While there are many guilty parties in inventory analysis, high demand deviation is the one that’s adding more to your expenses than to your profit. So today’s topic: how to manage erratic demand profitably.
Sales may be up, but erratic demand kills margins
A crime is happening right under your nose. Your sales are growing, but your profit margins are shrinking. This pattern results in a reduction in net profit for the company. You’ve been stung by one of the biggest profit stealers… erratic demand! The inventory team must act quickly, corral the usual suspects, and find the items to blame.
High demand deviation is a dangerous – yet highly fixable – threat to a distributor’s profits. Today in Part 1 of this 2-part series, we’ll discuss:
- What causes high demand deviation?
- What’s the profit impact of erratic items (and where can you find them)?
- How do you manage erratic demand profitably?
We will explore several item groups that require interrogation through data analysis, including:
- Items with erratic demand,
- Items with long lead times,
- High-buying multiples and slow movers,
- Poor service level strategies & resulting heavy safety stock, and
- Other profit stealers like fixed cycle buying, missed deal opportunities & focusing only on turns
High demand deviation is definitely the biggest monster under your bed, so we’ll spend our time today on that… then tackle the others in Part 2.
What Causes Erratic Demand?
Obvious, but important to share… The more an item sells, the more likely it is to sell in a stable pattern.
When an item is being bought actively by many customers, it will typically result in a smooth, consistent sales pattern. Conversely, a slow-moving item is bought by few customers, and likely the pattern will be erratic. While those facts sound obvious, what’s not always obvious is the impact of erratic demand on profit.
The Demand Deviation factor speaks volumes. Forecasting and reporting the demand deviation pattern for each item is expressed as the Demand Deviation of the item. It is a key source in creating the appropriate safety stock to achieve service goals. The Demand Deviation metric also provides a wealth of analytical information for making great inventory buying decisions.
From super-steady to highly erratic, analyzing your various deviation levels becomes easier when you group the items into logical categories as shown in the visual below.
Let’s look at the extremes:
As the picture below shows, Super Steady items are popular, fast-moving, low-deviation items which we often refer to as ‘A’ items. Their safety needs and safety stock expenses are low, creating a higher profit margin for the company. You can normally afford high service goals on these items, though these items often begin with lower margins.
Highly Erratic items are often considered the ‘D’ or ‘Y’ items (as in why do we have them?). Or worse. Safety stock needs are very high and become very expensive, typically forcing lower service goals. Margins typically begin higher for these items, but don’t always extend beyond the safety stock expenses.
Impact of Demand Deviation on Profit
How does high demand deviation steal profit? Most company income statements don’t show the entire picture. Gross margin is also very misleading. For true analysis, the inventory expenses of each item need to be measured. These include the cost of buying and the cost of carrying inventory.
The number of days of safety stock can be the key difference in the profit picture. Two items might both start with a 25% gross margin, but the item requiring three days of safety stock will return a higher profit than the erratic item needing 24 days of safety stock.
THE TALE OF TWO APPROACHES TO ITEM MIX
To describe the impact, let’s look at two types of stores we visit daily…
Ketchup, the great American sauce. Let’s visit two local stores to see how the approach differs. Ketchup demand in both stores is 1,000 units/week.
Your Local Club Store: Your club store does not worry about options. They want to deliver low prices. They offer one large SKU of ketchup and the entire demand of 1,000/week is in that one item. The demand for ketchup is so large and consistent that the item has a smooth, consistent pattern of 6% average deviation in demand.
The minimal need for safety stock keeps expenses very low. This allows the store to offer the item at a great price and still have profit remaining. In fact, if any items begin to experience high deviations, the store might stop offering the item.
Your Local Grocery Store: Approach the ketchup aisle at your local grocer, and you are likely to find ketchup offered in about 15 SKUs, including multiple vendors, sizes, flavors and bottle types. Consumers have options and they will pay for those options.
These options become expensive. That demand of 1,000/week is spread across 15 SKUs, which includes cycle stock and various levels of safety stock. As you can see in the visual above, one or a few items will have high demand and low safety stock needs; yet, most will push to the C & D item ranges. The cost of stocking more items and keeping much more safety stock is reflected in higher prices.
In addition to high safety stocks, these slower-moving items can’t afford to be replenished as frequently as the one fast-moving ‘A’ item. You will have greater cycle stock across the category.
Where Are the High-Deviation ‘Profit Stealers’ Hiding?
At this point, the answer should be obvious.
Narrow your zoom lens down to the items that sell below 10 per period. Then prepare to narrow it again for items in the 0 – 1/period category.
Experience across many retail and wholesale distributors tell us this: higher prices and effective margins can often be maintained on those items in the 1- 10 demand/period range. Customers typically do not shop price on these items, and the items are typically add-on items with lots of flexibility.
Unfortunately, the 0 – 1/month forecast items have a hard time escaping the negative-profit page. Every distributor has a list of items where they are actually losing money. Many of your negative-profit items are likely found in these slowest of items.
Don’t limit your search to the lowest sales ranges; you might find some surprises among items with higher forecasts.
Reducing Profit Loss within Erratic Items
The most important step in making great progress here is the collaboration between Merchandising/Category Managers and the Inventory Planning/Replenishment team. Inventory planning has valuable data that, when used within an integrated business planning strategy, will fuel great decisions.
Most companies are much better at adding items than subtracting items. This strategy has got to change.
Items that were once fast-moving will fall and could begin to be a profit burden. You have to have a process to catch these items and remove them, or at least lower their service goals. The categories have to have limits and rules.
The categories have to have limits and rules
What is your average Demand Deviation for each category of items? Begin to measure and respond to this value. Set a threshold that guides you to remove items from the mix.
There are many case studies of companies whose profitability surged as they narrowed down the number of items in each category. Establish the category values and limits. Stat!
Step 2: Challenge pricing strategies
Find the items that are losing money or living with super-narrow margins and consider price increases that remove the margin loss and provide as much gain as possible.
Many distribution businesses separate their supply chain planning and pricing strategies, but here are some great resources that prove the two should be tightly integrated:
Step 3: Lower service or turn the items to non-stock
Boldly decide if each item needs to be in stock. Remember, replenishment teams typically have the data which Category Management Teams need to make great decisions. If the item has to be there, see if you can return the item to profitability by reducing the service goal and safety stock. Share data, collaborate and win.
Step 4: Spread Demand Deviation Education Across the Organization
The profit-stealing items need to be exposed and understood by all. There might not be another element of information in your company that has more impact on your ability to create profit.
As the owner of a wholesale or retail distributor, you would always want to know the current Average-Dollar-Weighted-Demand-Deviation Value. You would want to know it overall for the Company, by Item Category, by Inventory Analyst, by Location, etc. That value describes the characteristics of demand for your active items and influences your profit picture.
So there you have it. You are now an expert on how to manage erratic demand and high demand deviation. Read Part 2 to learn some tips on managing:
- Long lead times
- High-buying multiples and slow movers
- Service level strategies
- Fixed cycle buying
- Deal opportunities
- And others
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