This article has been modified from the original article written for Chief Executive.

With many organizations looking to transform their supply chains, MIT’s Jonathan Byrnes wrote a piece on, “How to Design a High-Profit Supply Chain.” Below, Part 2 focuses on supply chain management.

Setting the right inventory makes all the difference between success and failure in today’s uncertain, unstable business environment. Yesterday’s core inventory metrics — inventory turnover (cost of goods ÷ average inventory) and inventory GMROI (gross margin ÷ inventory cost) — fail to provide the essential information that managers need to avoid the twin problems of missing critical potential profits while having to write off large tranches of costly inventory.

Precision Inventory Management (PIM), a core component of Enterprise Profit Management (which uses current general ledger information to create a full, all-in P&L on every transaction), gives managers the crucial missing information they need to capture and grow their high-profit business while achieving strong levels of inventory asset productivity.

The Managers’ Dilemma

During the past few months, I have fielded an increasing number of phone calls from top executives voicing concerns about their inventory productivity. For example, one CEO of a multi-billion-dollar company said that the company was growing fast, but inventory was growing faster, leading to a dire situation in which the company was running out of cash. In my experience, it was extremely likely that 20 percent or more of the company’s inventory was, in fact, “dead stock” that could be harvested for much-needed cash. The underlying question was how to set the right inventory levels in the first place.

This situation is all too common in company after company today. It is rooted in two pervasive problems that characterize virtually every company: (1) maximizing sales does not maximize net profits; and (2) maximizing gross margin does not maximize net profit. Yesterday’s inventory metrics—inventory turnover, and GMROI — are based on these two empirically incorrect assumptions.

Precision Inventory Management

In the prior Age of Mass Markets, which occurred throughout most of the 20th century, revenue maximization was the right objective. Companies had relatively uniform pricing, cost to serve also was relatively uniform as the products were just dropped at the customer’s receiving dock, and economies of scale meant that large production volumes led to diminishing unit costs. Diminishing unit costs, in turn, meant more revenues and profits.

In this situation, management’s primary goal was to maximize revenue while minimizing cost. The twin inventory metrics—turnover and GMROI—aligned with this objective. Moreover, in this prior era, before computers and advanced data capabilities became widespread, these metrics only could be produced for products on a company-wide basis—and not for particular products in specific customers and/or locations.

Over the past 30 years, however, our business system has changed enormously. We have entered what I call the Age of Diverse Markets. In this new era, companies have instituted complex pricing varying from customer to customer, and even product to product. Cost to serve varies again by customer, and even by product within a customer. Flexible manufacturing and outsourcing have enabled many niche products to achieve minimum efficient scale.

Enterprise Profit Management (EPM), a SaaS system which can be configured in a few weeks, provides the critical financial information that managers need today. Over years of experience with EPM, we have found that virtually all companies have a characteristic pattern of profit segmentation:

• Profit Peak customers—typically about 20 percent of the customers generate 150 percent of a company’s profits;
• Profit Drain customers—typically about 30 percent of the customers erode about 50 percent of these profits; and
• Profit Flat customers—typically the remainder of the customers produce minimal profit but consume about 50 percent of a company’s resources.

The same profit pattern characterizes every dimension of a company—suppliers, stores, sales reps, order lines, products and—importantly—inventory.

Because EPM shows the all-in P&L details of literally every customer and product, it is easy to see precisely where the company is making money, where it is losing money and why. Moreover, because EPM tracks the exact inventory used in each transaction, it is easy to calculate the precise (1) inventory profit productivity, and (2) inventory return on investment for each transaction. These are the correct inventory management metrics essential for success in today’s hyper-competitive, rapidly changing business world.

Enterprise Profit Management gives managers the ability to combine and recombine their transactions in order to map and evaluate their actual inventory profit productivity and inventory return on investment in literally every segment of the business: product, location, customer, store, branch and so on. This enables managers to immediately see where current inventory is producing strong profits, where it is costly and unproductive, and where it needs to be augmented. It also provides critical guidance for precision pricing, even down to specific customers buying particular products on certain days in selected locations.

This is the bedrock reason why Precision Inventory Management is so effective.

Inventory Profit Levers

Four key variables enable you to determine the correct amount of inventory to carry to maximize your inventory profit productivity and inventory return on investment: (1) customer; (2) product; (3) order cycle/interval (the time between when you receive an order and when the customer receives the product); and (4) price.

In the past Age of Mass Markets, it was not possible to determine a specific inventory level for each customer/product/location. Today, EPM enables managers to do this.

• Profit peak customers. These are your large, high-profit accounts. It is imperative that they receive fast availability of all products in all locations. For these critical customers, the overriding metric is the overall customer ROI, even if it means cross-subsidizing some money-losing inventory to meet the customer’s needs in order to retain and grow your relationship.
• Profit drain customers. These customers are large and lose money. Here, you need to be more selective. Some products may well be very profitable, even though the overall customer ROI is negative. These products should have adequate inventory to meet these customers’ needs.

