A Guide to Inventory Reduction

This article is also available on our website at PROACTION - Generating Best Practices. It is an excerpt of a paper originally written by George Miller, Founder of PROACTION. It has been modified and updated by Paul Deis, PROACTION CEO.

INTRODUCTION

How many firms think their inventory investment is low enough? What is low enough? INVENTORY is the largest single asset on the balance sheet of many manufacturers and distributors. It is usually the most expensive asset to own and maintain as well, with estimates of carrying costs typically running 25-30 cents or more on the dollar annually. Therefore, any useful suggestions to optimize INVENTORY investment and associated expenses would be most valuable.

The paper addresses how to manage INVENTORY investment to optimum levels, which means a reduction or major redistribution of it in most companies. Optimal INVENTORY levels come down as management makes the operation more efficient by improving processes, reducing lead-time, managing supply and demand better.

One can't "attack" INVENTORY effectively, but only its underlying causes, which will be discussed. Most INVENTORY "problems" are merely a reflection of management, design, process or operational problems. Current literature on Just-in-Time and World-Class Manufacturing addresses how inventory reduction is a by-product of doing things right the first time.

WHAT IS THE SIGNIFICANCE OF INVENTORY?

Why is INVENTORY "bad"?

INVENTORY is a major capital investment affecting cash flow and profitability. Inventory comprising one-third to one-half of companies' total assets isn't unusual. There are significant expenses associated with possessing it. INVENTORY reductions can do more to improve ROA (Return On Assets) in most companies than most other factors. For instance, a 50% reduction in INVENTORY will typically account for a 10-25% improvement in ROA! Certain industries, such as aerospace and defense, widely believe that INVENTORY is a non-issue, because they receive "progress payments" from customers or because they "write-off" job-end variances and leftover "residual" inventories. The facts are that these companies need to watch inventories even more closely but first they need to be made aware that there are INVENTORIES to watch. Just because the government or other customers finance the cost of money for INVENTORY, doesn't mean that there aren't many other hidden costs, most of which are hiding in burden and serve to make the company less competitive and profitable.

Excess inventories subject the manufacturer to additional liabilities for things such as obsolescence, rework, storage charges, etc. Most of these ultimately end up "written off" and are applied to "overhead", but this eventually raises the overhead rate, which increases costs of doing business, which raises prices, which makes companies less competitive. It really doesn't matter that much (except for tax purposes) whether costs end up as direct, indirect, expensed, burden, or whatever: they all affect profitability, investment and cost of manufacturing.

Carrying Costs

Let's look at what goes into INVENTORY "cost of ownership", frequently called the "carrying cost" and expressed in terms of percent cost of INVENTORY valuation per year of ownership. For example, a 25% carrying cost would indicate that it costs about $.25 to own each $1.00 of INVENTORY each year. These costs consist of:

