The recent trend towards SKU proliferation causes inventory dollars to balloon and margins to fall. These problems have been exposed by Covid-19 demand shifts.

Companies are falling into the trap of fractionalization in an attempt to appeal to all consumer types across all retail channels.

Product Portfolio Management as part of the S&OP process can be used to identify candidates for rationalization along with a valuable new metric: SKU Economic Value.

A few months back I read an article about plans by international snack food company Mondelēz to rationalize their SKUs by 25%. It was apparently part of a larger effort to simplify the supply chain in response to the Covid-19 pandemic, while also doubling down on—and delivering strongly against—core products.

Proctor & Gamble and Coca-Cola announced similar efforts to deliver a narrower portfolio of their most strategic products. Coke even announced it was discontinuing the Tab diet soda platform. It seems Covid-19 forced decisions that ultimately helped refocus resources.

It wasn’t long before the article started making the rounds on LinkedIn and various supply chain forums, and even less time before supply chain talking heads started pronouncing the ills of SKU proliferation. Then came the virtual finger-wagging. It was as if supply chain practitioners were complicit in some egregious crime.

I shook my head. This is not the first time recently that such pundits missed the point. So, after resolving my own work-related flurry of activity related to Covid-19, I thought I should add a few thousand more words to the public discourse around this topic.

Before settling down to write, I reached out to about a dozen colleagues in the consumer goods space and asked their opinions on SKU rationalization and portfolio management. From the outset, it was apparent they shared my personal observations. Every contact I polled had experienced extensive SKU growth within their organizations, and nearly all of this expansion was directly attributable to some very specific market drivers and dynamics.

No one felt that their product portfolios were bloated because of neglect or a broken process. It also became apparent that one cannot properly discuss or examine the problems of SKU proliferation without first contextualizing these influences.

Why Is SKU Proliferation Happening?

First and foremost, the primary reason for SKU proliferation is the ongoing adaptation (migration, transformation) toward new ways of doing business, notably e-commerce. The most common example is eCommerce retailers requiring a consumer package that is different than the normal open stock item—such as a product bundled as a three-count vs. a single count SKU.

I suspect the first question one might ask is “Why would they want a different pack out?”

The answer is pretty simple, e-tailers want to make money. And a larger-size or multipack offering improves the per order “ring” of any item and helps overcome the expensive order processing and shipping costs. This change to a multi-item pack out results in the creation of a completely different salable item, often much different than the traditional, open stock product sold by brick-and-mortar retailers.

Many of the companies I talked to admitted to nearly doubling the number of SKUs in their portfolios simply by establishing items specifically for sale via e-commerce.

Why There Is No Easy Solution To SKU Proliferation

While these eCommerce items afforded opportunities for sales in an explosive new growth channel, it also triggered a whole host of downstream repercussions, including fractionalization of demand, subscale operations, and additional costs.

In light of such implications it is easy to understand why traditional inventory metrics start to look out of control compared with those from just a few years ago, as inventory value increases disproportionately to top-line revenues, margins, or any other typical comparators.

Different Retail Channels Force SKU Proliferation

Of course, this reality begs the question: why not just create a common, open stock package that also serves the needs of eCommerce? It seems easy enough to do, right? It is not. Simply put, a package optimized for e-commerce may not be right for a brick-and-mortar retailer. Imagine for a moment having a shampoo product on a shelf at a typical brick and mortar retailer.

Then consider that the shampoo is taped and double-sealed to help prevent leakage in a format optimized for eCommerce sales. In the traditional retail environment, this iteration of the SKU prevents an at-shelf consumer from smelling the product they might wish to buy. The e-commerce version of the product works against the at-shelf consumer experience.

Of course, even if there were no in-person consumer implications, special pack outs for eCommerce can add considerable costs such as bundling and labeling materials, which you would not want to extend over the entirety of a product line.

Another reason for SKU proliferation is the prevailing strategy to be everywhere a potential consumer may shop.

