22726522 10 Keys to Inventory Reduction

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10 Keys to Inventory Reduction

Mark K. Williams, CFPIM, CSCP

Companies exist to service their customers. The primary service provided bymanufacturing and distribution companies is in the form of a raw material or componentthat the customer then processes into its own product, or a finished goods item that thecustomer re-sells. It is therefore critical that each company has a set of inventoryobjectives that allow it to provide this service profitably. The main inventory objectivesfor most companies seem deceptively simple:

provide the right product at the right place in the right quantity at the right time and at the right price

If a company does these five things, it will satisfy its customers and become extremelyprofitable. Although this inventory objective sounds simple, hard and often painfulexperience tells us that it is not. A forecast of the customers demands is based on pasthistory, but if a customer places an item on promotion the supplier may not have theright quantity. Most of the required product is in the Texas warehouse, and suddenlythe demand is heavy in Boston. A company stocks up on a new product that Marketingknowswill be a hit, and it turns out to be a dud. Or worse, a new product is suspectedof being a dud so very little is stocked, and it turns out to be a hit, leaving Marketing andthe customers mad.

The days are long gone when customers would accept shipments from suppliers thatwere 70 percent complete on a routine basis. Many companies will cease doingbusiness with a supplier that cannot maintain a service level of at least 98 percent. Ofcourse, a supplier without customers will quickly go out of business. Therefore, if acompany experiences fulfillment problems, the solution demanded by the SalesDepartment and the corner office is usually bring in more inventory and get rid of thesestock outs or else!

Inventory Isnt Free

A company can indeed add more inventoryand more, and more, and morein an

attempt to provide customers better service. Many companies do this, but then run intoa few problems. Their warehouse begins to fill up, and soon they need to rent anotherone. Their employees report it is becoming more difficult and time-consuming to findthe product that is in stock. The company has to go back to its bankers repeatedly toborrow money to support the higher levels of inventory. At the end of the year theyreceive a nasty surprisetheir taxes have increased! Then the company often has toconfront one final problem; their service level has not increased despite the increase ininventory.

www.w-scg.com The Williams Supply Chain Group, Inc. [email protected]


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What doesincrease is the cost associated with holding the inventory. This is becauseeven though inventory is listed on the books as an asset, increasing the amount ofinventory a company holds has an impact on many individual costs not recognized bymany companies. When we look at the components of inventory carrying costs, itbecomes clear how increased inventory levels lead to increased costs.1

Cost of Capital 1015%

Storage & Warehouse Space 25%

Obsolescence & Shrinkage 46%

Insurance 15%

Material Handling 12%

Taxes 23%

Total Annual Inventory Carrying Costs 2036%

Our challenge is to reduce our inventory, leading to a reduction in the associatedinventory carrying costs. However, we must simultaneously increase our service levels

to our customers, or risk losing them. Is this possible?

Fortunately, yes, it is possible to reduce inventory while increasing service levels.There is no magic bullet, but by working diligently to implement the following 10 Keys ToInventory Reduction, those two vital goals can be achieved.

1. Improve Inventory Accuracy

A rush shipment is being prepared for a key customer. According to the figures in thecomputer, there is enough stock of each item on hand to fulfill the customer needs.Based on this information, the customer is assured that the shipment will be complete.However, when the order is picked, 3 of the 10 items come up short! Now the customer

must be given the bad news. In order to make sure this does not happen again, thesupplier considers adding more safety stock to its inventory.

By simply adding safety stock in hopes of ensuring enough inventory the next time, thecore problem is not addressed. After all, according to the computer records, there wasenough stock to complete the order. The real problem in this situation is that theinventory on the shelf did not match the inventory figures in the computer. Willincreasing safety stock solve this problem? No, quite often it is aggravated becausenow there is more inventory to track.

