Leveraging ABC Classification - Part 2

Volume-based product segmentation (or ABC Classification) is one of the best from-scratch product segmentation methods. While more advanced segmentation methods can yield significant additional business benefits, there are some critical factors that signify readiness to make take the next step. These factors are not only the indicators of success; they represent the hurdles you will most likely encounter if you choose to implement a product segmentation strategy.

Check out "Leveraging ABC Classification" if you want to know more about volume based product segmentation.

 

 

How to know when you are ready...

The points below assume that a volume based classification has been implemented. Volume based classification is typically a good place to start. If you have seen some or all of the benefits below since implementing a volume based ABC Classification, the stage is set for a successful advancement of the concept.

1. Customer service has improved. Volume based product segmentation should drive the customer service trend upward. This trend should be particularly evident with higher volume "A" class products. 
2. Total inventory cost has decreased. Inventory typically grows in the early stages of product segmentation strategy deployment. Did you get that? Initially, your inventory will probably increase! Comprehensive product segmentation strategies will impact manufacturing strategy. Higher volume product inventory will grow while slower moving items will gradually ... painfully ... bleed down inventory. This mix shift can result in increased inventory. If you stick to your guns, it will come down.
3. Asset financial performance has improved. These measures will be affected when product segmentation strategies are deployed in manufacturing. The impact depends upon how much the manufacturing schedules are affected. Successful implementers find a way through these fluctuations, and on the other side, find financial performance trending positively.
4. The classification method has not changed. It takes time to navigate through the impact of changing product segmentation strategy. During its implementation, every function will want additional factors considered in the ABC Classification. This pressure comes in addition to the discomfort of having various financial measure fall away from targets. Beware! Succumbing to this pressure universally limits the potential benefits extracted from product segmentation strategies.

How to do it once you are ready...

Once each of the above statements are true, your organization is ready to advance to the final stage of ABC Classification. The next step is to consider one additional variable: Variation. Here is how it works:

1. Calculate the volume of a sample product as per volume segmentation.
2. Calculate the coefficient of variation for each product to be classified. 
3. Create a dot plot with volume across the horizontal axis and coefficient of variation on the vertical axis.
4. Define a threshold line distinguishing low volume and high volume, represented on a graph as a single horizontal line.
5. Define a threshold line distinguishing low variability and high variability, represented on a graph as a single vertical line.

The result will be a dot plot with four distinct quadrants, like this:

This example of a volume variability analysis was taken from Emerald Insight's web page.

Why it works...

Volume variability breakdowns like this can drive effort in a number of different areas. Below are some examples of the characteristics of products in each category that supply chain managers and inventory planners might use to inform their decisions:

• Low Volume / High Variability - These products sell rarely and stock out frequently. Forecast accuracy is low. Service-focused organizations produce these items to protect services and fill any holes in production schedules. This improves plant performance, resulting in high inventory. These products might look like candidates for SKU rationalization, but are often kept active to service a few key customers.
• High Volume / High Variability - Though difficult to forecast because sales are sporadic, when these products do sell the volume is significant. Sales is often driven by growth in emerging or unstable markets. This can cause steady customers in one market to take a back seat while one big order consumes all available inventory. Service problems on these items are typically highly visible, resulting in intense pressure to build "just-in-case" inventory.
• Low Volume / Low Variability - These are mature products that serve steady customers. Forecasts are typically highly accurate, and pattern changes are quickly identified by planners. The slow and steady nature of these products generally keeps them safe from cost-driven inventory reduction efforts. Since they rarely create service problems, these products are "if it ain't broke, don't fix it" portfolio builders.
• High Volume / Low Variability - These products are bread-and-butter revenue generators. Forecasts accuracy is high due to volume and broad reach of these products. Inventory is stable over long periods. their stability makes these products critical to maximizing utilization of key manufacturing assets. However, if inventory has to be reduced drastically in a short period of time, these products will suffer from significant and highly visible service problems.