• Cost of money - The cost of capital to the company or, in some cases the "opportunity cost" or return that could be earned on the money by applying it productively elsewhere. The cost of money has ranged anywhere from 6% to 18% in the last 25 years. Obviously, cost of money has a very significant impact on investment strategy.
• Obsolescence - The risk of INVENTORY never being used, or needing rework to make it usable, needs to be factored into the cost of owning INVENTORY. In theory (and practice), the larger the INVENTORY is, and the longer it is held, the more likely engineering changes, customer preferences and technological changes will render that INVENTORY unusable. In the clothing industry, it is not uncommon to see inventories depreciate as much as 90% when styles change. Certain portions of the electronics industry have problems with INVENTORY becoming obsolete very quickly due to technological changes.
• Shrinkage - A portion of INVENTORY becomes unavailable to the owner due to loss, damage, theft or spoilage. The longer INVENTORY is there and the more there is, the more likely this is to happen. Steps to prevent it only raise carrying costs in other areas, such as security, air conditioning, better control systems, recruiting policies, etc.
• Quality Factors - Allowances for yield, attrition, scrap and rework. This is really more of a function of the process than the amount of INVENTORY invested and is more related to throughput, but is usually expressed as part of the aggregate INVENTORY carrying cost.
• Technological or Price Obsolescence - Prices don't always go up. In fact, in industries such as electronics, prices often plummet due to constantly improving designs, product and process technology improvements. Therefore, it is desirable to minimize inventories in high-risk areas.
• Taxes - There are two dimensions to this: 1) In some areas, a tax is levied on inventories, so the more INVENTORY, the more tax is paid. 2) INVENTORY is regarded as an asset by most accounting and tax rules. Therefore, building large inventories shows "profits" and profits are usually taxed, usually by multiple government entities.
• Insurance - The cost of carrying insurance on INVENTORY needs to be considered, as well as insuring the space, equipment, people and other resources needed to control it.
• Space - Costly storage space sometimes occupies 25-30% of the total facility, when one considers raw material warehouses, stockrooms, work-in-process storage, receiving, shipping, outside warehouses, MRB and residual storage areas. INVENTORY reduction campaigns frequently help companies avoid the need to move to large facilities, or permit them to shut down or cut back existing facilities.
• Manpower - All of this INVENTORY needs people to order, receive inspect, record, move, count, store, retrieve, post it to the ledger, etc. People are the largest or second largest expense (behind material) for most manufacturers.
• Record Keeping Systems - Software, procedures, equipment and paper must be used to stay on top of INVENTORY.
• Material Handling/Storage Equipment - Conveyors, fork lifts, bar code readers, scales, AS/RS, trucks, carts, bins, racks, shelves must all be purchased, leased, maintained and cared for.
• Physical Inventories, Reconciliations - Must be conducted to ensure that inventories are properly accounted for and maintained.
• Transportation - Must be provided to move INVENTORY in and out of the facility, to vendors, within the facility to different workstations and storage areas.
• Energy - Heat, light, humidity control, air conditioning, refrigeration and fuel must be consumed to make all this happen.

WHAT AFFECTS INVENTORY?

One must "know thine enemy" to successfully deal with it. Now that we've discussed the significance of INVENTORY, let's determine why it exists and what makes it go up or down.

INVENTORY is not always evil. It usually exists for a reason, however a reason is not always true justification. INVENTORY is frequently kept as a buffer and masks other problems.

Major Reasons for Inventory

• Net Demand - Demand derived directly from customer requirements or internal demand.
• Pipeline - INVENTORY needed to sustain the process over its cumulative lead-time through all operations and holding points. Also included in the pipeline are paperwork operations, such as billing, which could increase inventory if not done timely enough.
• Quality - Yield, attrition, scrap, rework allowances impacting amount of inventory and time inventory is in process.
• Lot Size - Lot size considerations include vendor minimum order quantities, raw material and manufacturing lot sizes due to setup and other nonrecurring, lot-related cost considerations and run time impact considerations.
• Supply Buffer - Extra INVENTORY carried as a hedge against unreliability of vendor or factory schedules, inaccurate records, unpredictable quality or other fluctuations tending to reduce reliability of providing materials on demand. It is usually expressed in terms of "safety stock" (quantity or periods of supply) or "safety lead time" (bringing it in earlier).
• Demand Buffer - Extra INVENTORY planned due to uncertainty of the true requirement need date or quantity, which may vary due to poor forecasts, transportation problems, or various contingencies. It usually takes the form of larger quantities being put into process, or processes started earlier as a hedge against demand fluctuations. It is usually combined into the total buffer as described above. Another form of demand buffer is building "anticipation" inventory for seasonal fluctuations and other forecasted demand surges.
• Hedge - Inventory acquired for speculative purposes with the exception that prices will rise later, justifying the earlier investment risk.

