Taking Stock: How Can Inventory Optimization Improve Financial Performance?

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1 POINT OF VIEW Inventory optimizer Taking Stock: How Can Inventory Optimization Improve Financial Performance? Genpact The need to achieve growth targets in volatile times using shrinking investment pools has transformed the manufacturing CFO into a custodian of company value. Due to high working-capital requirements and volatile operating costs, the CFO is increasingly required to play an active role in supply-chain and inventory decisions. Suboptimal inventory directly impacts company value through working-capital pressure and unrealized revenue as well as through budgeting, planning, and risk issues. Demand- and supply-side volatility further aggravate these issues, ensuring direct negative impact on key financial metrics. Progressive manufacturing CFOs now realize that inventory optimization is one of the key levers to optimize working capital and cash flows and to improve sales and customer service. Genpact s research shows that inefficient inventory can consume as much as 10 percent more working capital than necessary and reduce cash flows by 4-5 percent. Suboptimal inventories can lead to stock-outs that reduce sales by 2-3 percent. Inefficient inventory practices can also result in slower order fulfillment, which extends the cash-to-cash cycle and raises the risk of penalty payments if customer service falls short of contractual requirements. The financial impact of poor inventory doesn t end there. It can also saddle companies with direct costs (such as higher interest expenses on inflated working capital) and many indirect costs. For instance, any cash tied up in inefficient inventory represents funds that the CFO could otherwise allocate to other sales or marketing initiatives. While poor inventory practices affect current sales and profitability, they can also silently and invisibly steal from the company s future. Many CFOs now realize that poor inventory can affect budgeting, forecasting, resource allocation, and strategy. For instance, companies that are often out of stock or incur costly write-offs from obsolete inventories find themselves wrestling with high variances between actual and planned.

2 The ultimate risk: A lower valuation Increased supply-chain complexity, poor inventory visibility, and high demand-supply volatility, significantly impair the CFO s ability to calculate the many hidden costs and risks associated with inventories. That, in turn, reduces the company s ability to determine the internal rate of return needed to justify new product launches. Finally, poor inventory systems can also impair the organization s ability to manage risk. If inventory is obsolete, it immobilizes cash and creates costly write-offs that directly erode profits. What s more, companies can incur significant legal liability from slow or failed fulfillment in industries, such as automotive and pharmaceuticals. They also face regulatory and environmental risks in certain industries (e.g. chemicals), if they are stuck with obsolete inventory that creates disposal issues. Add it all up, and the ultimate risk for organizations that struggle with inventory is a lower financial valuation (see Fig. 1). The cumulative impact of missed sales, lower profits, increased borrowing costs, and higher legal and regulatory risks can be a reduced market capitalization that investors assign to a company that has not optimized its inventory practices. Ultimately, suboptimal inventory levels hit company value Revenue Lost revenue due to sub optimal availability, slow cash flow due to poor order fulfillment, liquidation of inventory at low prices FCF Return Cost Volatility buffer inventories create higher carrying costs, cost of ordering, etc. Cost of supply-chain crises can severely erode customer value Significant disposal costs for obsolete inventory in chemicals, etc. CAPEX Opportunity cost: Unlocked working capital, cash flows could provide capital to fuel growth Company value Capital Working capital Volatile inventory levels lead to high working-capital levels resulting in higher cost of short-term financing Limited inventory visibility and inaccurate demand forecasting makes budgeting difficult Risk Company risk Product and inventory obsolescence results in write-offs Cash-flow risk due to slow-moving products, poor visibility Customer claims risk due to poor fulfillment in industries such as automotive, pharma, etc. Figure 1. Poor inventory practices can affect a company s cash flow, revenues, cost structure and, in turn, its overall valuation. CFOs in charge This revelation means that companies are making big changes in how they manage inventories. Historically, many organizations have allowed supply-chain managers in each business unit, factory, or distribution center to set their own inventory levels with little coordination. Unfortunately, too few of these organizations created standard inventory policies. Furthermore, they didn t even provide those units with the tools needed to determine optimal inventory levels. As global competition has intensified, though, companies realize that their success if not their survival depends on the ability to wring every inefficiency out of their systems. With a better sense of the financial impact of poor distribution practices, these organizations have put CFOs in charge of the supply chain. And with the CFO in charge, many of these organizations have embraced inventory-optimization solutions to improve financial performance. To start, these new optimization tools help CFOs and their staff increase the accuracy of demand forecasts, improve alignment between production and distribution, and reduce inventory levels with minimal effect on sales or profits. Genpact s work with clients has revealed that the best inventory-optimization solutions can help companies reduce inventories by as much as 25 percent -- while providing forecasts that are percent more accurate.

