Improving Service Level and

Business Performance Through

Inventory Optimization
The common perception is that inventory optimization (IO) ultimately
means cutting inventory. To many disciplines in an organization, particularly
the sales and customer service teams, this often comes across as a disaster
waiting to happen, since it is perceived as an exercise with one goal in mind
to cut thus putting service levels at risk. Its no wonder then that the
concept of inventory optimization as a tool to right size the inventory is
often met with some skepticism.

February 2014

Analyst Insight
Aberdeens Insights provide the
analysts perspective on the
research as drawn from an
aggregated view of research
surveys, interviews, and
data analysis.

The fact is that IO by design is the ideal tool to set inventory goals required
to hit the service level targets that need to be achieved. To highlight the
value of IO and its competitive advantage, our October CSCO Survey
revealed that the ability to better understand the tradeoffs between service
level and inventory investment was one of the top three capabilities for the
Best-in-Class. Perhaps more importantly, it was the number one capability
by far in terms of the largest differential compared to Industry Average and
Laggards, 86% to 54% and 36% respectively. Understanding the tradeoffs
between inventory and service level is what an IO solution delivers and the
Best-in-Class have clearly capitalized on it. A potential four-point
improvement in gross margin (Table 3) is an improvement that any business
would be interested in.
This report will look at the impact of inventory optimization not only in
traditional areas of improvement, such as obsolescence and carrying cost,
but also on service level and business metrics, such as gross margin. We will
examine the inventory optimization (IO) process itself to show how it can
be used in a predictive nature toward hitting service level targets. And
finally, we will discuss the use case tactically and strategically, along with
some key recommendations for all maturity levels. For this report, we
grouped single respondents using IO or Multi-echelon Inventory
Optimization (MEIO) and compared them to those that do not use either
solution, i.e., non-IO users.

Business Pressures Affecting All Companies

To further emphasize the connection between inventory and service level,
the top two business pressures shown in Figure 1 are reducing inventory
carrying costs to improve gross margin and improving service levels. The
juggling act that goes on between these two pressures is often viewed as a
win/loss exercise, which this paper will show is unwarranted when using IO
to determine those tradeoffs.
This document is the result of primary research performed by Aberdeen Group. Aberdeen Group's methodologies provide for objective fact-based research and
represent the best analysis available at the time of publication. Unless otherwise noted, the entire contents of this publication are copyrighted by Aberdeen Group, Inc.
and may not be reproduced, distributed, archived, or transmitted in any form or by any means without prior written consent by Aberdeen Group, Inc.

Improving Service Level and Business Performance Through Inventory

Optimization
Page 2

The combined pressure is to get inventory levels and the associated carrying
and obsolescence costs down to their lowest levels, while maintaining or
increasing service levels. By reducing carrying and obsolescence costs, the
third business pressure identified can be more effectively dealt with, which
is to reduce the product price to remain competitive without losing profit
margin.
Figure 1: Business Pressures
Need to reduce inventory carrying
costs to maintain or increase gross
profit margin

66%

Need to improve service levels

51%

Market pressure to reduce product

price

26%

0%

20%

40%

All Companies
60%

80%

Percentage of Respondents, n = 120

Source: Aberdeen Group, April 2013

Top Three Actions for IO Practitioners

Figure 2 shows the top three actions being taken by those using IO
compared to those that are not. We will discuss these in some detail, since
they are key to understanding how IO is used to improve service levels.