Other Factors Affecting INVENTORY

The reasons given above are those that apply for a given set of circumstances or basic assumptions about design, processes, etc. The factors below are more basic and can have a more profound long-term effect on INVENTORY:

• Product Design - The number and type of parts, difficulty to manufacture and specifications for materials, reliability designed in and other factors, do more to set basic parameters for INVENTORY than anything else. A product design that minimizes the number of parts, picks easily obtainable materials and components, lends itself to manufacturing with the simplest possible facilities and equipment will minimize INVENTORY costs over the long pull.
• Materials Supply - Specifying quality materials, well suited to the process and application, with easy availability, low prices, reliability of supply and short response time are all big advantages that can facilitate INVENTORY reduction. Having the best sources for key materials or changing existing arrangements can do a lot to help minimize inventories.
• Processes - Good, reliable processes will help reduce INVENTORY, because they will help reduce scrap, rework and attrition, and also provide a more reliable flow of supply, which will help reduce buffer stocks, safety stocks, safety lead time INVENTORY and eliminate much accumulation of INVENTORY on the production floor. Better processes will also serve to reduce many other burden activities, such as inspection, MRB, management intervention, expediting, etc. Better process design, coupled with improved equipment selection and tooling engineering cannot only minimize the amount of set-up and other nonrecurring or lot-related activities to be performed, but speed up the entire process. Reducing set-up not only cuts labor, but also improves facilities/equipment utilization and decreases the amount of time that INVENTORY needs to be invested. This can result in capital investment avoidance, which helps minimize the asset base and operating expenses, which further improves return on assets/investment.
• Facilities Layout/Design - INVENTORY may be increased significantly if this is not done properly. Widely scattered plants, multi-story buildings with inadequate material flow capabilities and processes distributed over many different departments, all increase the amount of part travel, possibility of loss, delays and need for manpower and extra equipment to support the process. Poor utilization of space will also increase the cost per square foot and the number of square feet required to support the process.
• Service Objectives - The required response time and reliability of service to customers has a big impact on INVENTORY costs. For instance, if industry standards allow making to customer specifications from scratch, there may be less need to maintain finished goods inventories. If customers or distributors carry stock, that reduces pressure upon the supplier to maintain inventories and reduce them quickly. Once a competitor attempts to improve service by keeping raw materials, work-in-process or finished goods available, or by making the process quicker and more efficient, it puts pressure on competitors to meet this new standard.
• Outside Processing - Some firms lament the amount of money spent on outside processing charges. This is not a problem unless they are significantly higher than comparable in-house costs. If only a little bit higher, it's better to leave them outside if the vendors are nearby, reliable and provide good service. The reason for this is that these services are hard to manage, are frequently outside the scope of the business and are better left outside when fluctuations in customer demand occur, since this reduces the amount of money needed to support underutilized capacity.
• Planning/Control Systems - Systems employed to manage supply and demand and control the production process have a large effect on INVENTORY. The policies that management sets, the education/training it provides and the ongoing follow-up to ensure that these points are implemented and data integrity maintained, are decisive.

The systems we refer to are:

• Front End
-Forecasting
-Production Planning
-Master Production Scheduling
-Capacity Requirements Planning
• Engineering
-Bill-of-materials
-Change Control
-Routing/Process
• Material Planning
-Time Phasing Tools
-Requirements Calculations/netting
• Shop Floor Control
• Data Integrity
-Bill-of-material
-MPS
-INVENTORY, PO, RM, WIP, QA, FG
-Process

Cost

• Material Costs - Material cost increases (obviously) raise INVENTORY. Lowest unit cost does not necessarily mean lowest cost of doing business, or even lowest cost of material, for that matter. These can be deceptive, because as material costs go up, turns do not decrease, because they are being measured on a new and higher base. In a standard cost system, "variances" may be expensed and not immediately show up in some inventory systems, such as standard cost.

• Overhead - Burden rates of 300%, 500% or more are not uncommon. Having a high overhead rate is not "bad", only total costs that are too high are "bad". Your overhead rate is a reflection of cost distribution and accounting techniques as well. However, if overhead is going up without attendant drops in other areas and if other industry competitors are doing better, then it's "bad."

