouts; less excess and obsolete product; better responsiveness to changing customer demand; and tighter control over shipping lead times, manufacturing yield rates and issues related to seasonality.

Optiant's software takes into account the full range of costs that affects a product's path to the buyer, Lizza says. Yet coming up with that number isn't always easy. Much depends on the quality and depth of the data provided by customers, who in turn must rely on their many partners in the supply chain. Often the application has to deal with incomplete data as well as the inaccuracies that plague even the best forecasts.

Still, says Lizza, the scenarios generated by the system manage to do a good enough job of matching up with reality. Boston Scientific, another Optiant customer, found that its model came within a few percentage points of the way things actually played out. The company ended up with inventory reductions ranging between 15 and 26 percent, and service levels of 98 to 99 percent, Lizza says.

Inventory strategies are also changing in the service-parts sector. As new-product sales stall in a questionable economy, companies begin to place more emphasis on the after-sales market as a means of boosting revenues and securing customer loyalty, notes Tim Andreae, senior vice president of global marketing for MCA Solutions in Philadelphia. In many cases, that means going from next-day service for repairs, maintenance or product replacement, to a same-day commitment. To make that possible, companies must shift their parts inventories to forward locations. They need to know exactly where that inventory has to go for maximum impact and minimum cost, he says.

Good forecasting, even with the inevitable errors, remains a crucial element in successful inventory strategies. The best way to cope with skyrocketing fuel prices "is to find a way not to ship it at all," says Wilson Rothschild, industry and product marketing manager with Infor in Alpharetta, Ga. "Forecast accuracy can eliminate transportation."

Improved forecasting tools add system constraints and allow companies better to reflect the real world in their planning. They also bring together the operational and strategic levels of the planning process, which have tended to be overseen by different individuals within the organization, says Rothschild. So companies can make high-level decisions on which DCs to open or close, then deploy operational planning tools for managing local inventory, customer demand and replenishment.

Ultimately, says Rothschild, supply chains will have to become "more risk intelligent." The array of IT systems within an organization must be able to recognize the location and condition of inventory, then factor in multiple risks related to stockouts, inventory placement, transportation, time to market, obsolescence and supplier performance.

External factors such as the cost of energy will keep on pushing companies to embrace new strategies for inventory optimization. "We're looking for people that are questioning their assumptions," says Lizza. "That's the trigger for us. That's what gets us in the door."

Resource Links:

Aberdeen Group, www.aberdeen.com
BASF Corp., www.basf.com
ILOG, www.ilog.com
Infor, www.infor.com
i2 Technologies, www.i2.com
JDA Software Group, www.jda.com
MCA Solutions, www.mcasolutions.com
Optiant, www.optiant.com
SmartOps, www.smartops.com
Supply Chain Consultants, www.supplychain.com