Improving Inventory Modeling

The first initiative, to improve inventory modeling, safety stock setting, and
inventory mix, is no surprise since that is the purpose of IO. The nature of
the modeling can be both tactical and strategic.
Tactically, the process involves review of each SKU (stock keeping unit) and
looks at the actual demand, compared to forecast, plus the actual receipt of
goods from the supply side compared to the plan. The safety stock is set
based on a given service-level target. The value of this approach is to
understand whether there are issues, from the forecasting accuracy point of
view or from the supply side execution that might affect the required
stocking level. With historical forecast accuracy being factored into the
equation for safety stock, achieving service level goals becomes predictive as
an outcome. The target setting is done on a fact-based view of performance,
which often results in increases for some products to meet demand, as well
as reductions for products that are overstocked.
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Improving Service Level and Business Performance Through Inventory

Optimization
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The greatest threat to inventory stocking policies is fear of the unknown,

which results in hedging at the planning level to ensure availability. This
typically occurs when inventory targets are set using a rule of thumb
approach, where fact-based information about each item is unknown or
approximated at best, or the systems in place cannot support SKU-specific
inventory policies/targets.
Strategically, IO can also be used to answer some of the tough questions,
such as where product should be made or the impact of facility closures at
the distribution or manufacturing level. Network optimization tools are
often used to address this question from a network cost standpoint
(primarily transportation and labor differences) but do not necessarily tackle
the inventory/service level tradeoffs. As noted in our case study in the 2012
report, Inventory Optimization - Impact of Multi Echelon Approach, the ability to
answer these what if questions (for example the impact of potential
closures or product moves on service and stocking levels based upon the
closure of a key facility) were feasible within hours. Whereas in our case
study example without the multi-echelon IO tool, the answer was
impossible to simulate manually in the time window required. With
increasing demand volatility due to the empowered customer, being able to
quickly discern the impacts of channel changes and adjust stocking policies
at the network level across multiple facilities is a competitive advantage. It
can have a huge impact on distribution and fulfillment costs by properly
aligning the inventory stocking levels with changing channel patterns.
Figure 2: Top Three Actions for IO Users
76%
67%

Improve inventory modeling, safety

stock setting, inventory mix

70%
62%

Improve demand forecasting accuracy

50%
52%

Improve inventory replenishment

strategies
Inventory Optimization
No Inventory Optimization

0%

20%
40%
60%
80%
Percentage of Respondents, n = 120
Source: Aberdeen Group, April 2013

Improving Demand Forecasting Accuracy

IO users are more likely to launch an initiative to improve forecast
accuracy. The driver behind this action is that they see greater improvement
in their modeling from better forecast accuracy than supply variability. That
does not mean that there may not be issues associated with supply, either at
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Improving Service Level and Business Performance Through Inventory

Optimization
Page 4

the manufacturing or supplier level, but improving forecast accuracy will

yield a greater return. In our August 2013 report, Inventory Optimization:
Balancing the Equation for Enough but not too Much, this fact came to light.
The top action for the Best-in-Class was to improve forecast accuracy and
they were much more likely to take this on versus all other maturity levels,
87% compared to 57%. As shown in the capabilities and enablers section,
the Best-in-Class have typically already deployed IO as part of their
capabilities and improving forecast accuracy is their first choice to improve
their supply chain modeling.
Improving forecast accuracy may come in two forms, the first being a bias
and the second being process changes, such as customer collaboration to
improve the timeliness and accuracy of information used to develop and
maintain the forecast. Bias can be seen in the SKU review and deals with the
issue of forecasts coming in consistently high or consistently low compared
to actual. Bias is not unusual when initially tackling forecast accuracy and
once realized can be factored out, leaving process improvement as the
challenge for further improvement.

Improve Inventory Replenishment Strategies

The third action, to improve inventory replenishment strategies, does not
show tremendous variation between IO and non-IO users, which may mean
that supply issues are similar across all groups and are not driven by the IO
process itself, whereas improvement in forecast accuracy was clearly seen
as a key action to undertake with quantifiable results based on the reduction
in forecast error. Since the safety stock targets are determined based on
historical accuracy, improvement in that accuracy will directly affect the
level of safety stock recommended in a favorable direction.
Although not as likely to be a point of concentration as forecast accuracy,
50% are still focused on improving replenishment strategies. The list may be
exhaustive to improve replenishment strategies, but tackling areas such as
postponement strategies, cycle time improvement in manufacturing, or even
review and upgrade of suppliers, are the type of actions that might apply.
Policies that alter the frequency of replenishment or change the point of
replenishment might also become factors. Using IO can help pinpoint which
products are susceptible to supply issues so that root cause and corrective
action can be applied.