Overall inventory accuracy depends upon conducting each process flawlessly, including

Receiving, Putaway, Picking, Shipping, and Invoicing. Some things that help improveinventory accuracy are:

unique SKU numbers for each part well-identified aisle/bin locations use of bar codes for inventory tracking a workforce that understands the consequences of inaccurate inventory figures a cycle counting program aimed at detecting and correcting errors in the process



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2. Eliminate Obsolete Inventory

Do some companies keep inventory that has been in stock for over five years? Theyhesitate to get rid of it because of fear that if they do, they will receive an order for theitem the very next week. And if that happens, the sales people will go absolutelyballistic. Unfortunately, for many companies that scenario is all too familiar. They hold

on to old, probably obsolete inventory because they feel that keeping it is safer thangetting rid of it.

However, there is another way to look at inventory that is doing nothing more thantaking up space. First of all, it is taking up valuablespace! As discussed earlier,inventory carrying costs are not free, they average 2036 percent per year. If thecompany has a 36 percent carrying cost, in three years the inventory will have beenpaid for twice once when purchased with cold, hard cash, and a second time throughthe costs associated with carrying inventory.

If we decide to get rid of the inventory, we can get some benefit from it. Many closeout

companies will pay between $0.10 and $0.40 on the dollar for the inventory. This maynot sound like much, but it is better than nothing. In addition, any inventory that isdisposed of for less than cost can be written off against the companys taxes.

3. Implement ABC Inventory Management Strategies

Do the people with inventory management responsibility have enough time to focus oneach part of their job? Do they have enough time to strategize and monitor each SKUin their inventory on a daily basis? Or have their job responsibilities increased so muchthat they sometimes do not know if they are coming or going?

A manager who has ample time to monitor each SKU daily, strategize the optimal

ordering and stocking of each of those SKUs is a rare breed in an ideal situation. Thosewho manage inventory in the real world have to decide what to doand what not to do.One of the most powerfulyet simpledecision-making tools in the arsenal of theinventory manager is the use of ABC stratification in setting priorities regardinginventory ordering and stocking decisions.

The concept behind ABC stratification is that some items are more important thanothers, and therefore deserve more managerial attention. If one is in charge of officeproducts, and the range of products extends from computers to paperclips, does it makesense to pay as much attention to how many computers are in stock as it doespaperclips? Common sense says, of course not, computers are so expensive, they

demand more attention. Does this mean a department can afford to run out ofpaperclips on a routine basis? No, that also is not one of the options. So how does oneset these priorities?

This is where ABC stratification emerges as an important option. There are a couple ofsteps that must be taken in order to prepare for using ABC stratification. First, an ABCanalysis spreadsheet is needed. To do this the cost of each item is multiplied by itsannual unit sales to get an annualized cost of sales, and then each item is ranked indescending order by this amount. In most companies, the top 20 percent of items are



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fast moving and usually account for approximately 80 percent of sales. These items fitthe A category. The next 30 percent of items are mid-movers and usually representabout 15 percent of sales. These go into B category. Finally, there are the slowmovers, usually about 50 percent of items that combined only represent 5 percent ofsales. These slow movers are classified C items.

Once sorted into the appropriate ABC classifications, it is time to apply the principle ofprioritization. In many companies, the same relative amount of inventory is maintainedfor all items. For example, a company will set the inventory level for all items to equaltwo-months sales. A company switching to the ABC approach sets inventory levelsdifferently. Realizing that the fast moving A items make up a much larger portion ofsales and are probably always on order, the company tries to maintain relatively lessinventory. Instead of eight-weeks of inventory, the company maintains a four-weeklevel. The company compensates for the lowered inventory level by paying moreattention to the A items to make sure they do not run out. Although the relativeamount of inventory is lower, the absolute value of the A inventory is higher than eitherB or C items, because the sales level of A items is so much higher. The B items

would maintain the inventory level of eight weeks. In order to concentrate our attentionon the fast moving A items, we increase the inventory level of our C items to doubleits previous level. Because this represents so many items50 percent of our totalitfrees up a lot of review and monitoring time. However, because the sales volume theseitems are based ononly 5 percent of salesdoubling the amount while cutting theamount of A items in half will still allow for a significant inventory reduction.