Another reason for SKU proliferation is the prevailing strategy to be everywhere a potential consumer may shop, and with a channel-appropriate product. This has caused both SKU and inventory bloat by creating more packaging options than ever before. Using our shampoo example, consider an organization seeking to penetrate the dollar class of trade by offering a smaller, more price-sensitive package—an 8 oz.  vs. a 12 oz. format for the same shampoo.

This downsizing creates yet another new SKU that further reduces scale, adds inventory, and adds demand volatility while increasing costs.

Beware The Pitfalls Of Fractionalizing Demand

Similarly, “supersizing”—the creation of jumbo sizing or multi-pack preferences specific to club-channel products—has the same effect. Very quickly the single open stock item for retail has grown into 4 different variants: open stock, eCommerce multi-pack, downsized dollar offering, and the club version of the product.

This desire to meet consumers at every consumption touchpoint is a significant driver of SKU proliferation. And to make matters worse, businesses are not targeting just any consumers; they are now targeting all manner of very specific consumer types.

Microtargeting All Consumer Groups Creates Downstream Problems Without Driving Revenue

Spurred by changing demographics in the U.S. alone, there are now more SKUs than ever before targeted to the needs of distinct population cohorts—with distinctive packaging reflecting the needs of these various communities. Many consumer goods companies have developed special multi-language packages, or packages with ethnic models, or slightly modified formulas or sizing to meet the specific needs of these consumer communities.

These consumer goods organizations are acting in earnest to meet the changing needs of their diverse consumer base. Of course, this effort requires a considerable number of special SKUs with all of the incumbent subscale and portfolio bloat implications.

I too know the difficulty of arguing to discontinue an item when the overarching commercial strategy insists that every case matters.

And finally, in the quest for every last revenue dollar, many items that traditionally would have been discontinued because of lost distribution at brick-and-mortar outlets have found a new home online. Whether these “long tail” items are sold through direct-to-consumer or eCommerce channels, it has become harder to give up and surrender revenue on items with residual sales and very limited overhead requirements.

Of course, not every item belongs online and many are less beneficial to margins than one might suspect. However, I too know the difficulty of arguing to discontinue an item when the overarching strategy insists that every case matters.

SKU counts have mushroomed and inventory has expanded and become more costly as we fractionalize our demand.

So yes, product portfolios and SKU counts have mushroomed; inventory has expanded and become more costly as we fractionalize our demand without a corresponding increase in top-line sales. It is a predictable side effect of trying to meet the demands of every consumer wherever they might chose to shop. To those of us working the supply chain front lines every day, we are very aware of these changes that the pundits and prognosticators have mostly missed in their analyses.

How Can We Manage Portfolio Bloat?

These seismic changes mean we need to think differently about a lot of things—most importantly, traditional measures of inventory need to be reprocessed to reflect our new reality. We should expect that inventory dollar values will swell with increased SKU counts. Product margins may sag as our MOQs and EOQs take a hit due to fractionalization. Ratios of inventory margins or sales-to-inventory will suffer, as top-line sales grow at a slower rate than that reflected by inventory expansion.

The new ways of doing business have altered set points from just a few years ago, making comparisons, well… silly. And it goes without saying that Covid-19 has accelerated the move toward e-commerce offerings. In fact, I am not sure the full impact of SKU proliferation has been realized yet.

I am a huge proponent of using the S&OP “Product Portfolio Management” process to manage product portfolios. If used well, the portfolio review process could be leveraged not just for new products but also to examine commercial innovations such as package size changes. The process can also be used to identify products for potential rationalization as well as those products in need of cost-based renovation.

When well executed, portfolio review examines the entire lifecycle of a product, from ideation to rationalization and all the changes in between.

When well executed, portfolio review examines the entire lifecycle of a product, from ideation to rationalization and all the changes in between. It is uniquely predisposed to assessing issues relating to SKU bloat and rationalization. The magic of this process lies not in establishing blanket rules like examining “anything less than 2% of top-line revenue in a product category” but with a more targeted approach that first evaluates the SKU-level economic value-add of an item.

This inherently elevates the level of analysis and promises more strategic precision in the process, while potentially preventing gross mistakes like cutting low-volume items that are nonetheless margin accretive while keeping higher-volume items that have little or no margin.

