Inventory Control: How to control & reduce inventory levels while raising customer satisfaction
Maintaining profitability and growth in the job shop market today is truthfully a challenge. Customers are demanding more, and foreign competitors are making new inroads to supply those customers. Some of these demands include:
- More, and lower volume new products
- Greater variability in products
- Complexity in customer needs
- Shorter lead times and faster delivery
- Lower prices, higher costs
These demands have had a great impact on the need for inventories. Some manufacturers have taken the shortest path.
What’s the easiest way to deliver quicker? Add finished goods inventory.
What is the faster 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 answers to those questions have devastating effects on inventories, costs, margins, and often on customer satisfaction. They can be the opposite of what you intended. Instead of lowering costs, raising customer satisfaction, and raising profits, those answers can lead to obsolete stock, cash flow problems, low production efficiency and reduced profits.
The fact is that material costs in many businesses now represent 55-75% of the total product cost. Inventories can often be the largest consumer of cash on the balance sheet. It now is one of the most critical areas of a business to manage in order to achieve success in a manufacturing business.
Reduce Inventory- Why do I need inventory at all?
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?
Reduce Inventory – The Real World
Unfortunately, our simple example is not how the real world works. We must normally supply product to our customer in a time frame that is shorter than our time to produce and deliver. Our customer also demands a high fill rate for their orders. But we must 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.
Reduce Inventory – What can we do?
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.
Reduce Inventory – A little understanding
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:
- Setup and ordering costs
- Carrying costs
- Handling cost
- Opportunity costs
- Insurance and taxes
These costs are often estimated at 25 to 35% of the accounting cost assigned to them. In other words, if the finished good has an accounting value of $100, the carrying cost would be $25 to $35 dollars. It is easy to see the huge impact on cash, costs and profits. 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.
Reduce Inventory – 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 the like.
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.
Basic principles of inventory control to achieve customer satisfaction
Reduce Inventory – Change the bottlenecks and the rest will follow
One of the most blatant issues that cause high inventories and poor delivery performance is the ignoring of production bottlenecks. A production bottleneck is any operation in the shop where the expected output of the operation exceeds its capability to meet that output.
For example, if operation B is capable of producing 25 parts per day, and we schedule 35 parts, 10 parts will not be produced that day. In fact, the 10 input parts for operation B will sit at the operation as work-in-process. We have now created 10 extra units of work-in-process inventory that were not necessary. And worse, the next operation C which is expecting the 35 parts from operation B will now be short 10 units and be idle for the time normally used for the 10 short parts. Unless our MES dispatchers can find a way around this, we may have idled all the subsequent operations for those missing 10 parts. Our production efficiency is poor, and our inventories high. And, guess what also happens to your scheduled delivery time to the customer? The delivery is missed, and the customer is questioning why he does business with you.
The loud and clear message is to not over schedule your operation capacities. With a good MRP plan, and a responsive MES schedule, you can correctly schedule your operations. At a minimum, you can determine where your bottlenecks are, and take corrective actions such as scheduling alternative processes, or deciding on overtime.
Another form of this over-schedule problem is the “special request” from your biggest customer or from your President to accommodate a special favor for a customer. Your ERP manufacturing system can quickly tell you whether this will cause a bottleneck, and help you to avoid building more inventories, lowering production efficiency, costing cash, and disappointing other customers. And, you can quickly estimate the cost of the “special order”, to illustrate the true cost of that order.
Reduce Inventory- No part or operation before its time
One of the strengths and original purposes of ERP manufacturing systems is to plan and execute production so as to minimize inventory. ERP does this by calculating the precise times to perform the activities so as to delay the process until the last optimal time. This saves investment in inventories, and still meets the customer delivery schedule.
As a simple raw materials example, let say that the customer ordered a product that is deliverable six weeks from now. The production time on the shop is calculated by the system, and is two weeks. Strong practices of ERP would bring the raw materials in four weeks from now, just in time for the production need. Now, many manufactures use two alternative costly methods. In one, the manufacturer orders the raw materials at the time the customer order is place. Clearly, they will have three weeks of inventory that the ERP system would not.
In another simple method, the manufacturer keeps the customer products in inventory, and orders them when inventory drops to a reorder point level. The order for parts is made each time the inventory drops below the order quantity, which is commonly the quantity which would cover demand for period of lead time to receive the part-three weeks. In this example, the part would be ordered each time the on-hand quantity dropped to six, to meet the customer order quantity of 6. If the customer typically ordered once a month, a quantity of six would be ordered every time an order was received. So, the inventory would have 6 on hand for the first three weeks, and then would have 12 on hand for the next three weeks. This would cause an excess inventory of six for the entire six week period. In essence, this would cause the inventory to quadruple.
The same effect can be experienced in work-in-process and finished goods inventory. You can see that doubling or quadrupling inventories would cause severe differences in cash flow. Now, add the cost of obsolete stock for when the customer changes products with ECO’s or experiences rapid declines in demand for his products, and you can see how costly this can become. Here some numbers to illustrate the results of using each of the three methods used above.
Only available if customer lead time is less than purchasing and production lead time.
As you can see, the levels of inventory can be vastly different.