10 Keys To Inventory Reduction

10 Keys to Inventory Reduction Mark K. Williams, CFPIM, CSCP Companies exist to service their customers. The primary service provided by manufacturing and distribution companies is in the form of a raw material or component that the customer then processes into its own product, or a finished goods item that the customer re-sells. It is therefore critical that each company has a set of inventory objectives that allow it to provide this service profitably. The main inventory objectives for most companies seem deceptively simple: • • • • •

provide the right product at the right place in the right quantity at the right time and at the right price

If a company does these five things, it will satisfy its customers and become extremely profitable. Although this inventory objective sounds simple, hard and often painful experience tells us that it is not. A forecast of the customer’s demands is based on past history, but if a customer places an item on promotion the supplier may not have the right quantity. Most of the required product is in the Texas warehouse, and suddenly the demand is heavy in Boston. A company stocks up on a new product that Marketing knows will be a hit, and it turns out to be a dud. Or worse, a new product is suspected of being a dud so very little is stocked, and it turns out to be a hit, leaving Marketing and the customers mad. The days are long gone when customers would accept shipments from suppliers that were 70 percent complete on a routine basis. Many companies will cease doing business with a supplier that cannot maintain a service level of at least 98 percent. Of course, a supplier without customers will quickly go out of business. Therefore, if a company experiences fulfillment problems, the solution demanded by the Sales Department and the corner office is usually “bring in more inventory and get rid of these stock outs or else!”

Inventory Isn’t Free A company can indeed add more inventory—and more, and more, and more—in an attempt to provide customers better service. Many companies do this, but then run into a few problems. Their warehouse begins to fill up, and soon they need to rent another one. Their employees report it is becoming more difficult and time-consuming to find the product that is in stock. The company has to go back to its bankers repeatedly to borrow money to support the higher levels of inventory. At the end of the year they receive a nasty surprise—their taxes have increased! Then the company often has to confront one final problem; their service level has not increased despite the increase in inventory. www.w-scg.com

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What does increase is the cost associated with holding the inventory. This is because even though inventory is listed on the books as an asset, increasing the amount of inventory a company holds has an impact on many individual costs not recognized by many companies. When we look at the components of inventory carrying costs, it becomes clear how increased inventory levels lead to increased costs. 1 Cost of Capital Storage & Warehouse Space Obsolescence & Shrinkage Insurance Material Handling Taxes Total Annual Inventory Carrying Costs

10—15% 2—5% 4—6% 1—5% 1—2% 2—3%

20—36%

Our challenge is to reduce our inventory, leading to a reduction in the associated inventory carrying costs. However, we must simultaneously increase our service levels to our customers, or risk losing them. Is this possible? Fortunately, yes, it is possible to reduce inventory while increasing service levels. There is no magic bullet, but by working diligently to implement the following 10 Keys To Inventory Reduction, those two vital goals can be achieved.

1. Improve Inventory Accuracy A rush shipment is being prepared for a key customer. According to the figures in the computer, there is enough stock of each item on hand to fulfill the customer needs. Based on this information, the customer is assured that the shipment will be complete. However, when the order is picked, 3 of the 10 items come up short! Now the customer must be given the bad news. In order to make sure this does not happen again, the supplier considers adding more safety stock to its inventory. By simply adding safety stock in hopes of ensuring enough inventory the next time, the core problem is not addressed. After all, according to the computer records, there was enough stock to complete the order. The real problem in this situation is that the inventory on the shelf did not match the inventory figures in the computer. Will increasing safety stock solve this problem? No, quite often it is aggravated because now there is more inventory to track. Overall inventory accuracy depends upon conducting each process flawlessly, including Receiving, Putaway, Picking, Shipping, and Invoicing. Some things that help improve inventory accuracy are: • • • • •

unique SKU numbers for each part well-identified aisle/bin locations use of bar codes for inventory tracking a workforce that understands the consequences of inaccurate inventory figures a cycle counting program aimed at detecting and correcting errors in the process

