In the last installment of this two-part series, the notion of inventory segmentation as a tool to facilitate SKU (stock-keeping unit) rationalization was introduced. The article described a stratification technique that was aimed at separating under-performing SKUs from those that contribute significantly to business results. Examples were cited that described clients who, armed with this stratification tool, were able to significantly reduce the number of under-performing SKUs in their product portfolio. The article also noted the tendency within many organizations for sales and marketing managers to seek retention of as many SKUs as possible, while operations managers tend to want to keep as few as possible. This column will describe a technique to deal with this conflict issue. While the previous article described the 2-D Inventory Efficiency Model of segmenting inventory into nine performance-related categories, this installment will describe a 3-D technique that addresses SKU profitability and volume. This process produces 27 distinct categories. While not all 27 are of equal interest, there are several that provide considerable insight to those seeking a rational approach to product-line management. This technique has been named Profit-Volume Inventory Model. The rationale for its name will become clear later on. Development Of The Profit-Volume Inventory Model The Profit-Volume Inventory Model was developed at a leading tire manufacturer, where operations management wanted to establish a compelling case for SKU reduction, which had historically been resisted by the sales and marketing staff. The first dimension used for stratification is historical usage value -- exactly the same as in the 2-D Inventory Efficiency Model. As was described in the previous article, the annual usage value (AUV) for each SKU is calculated as the annual demand multiplied by the cost and then SKUs are sorted in descending AUV order, with those SKUs comprising 80% of the cumulative AUV considered "A" items, those SKUs comprising the next 15% of the cumulative AUV considered "B" items and remaining SKUs considered "C" items. Following this single stratification, the "C" items represent a starting point for discussing SKU reduction opportunities. However, the case is hardly compelling. For example, there are new items whose history is sketchy at best, but whose future sales may be very important to the enterprise. This suggests the need for a forward-looking view to complement the backward-looking AUV. As a result, Forecast Usage Value (FUV) is utilized as a second stratification axis. The FUV calculation is similar to AUV, except forecasted usage is substituted for actual historical usage. Using just these two axes, we can now separate items into nine separate categories, from "AA", "AB" and so on, down to "CC." "CC" items have historically had little or no volume and, based on the forecast, this condition is not expected to change. Although focusing on this more refined grouping may create a more compelling SKU reduction case, sales and marketing staff may continue to argue for retention of low value items on the basis of high unit profitability. The need to understand and manage the profitability issue requires a third and final stratification to be introduced into the model. Although AUV and FUV calculations are quantitatively well defined, identifying an item as "Hi" (high profit), "Med" (medium profit) or "Lo" (low profit) requires some judgment to make the results useable. As a starting point, it is suggested that the break-even gross margin percentage be utilized as an approximate mid-point. This is the gross margin percentage that, if it is attained exactly, is just high enough to cover all remaining pretax costs such as selling, administrative and interest expense, so that the pretax profit is exactly zero. Alternatively, the corporate or division average gross margin or contribution margin also are frequently utilized as mid-points. For example, if we assume that the mid-point gross margin selected is 35%, a reasonable definition for a "Hi" profit item might then be any item with a gross margin of 3% to 10% above 35%, or 38% to 45% (i.e., clearly profitable). "Lo" profit items would then logically include any that are clearly unprofitable, with a gross margin of 25% to 32% or less. "Med" items would be those in the range between "Hi" and "Lo", reasonably close to average profitability. With the profitability definition in place, SKUs can be stratified along three axes into 27 different segments. For the purpose of convention, we typically list the axes in this order:
- Profitability
- Historical Usage Value
- Forecast Usage Value.
- Segment "Lo-C-C" The Profit-Volume Inventory Model was developed with a focus on this particular category. SKUs in this segment can be presented as candidates for deletion from the product line on the basis of their low profit contribution, low historical sales volume and low forecast sales volume. Still, an agreement from the sales and marketing folks to delete these from the active sales line is not likely to be a slam-dunk. (They probably wouldn't be too good in their jobs if they agreed on deletion too easily.) In any case, however, the operations management team has a rather powerful opening argument.
- Segment "Hi-A-A" These items contribute the most to the organization, so they deserve the special attention. There are many occasions when resource constraints do not allow all SKUs to get equal treatment. This happens, for example, when production capacity is constrained and it is not possible to produce every SKU that is required. When there is a need to allocate resources, "Hi-A-A" items deserve preferential treatment.
- Segment "Hi-C-C" In this segment, there is a group of items that generates high unit profits, but has not sold well in the past and is not forecast to sell well in the future. Logically, you should ask why and investigate. These SKUs may be subject to price competition, and it may be that a competitor's similar product is priced somewhat lower and is getting a greater market share. Unless this item already has a very high market share, opportunities to increase sales via pricing strategies (i.e., elasticity of demand) should be examined.
- Segment "Lo-A-A" In this segment, the opposite problem is encountered. These products are selling very well, but generating little or no profit. These SKUs can be troublesome in that they may consume capacity or other resources without generating an adequate return. Pricing increases or "bundling" with more profitable products are some of the alternative strategies that can be employed to improve the profitability of these items.
