Competitiveness is about profitability, but also responsiveness to changes and big ships turn slowly.
Profitability is the ratio of profit and capital employed (CE). Improved working capital ratios diminish capital employed, but also impact profit and responsiveness, most notably so Days in Stock (DIS). A key lever therein is the number of stock-keeping units (SKU).
For a primer on working capital management, check our recent eBook How to execute a working capital optimization project.
The Story of Mercury Corp.
A fictitious company Mercury Corp., an industrial manufacturer, has assumed differentiation as a source for competitive advantage. This strategy has yielded solid profits and cash flow over the years, but as the market begins to soften, problems unveil. As it turns out, Mercury Corp. has generated the profit with a product portfolio too complex and unstandardized for the organization to manage. A significant part of its finished good SKUs had not been sold more than once or twice a year, and a significant share of raw material SKUs have no consumption over more than two years.
Cost of complex SKU base
In addition to excessive amount of cash bound into its inventory, Mercury Corp. experienced the following profit downsides due to its SKU base:
Declining sales and the above downsides had by large overweighed Mercury Corp.’s upsides of keeping an infinite offering. The urgency for turnaround was evident.
An Approach to SKU Reduction
For Mercury Corp. it was imperative that the change needed to be done without losing competitiveness in the market. Given the siloed nature of the organization and identified gaps, the following three way approach was selected: increase ownership, improve portfolio efficiency and rationalize raw material base.
In Mercury Corp. the lack of ownership was self-evident. None of its functions let alone a designated person had the SKU base as a responsibility. In addition, facts for the decision making were not available and the company wasn’t used to cross-functional projects. Opening the history behind the SKU base wasn’t the most pleasant business for many in neither R&D, sales or purchasing.
Eventually, a project manager was assigned, cross-functional teams set-up and a business analytics tool for fact-based decision making ramped up to expedite the progress. After the project, the same set-up was to be repeated as part of the annual activities.
Product portfolio efficiency
By product portfolio efficiency Mercury Corp. referred to its ability to create earnings with a set investment. The metric selected to evaluate each product’s place in the portfolio was Earn & Turn, the product of profit margin (%) and inventory turnover, ITO. A low Earn & Turn indicated that a product either did not have a good profit margin or its inventory investment was exaggerated compared to actual demand. Within the scope of SKU reduction project, Mercury Corp. concentrated on the goods that generated a low margin and had a low ITO.
It was well known that a low ITO is a symptom, with multiple alternatives for a root cause. The following definitions were carried out to find which low Earn & Turn SKU should be ramped down.
Ending a product at Mercury Corp. was not easy even when backed by hard facts. A lot of politics, intuition and personal opinions were involved. The total cost of keeping a low selling SKU was not always straight forward to quantify. Despite the hurdles, the exercise was a huge success. It brought focus into sales, delivery models and lead times were revised to match sales strategy, replenishment parameters were updated to release cash from inventory and R&D got a clearer vision on where to drive product standardization and where to release resources. Some low margin products had gone unnoticed even and prices were updated.
The rationality of the raw material base
In Mercury Corp.’s case, the inefficient finished goods portfolio in conjunction with uncoordinated product ramp-downs and ramp-ups had caused raw material SKU base to expand. With Mercury Corp. there was more to it. Due to the high drive for differentiation, the R&D had in many cases launched incomplete products. Incomplete first versions, combined with real or anticipated changes in customer needs and R&D’s drive to find ever cheaper parts had forced most products to confront frequent modifications. As the modifications had not been coordinated with sourcing and engineering, Mercury Corp. had over the past ten years accumulated an immense tail of SKUs.
The first phase of the project started with data exercise to point out irrelevant SKUs. As inputs, Mercury Corp. used standard product lists, inventory transaction data, component grouping and bills of material in the system. The most material groups with most SKU reduction potential were extracted by using the below logic:
To Mercury Corp.’s disappointment, even these SKUs could not be scrapped in mass, but material group owners had to check the history and purpose of each item before the cross-functional decision-making meeting. Since then, it was clear that the issue needed to be approached from multiple angles and would require time since many of the BOM external SKUs were still used in special products that made a significant part of sales. Ramping up standard product sales was an important piece in the puzzle.
The second phase of the project targeted to reduce SKUs by rationalization. The following aspects were studied and implemented:
Mercury Corp.’s R&D team was able to improve part commonality quite quickly, whereas simplification of structures required a long-term effort. In the end, the upside from having less parts was well worth the investment.
Overextended SKU bases such as Mercury Corp.’s are quite common in today’s P&L focused line organizations where R&D, sales, sourcing and production functions work in silos. Companies have a difficulty of rewinding this evolution due to reasons similar to Mercury Corp.’s: lack of ownership, need for fact-based cross-functional decision making to slash product or to rationalize material base and the sheer workload the project generates.
In the end, it is worth the effort. Companies with lower SKU base have better productivity, lower personnel-, raw material- and quality costs and they have the prerequisites to be responsive to market disturbances. Hence, they are likely to be more competitive.
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