• Setup and Other Nonrecurring Costs - In most companies, these are either part of direct labor or buried in overhead. I broke them out separately here because of their differing characteristics. Many manufacturing people feel that the way to reduce the set-up portion of overall run time is to increase lot sizes. Unfortunately, the attendant increase in INVENTORY and other related expenses sometimes negates setup reductions. Another argument is that long runs increase capacity An interesting ideas, but large lot sizes also take up capacity and confuse priorities. The real answer is to reduce setup times.

• Labor Content - Reduction of direct labor has been one of the few bright spots in American productivity improvements over the years. It has gone down to a much lower percentage than before. It amuses me that some major manufacturers and government regulatory agencies focus so much attention on reducing direct labor content, which is a low as 3-5% in some industries. The area to look at is labor variances, due to down time, quality problems, material shortages, etc., and in indirect labor. In short, reduce the overhead due to other factors increasing labor.

The preceding sections should give you a better idea of the significance of INVENTORY, and what affects it. If you have been reading carefully, you have already seen opportunities for reduction, since knowing the question is frequently half of the answer. The next section will amplify and clarify some of these...

HOW TO REDUCE INVENTORY

Advice To The Boss

Let's now discuss some specifics for helping to tame the beast. To begin with, let's first set up a program to do this with little initial out-of-pocket costs, a fast payback and subsequent return on investment!

Your controller will love this.

It sounds almost ridiculously simple, but there is a sequence that one ought to address inventory reduction activities in:

• Don't bring it in. An ounce of prevention is worth a pound of cure. Don't order what you don't need. For existing commitments, cancel or reschedule where practical.
• If you already have it, ship it. Work on eliminating constraints to getting product shipped. Sell excess inventory at full price/cost, if possible.
• Try to rework or substitute. Attempt to rework, retest inventory, try to substitute it in place of parts that have been specified.
• Salvage it for cash at a reduced rate
• Dump it. If all else fails and it's really not needed, throw it away, because the tax write-off and lower holding costs alone will make it worthwhile.

Try the specific recommendations contained in the sections following...

Short-Term Activities

Since it is an "established" fact that most managers think "only of short term profits," let's cover the stuff we can do right away first. The author doesn't believe that most top managers really believe this but knows that in order to keep a business going and to keep your job, you do have to show short-term results.

Assign responsibility/accountability for inventory reduction

Not just to the materials people, but production, sales and engineering also. This should probably be a team, with ONE person clearly in charge, who should a vice president, rather than a summer intern.

Get Control of The Checkbook

This is one of the first things that "turnaround artists" always do to rescue a foundering company. Insist on getting justification for all new INVENTORY expenditures - especially "A" items (most expensive ones). Sign all major approvals and checks yourself. Brook neither opposition nor watering down of this until things are back in control, policies are established, being followed and look like they can stay that way. This has an amazing and rapid effect on INVENTORY and has been practiced first-hand by the author and customers. It requires nearly no cash to implement. Consider having the requisitioner show up in person to plead his/her case of why the inventory is needed and explain all the nasty problems.

Use this process to force those responsible to justify what they are doing and why and to think through these policies and their enforcement in a new light - that of investment management. While you are doing this, use it to study the dynamics of INVENTORY planning systems and to decide what INVENTORY investments should be and what problems really are. You should develop a matrix of inventory days coverage targets by commodity by product line by planner. Then cost it out and track actual performance. Be sure to track commitments and planned amounts, or you may be disappointed again fairly soon.

Conduct basic indoctrination of people affecting INVENTORY most dramatically—planners, buyers, production management, sales, customer service- establish some temporary "edicts" and enforce them until more formal policies/procedures can be established/changed later on. Make sure you know what you are doing before you establish these. Beware of mindless "across the board reduction" edicts that could result in hurting service and profits.

