Why Consumer Packaged Goods Companies Need to Get SKU Rationalization Right

Every item a consumer packaged goods (“CPG”) company sells has a Stock Keeping Unit, or SKU, number. Each SKU is an alphanumeric number that differentiates a specific product from other products as to size, color, and so forth. The SKU is used to accurately track sales data and inventory movements for that specific product. 

SKU rationalization, also known as product optimization, is the process of analyzing each product offering, each SKU, to determine which products to continue to sell and which ones to discontinue.  Every CPG company, no matter its industry, must understand and manage which SKUs are sold and the cost/benefits of each to the business. 

The number of SKUs that companies have varies considerably. In some industries (e.g., beauty, apparel) there can easily be thousands of SKUs depending on the number of different shades of lipstick or size of jeans. However, even manufacturers with only a few SKUs might package them differently for different retailers, and each different package configuration would have a separate SKU number. For example, a company with a fairly simple product line of five flavors of potato chips (five SKUs) might sell its products to Costco in variety packs with three flavors bundled together. Those bundles would have different SKUs. If they also sell a smaller snack size of each flavor, suddenly, this simple product line-up has closer to 16 SKUs. 

Each additional SKU not only generates more work for the management team to track overall sales and inventory movements, but it also creates additional costs associated with excess inventory on hand. Excess inventory ties up vital cash resources in the form of overstocks. While excess inventory can be sold to close-out companies, like TJ Maxx and Overstock.com, there is still significant costs associated with resale. Therefore, management must determine whether each SKU is worth the additional cost and complexity. Are these SKUs adding value to the consumer and to the bottom line?

There does come a point when too many products can create inefficiency and decrease profitability. SKU proliferation and its associated costs, which are sometimes not self-evident, often do not get enough management attention and can easily cut into profit margins. Management needs to recognize when products provide a strategic opportunity for incremental growth or when they create unnecessary cost, complexity, and losses. 

Some SKU proliferation costs include:

• Smaller and less-efficient production runs
• Lower volume discounts for raw material procurement (when using different materials)
• Additional sales and marketing costs
• Bespoke bundling and packaging configuration costs
• Cannibalization of existing product sales
• Increased warehousing, distribution, and handling costs
• Higher-probability slower-moving products will pass their sell-by date
• Increased difficulty of accurately tracking SKU stock levels
• Additional vendor management with less negotiating leverage

SKU rationalization ensures that companies can identify and reduce the additional costs incurred from proliferation and improve profit by focusing on selling the products that increase profitability. The rationalization process should consider all aspects of selling each SKU, particularly each one’s supply chain, customer demand, and profitability.

1. Evaluating supply chain complexity and risk includes considering: 

• Manufacturing and delivery lead times
• Exchange rate risk
• Customs regulations
• Quality issues
• Ease of procurement of raw materials and components
• Vendor relationships
• Packaging complexities
• Costs for delivery (e.g., size, weight, handling costs, pallet fit)
• Warehousing cost including special requirements (e.g., refrigerated, fragile)
• Shrinkage
• Picking and packing costs
• Expiration dates and risk of obsolescence

2. Product demand analysis should include: 

• Sales velocity and volume
• Seasonality
• Price elasticity and consistency
• Returns and allowances
• Competitive trends
• New, niche, or specialty product
• Marketing and promotion budget
• Incremental value to overall product line

3. The profitability of each SKU also should consider:

• Cost to produce the product
• Price point (less discounts)
• Additional costs (e.g., slotting fees)
• Contractual marketing or trade spend

Determining the profitability of each SKU is often the most challenging part of this process because it requires properly allocating costs to each SKU. Furthermore, determining the profitability by SKU for each sales channel is fundamental to a beneficial SKU rationalization process because a SKU may be profitable in one channel and incur losses in another. The accounting system and financial reporting must provide accurate data that supports this decision-making process. 

Generally, SKU rationalization shows that low volume products, especially those with supply chain or packaging complexities or low margins, should be eliminated. While this may seem obvious, there is sometimes an emotional attachment or subjective reasoning behind keeping these SKUs. Long-time employees may say: “but that was our first SKU” or “our favorite client loves that product.” This subjective reasoning makes it even more important for the SKU rationalization process to be data driven. Another challenge is that any reduction in SKUs available for sale will likely reduce the top-line revenue, so it is difficult for management to visualize how a reduction in revenue may increase the bottom-line profit. Management must understand the real costs and drag on profitability, perhaps additional warehousing and handling, associated with keeping low-margin SKUs active.

It can be daunting the first time a management team begins a SKU rationalization process. While there is a lot of information to gather, a June 2020 McKinsey article (“Harnessing the Power of Simplicity in a Complex Consumer-Product Environment”) stated that the “winners,” the companies that have proven themselves to be most adept at determining which SKUs to add or eliminate during an SKU rationalization process, can see up to an 8% increase in margins. The article states that these “winner” companies consider the “broader portfolio impact” of each decision including “baseline impact (revenue, volume, and margin), velocity, and supply chain complexity” when determining which SKUs to eliminate. So, it is critical that SKU rationalization is a holistic, data-driven, cross-functional process that includes the sales, operations, and finance departments.

Once a SKU rationalization process is instituted and costs properly allocated, the process should be easier and become a regular part of a SKU review process—perhaps annually or semi-annually. This analysis should also occur each time the CPG company considers adding a new SKU to its product mix. Most companies find that the information from this process can have far-reaching benefits beyond the SKUs involved. The analysis often provides a deeper understanding of customer habits and can help support decisions about marketing spend and supply chain management.

CPG companies can increase sales volume and customer appeal by offering a variety of products, but the benefit of each new product offering should be weighed against the costs and possible drag on margins.  Gathering the sales and cost data and evaluating the complexities associated with each SKU can be time consuming. Nonetheless, a regular SKU rationalization process is worthwhile and can result in a substantial savings to the CPG company’s bottom line.