Superior Capabilities Reflected for IO Users

In order to implement the top three actions, the capabilities that are in
place for those using inventory optimization stand out compared to those
that do not use inventory optimization. Reviewing Figure 3 reflects the key
capabilities and the sizeable gap between the two groups.
Having the ability to calculate safety stock at key nodes in the supply chain is
nearly self-explanatory. Without that ability, estimates or rule of thumb
policies come into play, which lead to hedging and excess buffering to
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Improving Service Level and Business Performance Through Inventory

Optimization
Page 5

ensure availability. The differential itself of 80% compared to 42% indicates

the overwhelming advantage the IO users have over those that do not use
IO.
The same observation applies for the ability to analyze demand patterns and
create accurate SKU-level forecasts. Using IO to review these numbers by
SKU provides immediate feedback on whether the variability is outside of an
acceptable process control. That is also why it is number one on the list for
Best-in-Class and is number two on the list for IO users to tackle. Without
an IO tool, it would be very difficult to have the visibility into whether or
not forecast accuracy has an effect on stocking or service levels. The
substantial gap between IO users and non-IO users of 78% to 48% again
indicates the huge advantage IO users have in analyzing SKU-level demand.
Figure 3: Capabilities
Ability to determine safety stock
targets for inventory at critical nodes in
the supply chain
Ability to analyze demand patterns and
create accurate stock keeping unit
(SKU)-level forecasts

78%

48%

Measurement of customer service

levels during the execution phase

51%

Availability of end-to-end inventory

data for performing inventory
management functions
Inventory Optimization
No Inventory Optimization

80%

42%

38%
0%

67%

59%

20%
40%
60%
80% 100%
Percentage of Respondents, n = 120
Source: Aberdeen Group, April 2013

Measurement of customer service levels during execution (fulfillment and

distribution) indicates the predictability of knowing the outcome on service
for operational decisions that are being made. Again, those utilizing IO have
a distinct advantage (67% to 51%) which supports the position that
inventory optimization will result in better service levels.
Availability of end-to-end inventory data when performing inventory
functions addresses the fundamental visibility question. Only 38% of those
without IO capability have that ability, compared to 59% of those with IO
tools. Without visibility into what is going on at the SKU level, developing a
fact-based plan is almost infeasible for non-IO users and is reflected in the
resulting metrics as covered in the next section.

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Improving Service Level and Business Performance Through Inventory

Optimization
Page 6

Proving the Case with Metrics

After reviewing the advantages that IO users have over those not using
inventory optimizations tools, we now examine the metrics to determine
how well they carry through into business performance. Improvements in
inventory-specific related metrics are expected simply because that is what
IO tools address, but examining service level and financial results will prove
the case that using inventory optimization will result in improved service
levels.

Inventory Related Metrics

Table 1 reflects the actual percentage decrease in costs associated with
improved inventory results for those IO users compared to non IO users.
As expected, there are clearly cost benefits coming from improved
obsolescence and reduced inventory carrying costs. The decrease in
obsolescence cost is 24% greater for IO users and carrying cost decreases
are 33% greater. When looking for ways to cut costs, inventory
optimization delivers. These improvements can show up in one of two ways,
either in margin improvement or as an enabler for companies to address the
third business pressure to reduce product prices without negatively
impacting margins.
Table 1: Costs
Data Summary

With IO

Without IO

Obsolescence cost reduction % Decrease

42%

34%

Carrying cost reduction % Decrease

36%

27%

Source: Aberdeen Group, April 2013

Table 2 reflects traditional inventory KPI improvements that also translate

into better financial metrics. The improvement in finished goods (FG)
inventory turns again shows a significant advantage for the IO users over
those that are non-users (51% improvement vs. 23%), which is more than
double. But improvement in FG turns is a result of cutting inventory in total,
which is exactly the fear of those who are concerned about the impact on
service. So this needs to be reviewed in context with the service level gain
or loss.
Table 2: Inventory and Asset Management
Data Summary
Finished Goods Turns improvement %
Average Cash Conversion Days