Tying it all together

Product segmentation methods like ABC classification are not just data manipulation techniques; they are valuable tools for managing numerous aspects of supply chain operations. Most often, supply chain practitioners see a simple volume based classification as too simple to be useful. At the same time, it can be quite difficult to fully leverage the concept for specific improvements in business results. Often, the limiting factor is complexity, which is driven by the need to create consensus around the classification method. The volume variability segmentation offers a robust improvement from the simple volume based classification, while minimizing complexity. Simple to calculate, easy to understand, and practical to use; these are the characteristics of successful segmentation techniques.

Leveraging ABC Classification - Part 1

Supply chain practitioners love to segment products. By far, the most common method of segmentation is the "ABC Classification". Based on the Pareto Principle, ABC Classification is a method for segmenting a product offering. The segmentation can be based on product volume, value, variability, or any number of other factors. It is such a ubiquitous concept that most Advanced Planning Software (e.g. SAP APO, JDA, Logility, etc.) offer extensive capability for calculating and storing ABC Classification. But despite its tried and tested nature, it can be tough for supply chain practitioners to extract tangible business benefit from the concept.

It doesn’t have to be that difficult. Below are some of the tangible benefits, how-to steps for getting started (or restarted), and some tips for maximizing impact.

When it works well…

Maybe your management team is skeptical. After all, they have seen this kind of segmentation a hundred times and it has rarely delivered any notable results. When well executed, ABC Classification can yield a number of significant benefits including:

l Improved forecast accuracy where it counts - Demand Planners can use it to focus forecasting effort and drive maximum value derived from interactions with sales & marketing.

l Lower inventory, same service levels - Inventory Planners can use it to stratify stock targets, resulting in more of the right inventory and less of the wrong inventory.

l Reduced waste and increased efficiency - Production Planners and Schedulers can use it to optimize production frequencies and lot sizes. This can create a positive feedback loop with inventory and forecasting.

l Lower fixed cost absorption and improved asset utilization - Plant managers can use it with their operations staff to optimize plant layout and critical asset placement for debottlenecking, improving throughput without changing headcount.

l Better negotiating position with key vendors - Procurement can even use it to maximize negotiating strength with suppliers

l Enables portfolio management – ABC Classification can help highlight the least valuable products in your portfolio. Identifying is the first step toward improved profitability through rationalization of outdated products and innovation of new products.

l Improves Planning Efficiency – This one is often seen as a bonus, but it is important to note that planner productivity can increase when ABC Classification is well implemented and broadly adopted.

How to…

 

There are many…many different ways to calculate an ABC classification. While the concept might be simple, its execution can be excruciatingly difficult. It can be helpful to have a model to start from to get the ball rolling, so here is a method you can use:

1.   Start with sales volume – Volume-based classification is both simple and easy to calculate, so it makes for a great starting point. Just load historical sales by product code into a spreadsheet, sort in descending order by the total volume and voilà, initial classification.

2.   Establish the percentages – Most of the time, people want more than just the top 80% and the bottom 20%. A more nuanced analysis is required. Experience suggests that the breakdown below provides a good starting point:

·         A = Top 70% - Not typically more than a few hundred codes

·         B = Next 15% - Similar number of codes to C Class

·         C = Next 10% - Similar number of codes to B Class

·         D = Next 4% - Usually 2x or more code than C class

·         E = Bottom 1% - Often thousands of codes

3.   Calculate the classes several different ways – Using sales volume, break down the classification by business unit, category, brand, product family, and producing site. This will help identify the optimal level in the product hierarchy at which to calculate ABC Classification. It will also answer questions that will come from functions about what class materials might be for them.

4.   Demonstrate its utility – Using individual codes, expand the dataset to include forecasted volume, inventory volume and value, production frequency, lot size, and gross margin. A picture of how to optimize the management of the code (or family of codes) will begin to develop.

5.   Commit to a result – Once you understand the potential for improvement, whether if relates to efficiency, capacity, profitability, or volume, connect it to a bottom line or top line improvement and commit.