3 Through inventory optimization solutions, organizations can reduce working capital, minimize write-offs of obsolete stocks, and recapture sales that are lost when the right inventory exists but is on the other side of the world. A study by IDC Manufacturing Insights found that organizations that use software, analytics, and other solutions to optimize their inventories cut their stocks by as much as 25 percent in one year and boost discounted cash flow by more than 50 percent within two years. Genpact s experience has shown that an average US$1 billion organization can increase revenues by up to US$10 million through inventory optimization, while reducing its working capital needs by up to US$15 million (see Fig. 2). Working Capital Revenue Realization Typical industry numbers Average inventory investments for ~ 6 to 8 inventory turns US$ million Average unrealized revenue ~2-5% US$ million Typical inefficiencies and errors High Inventory 20-30% High Carrying Costs 2-5% Obsolescence 5-15% Slow Fulfillment 1-2% Lost Sales 2-3% What can be saved? Up to 5-10% less WC ~US$ 5-15 million Up to 20% more revenue ~US$ 4-10 million Figure 2. Using Genpact s inventory optimization solutions, a typical US$1 billion company can reduce its working capital by as much as $15 million and increase revenue by as much as $10 million. How does volatility impact inventory? There are many sources of volatility in an increasingly fragmented, just-in-time, global supply-chain-inventory strategy that many companies struggle to cope with. For example, commodity-cost volatility has made the supply chain a more complex, crucial, and risky battleground. In a 2011 survey by Supply Chain Insights, 58 percent of Fortune 100 companies cited commodity pressures as a risk to profits. Yet fewer than 2 percent of these same companies were able to translate this market volatility into a feasible sales and operations plan. Volatility affects prices, production, and inventories in two ways: It directly affects the marginal value of storage (i.e., the flow of benefits from an extra unit of inventory). Hence, an increase in volatility can lead to inventory build-ups and raise prices in the short run. For a nonrenewable resource like oil, volatility affects the total marginal cost of production. An increase in price volatility can result in a decrease in production. In addition, fears of further spikes in commodity prices can lead to panic buying by many companies. Conversely, in markets where commodity prices have plunged, suppliers have been left holding excess inventories that they must either sell at a loss or write off. The good news is that recent breakthroughs in stochastic-based inventory-optimization tools now enable companies to manage inventories the same way they manage their cash. Using range forecasting, planning, price optimization, and POS-driven replenishment tools, companies can now protect margins from swings in commodity prices or other events that unexpectedly affect supply or demand.

4 Why isn t traditional inventory planning suited to high-volatility environments? Typical inventory processes Demand plans are based on time-series projections of previous three to four years. Demand-and-supply plans treat residual inventory at buying cost. Annual long-range forecasts are fed to sourcing to secure contracts for raw materials and semi-finished goods. Long-term contracts provide stable input costs. S&OP is focused on short-term revenue plans. Implications in the new normal With changing buying patterns, history is no longer valid. Inventory is no longer just the buffer stock. It s also a commercial hedge against commodity volatility. Statistical long-range forecasts are no longer sufficient without considering macroeconomic inflationary factors. A short-term price drop can become a missed opportunity. Hedging strategies must be developed and regularly reviewed for each input. Ignoring implications of long-term price trends can drastically reduce profitability. Inventory optimization can help CFOs improve financial metrics, enhance customer service levels By combining its experience in business-process and supply-chain with its proprietary tools and analytics, Genpact has developed a range of inventory-optimization solutions that enable clients to improve their financial performance. Compared to the other alternatives, Genpact s solutions are easier to customize and faster to implement. While other vendors provide softwarebased products that are time-consuming and disruptive, Genpact solutions can be installed on-premise, in the cloud, or managed largely via mobile applications. This enables an organization to achieve a return on investment in as few as four months and with a smaller upfront investment. Regardless of delivery method, Genpact offers five solution modules that map to the most critical issues of inventory : visibility, segmentation, planning and optimization, demand forecasting, and product obsolescence. These modules can be deployed individually or sequentially because they use the same IT platform and tools. Visibility : Today, even mid-sized companies manage supply chains that stretch across the world. Given the dispersed nature of the modern supply chain, you need real-time visibility into the flow of goods from suppliers, their subcontractors, and the transportation firms that shuttle all of these goods around the world. Genpact provides dashboards and centralized systems that give you a comprehensive view of key forecast and inventory metrics. This enhanced information then enables you to better segment inventory, prioritize remedial actions. and set realistic targets for improvement. Together, these moves can generate a 10- percent reduction in working capital (see Fig. 3) and help recover up to 20 percent of unrealized revenue (see Fig. 4). Genpact s solutions are built on Qlik View, a flexible, costeffective, and proprietary IT platform that enables us to customfit technology around the organization s reporting process. And where other vendors fall short, Genpact provides ongoing services, such as internal and external benchmarking on key metrics. Segmentation: Given the competitive pressure for suppliers to offer a wider range of products and services, it is common to see companies juggle hundreds of thousands of SKUs. The challenge is to locate and cost-efficiently redistribute each of these products. Genpact enables an organization to segment inventory by customer type, product type, location, and many other categories. This enables the organization to reduce excess inventories, focus investments in the highest-performing segments, and, strengthen financial performance. Genpact offers: A cloud-based, in-house solution that integrates with existing ERP systems. That means you pay only for the solution not expensive infrastructure. A multifaceted approach to inventory classification with metrics for financial (e.g., gross margins), operational (e.g., velocity of movement), and customer-oriented (e.g., high-volume products) criteria.

