Inventory Reduction - A How To Guide
INTRODUCTION
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 cant 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 isnt 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.
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.
Carrying Costs
Lets 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.
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 dont 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 weve discussed the significance of INVENTORY, lets 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.
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.
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 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.
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.
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.
Planning/Control Systems Systems employed to manage supply and demand and control the production process have a large effect on INVENTORY.
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.
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 its 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.
Labor Content Reduction of direct labor has been one of the few bright spots in American productivity improvements over the years. 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
Lets now discuss some specifics for helping to tame the beast. To begin with, lets 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:
Dont bring it in. An ounce of prevention is worth a pound of cure. Dont order what you dont 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 its 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, lets cover the stuff we can do right away first. The author doesnt 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. This has an amazing and rapid effect on INVENTORY and has been practiced first-hand by the author and customers.
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.
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. 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. Dont fall into paralysis by analysis. You can do more in the first few months than you think.
Establish formal problem solving methodology
Use task teams, quality circles, natural work groups, tiger teams or whatever theyre calling them this month and have these groups identify major problems, opportunities and then address the solutions.
Perform stock location audit
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. Dont even bother to count it (thats what takes the longest).
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.
That depletes my INVENTORY of quick fixes. Now it gets a little harder
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 thats all you can find, but it has its disadvantages). If you dont 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!
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 in 60- Days!
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.
How to Optimize inventory Levels
If youre expecting a neat formula here to plug in your numbers, youre sadly mistaken. It doesnt exist and if someone tells you it does, it probably doesnt work. Here are a few ideas that have worked for me:
Estimate target days coverage using the teams 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.
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 Paretos 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.
This article is also available on our website: 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.
ABOUT THE AUTHORS
Paul Deis, CFPIM, is CEO, PROACTION. He brings over 25 years of consulting and senior executive experience to his work, including detailed work with nearly 60 companies. Prior to acquiring PROACTION, Pauls experience includes running a small ERP software company, leading other consulting businesses, prior work with PROACTION, Manager at Deloitte & Touche, VP Manufacturing at Raypak, Inc., where he was very successful with an early Lean management initiative, and dozens of projects in the areas of enterprise software, operations management,crisis resolutions, in a wide variety of industries, business types, and scales. Our website: PROACTION Generating Best Practices.
George J. Miller, CFPIM, is Founder of PROACTION. Prior to selling the company to Paul Deis, George had worked with dozens of companies in assignments involving productivity, quality and service improvement, business systems, change management, acquisitions, divestitures, expert witness testimony, and others.
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