More and more companies are paying closer attention to managing end-of-lifecycle (EOL) inventories in an effort to lower costs and boost product lifecycle profitability. As products age beyond useful life, they consume increasing amounts of resources and negatively affect customer satisfaction. Increasingly, companies are recognizing that they need policies and procedures in place that address this situation.

The EOL inventory problem is widespread, affecting many companies in many industries. Consider the following example from a major manufacturer of computer servers and mainframes. This company recognized that it had a problem with slow moving and obsolete (so-called “SLOBS”) inventory. But it didn't realize the extent of the problem until it did a thorough accounting that identified approximately $500 million in such inventory. The company took corrective action and almost immediately saw an improvement in its earnings per share.

A big reason for the EOL inventory problem is most companies focus their efforts on the early stages of the product's lifecycle as they rush to get it out the door. They pay comparatively little attention to the later stages of the cycle when products reach the point of high maintenance and low sales. Yet it's at this stage—when companies struggle with questions of if, when, and how to terminate—that unsold products begin to consume a lot of money and resources.

This article speaks to that end-of-life dilemma. It offers approaches and techniques to reduce the impact of price erosion over the product lifecycle, to improve cash flows, and to lower variable and indirect operational costs associated with managing the SLOBS. In particular, we delve into product inventory disposition (PID), a technique for continually evaluating viability and profitability throughout the product's lifecycle. We also look at the causes of excess inventory, examine the related financial impact, and offer guidelines for moving forward on managing the product lifecycle.

Before considering the techniques for managing the EOL slow-moving inventories, it's helpful to first explore the question of why excess inventories are generated in the first place. Ideally, you would produce exactly the right amount of inventory to meet real demand—no more or less. But in reality, excess inventories are everywhere. They range from safety stock, to excess promotional products, to a variety of goods in the returns pipeline. (Exhibit 1 summarizes the types of excess inventories and the conditions that can lead to them.)

Companies have adopted a number of techniques to mitigate the excess inventory problem. Some, for example, try to build to order or build to demand on a short-term basis, hoping to lessen the impact of excess inventory down the road. Some companies simply scrap slow-moving and obsolete products. Others attempt to make markets for their SLOBS using antiquated, labor-intensive systems that employ, for example, phone/fax/e-mail routing of inventory lists to a captive broker audience. Still others, including large retailers, engage third-party providers of reverse logistics services to clear channels of goods such as appliances and hardware. One such provider, GENCO, recently created the position of “junk man” to aid their clients in disposing of returns in the resale market or in scrap markets.

Even eBay has entered the fray. The online company has enabled users to buy a pallet of EOL products and then sell units of one to buyers. The eBay traders engage firms like UPS and FedEx to move the products from garage and home-office backroom operations to consumers.

Countervailing these efforts are the incessant pressures by sales to offer broader product lines and by major customers to provide specific stock-keeping units (SKUs). More often than not—and despite the mitigation efforts that may be in place—many companies continue to struggle with product proliferation and a concentration of slow-moving items (some with as little as one sales hit per year after three years). As products mature and go into declining sales, inventory risks increase, prices erode rapidly, and promotional expenses escalate as companies try to clear this inventory. Plus, these products consume an inordinate amount of time and resources to manage.

As ultimate consumer demand for the product declines, inventory at the original equipment manufacturer (OEM) increases as parties in the trade channels start returning products. This increase forces firms to dispose of inventories through liquidation sales (typically at cents on the dollar) and eventually to scrap products. Higher levels of product returns combined with poor management of excess and end-of-life inventory lead to higher inventory reserves overall. With inventory carrying costs approaching 50 percent, the end result is lost profits and lower earnings.

Better forecasting over the product lifecycle is part of the answer. The problem is that accurate forecasting is difficult given all of the forces and factors that can occur in today's business environment. A forecast with 70-percent accuracy is considered good in some industries. But that accuracy level obviously still leaves a huge margin for error.

Having a solid sales and operations planning (S&OP) process is a positive step toward more closely matching demand with supply over the product lifecycle. But S&OP processes seldom address all of the conditions leading to excess in inventory shown in Exhibit 1, particularly those associated with the later stages of product lifecycles. Clearly, what's needed is a structured approach for analyzing the complete product lifecycle and for disposing of EOL excess inventories in a way that minimizes costs and maximizes profit potential.