5 Planning and optimization: Genpact s replenishment and distribution processes help the organization analyze supply and demand to predict order and fill rates. Our planning processes help optimize lead times by making continuous adjustments based on supplier inputs. This helps minimize carrying costs, stock-outs, and ordering costs while maintaining adequate service levels. Genpact provides its planning analytics over a flexible and cost-effective IT platform to custom-fit technology and process to the organization s environment. Total improvement up to 10 percent of working capital Improvement potential Visibility 1.5% Near-time KPI visibility aids quick decisions Multi-criteria inventory classification 2.5% Structured techniques for optimal segmentation and prioritized inventory investments Demand forecasting 3.0% Advanced models coupled with market intelligence to improve forecast accuracy Planning and optimization Obsolescence 10% 2.0% 1.0% Proprietary techniques for optimal replenishment and service strategies Proactive forecasting, tracking, and of inventory risks throughout the lifecycle Figure 3. Genpact s inventory optimization solutions can help reduce working capital as much as 10 percent Total improvement up to 20 percent of unrealized revenue Improvement potential Visibility 4% Near-time KPI visibility aids quick decisions Multi-criteria inventory classification 2% Structured techniques for optimal segmentation and prioritized inventory investments Demand forecasting 7% Advanced models coupled with market intelligence to improve forecast accuracy Planning and optimization 3% Proprietary techniques for optimal replenishment and service strategies Obsolescence 20% 4% Proactive forecasting, tracking, and of inventory risks throughout the lifecycle Figure 4. Genpact s inventory optimization solutions can help organizations capture as much as 20 percent of unrealized revenues Demand forecasting: Predicting future demand can be difficult, given the seasonal nature of many markets and changes in competitor offerings. Genpact offers advanced forecasting models that account for ongoing demand volatility. Genpact helps create standard processes that improve forecast accuracy and adapt to dynamic market conditions. Genpact s demand forecasting models incorporate: Advanced algorithms (e.g., Croston, Fourier) to handle dynamic and intermittent demand while reducing forecasting errors Exception and scenario development to help you better respond to dynamic market conditions Real-time market intelligence to help you forecast more accurately

6 Obsolescence : In many industries, product cycles have become so short that some goods can become obsolete within months of launch. Genpact s obsolescence- solutions help identify and then adapt to any risks that could render products obsolete earlier than expected. We enable companies to: Minimize working capital and boost profits by releasing cash from excess inventory Redeploy inventories more effectively Identify existing and potential obsolescence Estimate the risk of obsolescence Why Genpact? Genpact s inventory-optimization solutions leverage the extensive skills and resources developed during our years as a subsidiary of GE Capital. Genpact combines custom analytics and a proprietary inventory-optimizer tool, as well as experience in business process, supply chain, Six Sigma, and Lean Six Sigma disciplines to develop actionable solutions for clients. As a leader in inventory optimization, Genpact has helped clients that manage more than US$5 billion in inventories and 500,000 different SKUs, generating a combined US$250 million in savings. Our solutions help clients segment inventories by customer, cost, product line, and other categories. This enables them to plan and optimize inventories across multiple sites, build demand forecasts and simulations to predict future inventory needs, and develop strategies for reducing the risk of inventory obsolescence. Genpact employs more than 250 experts in supply-chain analytics and more than 150 inventory specialists across three global locations. Our global delivery model provides cost efficiencies and enables Genpact to leverage local market insights. Most of these specialists have earned advanced degrees, possess experience in multiple industries, and have experience in leading third-party applications including FGS, Servigistics, and I2. Genpact also brings to each assignment proprietary tools that are modular, configurable, and technologically unobtrusive, and that supplement current ERP and IT infrastructures. These include our integrated forecasting application, PRODE, and our proprietary inventory-optimizer tool. Genpact provides its inventory optimization services as one-time engagements or as part of long-term engagements. Using a modular approach and flexible cloud delivery, Genpact can deploy solution modules in as little as two months. That, in turn, can enable clients to generate early results in as little as four months with little or no upfront investment. About Genpact Genpact Limited (NYSE: G), a global leader in business process and technology services, leverages the power of smarter processes, smarter analytics, and smarter technology to help clients drive intelligence across the enterprise. Genpact s Smart Enterprise Processes (SEP SM ) framework and its unique science of process, combined with deep domain expertise in multiple industry verticals, leads to superior business outcomes. Genpact s Smart Decision Services deliver valuable business insights to clients through targeted analytics, reengineering expertise, and advanced risk. Making technology more intelligent by embedding it with process and data insights, Genpact also offers a wide variety of technology solutions for better business outcomes. For more information, visit Follow Genpact on Twitter, Facebook and LinkedIn. Copyright Genpact All rights reserved. For more information, contact: inventory.optimizer@genpact.com Please visit our website at: