Variation and Inventory

No one wants to hold inventory. It is necessary because of variation: variation in demand, variation in lead times, variation in raw and finished good quantity, variation in yield (production line reliability), variation in transit times, and of course random shocks from weather to other factors that effect raw and finished good availability. Let’s call this normal or Systemic Variation. Good supply chain managers will work to reduce this kind of variation to improve costs and over all supply chain reliability. This kind of variation is primarily in the hands of the Supply Chain. It is on us, the Supply Chain Team, to constantly be working to reducing the variations in these variables. When done right, with a sound system of management, the result is that inventory is optimized and constantly improved upon.

This is another source of variation. Let’s call this Variation Due to Internal Errors. This kind of variation is a killer. Let us call this V-DIE. This variation is due to self-inflicted wounds that cause us to carry more inventory. V-DIE causes us to make faulty assumptions when it comes to planning: Demand Planning, Production Planning, Inventory Planning. The communication of those plans to suppliers just passes and amplifies the variation . Inventory inaccuracy is also attributed to V-DIE. The kind of errors can create spikes in inventory that could take months to draw down especially if they are over forecasts which result in over procurement of raw materials, or over production of finished goods.

When inventory gets out of control because of errors,because of V-DIE, the levels of inventory will not decrease and will probably continue nudging up until these kinds of errors are fixed. V-DIE should be dealt with equal vigor as the Systemic Variation can be addressed. V-DIE can and will bias the analysis of Systemic Variation. For sure, V-DIE limits the improvement that a company can achieve in terms inventory. We will go far to say that in our experience that for a company mired in V-DIE, the culture is corrupted as well. Strong leadership is required to set the tone to eliminate this kind of variation.

What do we mean when we say that V-DIE limits the improvement a company can achieve in inventory management? Many companies task the supply chain management with reducing working capital. The supply chain team works diligently to reduce supplier lead times, implementing pull systems, working on lean manufacturing in general, and implementing new KPIs if needed. The team drives changes and takes the slack out of everything they can control. Here lies the rub or the limitation. There is only so much the supply chain management can do.

There are three major areas where the supply chain cannot drive improvement by themselves:

1. Forecast accuracy


2. Reducing Excess and Obsolete (E&O) inventory


3. Month and quarter end peaking

We have written about each of these in this blog and will touch on them again briefly.

[1] Forecast accuracy is based on two things: The forecast itself and the execution against the forecast i.e. sales. In both cases, the supply chain must work with sales and marketing to determine the forecast. Then it is up to sales to deliver sales to the forecast and the supply chain to make sure the right products are available in the right quantities to fulfill orders should the forecast be realized.

[2] If inventory is “out of whack,” there will undoubtedly be too much E&O in the system. Poor decisions in the past will have invariably led to having the wrong quantities or the wrong mix of products in the wrong places at the wrong time. This leads to inventory accumulation mostly in goods that are not selling. The stocks of these products build and become excess and invariably obsolete. Then… the inventory just sits there. The supply chain is beaten up for not reducing it. Without sales trying to sell the E&O and finance agreeing to write-off and scrap some of the excess, the E&O will not go down and, worse, will continue to grow.

[3] Many companies have a sales cycle that results in a large percentage of their monthly or quarterly sales taking place in the last few days of the month or quarter. These spikes can be as high as 50-60% of the period sales. No matter how lean a supply chain is or how well a pull system is designed and run, peaking of this magnitude requires advanced planning and building inventory based on forecast. In short, it requires operating in a push based system. Many companies that claim to be lean and operating in a pull environment only do 80% of the time. When this happens demand variation is a large factor in inventory planning. The supply chain cannot reduce this. Only sales can.

Optimal inventory can be calculated but unless V-DIE is addressed at the same time as Systemic Variation inventory will never achieve optimal results. V-DIE will flare-up and cause inventory to go up. Senior management will react and pressure those responsible for inventory in the supply chain to improve. But, because the V-DIE issues are not entirely in control of the supply chain, improvements are harder to come by. If all the slack has been taken out the Systemic Variation parameters, further gains in inventory reduction can only come from V-DIE parameters.

At Cadent Resources, we advocate our concept of Supply Chain Physics. In brief, at any given times, there are Laws of Physics that govern the behavior of our Supply Chains. The laws are:

1. The law of interdependency


2. The law of constraints


3. The law of information

V-Die squarely impacts the first two. V-DIE is a good measure of cross-functional cooperation within a company. When this kind of variation is present and dominant, it is a measure of the lack of coordination between functions. The Law of Interdependency is at work. Forecast accuracy at every level requires the cooperation of the supply chain, sales, marketing, and finance functions. Reducing E&O inventory again requires the cooperation of the supply chain, sales, and finance. In fact, measures to not increase E&O starts with improved forecasts and the even harder part: execution against the forecast. Lastly, breaking of the month and quarter end sales peaking pattern is dependent on sales, finance, and general management working hard to change the well established sales patterns which are ingrained in the minds of customers. Assigning these objectives only to the supply chain does not acknowledge the interdependency at work here and thus limits the improvements that can be made. The limits set are a constant source of frustration in the organization and reinforces the walls of the silos that already exist. It is that simple and that complex.