Part Monthly Sales% of Total

Cost ofSales

Value of EqualInventory(8 Weeks)

ABC Inventory

A 785,000$ 78% 1,570,000$ 785,000$ (4 weeks)B 160,757$ 16% 321,514$ 321,514$ (8 weeks)C 63,215$ 6% 126,430$ 252,860$ (16 weeks)

Total 1,008,972$ 100% 2,017,944$ 1,359,374$ 33%InventoryReduction

As you can see from the example above, a company implementing the ABC strategywill carry 33 percent less inventory than a company that maintains the same inventorylevel for all items. That is not only a significant inventory reduction, but also normally

leads to an increase in customer service level.

4. Review Safety Stocks

Do some companies set their safety stock levels uniformly for all itemsfor example,one month of safety stock for each SKU? If so, they are making a very commonmistake. The level of safety stock should be determined based on the variability ofdemand. As an example, look at the following two items:



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Item # January February March Apri l May June Total

A-45 99 102 103 95 103 98 600

B-14 10 13 241 24 280 32 600

Both have sales of 600 units over a six-month period for an average of 100 per month.All similarity stops there. Item A-45 has a very steady sales pattern, varying from its

average of 100 monthly units by five or less during any month. Keeping one monthsworth of safety stock, or one hundred extra units on hand for this item is surely a wasteof inventory. However, the same safety stock level for item B-14 would not be enoughto cover the two peak months of March and May.

There is another method of calculating safety stock, based on the variation in demand.This method assumes that an item exhibits normal demand characteristics, includingconsistent demand. In order to employ this method of setting safety stock, we must firstdetermine the Mean Absolute Deviation (MAD).2 To determine this, we must find thetotal absolute deviation from the mean and divide it by the number of months. Let usdetermine the MAD for each item above.

TotalAbsoluteDeviation 16MAD=

Number ofPeriods

=

6

= 2.67

Part B-14

MonthMonthlySales

AverageSales Deviation

AbsoluteDeviation

January 10 100 -90 90

February 13 100 -87 87

March 241 100 141 141

April 24 100 -76 76

May 280 100 180 180

June 32 100 -68 68

600 642

Total

Absolu teDeviation 646MAD=

Number ofPeriods

=

6

= 107

After deciding on a target service level, we use the Table of Safety Factors to determinethe appropriate safety factor.3

Service Level % Safety Factor50% 0.0075% 0.6780% 0.8485% 1.0490% 1.2895% 1.6598% 2.0599% 2.33

Part A-45

MonthMonthlySales

AverageSales Deviation

AbsoluteDeviation

January 99 100 -1 1

February 102 100 2 2

March 103 100 3 3

April 95 100 -5 5

May 103 100 3 3

June 98 100 -2 2

600 16



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If a 95% service level is desired for both items, lets look at the different safety stockrequirements.

Part # MAD Safety Factor (SF) Safety Stock (MAD x SF)

A-45 2.67 1.65 4.4 (or 5)

B-14107 1.65 176.5 or (177)

Even though both items averaged 100 units per month, the safety stock for A-45 is only5 units, while for B-14 it is 177 units. This is proof that due to the variation of demand,one size does not fit all.

5. Reduce Lead Times

One very legitimate use of inventory in both distribution and make-to-stock businessesis to serve as safety stock. Safety stock is used to compensate for the uncertainty ofdemand. One cannot predict the future or the precise buying habits of customers, sokeeping safety stock ensures a good service level.

However, the level of demand uncertainty is not static, it increases as lead-timeincreases. The longer the lead-time, the greater the potential changes in demand,which must be supported by higher levels of safety stock. More unforeseen things canoccur in six months than in six days.

In order to minimize safety stock-related inventory, lead times must be reduced. Byexchanging information with customers, suppliers can find out when customers areplanning to order and anticipate the demand. By adopting just-in-time techniques, WIPcan be minimized and throughput improved.

6. Partner With CustomersA distributor or make-to-stock manufacturer is expected to be able to supply itscustomers needs from on-hand inventory. Determining those needs is one of the mostdifficult tasks for most suppliers because they rely on an internally generated forecastbased on their customers past purchases. This works just fine as long as the future isidentical to the past. However, in todays fast moving world, this is rarely the case. Soshould a company just give up?

Of course not, to give up is to cease operating. A better idea is to establish a closerelationship with the customers so that they will make their future requirementsavailable. After all, the customers probably already know their future requirements.