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2. Eliminate Obsolete Inventory Do some companies keep inventory that has been in stock for over five years? They hesitate to get rid of it because of fear that if they do, they will receive an order for the item the very next week. And if that happens, the sales people will go absolutely ballistic. Unfortunately, for many companies that scenario is all too familiar. They hold on to old, probably obsolete inventory because they feel that keeping it is safer than getting rid of it. However, there is another way to look at inventory that is doing nothing more than taking up space. First of all, it is taking up valuable space! As discussed earlier, inventory carrying costs are not free, they average 20—36 percent per year. If the company has a 36 percent carrying cost, in three years the inventory will have been paid for twice — once when purchased with cold, hard cash, and a second time through the costs associated with carrying inventory. If we decide to get rid of the inventory, we can get some benefit from it. Many closeout companies will pay between $0.10 and $0.40 on the dollar for the inventory. This may not sound like much, but it is better than nothing. In addition, any inventory that is disposed of for less than cost can be written off against the company’s taxes.

3. Implement ABC Inventory Management Strategies Do the people with inventory management responsibility have enough time to focus on each part of their job? Do they have enough time to strategize and monitor each SKU in their inventory on a daily basis? Or have their job responsibilities increased so much that they sometimes do not know if they are coming or going? A manager who has ample time to monitor each SKU daily, strategize the optimal ordering and stocking of each of those SKUs is a rare breed in an ideal situation. Those who manage inventory in the real world have to decide what to do—and what not to do. One of the most powerful—yet simple—decision-making tools in the arsenal of the inventory manager is the use of ABC stratification in setting priorities regarding inventory ordering and stocking decisions. The concept behind ABC stratification is that some items are more important than others, and therefore deserve more managerial attention. If one is in charge of office products, and the range of products extends from computers to paperclips, does it make sense to pay as much attention to how many computers are in stock as it does paperclips? Common sense says, “of course not, computers are so expensive, they demand more attention.” Does this mean a department can afford to run out of paperclips on a routine basis? No, that also is not one of the options. So how does one set these priorities? This is where ABC stratification emerges as an important option. There are a couple of steps that must be taken in order to prepare for using ABC stratification. First, an ABC analysis spreadsheet is needed. To do this the cost of each item is multiplied by its annual unit sales to get an annualized cost of sales, and then each item is ranked in descending order by this amount. In most companies, the top 20 percent of items are www.w-scg.com

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fast moving and usually account for approximately 80 percent of sales. These items fit the “A” category. The next 30 percent of items are “mid-movers” and usually represent about 15 percent of sales. These go into “B” category. Finally, there are the slow movers, usually about 50 percent of items that combined only represent 5 percent of sales. These slow movers are classified “C” items. Once sorted into the appropriate ABC classifications, it is time to apply the principle of prioritization. In many companies, the same relative amount of inventory is maintained for all items. For example, a company will set the inventory level for all items to equal two-month’s sales. A company switching to the ABC approach sets inventory levels differently. Realizing that the fast moving “A” items make up a much larger portion of sales and are probably always on order, the company tries to maintain relatively less inventory. Instead of eight-weeks of inventory, the company maintains a four-week level. The company compensates for the lowered inventory level by paying more attention to the “A” items to make sure they do not run out. Although the relative amount of inventory is lower, the absolute value of the “A” inventory is higher than either “B” or “C” items, because the sales level of “A” items is so much higher. The “B” items would maintain the inventory level of eight weeks. In order to concentrate our attention on the fast moving “A” items, we increase the inventory level of our “C” items to double its previous level. Because this represents so many items—50 percent of our total—it frees up a lot of review and monitoring time. However, because the sales volume these items are based on—only 5 percent of sales—doubling the amount while cutting the amount of “A” items in half will still allow for a significant inventory reduction.