Maximizing benefits...

With an understanding of the potential benefits and at least one method of implementation, here are some ways you can maximize the business impact ABC Classification can have on results:


1.  Keep it simple - Even if no one likes the way it's defined, ABC Classification should be easy to understand. Preferably within about 30 seconds...people just don't use tools they perceive to be overly complex.

2.   Set ownership in stone – Continuity is the key to a well utilized ABC Classification. This is most likely achieved when ownership and accountability lie within a single function. Ideally, supply chain.

3.   Develop expertise – Allow time to get familiar before making any significant changes to the calculation method. Maximum benefit comes when planners are familiar and comfortable with the method.

4.   Establish results, then upgrade – There may be significant pressure to make the method more “elegant”, but when it comes to ABC Classification, complexity kills results. Resist the temptation to add variables until benefits can be clearly tied to the method. Then tie any changes to specific improvements in outcomes.

Tying it all together…

ABC Classification can be tremendously impactful if it is properly implemented. A clear understanding of a simple approach will put you on a path to rapidly realizing real business benefits.

Want to know more?

Need a Competitive Edge? Look into Cash Conversion Cycle

When the leadership team of a large medical device manufacturer announced that improving Cash Conversion Cycle would be a key part of the strategic plan, it made a lot of folks uneasy. Many of the staff privately admitted they didn’t fully understand the measure. What they did know made cash conversion seem too “high level” to be useful. But an announcement by the VP of Supply Chain made its importance crystal clear: “No more external investment. If you want to grow, you will have to finance it from operations.” Freeing up cash became a top priority. A Cash conversion cycle in excess of 100 days highlighted the low hanging fruit like no other measure could: Too much cash was tied up in inventory.

Long cash conversion cycle is like an old lady driving a 69 Camaro SS; though the car is capable, it won’t win many races. The shorter the cash conversion cycle the closer the driver gets to the car’s full capabilities. If the driver is Amazon, she can do a big, smoky burn out…blowing away the competition. That is what cash conversion can do for your business.

Cash conversion is a highly visible measure of your organization’s supply chain performance. Connecting performance objectives and improvement ideas with a specific cash conversion outcomes can be transformative for your business. Here are some things you should consider if you want to supercharge your organizations cash conversion cycle.

Cash Conversion for Supply Chain Managers

First, let’s demystify the concept. After having spent a fair amount looking through old textbooks (and Google of course), I am taking a crack at "defining" cash conversion for regular, non-financial type managers. This is as simple as I know how to make, so if you need something more official sounding I encourage you to look it up on Wikipedia:

Cash Conversion Cycle is a measure of the time between receiving materials from a supplier and receiving money from buyers of your finished products.

Cash conversion is typically expressed in a number of days and generally ranges from a few hundred to less than zero. Companies like Amazon and Wal-Mart are so good at cash conversion they have negative cash conversion cycles. When cash conversion goes negative it means the business is turning product into cash before the bills come due! This provides maximum financial flexibility and is the place to be if your company is trying to grow through acquisition.

Cash conversion cycle is composed of three primary components:

1)      Days Payable Outstanding or DPO

·         How long creditors give you to pay them. Since payment terms are usually governed by contract terms, and procurement usually negotiates contracts, Procurement often has the most influence over DPO.

2)      Days Inventory Outstanding or DIO

·         How long your inventory will last at current sales levels.  DIO performance is most often directly controlled by supply chain functions (e.g. Manufacturing, Logistics, Distribution, Operations)

3)      Days Sellable Outstanding or DSO

·         How long you give customers to pay you. Generally, accounting and/or corporate finance functions have the most influence on DSO performance.

Benchmarking Cash Conversion Cycle

Many times leaders don’t react well to external benchmarks. While it is fair to say that no two business are exactly alike, external benchmarks can help you craft the change message, especially if there is a significant gap between your company’s performance and that of a competitor.

