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blog | August 10, 2015

Reduce Inventory without Sacrificing Customer Satisfaction – Part 1

Maintaining profitability and growth in the job shop market today can be a challenge. Customers are demanding more, and foreign competitors are making new inroads to supply those customers....

By WorkWiseSoftware

Maintaining profitability and growth in the job shop market today can be a challenge. Customers are demanding more, and foreign competitors are making new inroads to supply those customers. Some demands include:

These demands have had a great impact on the need for inventories. Many manufacturers look for fast, easy methods to fix this:
What’s the easiest way to deliver faster? Add finished goods inventory.

What is the quickest way to lower material costs? Purchase large quantities of raw materials.

What is the fastest way to lower production costs? Run large order quantities with the resultant large work-in-process inventories.
Unfortunately, these solutions often have the opposite effect in the long run, and can have devastating effects on inventories, costs, margins, and often on customer satisfaction. These quick-fix solutions can lead to obsolete stock, cash flow problems, low production efficiencies and reduced profits.

The fact is, material costs in many businesses now represent 55-75% of the total product cost. Inventories can be the largest consumer of cash on the balance sheet. It is now one of the most critical areas to manage in a manufacturing business.

Why is inventory so complicated?

If the world was a simple place, you wouldn’t need inventory at all. The customer would place the order, and accept a delivery date that exceeds your lead time to order materials and produce that product. Also, you would need no constraints on the shop floor, and could produce an unlimited quantity of products to satisfy whatever your customer needs. Your customer would order from you, you would order materials and produce the product, and ship all within the customer lead time. Simple, right?

Unfortunately, this example is not how the real world works. Normally, we need to supply product to our customer in a time frame that is shorter than our time to produce and deliver. Customer also demand high fill rates for their orders. But we need to balance this against the discounts we experience since we had to overstock the products. We can’t buy large quantities of raw materials because of its impact on cash, and the resultant effects on profits because of write-offs of obsolete stock. We also can’t make huge production runs in the shop because of the same effects on cash and obsolescence.

Fortunately, there are things that we can do to lower inventory levels, while also maintaining or raising customer service levels. We will discuss a few of those methods and techniques below.

A Little Background

Before we begin the discussions of methods and techniques to lower inventories, let’s define and illustrate a few items.
What is the cost of holding inventory?

There are many items that weigh into the true cost of inventory. Besides the material costs themselves, inventory includes:

Most of the costs are self-explanatory, but opportunity cost may need a bit more explanation. Opportunity costs are profits foregone due to the inability to invest somewhere else. For example, if you had $100,000 of excess inventory that you could have been invested in another product, you are losing the margin on that other product. If your margins on that product are 25%, then the lost margin or opportunity cost is $25,000.
The costs listed above are often estimated at 25 to 35% of the accounting cost assigned to them. It is easy to see the huge impact on cash, costs and profits these costs have.

Independent vs. Dependent Demand

Independent Demand is the requirement for your finished goods from your customers, or basically demand originating outside of or independent from your business. These are the items you plan from forecasts, such as sales forecasts, service parts history, and so on.
Dependent Demand is the requirement for components that are needed to build the independent demand items. Fortunately, we know the exact quantities needed from the bill of material (BOM), and the exact times needed for production from the routing. We don’t have to forecast these items, because once we know the finished product forecast, we know the exact parts and operations that are needed.

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