Have your people perform a quick "thumbnail" INVENTORY analysis

Start with items currently on order, in process, or being planned. As Al Agosti of IQR says, "first stop the bleeding. Then take away the knife." It always amazes me that companies will spend a fortune to analyze INVENTORY, which is already there, but ignore huge impending expenditures, which they can do something about before disaster strikes. If your company can't save a bundle the first month of this methodology, maybe it's too late already. To do this, perform a quick "ABC" analysis, identifying only the expensive ("A") items initially. In most companies, these are only 5-15% of the total items and can be leveraged to provide quick benefits in terms of investment management. After this has been done, get together with the management team, do a quick brainstorm and put together a Pareto chart, showing problems in descending order of importance.

Start with a calculation of what is actually needed:
• Go through all the arguments of why people need more, sooner and then get people to agree on how they can avoid doing that.
• Cut new INVENTORY scheduled to come in whenever possible.
• Determine right away what can be cancelled, rescheduled, returned to vendor for credit or sold for salvage. Balance the costs of doing this against the relative benefits.
• Work on getting product shipped and billed to get INVENTORY relief.
• Try to match INVENTORY input closer to ship date (reduce lead times and carrying time)
• Determine if excess/obsolete finished goods can be put on promotion or "fire sale." Do so if appropriate.
• Lean on customers who have cancelled/rescheduled orders to your detriment. Try to get them to pay for part of these costs, accept the INVENTORY, or use these incidents as levers to improve future terms.
• Look for obvious bottlenecks in the planning and processing of orders such as:
-Amount of lead-time and queue permitted.
-Lot size and cycle times.
-Scheduling assumptions
-Major bottlenecks caused by improper manning, defective or poorly maintained equipment, etc.
-Build-ahead and buffer policies

Set goals for inventory down to the level of managers and planners

Do this "rough cut," for "A" items first—more detailed analysis comes later. Set targets by planner, buyer, product line or any other meaningful political or production entity that will foster accountability, which you will want to later measure results against and enforce.

Go for the "easy wins" with the best payback first. Don't fall into "paralysis by analysis." You can do more in the first few months than you think. It won't cost much and will provide large net benefits. So far, we have not asked Information Technology to put together any fancy reports or programs, we haven't hired any new people, no new equipment has been purchased and we haven't revolutionized the way the business is done. That comes later:

Establish formal problem solving methodology

Use task teams, quality circles, natural work groups, tiger teams or whatever they're calling them this month and have these groups identify major problems, opportunities and then address the solutions. Our experience has been that almost any prior training in problem-solving approaches and reasonable coaching will greatly enhance results.

Perform "stock location audit"

In many cases, lost inventory holds up shipments and inflates inventory needlessly. Location audits are a quick way to find some of it. Simply go out to the shop and write down only the identity (part number) and location of all storeroom and/or work-in-process and other inventories, then compare to your records. Don't even bother to count it (that's what takes the longest). You will probably discover things you had lost or never even knew you had.

Take your "hits" for inventory early

As soon as you have some idea of the magnitude of excess/obsolete inventory, work on getting financial and general management to "write it off", in order to get the tax benefits, where favorable. There is normally reluctance to write-off because of the adverse "paper" affect on the financial statements and fear of blame. However, it's the best thing for the company in most cases, except for instances when stock prices, pending loans, etc, may be affected. Be careful, because failure to recognize true inventory worth might be considered misrepresentation in those cases, though. See your lawyer if in doubt.

That depletes my INVENTORY of quick fixes. Now it gets a little harder...

Mid-term Activities

In this phase, more careful planning, analysis, discipline and systems are needed. These programs should start early on and may not bring a lot of results for months or more.

Eliminate Bottlenecks

As an extension of the short-term problem solving activities, work on formally addressing major bottlenecks in areas such as material, capacity/equipment, paperwork/systems, engineering, personnel/training, etc. A good master scheduling approach should be included in these activities. Focus on cycle time reduction.

