Are you on top of inventory?

Dale Billet, director of performance-improvement consulting for RSM McGladrey Inc, says most of the companies he visits are severely inventory-challenged.

They tend to buy more, produce more, and warehouse more inventories than they really need.

“Those high inventory levels tend to mask other problems within the company,” he said. “If you're trying to improve your manufacturing processes, high inventory makes that much more difficult. If you're a lean advocate and you're trying to reduce waste and shorten cycles, high inventory gets in the way.”

He said there is rampant confusion about who is responsible for inventory levels.

In finished goods (FG), is it materials management/inventory control, because they schedule when finished goods are going to be made? Is it manufacturing, because they determine what they work on and what goes out the lot? Is it sales, because they provide the orders or projections? Is it no one? Everybody?

In work in process (WIP), is it materials management/inventory control, because they release materials? Is it manufacturing, because they decide what gets pulled off and put back on? Is it sales? No one? Everyone?

In raw materials (RAW), is it purchasing, if there is too much? Is it materials management, because they gave the requirements to purchasing on what to buy? Is it manufacturing, because they may requisition materials and say, ‘We're getting low, go and buy some’?

“There is no clear line of responsibility of who's in charge of inventory,” he said, “and that's a symptom of why there are typically inventory issues.

“How do you view inventory? As an asset? As insurance for demand fluctuations? As insurance for production problems? You might use it in case of incorrect bills of material, saying: ‘My bills and materials might not be correct, so I'm not sure what's going to go in that unit, so I'm going to cover a little extra inventory.’ Or you might say, ‘I've got shortages now, so if I add more inventory, those shortages should go away.’ Or on-the-floor engineering changes: ‘He found a better way to build that. He didn't tell anybody. I'd better have some extra inventory because I'm not sure what he's using unless I go out and track what he's using.’”

No value created

He said one of the seven wastes of lean says that inventory is a waste because it doesn't create any value for the company: Sitting in inventory does nothing.

The impact of inventory is felt in holding costs (cost of capital, warehousing, lost items, theft, damage, insurance, physical inventory counting), obsolescence, opportunity costs, and missed sales.

Key symptoms of an inventory problem:

  • A company has too many of the wrong items and production shortages.

  • Frequent overnight shipments.

  • The perpetual levels on the computer are always wrong.

  • Large end-of-the-year write-offs.

  • Congested plant floors.

  • Reminders of the “Lost Ark.” “If someone's looking for an item, the whole crew has to go out and search.”

  • Responsibility for inventory levels is unclear.

“Inventory problems are a symptom of many other issues,” he said. “And since it is a symptom, if you're going to create a lasting solution, you need to look at the causes. The CEO comes in and says, ‘We have to do something.’ So everybody works hard for a few months and inventory starts to come down, and then the pressure goes off and you haven't changed anything about how you do business. That's because the causes are still there.

“The typical causes of excess inventory: The customer demands finished goods on hand; the supplier is unreliable, so you have to put in extra inventory to cover; you allow extra for scrap; the vendors are allowed to ship the ‘week of’, so if you need something next Friday, you think, ‘I'd better get it in this week’; customer orders are released earlier than needed; the MRP system is unreliable and you don't have accurate data; the customer changes specifications; a standardization program does not exist; the focus is on material yield, which leads to excess part numbers; manufacturing is measured on utilization of equipment; and the attitude of, ‘No one cares if we build inventory. Inventory is looked at as a good thing. I know I can supply my customers if I have inventory.’

“Other causes: Purchasing gets measured on price reductions or production shortages; customer forecasts are not accurate; inventory-reduction goals tied to incentives do not exist in the organization, so no one measures trying to maintain an inventory that has high turns and a low level of inventory; there is no sales forecast; vendor-managed (and counted) inventory; obsolete inventory is retained in case it can be sold; more inventory is purchased than the customer needs because that is viewed as good customer service; change orders are not communicated from sales to purchasing, so a company is ordering materials it doesn't need and expediting materials it does need.”

He said strategies for the business will impact inventory levels.

“Management may say, ‘I want to keep inventory levels,’” he said. “Depending on your strategy in the marketplace, your inventory strategy is going to be different. If you're competing on cost, you're going to have a different strategy than if you're competing as the innovative, high-end entry in the marketplace.

“How orders are launched within the plant will affect inventory levels, as well as how inventory is controlled. The more agile and flexible the manufacturing floor, the less need for inventory.”

How does a company determine if it has an inventory problem? The key measurement is inventory turnover, he said. Inventory turns measure the number of times that an average amount of inventory is sold within a year. They equal the cost of goods sold divided by the average inventory on hand.

He said there should be inventory turnover segregation, where inventory is examined by classification: RAW, WIP, and FG. That's because an aggregate figure can hide where the true problem lies.

