Don't be Naive About Inventory Management

For the first part of this posting, you have to pretend that it is 1975 and not 2011.

You are given a mandate to reduce inventory by 10%. The totally naive thing to do would be to cut inventory across the board by 10%. It is, to the naive, also the easy and apparent thing to do. It has an egalitarian ring to it. It is a quick and easy objective to set and immediately start working on.

But once you get started on the project it somehow gets a bit harder and more complicated than first imagined. To follow this approach means:

• Cut each finished good held by 10%


• Cut each material by 10%


• Cut WIP by 10%


• Cut in-transits by 10%

You learn the hard way that by cutting in-transits, for example, might have a bigger adverse effect on customer service than cutting finished goods or the materials in the raw and pack warehouse.

Believe it or not in the days before ERPs and modern materials management, people managed inventory in this manner. This was even true of many Supply Chain leaders as hard as that is to believe today.

Most people working in the Supply Chain today would never ever take this naive approach. One of the primary reasons we do not succumb to the naive approach is because of the systems capabilities we now use to run our businesses. We have much more data and the systems, especially in ERPs, function on user set parameters. It is for us to determine the parameters to deliver the inventory and customer service results we desire to have.

While we have much more sophistication than we did in the old naive days of cutting everything across the board, we can still make naive errors by relying entirely on the system.

You might be challenged today to reduce inventory by 10% again.  But today you might not make the same mistake because of the sophistication of the systems used to run your business. This is especially true of ERP systems like SAP and Oracle. The catch is you have to know how to use the system to analyze the data. It is still easy to make naive errors.

You are charged to reduce inventory by 10%. The first thing you have to do is make sure all the data in the system is up to date and accurate in terms of:

• All the lead times 


• All changeover times 


• All run rates 


• All minimum order quantities 


• All safety stocks

This is takes out the slack, if any exists, in the system. This will result in the right sized inventory for the current state of your Supply Chain, for the current Physics of your Supply Chain. Further reductions in inventory require structural changes that will alter the parameters of your Supply Chain.

• What to change? 


• What changes will yield the 10% reduction? 


• And, at what expense? 

The expense question is often the most important question. Expense? The expenses include the discount sales of excess inventory and perhaps the write-off of obsolete inventories. These classes of inventory exist because of poor planning or poor business practices. They exist because of past sins. Expenses of this kind come right off of the bottom line and thus not something that the CFO or CEO will easily agree to. They will often encourage selling of the goods if possible. Yet, these goods are excess and obsolete for a reason. They are outmoded, outdated, and perhaps even unsalable. If they can be sold, it is often at a less than desireable margin which will also impact the bottom line. Excess and obsolete items are much easier to create than to eliminate.

When it comes to reducing inventory 10%, we find that we may not be able to touch the Excess and Obsolete stocks. Thus, we can only impact the inventory that is actually moving or the active inventory. To reduce overall inventory 10% will require reducing the active inventory by even more depending on how much of the overall inventory is actually excess and obsolete. Read our posting The E&O and Inventory Turn Relationship to learn more. Active inventory may have to be reduced 12-15% or even more to achieve the overall goal of 10%.

Within the active inventories, we still cannot simply reduce inventories X% across the active inventories. Even within the general class of active inventory, not all inventories are created equal. Some items move faster than others, thus it is well advised to conduct an ABC classification of items and determine:

• If they are sized properly? 


• What can be trimmed or right sized? 


• What can be eliminated? 

It is necessary to study the depth and breadth of the goods and materials to determine which items can be eliminated. If this is not done on a regular basis, and few companies do so, we have found that there are always too many items contributing to unneeded complexity and inventory.

Other aspects must also be evaluated, including:

• Should finished goods be made in-house or contract manufactured? 


• Can the inventory of materials and goods be vendor managed and thus not on your books until needed? This is a popular practice with larger companies that are the number one or two customer of the supplier. Smaller companies may not be able to influence the supplier to participate without paying a premium. 


• Are the inventory buffers in the right place? This applies if you, of course, have one or more buffers. 


• Are you using the right variation to calculate the size of the buffer? Often times, even today, buffers that supply manufacturing lines or intermediate finished goods buffers are sized using sales variation. (This topic itself will be the subject of a future blog.) If you import from Asia (and who doesn’t?), is your supplier integrated into your demand and materials planning? 


• One of the best ways to reduce inventory, is to reduce lead times. If you import goods or materials from Asia, are you saving enough to justify the added inventory the long lead times justify? Is this changing with the spiking oil prices? What would you add to these recommendations? 

These are a few of our ideas. What have you done to reduce inventory that you would recommend to others?

Comments

[Kerry]

So let me get this right, you mean computers and ERP systems didn’t always exist? How did people live? I know I couldn't live with SAP Business One and I know fellow accountants would feel the same. Thanks for the post, very informative and valid points - bookmarked your site.