Part A B C Total

% of Total Monthly Sales Cost of Sales $ 785,000 78% $ 160,757 16% $ 63,215 6% $ 1,008,972 100%

Value of Equal Inventory (8 Weeks) $ 1,570,000 $ 321,514 $ 126,430 $ 2,017,944

ABC Inventory $ $ $ $

785,000 321,514 252,860 1,359,374

(4 weeks) (8 weeks) (16 weeks) 33% Inventory Reduction

As you can see from the example above, a company implementing the ABC strategy will carry 33 percent less inventory than a company that maintains the same inventory level for all items. That is not only a significant inventory reduction, but also normally leads to an increase in customer service level.

4. Review Safety Stocks Do some companies set their safety stock levels uniformly for all items—for example, one month of safety stock for each SKU? If so, they are making a very common mistake. The level of safety stock should be determined based on the variability of demand. As an example, look at the following two items:

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Item # A-45 B-14

January

February

March

April

May

June

Total

99 10

102 13

103 241

95 24

103 280

98 32

600 600

Both have sales of 600 units over a six-month period for an average of 100 per month. All similarity stops there. Item A-45 has a very steady sales pattern, varying from its average of 100 monthly units by five or less during any month. Keeping one months worth of safety stock, or one hundred extra units on hand for this item is surely a waste of inventory. However, the same safety stock level for item B-14 would not be enough to cover the two peak months of March and May. There is another method of calculating safety stock, based on the variation in demand. This method assumes that an item exhibits “normal” demand characteristics, including consistent demand. In order to employ this method of setting safety stock, we must first determine the Mean Absolute Deviation (MAD). 2 To determine this, we must find the total absolute deviation from the mean and divide it by the number of months. Let us determine the MAD for each item above. Part A-45

Part B-14

Monthly Average Absolute Month Sales Sales Deviation Deviation January 99 100 -1 1 February 102 100 2 2 March 103 100 3 3 April 95 100 -5 5 May 103 100 3 3 June 98 100 -2 2 600 16

Monthly Average Absolute Month Sales Sales Deviation Deviation January 10 100 -90 90 February 13 100 -87 87 March 241 100 141 141 April 24 100 -76 76 May 280 100 180 180 June 32 100 -68 68 600 642

MAD=

Total Absolute Deviation Number of Periods

=

16 6

=

2.67

MAD=

Total Absolute Deviation Number of Periods

=

646 6

=

107

After deciding on a target service level, we use the Table of Safety Factors to determine the appropriate safety factor. 3

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Service Level %

Safety Factor

50% 75% 80% 85% 90% 95% 98% 99%

0.00 0.67 0.84 1.04 1.28 1.65 2.05 2.33

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If a 95% service level is desired for both items, lets look at the different safety stock requirements. Part # MAD Safety Factor (SF) Safety Stock (MAD x SF) 2.67 1.65 4.4 (or 5) A-45 107 1.65 176.5 or (177) B-14

Even though both items averaged 100 units per month, the safety stock for A-45 is only 5 units, while for B-14 it is 177 units. This is proof that due to the variation of demand, one size does not fit all.

5. Reduce Lead Times One very legitimate use of inventory in both distribution and make-to-stock businesses is to serve as safety stock. Safety stock is used to compensate for the uncertainty of demand. One cannot predict the future or the precise buying habits of customers, so keeping safety stock ensures a good service level. However, the level of demand uncertainty is not static, it increases as lead-time increases. The longer the lead-time, the greater the potential changes in demand, which must be supported by higher levels of safety stock. More unforeseen things can occur in six months than in six days. In order to minimize safety stock-related inventory, lead times must be reduced. By exchanging information with customers, suppliers can find out when customers are planning to order and anticipate the demand. By adopting just-in-time techniques, WIP can be minimized and throughput improved.