Because economic value-add methodologies account for the implications of inventory carrying costs (of any product), the portfolio review offers a stronger assessment of an item’s margin quality. Any item with a low or negative economic value deserves a robust assessment to determine whether to keep it. Following this analysis, other filters, such as volume percentages within a category, can be considered and properly weighted.

Slimlining Your Portfolio Using The SKU Economic Value Formula

SKU economic value is really a simple calculation if you want it to be: SEVA= (SKU Margin—Inventory Costs). The complexity comes in defining margin, and the inventory cost. Here again, as a first level sieve, I keep the math simple. Gross margin contribution for the SKU—the cost of capital for the average inventory held in support of the SKU.

I don’t include all of the other costs of inventory such as insurance, administration, loss etc. as they tend to be captured in COGS. I include all forms of inventory (raw, pack, WIP and FG) against either a set of averages or an inventory simulation.

In the past, I have assembled these and other relevant metrics and facts into a matrix with other elements that are important to decision-making. Most of these are typical commercial or operational parameters.

I then consider a raft of simple yet relevant questions for discussion. For example, “Does the item have a strategic purpose?” The number of potential questions for evaluating SKUs are countless. Ask yourself:

• Is the SKU an entry product in a category you wish to penetrate?
• Is the product a placeholder for a future one-for-one swap out?
• Does the product cannibalize your core offerings?
• Is the product easy to make?
• Are there reasonable cost improvement opportunities to improve margin?
• Are there opportunities to reduce EOQs and/or MOQs to make the product less impactful from an inventory perspective?
• Does the product help to absorb significant overhead expenses?
• Can different package formats be collapsed?
• Does the product have an on-shelf purpose (i.e. to enhance a billboard effect)?
• What is the ACV percentage?
• Has the product experienced delistings at multiple retailers?
• Is the product competitive with other product offerings?

The list can go on. While these questions reflect some obvious CPG examples, every organization across any industry should be able to establish similar market-based criteria that can be leveraged for SKU analysis. The questions are always best when tailored to the specific operating model and commercial strategy of an organization.

Once completed, this matrix and questionnaire become the source documents for constructive conversation within the product portfolio review process.

I would also highly recommend investigating technology solutions currently available that merge big data sources with predictive analytics engines to help understand the futures of some products, as well as the changes in consumer behaviors and demographics.

I have found these useful in providing some the “relevant factors” I mention. However, I do not think these tools are best used as a primary filter but instead better leveraged when the analysis of low/no economic value is completed.

Merging the S&OP product portfolio process with SKU-level economic value analysis is a much smarter way to manage your SKU portfolio.

Merging the S&OP product portfolio process with SKU-level economic value analysis—while also examining targeted, relevant factors—is a much smarter and deliberative way to manage your SKU portfolio. It helps define the value and role of each item in the portfolio. And deepening the analysis by building a questionnaire helps to refine and improve the decision-making around individual SKUs.

Despite these very public pronunciations by the likes of Mondelez, I suspect expanded SKU counts will remain higher than the targeted reductions. Hopefully, the teams assigned to execute against the strategy work through a smart and deliberate approach to evaluating which SKU’s should stay.

I have personally observed the combined focus on value-add, the leveraging of relevant factors and analytics, and the questioning process I describe lead to pricing changes, size consolidations, cost-based renovation and reformulations, improvements in plant operating parameters, agreements from vendors for lower EOQs and from contract manufacturers for lower MOQs, as well as the expected discontinuations. It is an effort that always puts money on the table.

If you are not currently using a product portfolio review process, read this article that can offer insights into the elements required.

At Hershey’s, our entire Latin American portfolio suffered from a malaise that plagues countless other corporations – a portfolio that drastically exceeds the optimal number of SKUs. The result of this unfortunate situation? Unprofitable items, under-optimized items and the risk of losing customer loyalty and brand equity. Unprofitable or dead-end SKUs are a drain on resources and take up time and effort that can be spent on your most valuable products. Culling unprofitable SKUs through SKU rationalization, therefore, is a must, and in this article you’ll learn how do it effectively. But what’s more interesting is identifying the SKUs with untapped potential and figuring out the ways to increase their profit margins. Here’s how I did exactly that Hershey’s.