As a result, constraints are established. It is the constraints that set the level of improvement.

• Forecast accuracy is < 60% is repsonsible for X-amount of inventory that will always be in the system


• E&O > $Y Million truly means that you will always have at least $Y Million of inventory in the the system


• 50% of your sales in the last week of the quarter means you have to order and build to forecast, which means you end up with Z (on top of the aforementioned) X amount of inventory because of the chaos in the operations caused by such a sales spike.

Hammering, tasking, and incentivizing just the supply chain will not change the physics of the situation.

Variation is indeed the enemy. Reduction of variation is the goal. It is the goal in quality improvement. It is the goal in lean manufacturing. It is the goal in inventory management. The tools and skills needed to address variation reduction are the same. They exist in most companies. In the case of inventory management, V-DIE is the enemy. If your V-DIE is low or non-existent, we will guess that you are probably already managing your inventory quite well. If you have no clue, you are probably not happy with your inventory management. In this case, measure and begin to look at the three major V-DIE components: Forecast Accuracy, E&O, and Sales Peaking.

The E&O and Inventory Turn Relationship

At Cadent Resources, we are dedicated to helping small- to mid-sized manufacturing and distribution companies better manage their planning and inventory. We try to do that using simple concepts, intuitive tools, and straightforward processes.

In our work with clients, we have come to realize unrealistic expectations are set regarding inventory turns and the level of excess and obsolete inventories (E&O). Our contention is that E&O is like cholesterol, the bad kind, in the supply chain. It clogs up and diminishes the productivity of warehouses and ties up precious working capital.

Too often, we see companies trying to improve inventory without addressing the E&O. There is a natural reluctance to address this because the goods are often un-salable. They either have to be scrapped or sold at very low prices which both reduce the bottom line. To really make it interesting and exciting, companies do not usually pay attention to the E&O until it is the size of a mountain. Rarely do we look at the mix of active (Materials & Finished Goods) and E&O inventory and how they both effect inventory turns.

Consider a fictitious company with $1,000 in sales. It could $1,000 M or K, it does not matter. The Cost of Goods Sold (COGS) for this company are 36% which is representative of the kinds of businesses we work with. For the purposes of this exercise, we are going to assume that sales and COGS are static. We begin with active inventory at $50 and E&O at $30. This makes E&O at 37.5%. This is a bit on the high side but not as rare as you might think.

The table below shows that our company is turning the inventory 4.5 times per year. If E&O were eliminated the turns would be 7.2. Thus, the dead weight of the E&O accounts for or absorbs 2.7 turns.

	Avg Inventory	Sales	COGS %	COGS	Turns
Matls & FGs	$50.0	$1,000	36.0%	$360	7.20
E&O	$30.0				-2.70
Total	$80.0				4.50

Management has challenged us to get to 10 turns. Can we achieve this without touching the E&O? Sure we could, our little calculator show that we would have to reduce our active inventory to $6, a reduction of 88%. The active inventory would then turn 60 times to give us 10 turns overall with the E&O absorbing 50 turns and comprising 83% of total inventory.

	Avg Inventory	Turns
Matls & FGs	6.0	60.01
E&O	30.0	-50.01
Total	36.0	10.0

This is certainly an extreme example. What if we were to merely cut the active inventory in half from $50 to $25? How much would we have to reduce the E&O to get to 10 turns overall? We see that E&O would have to go from $30 to $11 which is a reduction of 63%. In this scenario, E&O is still 31% of total inventory.

	Avg Inventory	Turns
Matls & FGs	25.0	14.40
E&O	11.0	-4.40
Total	36.0	10.00

If this company were our client, we would recommend the following scenario to get to 10 turns:

1. Work down the E&O to $5. This would reduce E&O by 80% and make it only 17% of total inventory.


2. Reduce the active materials and finished goods by 40% to $30.

	Avg Inventory	Turns
Matls & FGs	30.0	12.00
E&O	6.0	-2.00
Total	36.0	10.00

This should be the goal of this company if they truly want to get to 10 turns a year. They will have freed up $44 in working capital.

The goal, as most goals are, is easy to establish. Reducing inventory by $44 or 55% is much more difficult. It will be difficult to reduce the active materials and finished goods. This will require adoption of lean methodologies along with disciplined and focused continuous improvement activities. It is not easy but can happen provided that management makes it a priority. This can be done entirely within the supply chain for the most part. The limiting constraints are:

• The sales patterns: smooth vs. high month end peaking.


• Supplier lead times.

Reducing E&O is another matter. This cannot be done within the supply chain unless, in the rare exception, E&O goods can easily be converted into current salable goods. E&O reduction requires the coordination of the supply chain, sales, and finance. In this arena, finance is the big dog. Finance sets the rate at which E&O goods can be scrapped or sold at deep discount. This is a good thing because, as stated above, either of these actions will impact profits.