He said that assuming that the annual holding cost of inventory is 10% — a conservative number — if the turns are increased from four to eight, the cost of goods sold is still the same ($4 million), but the average inventory on hand would need to shrink from $1 million to $500,000. The minimum annual savings would be $50,000 (because the $500,000 inventory was reduced by 10%), but more importantly, the increased cash flow is $500,000.

“Of the three classes, poor finished-goods turns are the worst because labor and machine time are already invested,” he said. “Teardown and rebuild are often a temptation: ‘We can change this and change that.’ Now you're putting a lot more value into it just to get it off the lot.

“Raw material is an indication of how well the company has its basic infrastructure, BOM's purchasing, and vendors under control. I see lot of improvement in the area of WIP because of the adoption of lean principles. It is slowly disappearing from the shop floor, but poor WIP turns may indicate jumbled manufacturing processes and/or flows.”

Correlation noted

He said higher raw-material turns may indicate minimal obsolescence, effective buying, and better material forecasting processes. Research studies have shown a high correlation between high profitability and high inventory turns.

With WIP and FG, higher turns may indicate effective production scheduling, shipping coordination, and forecasting. Low turns may indicate obsolescence, slow-moving issues, and poor integration between production and sales plans.

Billet said if a company is below the midpoint for its industry type, it needs to address the problem, examining the underlying processes that govern inventory requirements.

The initial questions for WIP inventory: Frequent expediting/ schedule changes? Overloaded schedule? Poor quality (scrap/rework)? Large lot sizes? Executive decision to hold WIP inventory?

Rules of thumb: How orders are launched within the plant will determine inventory levels and how inventory is controlled; order launching and expediting results in excess inventory; and the more agile and flexible the manufacturing floor, the less need for inventory.

“Are finished goods a company strategy?” he said. “When I drive by a trailer client, there's typically a whole yard of inventory. Now, they're going to tell me most of that's sold, but it's still sitting there. So ‘sold’ is maybe not quite sold, but we think we're going to sell it or, ‘I've got an order, but haven't released it yet.’

“Does inventory cover other problems — poor BOM's, poor storage layout, poor quality? Is there inaccurate forecasting? I may have made what I thought the forecast said I needed, but if it wasn't very accurate, I may have the wrong stuff.”

He said if no one in a company has the formal responsibility of forecasting, then typically manufacturing or production planning forecasts the finished goods, and purchasing forecasts the raw materials. He said the function closest to the customer has the best information from which to forecast, so sales should be doing the forecasting.

Types of demand

Billet said there are two major classes of demand:

  • Dependent demand

    Items are only purchased when a parent item has been ordered or scheduled (such as wheels for trailers).

  • Independent demand

    Finished products, service parts, and other items that are driven by market demand.

Only independent demand items should be forecast. Dependent demand items (wheels, axles, aluminum, wood, generators, steel, etc) should be calculated from the independent demand (trailers).

“We know sales are a pretty optimistic bunch,” he said. “They know if the forecast is too low, you may not be able to supply it. So they say, ‘Let's forecast kind of high,’ and so with that high forecast it drives material requirements and you get lots of inventory.

“There should be feedback on forecast accuracy, including history of past usage by model/option and performance measurement/compensation affected by forecast accuracy. You want to balance finished-goods, inventory-turns goals with sales goals.”

He said production strategies affect inventory levels. Customer demand is not uniform — there is seasonality — and as a result, production planners use basic strategies:

  • Vary production to meet demand

    The primary area adjusted is employment: hirings, firings, layoffs, overtime, and subcontracting. Inventory stays fairly constant.

  • Constant-rate production

    Utilizing a constant rate of production in which inventory levels increase and decrease based upon demand — anticipatory demand, excess demand above the constant rate that can be handled by subcontractors, and discounting that is used to reduce inventory.

  • Stable workforce

    It could be one of the most often-used techniques. It keeps workers constant and permits overtime, part time, and idle time. The primary goal is to avoid layoffs and dramatic changes in workers.

He suggested an action plan for inventory improvement, with these key tasks:

  • Identify company strategies affecting inventory.

  • Review and modify forecasting processes.

  • Review sourcing, ordering/releasing of purchased inventory.

  • Review production scheduling/order changes.

  • Review and measure data accuracy (bills of material, inventory balances, etc).

  • Review and analyze receiving, storage, and inventory process flows.

  • Review and analyze obsolete, slow-moving, and substitute-inventory processes.

  • Provide tools, information, and physical systems (including performance measurements).

  • Develop and implement cycle counting.

  • Set policies and procedures.

  • Assign ongoing responsibility and performance measurements in each area.

“Controlling inventory is really not about the inventory but rather the management of the company strategies, processes, and practices that result in inventory,” he said. “Until you address those, you'll never get a lasting solution that allows you to manage inventory effectively.”

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