Industries

Focusing on the factors that affect your inventory rather than solely on the inventory itself

By Dale Billet CPIM, CIRM, CSCP
Director, Performance Improvement Consulting
RSM McGladrey Inc.

Inventory is a very difficult area to manage for most companies. In fact, many businesses are purchasing, producing and warehousing too much inventory. These high inventory levels mask other problems and can delay improvements in operations. Typically, the multiple causes for poor inventory management are not well understood and the lines of responsibility are blurred.

Inventory Responsibility
Who should be responsible for inventory? Often times, the Materials Management or Purchasing areas are held responsible for maintaining levels. After all, these groups purchased and scheduled the inventory to be produced, yet they typically do not have the tools to address the causes that lead to high inventory levels.

In other organizations, inventory management is a shared responsibility. When levels become too high or obsolete inventory becomes a problem, the mandate to everyone is to “reduce inventory.”  With a focus on inventory, some early reduction may occur but when the spotlight is no longer on reduction, the inventory tends to climb back to previous levels because the causes have not been addressed. When everyone is responsible for something, then typically, no one is responsible for it and no lasting solutions are achieved.

Impact, Symptoms and Causes of High Inventory
How you view inventory often determines the practices you employ to manage it. Listed below are some of the common views of inventory that are often encountered in most companies:

• Asset (because it is listed on the left side of the balance sheet)
• Insurance for demand fluctuations
• Insurance for production problems (scrap, incorrect bills of material, shortages, on the floor engineering changes)
• Waste

The impact of inventory is due to multiple cost factors. Frequently, many companies view inventory costs as simply the cost of borrowing money to finance the inventory. The true costs are significantly higher and include the following:                                                

• Holding costs (cost of capital, warehousing, lost items, theft, damage, insurance, physical inventory counting)
• Obsolescence
• Opportunity costs (missed sales)

When all costs are considered, most companies find that inventory costs are in the 25 percent to 35 percent per year range.

A company can very quickly perform a self assessment to determine the potential for improvement with inventory management. Listed below are common symptoms that indicate inventory management is a weak area:

• High number of slow-moving items along with production shortages
• Frequent overnight shipments
• The perpetual quantities on the computer are always wrong
• Large year-end write-offs
• Congested plant floors
• Responsibility for inventory is unclear
  

If you have a number of these symptoms, the most effective approach is to identify the causes rather than focus on these symptoms. Among the typical causes of excess inventory are:       

• The customers demand finished goods on hand
• Suppliers are unreliable
• Extra inventory is purchased or manufactured as a scrap allowance
• Customer orders are released earlier than needed
• The MRP system is unreliable
• Inventory is manufactured to absorb burden
• Manufacturing is measured on utilization of equipment
• Purchasing is measured on price reductions or production shortages
  

To improve inventory management you should review some basics. Inventory is not an asset (despite what your accountant tells you), it is waste. There is a high correlation between companies with high profitability and high inventory turns (i.e. less inventory). The business strategies of your company will affect your inventory levels. If you are highly innovative and have a strategy of offering many options to your customers, you will typically need to carry more inventory than a company that competes on price and attempts to minimize product cost.

Inventory Measurements
A key measurement of your effectiveness with managing inventory is turnover. Inventory turnover measures the number of times inventory is sold within a year.                                 

Inventory turnover =  Cost of Goods Sold/Average Inventory on Hand                                                                                 
The inventory turnover must be segregated by class (Raw, WIP, Finished Goods) because an aggregate figure can hide where the true problem lies. Poor inventory turnover for finished goods is the most damaging because labor and machine time are already invested and teardown and rebuild is often a temptation. Improving inventory turns can produce significant annual cost savings (calculated by dollars of inventory reduced times annual carrying cost) and a one-time improvement in cash flow.                                                                                                    

Benchmarking yourself against your competitors can identify if you have low inventory turnover for your industry. If you are below the midpoint for your industry type, you need to address the causes of the low turnover.

A 10-Step Inventory Improvement Action Plan
Now that you have identified inventory as an area needing improvement, how do you determine what steps to take to improve your inventory management? Listed below are major steps to identifying the causes of poor inventory management and implementing corrective actions.

1. Identify company strategies that affect inventory - The strategies may be written or unwritten but an evaluation of how the strategies affect inventory is a good starting point.                                                                                                            
2. Review and modify forecasting strategies - Do you have a forecast accuracy feedback process? Who is responsible for forecasting? Are you only forecasting independent demand items?

3. Review sourcing, ordering and releasing of purchased inventory – How is Purchasing measured? If the primary measurements are cost reduction and shortages, you will need to add other metrics (such as inventory turns) that the balance these metrics and measure the inventory management responsibilities of Purchasing.                                                                                                                                 

4. Review scheduling and the order change processes – Is the schedule changed in the short term to add more orders without rescheduling the orders already in the schedule? Are change orders to units already on the production line implemented without consideration of the inventory that is no longer needed?                     
5. Review and measure data accuracy (bills of material, inventory balances, etc.) - If the data that supports the decisions on inventory to purchased, scheduled and shipped is inaccurate, the result will be excess and obsolete inventory along with production shortages.                                                                                                                
6. Review and analyze receiving, storage and inventory process flows and practices – Are there gaps and disconnects in the processes that support inventory processes? Are there controls in place to monitor the accuracy of transactions in the processes? Are storage areas well lit and orderly and are responsibilities for inventory transactions clearly understood.                                                                                 
7. Provide tools, information and physical systems - It is critical for those responsible for inventory management to have adequate information (computer reports, on-line access, etc.) and physical systems (racking, labeling, bar coding) to be successful. If this area is not adequate, employees will become frustrated and ineffective in achieving the improvements needed.                                                                                                                     
8. Develop and implement a cycle counting program – To maintain the level of accuracy needed to support effective inventory management, a structured cycle counting program with emphasis on measuring accuracy, identifying causes of inaccuracy and implementing corrective actions is needed.                                                    
9. Set policies and procedures – Each person involved with inventory management must have clearly defined and documented procedures for inventory processing tasks                                                                                                                                             
10. Assign ongoing responsibility and performance measurements in each area - “Tell me how you measure me and I will tell you how I will act” is a common cliché but it applies to inventory management. A balanced set of performance metrics with clear lines of responsibility is vital to effective inventory management.

Final Thought
Inventory management is not really about the inventory but rather the management of company strategies, processes and practices that result in inventory. Focus on the factors that affect the inventory rather than solely on the inventory itself and your business will be more successful.