Even before E&O is reduced to the desired level, the supply chain, sales, and finance must work together to establish an E&O policy that includes:

• Reviewing and revising the definition both Excess and Obsolete


• Quarterly actions to taken to keep the E&O molehill from becoming a mountain.

Questions you can ask/Actions you can take right now:

1. Do you know how much E&O you have? How many turns that sludge inventory is absorbing? If not, you should.


2. How many turns should your business be at? How do you plan to get there?


3. Join the discussion on this posting to share your:
   
   
   
   1. Successes in reducing and managing your overall inventory and E&O
   
   
   2. Frustrations with not being able to reduce and manage the above as quickly as you would have hoped
   
   

In a future post, we will introduce our web-based inventory calculator. The tool will help you calculate your total turns, the active inventory turns, and the amount of turns absorbed by your E&O.

New Forecast Detail Item Search Field

Today we updated DemandCaster with a new item search field from the Forecast Detail interface. 

Previously, a user was only able to enter a new item to view from the forecast detail tab.  The search field is no longer tied to a single tab. You will now be able to enter and view a new item from any tab thereby eliminating a couple of extra clicks.

We hope you find this modification helpful.

As always, keep those suggestions coming.  As an organization that is dedicated to helping companies drive efficiency in their decision making and operating processes, we want to make sure DemandCaster abides by these principles and does not introduce any unecessary steps.

New "Forecast Options" DemandCaster Report

Our users have often asked us for a way to quickly review all the settings applied to their items.

To this end, we released a new excel report that can be generated on demand to allow the user to review all their item settings in DemandCaster. 

You are able to run this report by going to the "Reports" interface and clicking on "Forecast Options Report." We hope you find it helpful.

Supply Chain Resolution 2011

As we did last year, we would like to share our business perspective for the coming year and what it means from a supply chain standpoint.

From a macro-economic standpoint, we see the slow steady growth experienced in 2010 to continue. Our demand plans should not be overly risky or overly conservative.  It is a good time to be moderate. We are keeping an eye on the following potential issues that could minimally dampen the pace of recovery or, in the worst case, cause another recession:

Unemployment in the US is still high at around 9%.  There are indications that it has flattened out. Reports from month to month show decreases and increases.  Things are slowly getting better. Unemployment seems chronic for older workers and it is also tough for recent college graduates. Business is still tough for search firms.

Foreclosures are quite high.  This is the second shoe of the recession that many have been expecting to fall for the past three years.  It just has not happened.  These high rate are due to a combination of the mortgage crisis and the subsequent high unemployment levels.  There are too many properties where owners have negative equity and payments they cannot afford.  They default on their mortgages or their taxes.  The inventory of foreclosed properties is so high they are depressing the entire housing market and related industries.  If your business is housing related, your already depressed business could become even more dismal.  You need to pay special attention to developments in this arena.

Governmental problems may be the nastiest of the lot.  The problems of countries in the EU like Greece and Ireland have been prominent in the news.  The problem of states and municipalities in the US is less well publicized but equally risky.  There are serious concerns about large states like Illinois and California.  Will they be able to pay their bills?  Will they be able to honor the pensions of their employees and retirees?  There are municipalities that are in equally dire straits. 

Oil Prices have been creeping up in the past year.  The growth has been slow and steady unlike the bubble experienced in 2008.  We believe this trend will continue through 2011 and needs to be factored into budgets and budget revisions. 

All of the above lead us to believe that we have recovered but at a new level that is somewhat lesser economically from the go-go years of earlier this century.   This has become to be known as the New Normal.   There can be all kinds of debates if this is really true and whether the US will return to 2006 levels or if have become more like a European country like the UK or France.  No matter how this matter is debated, businesses have already adapted to the New Normal whether they admit to it explicitly or not.  This is precisely why business results and stock prices have returned.  Businesses have adapted to the New Normal and not staffed back to the pre-recession levels.

Businesses will only add jobs are they need too.  Employees, while perhaps weary of added tasks and longer hours, are still happy to be employed and will continue to work hard especially as there is nowhere else to go.

We also believe in this New Normal.  We have exported too many manufacturing jobs.  Our economy is now adjusting to that reality.  We most likely will not return to the levels of consumption and low prices that we had pre-recession.

So, what is the prognosis for 2011.  Our call, much the same as last year, is for cautious optimism.  In January of 2010, we had claimed stabilization and looked for modest growth.   The economy did modestly grow.  This year, we expect that modest growth to continue.   The aforementioned issues will, at best, continue to hamper growth and recovery… at worst, these issues could bring about another recession.

A few questions for consideration:

• How do you see 2011 from the perspective of your business?  Is the glass half-full or half-empty?


• What is your greatest hope?


• What is your biggest fear?


• Do you agree with the four issues (Unemployment, Foreclosures, Insolvent Governments, and Oil Prices)?  Is there anything we missed?

Your input will be appreciated.