What Is The Optimal Number of SKUs In Demand Planning?

Sales and Marketing’s motivations will not always align with yours as a demand planner. They will always seek to maintain a rounded portfolio and introduce seasonal and non-seasonal SKUs that drive your planning book items up, and Hershey’s was no exception. In our case for Mexico it went over 500 SKUs and over 2000 for the rest of the region. For us, in our particular industry, we didn’t want more than 100-120 SKUs to plan for, instead focusing on the 10-20 top SKUs that provide most of the revenue (+80%). Given our over-sized portfolio, it was no surprise to see that the majority of my demand variation came from the tail end of 70-100 SKUs. These were C grade items that together generated less than 5% of the total revenue.

We had a compelling case to cut these lower tier SKUs that were difficult to forecast. Cutting them was easy to sell to Finance but we faced a struggle with Sales & Marketing, who saw this SKU rationalization as a threat to customer needs and brand strategies. This resistance made me want to bolster my argument by gaining extra insight that most demand planners wouldn’t consider. But first, let’s look at the initial steps I took to rationalize and streamline our very bulky portfolio.

SKU Rationalization Step 1: SKU Rationalization And Segmentation For A Healthy Portfolio

This was a simple case of sitting down with Finance and crossing off SKUs that negatively impacted revenue. This was straightforward because we can easily identify the SKUs that lose money, and there is little argument to keep them unless there is a wider brand strategy at play.

SKU Rationalization Step 2: Analyze Your Tail Items

Then we focused on that dreaded tail, those difficult to predict, barely profitable items that are rounded up or linger for reasons unknown even to the commercial teams. These are often items that used to make money but have since become unprofitable, or have become too complex to manufacture. Often these items have been challenged for years by demand planners, but have remained in the portfolio as demand planners consistently fail to communicate the benefits of cutting them.

SKU Rationalization Step 3: SKU Performance Analysis and Phasing Out

We conducted analysis into SKU performance by generating 2x2s based on revenue, or gross margin, and total sales per year. Those quadrants were divided by standard or expected gross margins or break-even revenue by item. When doing this, concentrate on eliminating or phasing out over 6-12 months as there can be implications with retailers and inventory planning. We chose this 6-12 month in conjunction with our Brand Managers who knew what the negative implications of withdrawing particular SKUs from their portfolio would be. This gave them enough time to develop short term strategies to mitigate any negative effects.

SKU rationalization is key to a healthy product portfolio

SKU Rationalization Step 4: Identify Items That Are Profitable But Cannot Be Improved

Then we looked at the items that were profitable but lacked dimension capacity for increasing more sales volume by correcting distribution or substituting less profitable items. In short, these are profitable items but ones that cannot be further optimized for greater profit. Cutting these SKUs is important to the long-term strategy as we want to prioritize our bread and butter items, those workhorses that are profitable and still have plenty of room to increase revenue via CI or financial initiatives. We knew our core was chocolate, and in the chocolate group we had 8-10 items we could improve our revenue projections for. These improvements required moving away resources away from lower tier items. This reallocation of resources allowed us to increase tier 1 sales mix and volume.

SKU Rationalization Step 5: Gain Multidimensional Insight From Across The Business

A great component to consider when making these decisions is a thru analysis on several dimensions from your financial partners and manufacturing colleagues. Yes, it makes sense to consider total sales and gross margin (or standard gross margin) as your initial differentiators to create your 2×2, but I expanded this out to include insight from other areas of the business. From the demand planning side, you need to look at fixing errors to improve forecast accuracy, namely WMAPE and BIAS. But going beyond this, I sought out opinions from experts in the fields I knew impacted profitability. From Manufacturing, I extracted data on turns, number of cycles and batches. Given the nature of our products at Hershey’s, it was important to consider the remaining shelf life after the date of manufacture.

