Adam J. Fein: Building a lean supply chain

There is a widely held, but inaccurate, perception that new technologies have led directly to declines in the inventory-to-sales ratio, an important indicator of “buffer inventory” in the supply chain. In theory, information technology-based supply chain practices such as just-in-time (JIT) inventory management, warehouse automation, and the introduction of bar codes should have allowed companies to improve their management of orders and stockpiles of materials. 

However, the empirical evidence for leaner supply chains is surprisingly weak. Economic research studies continue to find that aggregate manufacturing, wholesale, and retail inventory-to-sales ratios remain within historical ranges. For example, the inventory-to-sales ratio for wholesale distribution was essentially unchanged in the 1990s and has only begun trending down slightly in the past four years. 

I recently conducted my own study of 45 manufacturing, wholesale distribution, and retail trade industries during the 12 year period from January 1992 through December 2003. (The full research paper is available from the Census Bureau’s Center for Economic Studies.)

To my surprise, half of the 18 major sectors within the wholesale distribution industry had no meaningful change or experienced an increase in the inventory-to-sales ratio from 1992 through 2003. Information technology may indeed have improved inventory management, but this improvement was not reflected in a key performance metric for many parts of the wholesale distribution industry.

The pharmaceutical industry provides a useful case study that illustrates why technology is necessary but not sufficient to build a lean supply chain. 

Until 2002, most drug makers compensated wholesalers by allowing them to purchase more products than near-term sales demand required. Since drug prices were increasing, wholesalers could earn as much as 40% of their margin by holding extra inventory and selling it when prices increased. Wholesalers’ operational efficiencies and a low cost of money enabled the profitability of this system by minimizing inventory carrying costs. 

Note that excess supply chain inventories persisted despite highly sophisticated warehouse management technology use by wholesalers. For example, more than 90% of products received by wholesalers are bar coded and one-fifth of invoice lines are picked in warehouses by fully automated methods. 

Channel relationships were transformed only after manufacturers and distributors began signing new fee-for-service and inventory management agreements in 2003. Today, manufacturers are successfully paying U.S.wholesalers not to hold more than one month of inventory. Most arrangements offer some form of performance benefit to help distributors offset revenues they’ve lost by discontinuing inventory investment. For example, wholesalers can receive higher payments for making more accurate forecasts of prescription demand.

As a result of these new business arrangements, the inventory-to-sales ratio in the wholesaler channel has declined by 50% in the past four years even as total wholesaler sales grew by one-third. Distributors have avoided adding an incremental $7.5 billion of inventory to their balance sheets.

Naturally, this lean supply chain behavior is being enabled by new technology linkages between trading partners. Wholesalers continuously share order, inventory-to-sales, and shipment data with manufacturers. Manufacturers use real-time analyses of these data to evaluate wholesaler orders, balance inventory-to-sales levels in the channel, prevent leakages into the secondary market, manage service fill rates, limit unauthorized distribution, and compensate wholesalers for accurate and complete reporting. 

The business benefits of new relationships are being felt throughout the health care supply chain. Manufacturers can automate manual processes, better comply with new accounting regulations, and lower supply chain costs associated with unanticipated fluctuations in order patterns. Wholesalers have benefited from sharp increases in operating cash flows thanks to a reduced need for significant inventory sales investments. Limits on excess channel inventories also improve the likelihood that products reach the right patients.  

As I point out in The Productivity Imperative, technology alone neither replaces a clear business strategy nor mandates business improvements. Wholesale distribution executives in other industries should use the pharmaceutical example to begin new discussions with efficiency-focused manufacturers. Joint lean initiatives, such as explicit inventory management agreements or fee-for-service contracts, can make a channel partnership more productive and lead to win/win results.  

Innovative wholesale distribution executives should consider taking the initiative to upgrade channel management dialogues with suppliers so that both parties can reduce costs and raise productivity. Identify which of your suppliers have robust, effective lean manufacturing programs and find out if they are interested in extending their efforts to collaborate on genuine supply chain improvements. Show manufacturers that supply chain improvements can offer economic benefits to distributors, thereby offsetting the need to always offer discounts and rebates as incentives to distributors. 

Distributors should “lead from the middle” to cement relationship with their most important suppliers. Ultimately, customers will benefit as supply chain productivity leads to higher service levels and lower acquisition costs.