6. Partner With Customers A distributor or make-to-stock manufacturer is expected to be able to supply its customers’ needs from on-hand inventory. Determining those needs is one of the most difficult tasks for most suppliers because they rely on an internally generated forecast based on their customers past purchases. This works just fine as long as the future is identical to the past. However, in today’s fast moving world, this is rarely the case. So should a company just give up? Of course not, to give up is to cease operating. A better idea is to establish a close relationship with the customers so that they will make their future requirements available. After all, the customers probably already know their future requirements. Many companies will happily share their anticipated needs, if they believe it will allow their suppliers to improve their service level and there are assurances of confidentiality. There are several ways to obtain this information from customers, through schedule sharing, participating in a vendor managed inventory (VMI) program, receiving point-ofsale data directly, and by using collaborative forecasting. 4 Whichever tool is chosen, one thing is certain, getting information directly from the customer is almost always going to be more accurate than even the best forecast.

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7. Partner With Suppliers Often we maintain safety stock in our raw materials inventory because we are working with suppliers who have a poor on-time delivery record. In order to provide timely service to our own customers, we keep safety stock to compensate for those inevitable instances when we receive late deliveries from our delinquent suppliers. One way to solve this problem is to switch suppliers in the hope that the new one will have better performance. However, before taking this drastic step, ask one question. Could your company be a major part of the problem? Is your company’s order pattern extremely erratic, making it difficult for a supplier to anticipate its needs? Does it provide its suppliers with its anticipated needs? It was stated earlier that a customer and supplier should communicate their scheduling information in order to anticipate each other’s needs. Has your company provided the same information to its suppliers? Or does your company send them a purchase order and expect them to respond to its ever-changing needs? Partnering with suppliers, supplying them with anticipated needs so they can be prepared for them, is often the quickest and most effective way to improve a supplier’s delivery performance. Grouping your purchases by supplier in the computer system and sending your key suppliers a copy of the portion of the purchasing report that relates to them will allow them to prepare to meet your needs. 5 Will it always work? Unfortunately no, some suppliers just do not understand the importance of on-time delivery. Replacing such suppliers is often the only way to get better performance. However, providing most suppliers with their customers’ anticipated needs will turn poor performers into on-time deliverers!

8. Reduce WIP Space In a manufacturing plant, there is one piece of conventional wisdom that is usually true — inventory will grow to fill the space given it. This is particularly the case with Work-InProcess (WIP) inventory in a job-shop. If there are 50 square feet allotted to inventory, it will not be enough, so it is increased to 100 square feet. This will suffice for a few weeks until more is needed. This is because inventory is often used to cover a multitude of sins. Everything from frequent machine breakdowns (due to lack of a preventative maintenance system), to long setups (no setup time reduction program) or frequent high levels of scrap (no statistical process control program) are compensated for by keeping lots of inventory between operations so that part supplies are maintained even when problems are encountered. In order to counter these problems, companies should reduce the amount of space between operations where inventory can be stored. As space is decreased, it will force underlying problems (machine breakdowns, long setups, poor quality) to the surface where they will be visible for all to see. As an underlying problem surfaces, companies should direct all efforts to solving the problem. Once the problem(s) is solved and the operation is functioning smoothly with less space, reduce the WIP space some more to uncover even more “opportunities” for improvement!

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9. Eradicate Individual Incentive Systems Compensation exerts a strong influence on people’s behavior. In many traditional manufacturing environments, individual incentive systems based on production are the norm to boost productivity. Unfortunately, when an individual can earn a bonus by simply producing more, quality or reduced inventory levels will be the furthest things from his/her mind and instead will strive to produce more units whether or not the product is needed. By contrast, inventory reduction should be a team goal and achievement. Once all employees understand that inventory reduction is desirable, they can band together to make it happen. Few things can compromise the drive toward inventory reduction more than individual incentive systems based on productivity. In order to change the mindset of employees who are used to individual incentives, the wise company will move in two directions. First, instead of individual incentives, the company will move to a group incentive involving everyone in the department or plant. This will encourage employees to work with the team, instead of just pushing out more of a given item, regardless of whether it is needed. Secondly, instead of basing the incentives on production only, the new group incentives should be based on other important goals such as quality, inventory reduction, and safety in addition to production. This will focus employees on the myriad of elements needed to make manufacturers successful.