SKU Rationalization Step 6: Look at How Transportation Costs Affect Item Profitability

Then I turned to Logistics, focusing on a very important point: total transportation costs. There were some customers that are located far away from our distribution network and as such are more expensive to deliver to. I identified these customers by looking at product per pound shipped and the number of racks we used, indicating utilization of space. This gave a sense of how complex and costly it was to move and distribute particular items

SKU Rationalization Step 7: Incorporate All The SKU’s Financials Into One Easy To Understand Figure

On the financial side, we looked at every single indicator of profitability including SGM, VCM and SAM, etc., but we also focused on final sales margins, accounting for G&A and marketing expenses as well as costs of obsolescence. To each dimension I gave a weight and multiplied all dimensions in order to generate one representative number that helped me differentiate one item from the other. This was incredibly useful in making final recommendations to Sales & Marketing, helping me explain why some SKUs deserve to continue due to their strategic or brand value, or whether they needed the attention of our engineering teams to reconfigure packaging or other manufacturing improvements, or maybe outsourcing to reduce our fixed costs. In all cases, these numbers meant something to other areas of the organization that had expressed concerns but had no way to make themselves heard, or were overlooked because there was no way they could clearly illustrate the negative impacts of certain things on the product. We succeeded in quantifying these concerns in a way that was easily understandable and communicable to all stakeholders.

This all resulted in cutting the portfolio by 25-30% and helped boost profit margins for our leading items. One important point I learnt throughout this whole process was that item review must be done on a regular basis, at least once a year to provide an update on items that were improved, and to see the actual impact of the discontinuation or substitution initiatives. That way we can check which decisions added value and those that didn’t.

IBF’s LinkedIn discussion group presently features a  lively conversation going on about SKU rationalization, a favorite topic of mine. Anthony Davidson initiated the conversation by posting the question,“…what key factors should be considered in determining which SKUs should be eliminated from the mix?”

It is generally agreed upon that unchecked product proliferation will result in very negative consequences. This is due largely to the cost and complexity of managing an ever increasing product portfolio, and the self-cannibalization of your own demand.

As a first cut, several of the respondents suggested ranking products by gross margin dollars or percent. However, I’m skeptical of financial metrics that purport to allocate costs (and compute the marginal profitability) of individual products.  As a result I prefer to stay away from those kinds of measures.

Instead, a good first step is to create a Pareto chart ranking all products by unit volume or revenue.

As we can see in this example, the top 1/3 of items generate about 90% of revenue, the middle third generates about 10% of revenue, and the bottom third generates less than 1%. A Pareto analysis of your own products should yield a similar result – the 80/20 rule will likely apply. Two real-life examples are:

• A food company found that 25% of their items yielded just 0.5% of total revenue.
• An apparel company found that half of their products generated just 1% of total revenue.

Be aware that negative volume or negative revenue can also be observed (when product returns exceed product sales).

Based on the initial volume (or revenue) ranking, you may decide to prune everything below a certain cutoff. You may also take into consideration the dozens of other contributing factors such as customer service levels for the product, remaining inventory, complexity of sourcing or production, or availability of substitute items. Sumit Sinha made a good point in the group about SKU rationalization being an ongoing process – at least annually for sure, and quarterly,or even on a continuous basis would be  even better. Rob Miller posted a comment that appeals for a more sophisticated determination of whether a product serves a strategic role before pruning it.

I’m particularly fond of a comment in the group made by Louis Upton,  “…everybody is in favor of rationalization until they see the products they want to kill.” Pruning items is likely to save on costs, but there is always the fear that we would also lose a small amount of revenue by giving up on extremely low volume products. However, it is not unreasonable to expect that revenue will actually increase, because now you can focus your organizations efforts on the more important items and increase their customer service level. Filling a higher percentage of orders for the important items can quickly make up for the revenue lost by the pruned items.

For more discussion of this topic, including when not to prune an item, see “SKU Rationalization: Pruning Your Way to Better Performance” in the Fall 2011 issue of the IBF’s Journal of Business Forecasting.