In pursuing such a structured approach to EOL inventory, you first need to address some basic questions:

How should the product lifecycle be defined? Product lifecycles (PLCs) can be defined in many ways—by firm and its overall company profitability growth, by industry and market share, by business unit and/or region, by product line, by individual SKU, or by engineering changes occurring during the product's life. Oftentimes, PLCs within an organization are defined in different ways, further complicating the EOL management challenge. For the sake of simplicity, this article will focus on individual SKU PLCs in which inventories are put at risk as competition increases or as the firm introduces engineering changes.

How should products be defined? The product itself can be defined in different ways, too, for example:

• By individual SKU independent of any engineering or upgrade change.
• By unitized SKUs that incorporate engineering changes that extend the product lifecycle.
• By unitized promotional SKUs (for example, suppliers preparing private-label and large-volume SKUs for big box retailers and distributors).
• By like functionality, in particular products that use old technology but are still usable and saleable.

What time period of analysis is appropriate for your company? Consumer electronics, computers and peripherals, telephones, and cameras are just a few examples of products with a relatively short PLC—often months and sometimes even weeks. Pharmaceuticals or industrial machinery PLCs typically stretch out over years. You need to make the determination of what's right for your particular company.

What basis of measurement should be used for PLC analysis? For example, measures could be based on units of sale or dollars of sale revenue with associated costs that vary with production volume.

How will the company determine the impact of “cash flow” on profitability? The analysis here focuses on outflows, inflows, period cash-flow returns, and discounted present values of net cash flows over the product lifecycle.

With the basic questions addressed, a company can begin its systematic approach to meeting the PLC challenge. We recommend that a cross-functional S&OP team take the lead here. It should be composed of decision makers from engineering, research and development, marketing, sales, operations, logistics, purchasing, finance, and accounting. A strong supply chain management planner should be named to head the effort. This individual should be able to build consensus and communicate persuasively with senior management. Consensus and top management buy-in is critical since the PLC management process has an impact on so many parts of the organization.

The first step in creating a systematic approach is to break down the different stages of the product's lifecycle, which we have defined in the context of the individual SKU. The S&OP team should conduct a cash flow and profitably analysis within each of the following seven critical stages. (The abbreviations in parenthesis are used in the PLC charts in Exhibit 2.)

1. New Product Basic Research (NPD BR). During this stage, the firm assesses the product's commercial viability. Research and development, engineering, marketing, and top management all typically participate here. The team uses prototypes or test products to look at possible functionality and benefit feasibility at this stage.

2. New Product Capacity Planning (NPD Cap). The economic feasibility of producing this product in volume is evaluated at this point. Required capacity, manufacturing location (inside or outside of the United States), production learning curve, and total landed costs are among the factors considered. Firms need to ask whether this is an entirely new product requiring a substantial investment in production capacity or if existing capacity is available. They also need to ask if supplies and supply chain resources are available to produce this product economically.

3. Introduction of SKU to market (Intro). Here companies need to assess the costs of readying products for market entry and sales to early adopters. The costs of building inventories to stock channel inventories for major marketing and sales promotions are also considered here.

4. Growth (Growth). This is the steep sales curve of the product lifecycle as broad market adopters buy the product. Inventories are now being produced to demand.

5. Maturation (Maturation). As the product matures, laggards now are also buying the product, which leads to an overall increase in sales. Yet prices begin to erode as competition forces marketing and sales to cut prices. At this stage, engineering upgrades often are implemented to prolong the product lifecycle. In these cases, the old product must be cleared from the trade channels.

6. Decline (Decline). Sales decline, and prices erode by as much as 33 percent in this stage.

7. Termination (EOL). Production stops. Liquidation sales may take place with many products sold at ten cents on the introductory sales dollar price. Most firms have business policies for returns that bring back inventories, which sometimes reach millions of dollars. Return policies typically entail extremely high costs in reverse logistics and recuperation.

The next step is to analyze the product lifecycle for ways to minimize costs and maximize profits at each of these stages, particularly in terms of inventory disposition. One effective technique that a number of leading companies have adopted is called product inventory disposition (PID), a concept originally developed by FreeFlow.