Many other products bought by these money-losing customers, however, will have a negative inventory ROI. It is not economically justified to carry this inventory, which would have to be cross-subsidized. However, you can raise the effective inventory ROI in two ways: (1) offer these customers a longer order cycle, which enables you to source the product from a central warehouse rather than a local distribution center, reducing the need for costly local safety stock; and (2) raise the price of the selected money-losing products to compensatory levels (including imputed inventory carrying costs).

• Profit desert customers. These are small customers with marginal profitability. Some are important development accounts and/or technical/fashion leaders. It is important to provide fast, reliable service to these customers, even at a loss.

The majority of your profit desert customers, however, are small accounts. Some profit desert customers, perhaps a quarter of them, are small, but profitable. These customers warrant relatively fast service, generally from local stock—even for low-profit products—in order to retain and grow these profitable relationships. In a pinch, however, your Profit Peak customers should have priority if your local stock runs low.

The remaining non-development profit desert customers are small and unprofitable. Some products that they order may be very profitable, in which case they should receive fast service. The remaining low-profit or money-losing products are not economical to provide unless you can raise the price and/or lengthen their order cycle to lower your effective inventory cost by sourcing from a central facility’s stock.

Three Stages to Inventory Productivity

In our experience with PMI, it is best to proceed in three steps. Step 1 – Product-optimized Inventory is based solely on product and location, and is within easy reach of virtually any company with EPM. Step 2 – Customer-optimized Inventory builds on Step 1 by adding customer to product and location. Step 3 – Fully Optimized Inventory incorporates all four inventory profit levers, setting transaction order cycles and prices as well.

Step 1 – Product-optimized inventory. This is a relatively straightforward way to avoid major inventory pitfalls. It begins with EPM clustering product inventory (both company-wide and in each location) into profit peaks, profit drains and profit deserts (regardless of customer). The simple rule of thumb is to ensure that you have an ample amount of profit peak inventory, a tight amount of profit drain inventory and an adequate amount of profit desert inventory. This will enable you to avoid major stockouts in your high-profit products, and write-offs in your profit drain products—creating strong positive profit and cash-flow benefits.

Step 2 – Customer-optimized inventory. All products sold to profit peak customers should have ample inventory to give these key customers fast, reliable service (even if a particular product is a profit drain). In addition, all profit peak products should have ample inventory to provide all customers with fast, reliable service. On the other hand, profit drain and profit desert products sold to profit drain and profit desert customers should have tightly managed inventory.

These customer/product decision rules enable you to derive the correct amount of inventory for each product destined for each customer in each location. They generate significant additional profit, cash flow and customer service benefits.

Step 3 – Fully-optimized inventory. While it may seem overly complex to set your base inventory levels for every transaction based on the four inventory profit levers (customer, product, order cycle/interval and price), many sophisticated order management and inventory systems can handle this, especially with the rapid increase of digitized customer order processes that are rapidly becoming the norm.

In addition, in some high-technology and seasonal companies, product obsolescence has to be factored in. For example, one retailer’s EPM system showed that over two-thirds of its profit drain business (inventory write-offs) stemmed from its profit drain products in its profit drain stores, especially at the end of the seasonal product lifecycle.

Product and Customer Variety

Beware of two very common myths that underlie a surprising amount of inventory productivity problems,

First myth. Maximizing the number of customers is good. This is incorrect. Rather, maximizing the number and growth of your profit peak customers is a terrific objective, while adding profit drain and profit desert customers only reduces your profits.

Second myth. Maximizing your product selection (product variety) is good. In fact, it is very hard for people to choose among similar items. In experiments, physicians faced with the choice of prescribing two similar medications prescribed neither much more often than those physicians who only had one medication available. This is why effective retailers purposely limit their selections to “good, better, best, technology and/or fashion,” while ineffective retailers (and distributors) assume that every additional alternative product will increase revenues and profits.

People imagine that they would prefer variety more than they do. The reality is that they only prefer variety if habituation sets in. Otherwise, in episodes separated by time, they strongly prefer favorites.

Path to Profit Growth

In these perilous times, with rapid demand shifts and widespread supply chain disruptions, setting the right inventory is essential to company success. Yesterday’s obsolete inventory metrics—inventory turns and GMROI—are based on empirically incorrect premises and simply will not enable you to avoid the twin perils of losing high-profit sales and incurring costly write-offs.

Precision Inventory Management, on the other hand, is rooted in the right inventory metrics—inventory profit productivity and inventory return on investment. These powerful metrics are essential for success in today’s hazardous, rapidly changing business environment. They will provide you with the surest path to strong profit growth.