Many companies will happily share their anticipated needs, if they believe it will allowtheir suppliers to improve their service level and there are assurances of confidentiality.There are several ways to obtain this information from customers, through schedulesharing, participating in a vendor managed inventory (VMI) program, receiving point-of-sale data directly, and by using collaborative forecasting. 4 Whichever tool is chosen,one thing is certain, getting information directly from the customer is almost alwaysgoing to be more accurate than even the best forecast.



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7. Partner With Suppl iers

Often we maintain safety stock in our raw materials inventory because we are workingwith suppliers who have a poor on-time delivery record. In order to provide timelyservice to our own customers, we keep safety stock to compensate for those inevitableinstances when we receive late deliveries from our delinquent suppliers.

One way to solve this problem is to switch suppliers in the hope that the new one willhave better performance. However, before taking this drastic step, ask one question.Could your company be a major part of the problem? Is your companys order patternextremely erratic, making it difficult for a supplier to anticipate its needs? Does itprovide its suppliers with its anticipated needs? It was stated earlier that a customerand supplier should communicate their scheduling information in order to anticipateeach others needs. Has your company provided the same information to its suppliers?Or does your company send them a purchase order and expect them to respond to itsever-changing needs?

Partnering with suppliers, supplying them with anticipated needs so they can beprepared for them, is often the quickest and most effective way to improve a suppliersdelivery performance. Grouping your purchases by supplier in the computer systemand sending your key suppliers a copy of the portion of the purchasing report thatrelates to them will allow them to prepare to meet your needs.5 Will it always work?Unfortunately no, some suppliers just do not understand the importance of on-timedelivery. Replacing such suppliers is often the only way to get better performance.However, providing most suppliers with their customers anticipated needs will turn poorperformers into on-time deliverers!

8. Reduce WIP Space

In a manufacturing plant, there is one piece of conventional wisdom that is usually true inventory will grow to fill the space given it. This is particularly the case with Work-In-Process (WIP) inventory in a job-shop. If there are 50 square feet allotted to inventory,it will not be enough, so it is increased to 100 square feet. This will suffice for a fewweeks until more is needed. This is because inventory is often used to cover amultitude of sins. Everything from frequent machine breakdowns (due to lack of apreventative maintenance system), to long setups (no setup time reduction program) orfrequent high levels of scrap (no statistical process control program) are compensatedfor by keeping lots of inventory between operations so that part supplies are maintainedeven when problems are encountered.

In order to counter these problems, companies should reducethe amount of spacebetween operations where inventory can be stored. As space is decreased, it will forceunderlying problems (machine breakdowns, long setups, poor quality) to the surfacewhere they will be visible for all to see. As an underlying problem surfaces, companiesshould direct all efforts to solving the problem. Once the problem(s) is solved and theoperation is functioning smoothly with less space, reduce the WIP space some more touncover even more opportunities for improvement!



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9. Eradicate Individual Incentive Systems

Compensation exerts a strong influence on peoples behavior. In many traditionalmanufacturing environments, individual incentive systems based on production are thenorm to boost productivity. Unfortunately, when an individual can earn a bonus bysimply producing more, quality or reduced inventory levels will be the furthest things

from his/her mind and instead will strive to produce more units whether or not theproduct is needed. By contrast, inventory reduction should be a team goal andachievement. Once all employees understand that inventory reduction is desirable,they can band together to make it happen. Few things can compromise the drivetoward inventory reduction more than individual incentive systems based onproductivity.

In order to change the mindset of employees who are used to individual incentives, thewise company will move in two directions. First, instead of individual incentives, thecompany will move to a group incentive involving everyone in the department or plant.This will encourage employees to work with the team, instead of just pushing out more

of a given item, regardless of whether it is needed. Secondly, instead of basing theincentives on production only, the new group incentives should be based on otherimportant goals such as quality, inventory reduction, and safety in addition toproduction. This will focus employees on the myriad of elements needed to makemanufacturers successful.