According to the Medical Device and Diagnostic Industry Web sitethe companies listed below are among the top 10 medical device companies in the US. They provide an interesting industry perspective to illustrate cash conversion cycle
Here is an example:

Company	CCC	DSO	DIO	DPO	Inventory Value (USD Bn)
Johnson& Johnson	70	61	41	-32	$12.90
GE Healthcare	44	45	53	-55	$13.70
Seimens AG	98	62	73	-37	$20.60
Medtronic	114	86	41	-13	$1.80
Covidien PLC*	137	52	128	-43	$1.70
Novartis AG	72	65	43	-36	$6.70
Cardinal Health Inc*	8	22	28	-42	$7.90

 *Note: For consistency, I calculated cash conversion using a negative value for DPO. Rocket’s financial analysis depicts DPO as a positive value. Sources: 

http://www.stock-analysis-on.net  & Rocket Financial

(To give you an idea of how easy it is to develop external benchmarks, this table was compiled with a slightly-better-than-dial-up internet connection in less than an hour.)

I like the contrast between Cardinal Health and Covidien. Cardinal is heavily involved in hospital and wholesale distribution, whereas Covidien is primarily a medical device manufacturer. Cardinal’s DIO of 28 days suggests that they are the best product mover on the list. Covidien may have less money tied up in inventory, but a DIO of 128 days suggests that their inventory position (compared to sales) is at the very least conservative. Comparing the two make a pretty clear statement about Covidien’s potential opportunity to lean out inventory.

Obviously this is not the whole picture. I am sure the management at Covidien has perfectly good reasons for their cash conversion cycle. But I think the analysis illustrates the utility of the cash conversion metric, and how it might be useful to supply chain leaders.

Putting it all Together

So, let’s say you're on track to understanding Cash Conversion Cycle and after perusing the analysis you think it could really help your organization. Before you jump in head first, here are some tips that can help you secure buy in and maximize results:

·         Educate, educate, educate – If you find your colleagues scratch their heads when you mention cash conversion, arm them with information. A couple of slides with references are easy to develop and can lead to much broader buy in.

·         Benchmark – External benchmarks are good, but the best benchmark is your own organizations past performance. If you are part of a larger corporation, look into how other business units are doing. Worst case, you can start measuring it right now.

·         Collaborate – Changing cash conversion results is truly a team effort because of its broad scope (receivables, inventory, payables). That makes coordinated cross functional effort vital to creating and sustaining improvement.

·         Create meaningful performance objectives – Typically, ERP systems have gigabytes of information on inventory, so it might be easy to break total inventory value down by stock type (i.e. Raw Material, Work-in-Process, Packaging Material, Finished Goods, Etc.) Pushing the data as low as possible enables driving the target as low as possible in the supply chain organization.

·         Align performance objectives with Cash Conversion results – particularly in supply chain, but also across the entire organization, it is possible to drive cash conversion targets into the performance objectives of every team member.

Here is an example of how you might segment accountability:  

Function	CCC	DPO	DIO	DSO	Inventory Value
Leadership Team	X
Sales					X
Marketing					X
Supply Chain	X		X		X
Logistics			X		X
Operations			X		X
Manufacturing			X		X
Scheduling					X
Demand Planning					X
Procurement		X			X
Finance	X			X	X

Notice the Leadership Team is measured only by cash conversion.  It tends to be a good measure of the whole leadership teams effectiveness. As you drive the target down, more detailed targets will help keep the objective smart for each person. For example, a raw material planner could have an aligned inventory value target for the portfolio they manage, but because Cost of Goods Sold is typically only accrued against finished goods, a DIO target would probably seem too abstract.

Leverage Cash Conversion Cycle for Success

Cash conversion can be a fantastic tool for defining meaningful opportunities to improve your company’s financial performance. Even better, it can be sliced and diced at detail levels that enable comprehensive vertical alignment with even rudimentary enterprise data systems. Take a look at cash conversion and think about how your boss, you customers, and your company’s shareholders would view breakthrough, best-in-class outcomes. You might find it is worth a look.