FreeFlow is an Irish-based firm that began about five years ago to help companies manage at-risk inventories late in the product lifecycle. The firm helps clients efficiently make markets for and dispose of EOL inventory in a way that maximizes available return on investment. PID is, broadly speaking, a technique for identifying at-risk inventory and determining the best disposition options. It involves continual analysis of lifecycle stages, regardless of where that product is located in the trade channels. The PID approach consists of four steps:

1. Define inventory thresholds for each stage of the PLC from initial production prior to introduction to termination. The primary objective of this initial step is to determine the thresholds above which inventories are considered “at-risk” and, as such, are eligible for progressive disposition. Exhibit 2 depicts a typical PLC based upon units of production, sales, and inventories for a SKU in the consumer electronics industry. Note that the PLC starts with NPD-BR and goes to EOL, spanning less than a two-year period. It's important to note that once products are produced in volume—even before market introduction—inventories can be at risk (the potential excess and obsolete (E&O) inventory line on the chart). The S&OP team needs some sort of business intelligence system to help them determine which inventories will become at risk and at what point in the product lifecycle.

As part of a sound PID approach, S&OP teams also need data relative to production, sales, and inventories for each stage of the lifecycle. Using these data at weekly planning meetings, the team can determine how much inventory is at risk and how and when it should be disposed. Inventory levels above the thresholds set are deemed to be at-risk and, as such, are eligible for progressive disposition. Examples could include: excess active inventory (disposition within 16 weeks), EOL and at-risk inventory (disposition within four weeks), and returns inventory (disposition within one week).

2. Develop mechanisms for the effective disposition of the identified inventory. Different types of inventory need to be disposed of in different ways. For returns inventory, disposition mechanisms might include competitive online auctions, product sold “as-is,” or product sold refurbished. For excess at-risk active inventory, a good disposition solution might involve developing of a private marketplace between the manufacturer and members of its trade channel.

Creating effective product-disposition mechanisms is the most resource-intensive part of the PID process. Because of this, many companies elect to engage the services of external partners to assist in this activity. (For more on this option, see the discussion below on “Financial Impact of Improved PID Process.”)

3. Assign primary ownership and accountability for product disposition. Identify who in the organization is responsible for inventory disposition. One department or set of individuals does not necessarily have to be responsible for everything. The tasks can be broken down according to the thresholds established in step one. For example, it might make sense for sales to handle disposition of active inventory. The supply chain S&OP team might be in the best position to manage the disposition of returns and other excess at-risk inventory.

4. Measure performance. Metrics matter. Develop metrics that express excess inventory levels as a percent of overall inventory and track it as a trend. Do the same for related expenses such as warehouse and inventory-carrying costs. The best metrics are expressed as dollar costs. These will give you meaningful insights when analyzing cash flows, tracking asset-recovery dollars, and finding ways of driving increased recovery of sales dollars while reducing product-disposition costs.

So far the discussion has centered on managing “unit” inventories. But top management is interested in earnings, and finance, accounting, sales, and marketing are primarily interested in “dollars.” Therefore, the PLC analysis also needs to be expressed in dollar sales. The translation from unit inventory to dollar costs is no small task. To do the job properly, the S&OP team and functional units must associate unit sales with the work involved in producing that unit and consider the costs associated with building inventories and fulfilling customer demands.

Doing so, however, can be an effective way of expressing to the company the importance of managing the whole product lifecycle. Exhibit 3, for example, depicts how unit sales, expressed as dollar sales, can erode over a 12-month product lifecycle period. The top curve shows the dollar sales where a PID service had been used (specifically, PID service after transactions expenses). The bottom curve is without a PID service. The main message here is that the dollars associated with a product drop sharply as the product matures. This graphic clearly shows that effective management of the whole PLC—with or without the use of a PID service—is absolutely essential to profitability.

• Invested cash from changes in operations as affecting the income statement.
• Sources and use of cash in the balance sheet.
• Profitability as measured by gross margin contribution divided by net cash-flow changes in the income statement and balance sheet across the full product lifecycle.
• The time value of money expressed as the discounted, constant value of net cash flows for all key periods of the product lifecycle.

In conducting the financial analysis, avoid the assumption that all costs vary with production levels of the unit. As with the traditional economic order quantity (EOQ) formula, if unit costs are all treated as varying with unit levels of demand or by the number of orders or production setups, erroneous results can occur. The EOQ formula provides a good basis for inventory level management in the short term but lacks operating details and sound activity-based costing foundations for PLC management. Exhibit 4 identifies key areas of variable and fixed costs directly related to inventory management along with key assumptions relative to the level and sourcing of cost information. Note that all costs are not assumed to be variable with “unit” levels of production. As Edward Deming often stated, “You die in averages, and you must manage the variation in work to gain improvement.” Some costs vary with large steps in production while others vary with major shifts in production, such as moving production offshore during the growth stages of the product lifecycle to lower unit production costs. These costs span multiple accounting periods.