10. Educate & Train!

The tools and drive to reduce inventory is not something innate to managers oremployees. These must be learned. Many companies with inventory problems decidetheir salvation lies in the newest software program on the market. They do not see thewisdom of first educating their employees about the basics of good inventory

management. If some of their employees cannot count, and they are responsible forkeeping track of their production, no software program in the world will help them.

Most companies can reduce their inventory while improving their service level bymaking a concerted effort to train their employees in proper inventory managementtechniques. These employees are not just those in inventory management orpurchasing positions (although they are definitely included), but the rank and fileemployees who do the work in the organization. If a receiving clerk routinely enters thewrong data into the system, if a stocking clerk often places goods in the wrong place, ifa picker does not bother to accurately count the product being picked or if the shippingclerk puts the wrong label on boxes, the inventory wont ever be accurate. In these

instances, a company will never have the ability to safely reduce inventory withouthurting its service level. Only by training the employees in the importance of doing their

jobs correctly and giving them the tools necessary, will you be able to create the bestkind of inventory reduction teamyour entire workforce!

Conclusion

Companies exist to service customers. However, if a company attempts to service itscustomers by maintaining an extremely high level of inventory, it may find itself with a



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serious cash flow problem. Companies have even gone bankrupt while having plenty ofassets because too large of a percentage of those assets were tied up in inventory, andthe company could not meet payroll or pay its bills.

If a company aspires to maintain a high service level while minimizing inventory, it will

take hard work, dedication, and teamwork. Ensuring an accurate inventory of items thatsupplier and customer agree must be in stock is a good starting place. This requiresprecise recording and counting processes, along with an understanding of ABCinventory methods and a commitment to clear, timely, confidential communicationsregarding needs and expectations. Within either company, steps should be taken toeducate all people responsible for inventory accuracy in proper procedures for reducinginventory and the space allotted to WIP storage. Team goals and incentives should beestablished to bring about these ends, thus phasing out counterproductive individualincentives. Improving communications and processes, increasing accuracy, and raisingthe awareness and commitment of workers at all levels to inventory reduction willultimately enhance any companys bottom line. There are no magic bullets, but if a

company employs the tools and techniques found in both this article and in the APICSbody of knowledge, it will be on the right path towards achieving these dual goals.

1Ross, David Frederick, Distribution Planning and Control, Chapman & Hall, 19962Arnold, J.R. Tony, Introduction to Materials Management, Prentice Hall, 1998.3Arnold.4Williams, Mark K., Critical Tools of the Supply Chain, APICS 42ndInternational

Conference Proceedings, 1999.5

Williams, Mark K., Information and TeamworkKeys to Supply Chain Success,APICS 43rdInternational Conference Proceedings, 2000.

About the Author

Mark K. Williams, CFPIM, CSCP, is President of the Williams Supply Chain Group,Inc., a consulting firm specializing in supply chain management and training.

Mark has over 20 years of industry experience in various roles including Director ofDemand Planning, Senior Manager of Materials, Plant Manufacturing Manager,Distribution Center Manager, Corporate Internal Auditor and Production ControlManager.

He is an APICS Certified Fellow in Production and Inventory Management (CFPIM).He is also a Certified Supply Chain Professional (CSCP). He has many years ofexperience teaching APICS certification review courses and developing customizedinventory and supply chain management courses for corporate clients. He has spokenat numerous APICS International Conferences, three European Supply Chainconferences, two Australian Logistics & Supply Chain Conferences, a South AfricanSupply Chain Conference, as well as numerous local and regional supply chain


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meetings. In addition delivering seminars in most of the United States, Mark hasdelivered seminars for clients in Singapore, Malaysia, Indonesia, Bulgaria, and

Australia.

Mark is online at www.w-scg.comand he can be contacted at [email protected]

Seminars Offered by Mark K. Wil liams, CFPIM, CSCP

CPFR for FMCG (Fast Moving Consumer Goods) Companies

Inventory Reduction & Demand Planning

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Project Management

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*Complete Course on Inventory Management

*Managing Inventory & Cycle Counts

*Warehouse Conference

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*How to Get Better Deals from Suppliers & Vendors

**APICS CPIM Certif ication Review Courses

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22726522 10 Keys to Inventory Reduction