Inventory Analysis/Target Setting

Joe Barcy of Inventory Performance Systems calls it the "Divide and Conquer" approach. What he meant is that a company has to bring decisions and measurements down to the level of accountability and below (to the person/part/number/cost element level) and also aggregate this information up to meaningful levels for analysis by various levels of management.

First, group INVENTORY items at the part number level into categories by responsible planner and/or buyer and commodity. Do this in descending dollar sequence, preferably by projected usage (historical usage, if that's all you can find, but it has its disadvantages). If you don't have the ability to do this by computer, do it by hand for the A items first - look up production plans, sales forecasts and buy cards, then extend quantities by approximate costs. Use purchase history, quotes, accounting department support, or whatever you can get. Getting it done fast and approximately is much more important than carrying it out to four decimal places. Remember: money is being wasted while you delay!

If your current formal systems cannot deliver this type of information, consider using a "4th generation" report writer (they're calling them "Decision Support Systems" and "Data Warehouses" now and correspondingly inflating the prices), or maybe a system designed specifically for INVENTORY analysis and reduction.

Analyze INVENTORY on the following suggested parameters:

1.ABCD classification (by annual usage value)
2.Turnover/investment performance
3.Highest dollars committed
4.Highest dollars in INVENTORY
5.Most longest period coverage planned/available
6.Items with coverage/commitments greater than policy

Once you have all this data, set targets, measure and control performance.

Data Accuracy Program

Set up a formal, ongoing program to clean up and maintain accurate records for inventory, bill-of-material, routings and planning data. See my article: Inventory Accuracy: How We Did it In 60- Days! (APICS Intl Conf. Proceedings 1989).

Policies/Procedures

Write/update policies and procedures to guide your operation. Conduct an ongoing education and training program to ensure that people know what to do and how to do it. Sometimes this is regarded as a "soft" project with indeterminate payback. Our experience and observations have shown us that a well founded and run program to do this is an excellent investment in a company's future. Even simple handwritten ones may be a big improvement, especially if you have none, or worse yet, they are so bad that no one will use them.

How to Optimize inventory Levels

If you're expecting a neat formula here to plug in your numbers, you're sadly mistaken. It doesn't exist and if someone tells you it does, it probably doesn't work. Here are a few ideas that have worked for me:

• Estimate target days coverage using the team's best judgment for each commodity/product line. Obviously there will be some exception items.
• The "one less" approach: Try reducing inventories in doubtful areas a little bit at a time. Pull back when you get in trouble or when you spot a constraint. Continue after you have relieved the constraint(s) some.
• The lead time/cost build up chart: Construct a graph per product showing the time phased cost buildup in cost of goods sold amount. Have the team meet to see where lead times, lot sizes, attrition factors and buffers can be reduced.
• Modeling tools, Advanced Planning Systems (APS), have some potential for optimizing certain situations, but they have been a bit oversold and are not easy to set up and maintain.

Long-Term Activities

Making really major changes takes much longer. While I will enumerate some recommended programs you should probably embark upon, a thorough discussion is beyond the scope of this paper and falls under such categories as World Class Manufacturing, Just-In-Time, Computer Integrated Manufacturing, Quality Function Deployment, Manufacturing Resource Planning, ERP, Total Quality Management and other high-sounding names. By the way "long-term" doesn't mean you wait a long time to get these started, but that is takes a long time to get results...and time's a wastin'!

Key Points

To summarize some important points for your future reference:

• Inventory reduction is one of the cheapest ways to improve profits
• Get control of the "checkbook"!
• Use Pareto's 80-20% principle to leverage your time and investment - choose your battles - biggest bang for the buck.
• Once of prevention = pound of cure
• Set targets - "divide and conquer"!
• Force accountability- Set up a responsible team- hold it accountable. Include in performance appraisals, incentives
• Question assumptions - eliminate waste
• Doing business right will automatically reduce excess inventory in most cases, but still needs monitoring and control