There is a definite positive financial impact from managing the EOL process more effectively. To quantify that cash flow impact, I used case data provided by FreeFlow, a firm providing outsourced PID services. FreeFlow counts among it customer base Logitech, Motorola, SanDisk, and Apple. The firm seeks to help companies: 1) increase cash flow by reducing price erosion by as much as 100 percent, 2) reduce costs in making better markets for SLOBS, and 3) reduce inventory investment and carrying costs.

The analysis found that by using a structured PLC approach supported by the PID service, companies were able to improve disposition and liquidation sales revenue from 10 cents to 20 cents on the initial sales dollar. They also were able to significantly reduce personnel and logistics costs associated with product disposition.

Looking at a specific example, a major OEM that targeted a consumer electronics product line to generate $200 million in sales used FreeFlow's PID service to generate an additional $8.8 million in cash. This number is based upon the net present value of the product's PLC cash performance using an 18 percent before tax discount rate. Using the product inventory disposition process, the OEM aggressively made markets for products in the declining stages of maturation and logistically deployed those products in a more efficient manner. The sales prices for these products were on average 100 percent higher than under the old end-of-life product disposition being used.

Exhibit 5 summarizes the gain, showing a 91 percent increase (from 11 percent to 21 percent) in average gross margin (GM) before profits, overhead, income taxes, and interest expenses on a monthly basis from the time that sales began to decline in the maturation stage. These increases in margin resulted in some $9.2 million from increased sales revenue as a result of higher sales prices, reduced costs in managing SLOBS, reduced costs of carrying inventories, and the positive cash flow as represented by reduced cash commitments in inventories as represented in the firm's balance sheet.

Implementing an effective product lifecycle management program is a structured process as we have emphasized more than once. By taking the five suggested steps offered here, companies can overcome some of the recurring early hurdles and position their program for greater success more quickly.

Mobilize for action. The fist action here must be to engage top management support for the PLC project. Senior executives typically devote more time and effort to new product and market opportunities that they do to end-of-lifecycle issues. Top management must be educated to the opportunities associated with good EOL management of at-risk product. A top executive, in fact, should assume the ultimate responsibility for achieving potentially higher returns from PID.

Create or empower an S&OP team. Top management must sponsor a cross-functional S&OP team to define the program's parameters and analyze its progress. The team should include representatives from engineering, marketing, sales, production, operations, purchasing, logistics, accounting, and finance. Their main job is to define and understand the “as is” product disposition processes and chart a course for the “should be” state. Key tasks here include identifying dedicated resources and needed alliances with possible outsourced trading parties. The team should also define key outcomes and key performance indicators (KPIs). As part of this effort, the team should benchmark firms that have established leading-edge product inventory disposition processes.

Redesign costing approach. The controller plays a key role in leading S&OP team efforts to identify product unit and dollar sales, cost information, and analytical procedures to process the data. A main objective of analyzing EOL “at-risk” products is to identify variable and supporting costs leading toward total cash invested in income-statement and balance-sheet accounts. Remember: Not all costs are variable; some costs occur in large sums as volumes of sales incrementally step up and not on a unit basis. In redesigning the costing approach, consider the “double whammy” effect on inventory in the product lifecycle. It affects (1) the balance sheet in cash investments in current assets and in the commitments of fixed capital resources of the firm and (2) the income statement in value-added costs of goods sold plus the costs of carrying inventories.

Consider outsourcing options. The S&OP team now has the task of redesigning a “should be” process, and it should be investigating in-house and outsourced services, such as the use of an outside PID service. Don't overlook the opportunity to work with third parties that may already be providing your company with returns or reverse logistics services. With or without the aid of outside help, the team needs to estimate the potential savings and KPI impact from a redesigned PID process.

Implement pilot program. Conduct a pilot PLC test for a significant SKU or product line to demonstrate the potential positive impact. As part of the program, engage key customers, suppliers, and third-party services providers.

Capture the benefits. If results of the pilot prove promising, you can gain top management's support for full-scale implementation of a comprehensive product lifecycle PID initiative.

Following these implementation tips will get you on your way to creating a sustained solution to those slow-moving, end-of-lifecycle, at-risk products that drain the organization of energy and resources.