With IO

Without IO

51%

23%

28 days

33 days

Source: Aberdeen Group, April 2013

The KPI of average cash conversion also shows a 15% decrease for the IO
users, which is the equivalent of returning that percentage of cash to the
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business to use in other ways such as capital equipment, acquisition,

expansion or funding other critical initiatives. However, improvements in
inventory and cash flow must be measured in conjunction with service level,
which we examine next.

Service Level and Gross Margin Metrics

Table 3 shows the improvement in service level for those with and without
IO. Arguably, if service level remained the same and inventory was reduced,
it would still be a gain for the business, but the results are much better than
that, with 80% of the IO users reporting that service level remained the
same or increased compared to 62% for those not using IO. Discounting
those who stayed even, the percentage of those who reported an increase
easily favored the IO users at 49% compared to non-users of 39%.
The question is answered. Using IO solutions does improve service level in
addition to a reduction in inventory itself and the costs associated with it.
Table 3: Service Level and Business Metric Improvement
Data Summary

With IO

Without IO

Perfect order percentage (on time and

complete) to customers Remained the
same or increased

80%

62%

Perfect order percentage (on time and

complete) to customers showed increase

49%

39%

Gross Margin %

26%

22%

Source: Aberdeen Group, April 2013

The gross margin reflects a four-point improvement for IO users compared

to non-users, which is a huge improvement. For a company of $100 million,
that is $4 million improvement that falls to the bottom line. Whether that is
used to improve profitability or used to offset reduced product pricing in
the marketplace, four points are significant.
Not only does IO drive improved service level performance, it also drives
superior financial results as well, which makes an IO solution a compelling
argument.

Key Takeaways
Inventory Optimization goes beyond addressing inventory levels and
reducing carrying cost and obsolescence costs. It results in improved service
levels and overall business performance as shown through the improved
metrics. Summarizing briefly, those companies using inventory optimization:

Have the ability to set safety stock at critical nodes in the supply
chain and determine forecasts at the SKU level (80% vs. 42%).

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Improving Service Level and Business Performance Through Inventory

Optimization
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Show a 24% greater decrease in obsolescence costs and 33%

greater decrease in carrying costs.

Show an improvement in service level (49% vs. 39%) of non IO

users.

Show a four-point improvement in gross margin.

Inventory optimization can be a game-changing solution for companies that

have never considered it as a must-have solution. Not only does it drive
improvements in traditional inventory KPIs but it also results in substantially
improved service level and business results. Given the demand volatility and
fulfillment challenges serving multiple channels, IO becomes top of mind as
an essential solution to help manage the changing environment, tactically and
strategically. Spreadsheets and rules of thumb are no longer sufficient or
competitive. If not already in place, invest in inventory optimization now!
For more information on this or other research topics, please visit
www.aberdeen.com

Related Research
Inventory Optimization: Balancing the
Equation for Enough but not too Much;
August 2013
Inventory Optimization - Impact of Multi
Echelon Approach; February 2012

Inventory Optimization: How Best-in-Class

Stack Up on Customer Service
Performance While Optimizing their
Inventory; March 2012
Demand Planning: Renewed Focus for
Companies to Drive S&OP and
Operational Improvements; November
2012

Author: Bryan Ball, Vice President and Group Director, Supply Chain Practice
(bryan.ball@aberdeen.com)
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This document is the result of primary research performed by Aberdeen Group. Aberdeen Groups methodologies
provide for objective fact-based research and represent the best analysis available at the time of publication. Unless
otherwise noted, the entire contents of this publication are copyrighted by Aberdeen Group, Inc. and may not be
reproduced, distributed, archived, or transmitted in any form or by any means without prior written consent by
Aberdeen Group, Inc. (2014a)

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