10. Educate & Train! The tools and drive to reduce inventory is not something innate to managers or employees. These must be learned. Many companies with inventory problems decide their salvation lies in the newest software program on the market. They do not see the wisdom of first educating their employees about the basics of good inventory management. If some of their employees cannot count, and they are responsible for keeping track of their production, no software program in the world will help them. Most companies can reduce their inventory while improving their service level by making a concerted effort to train their employees in proper inventory management techniques. These employees are not just those in inventory management or purchasing positions (although they are definitely included), but the “rank and file” employees who do the work in the organization. If a receiving clerk routinely enters the wrong data into the system, if a stocking clerk often places goods in the wrong place, if a picker does not bother to accurately count the product being picked or if the shipping clerk puts the wrong label on boxes, the inventory won’t ever be accurate. In these instances, a company will never have the ability to safely reduce inventory without hurting its service level. Only by training the employees in the importance of doing their jobs correctly and giving them the tools necessary, will you be able to create the best kind of inventory reduction team—your entire workforce!

Conclusion Companies exist to service customers. However, if a company attempts to service its customers by maintaining an extremely high level of inventory, it may find itself with a www.w-scg.com

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serious cash flow problem. Companies have even gone bankrupt while having plenty of assets because too large of a percentage of those assets were tied up in inventory, and the company could not meet payroll or pay its bills. If a company aspires to maintain a high service level while minimizing inventory, it will take hard work, dedication, and teamwork. Ensuring an accurate inventory of items that supplier and customer agree must be in stock is a good starting place. This requires precise recording and counting processes, along with an understanding of ABC inventory methods and a commitment to clear, timely, confidential communications regarding needs and expectations. Within either company, steps should be taken to educate all people responsible for inventory accuracy in proper procedures for reducing inventory and the space allotted to WIP storage. Team goals and incentives should be established to bring about these ends, thus phasing out counterproductive individual incentives. Improving communications and processes, increasing accuracy, and raising the awareness and commitment of workers at all levels to inventory reduction will ultimately enhance any company’s bottom line. There are no magic bullets, but if a company employs the tools and techniques found in both this article and in the APICS body of knowledge, it will be on the right path towards achieving these dual goals.

1

Ross, David Frederick, Distribution Planning and Control, Chapman & Hall, 1996

2

Arnold, J.R. Tony, Introduction to Materials Management, Prentice Hall, 1998.

3

Arnold.

4

Williams, Mark K., “Critical Tools of the Supply Chain,” APICS 42nd International Conference Proceedings, 1999.

5

Williams, Mark K., “Information and Teamwork—Keys to Supply Chain Success,” APICS 43rd International Conference Proceedings, 2000.

About the Author Mark K. Williams, CFPIM, CSCP, is President of the Williams Supply Chain Group, Inc., a consulting firm specializing in supply chain management and training. Mark has over 20 years of industry experience in various roles including Director of Demand Planning, Senior Manager of Materials, Plant Manufacturing Manager, Distribution Center Manager, Corporate Internal Auditor and Production Control Manager. He is an APICS Certified Fellow in Production and Inventory Management (CFPIM). He is also a Certified Supply Chain Professional (CSCP). He has many years of experience teaching APICS certification review courses and developing customized inventory and supply chain management courses for corporate clients. He has spoken at numerous APICS International Conferences, three European Supply Chain conferences, two Australian Logistics & Supply Chain Conferences, a South African Supply Chain Conference, as well as numerous local and regional supply chain

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meetings. In addition delivering seminars in most of the United States, Mark has delivered seminars for clients in Singapore, Malaysia, Indonesia, Bulgaria, and Australia. Mark is online at www.w-scg.com and he can be contacted at [email protected]

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