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Cost Reduction Using Ten Inventory Management Techniques

Author(s):

Mark S. Miller, C.P.M., CIRM
Mark S. Miller, C.P.M., CIRM, Purchasing Manager, Case Corporation, Racine, Wi. 53404, 414/636-6565, mmiller@casecorp.com
Thomas M. Graddy, C.P.M., CIRM
Thomas M. Graddy, C.P.M., CIRM, Manager, Supply Chain Management, Case Corporation, Racine, Wi. 53404, 414/636-7975, Tgraddy@casecorp.com

85th Annual International Conference Proceedings - 2000 

Abstract. The annual investment our companies make in inventory represent between 20% and 40% of invested capital. Inventory ties up cash, takes up space, requires handling, deteriorates and is sometimes lost or stolen. Purchasing can play a major role in managing the investment in inventory. We will discuss how inventory reduction impacts bottom line costs and outline ten inventory management techniques that the buyer can use to reduce inventory costs.

Impact on the bottom line.

It is critical that purchasing management recognize the financial impact that inventory plays. For purchasing to get the proper credit cost for reducing inventory it is important to recognize its impact to the balance sheet, the income statement and cash flow.

Impact to the balance sheet.

Inventories can be found under the current asset section of the balance sheet. Inventories are often also broken down into segments: raw material, work in process and finished goods. Financial analysts carefully watch changes in the year to year inventory balances.

Impact to the income statement.

Inventory is included on the income statement in the calculation of cost of goods sold. If the inventory investment is reduced, the net income is increased. The table below shows that for every dollar that the inventory is reduced, net income is increased by the same dollar.

Sample Income statement
Base $10 less Inventory
Sales 300 300
Cost of goods sold
Material purchases 100 100
  Labor 50 50
  Overhead 40 40
  Change in Inventory 0 (10)
Total COGS 190 180
Gross profit from sales 110 120
Expenses 50 50
Net Income $60 $70

Impact to cash flow.

Good inventory management frees up cash that your company can use to invest in future growth opportunities. Cash flow is a calculation that measures the amount of cash available. Factors that are included in the calculation of cash flow are: change in inventory, change in accounts receivables and change in accounts payable.

In determining inventory management strategy, it is important to determine the balance between customer service and inventory investment. You can reduce inventory but if customer service and sales are also reduced profits will be adversely affected. The goal is to find ways to reduce inventories without affecting customer service. The following are ten techniques that can be used to reduce inventory costs.

Ten inventory Reduction Techniques (Cavinato)

  1. Improve communications in the supply chain.

    The supply chain is the network by which products and services are moved to the customer. Historically there is duplicate safety stock (back up inventory) carried at each level of the supply chain. By improving communications safety stock can be reduced without impacting customer service. There are many tools that purchasing can use to foster better communication in the supply chain. Two of these tools are:

    • Electronic commerce- Exchange information throughout the supply chain  electronically. Purchasing can work with suppliers to establish  electronic links. Information can also be passed electronically from  customers to suppliers.

    • In house supplier personnel- Another tactic purchasing can use to help communication is to locate supplier personnel at different levels of your supply chain. Some non-traditional ways the supplier can be involved are:
    • Supplier personnel in house in your office to expedite orders and manage schedules.
    • Supplier systems personnel working with our retail locations to capture retail sales.
    • Suppliers help in selling and promoting products to increase sales.
  2. Reduce supplier lead times.

    Lead times have a direct impact on the amount of inventory that is carried. The shorter the lead-time, the less backup stock that needs to be carried. Lead times consists of as much as 95% of idle time and 5% of actual production time needed to make the product. The challenge for purchasing is to work with suppliers to reduce the idle time. These are steps to take to reduce supplier lead times:

    • Track and measure lead times - Measure how long it takes for each step of the  supply chains. Track supplier lead times, inbound transportation time,  transport time to the customer, manufacturing lead times and distribution  cycle times. Recognize which suppliers and which commodities have the  longest lead times and start with these.

    • Negotiate lower lead times - The buyer must challenge supplier lead times.  Ask for a break down of the components of the lead-time. Compare one  supplier lead-time to others. Challenge the supplier to reduce his idle  time. For some products utilizing distributors is another method to  reduce lead times.


  3. Standardize.

    Purchasing should work with suppliers to reduce the number of items carried. The number of parts can be reduced by:

    • Substitute for standard parts
    • Consolidate common part numbers

    Fewer items with greater quantities makes forecasting more accurate. The lower the number of items to buy means less safety stock is needed and inventory is lowered. By standardizing the buyer will also: lower costs, lower process costs and often have less quality problems.

  4. Reduce surplus/obsolete inventory.

    Surplus or obsolete inventory can be reduced without risk to customer service. Purchasing should be active members of the committee to review and dispose of surplus. The following are methods that can be used to dispose of surplus or obsolete inventory:

    • Use it elsewhere within your firm.
    • Negotiate to return it to the supplier.
    • Sell the inventory to other companies
    • Promote and sell at a discounted price to customers.
    • Donate the inventory to a local charity.
    • As a last resort scrap the parts.


  5. Improve supplier quality.

    Poor supplier quality will result in added costs in many areas including additional inventory as well as the cost of rejections, rework, warranty, inspection and excessive expediting. The challenge for purchasing is to select suppliers with superior quality. The buyer should be involved in the supplier quality audit process or push the supplier to become ISO certified. When suppliers have quality problems, the buyer should initiate a corrective action plan and make sure it is followed. By improving supplier quality the amount of safety stock inventory can be reduced.

  6. Challenge MOQ's and price quantity breaks.

    Supplier minimum order quantities and price quantity breaks can cause surplus inventory. Suppliers require MOQ's or quantity price breaks to compensate for their costs of setting up a job. The goal is to work with supplier to reduce set-ups. Another option is to propose an annual commitment agreement with the supplier so he can build the entire MOQ, but agrees to hold the inventory and ship it in small quantities.

    Have parts delivered more frequently.

    The more often a part is delivered the lower the investment in inventory. The chart below displays how increasing the order frequency of your high volume, A and B class items, will reduce your average weeks supply of inventory from 3.7 weeks to 1.9 weeks.

    Class Frequency Ave. Inventory New FrequencyNew Ave. Inventory
    A Monthly 2 weeks Weekly .5 weeks
    B Quarterly 6 weeks Monthly 2 weeks
    C 6 Months 24 weeks 6 Months 24 weeks
    Average Inventory 3.7 weeks 1.9 weeks

    The cost of ordering and receiving. For most companies the correct strategy in to increase the order frequency of the high dollar "A" items only.

  7. Improve on time delivery.

    One of the reasons that extra inventory is carried is to compensate for suppliers who can't be counted on to deliver on time. Recent surveys of purchasing professionals indicate that the average on time delivery percentage is about 70%. With such poor delivery performance, our choices are either: 1) carry great amounts of safety stock, or 2) drain purchasing manpower by expediting parts to keep the production line going. Either choice adds costs to our operations. The following are steps the buyer can take to improve supplier delivery:

    • If you don't measure on-time delivery, you won't improve it -There are many  different methods to measure on-time delivery. The method you select  doesn't matter as long as supplier on-time performance is tracked.

    • Make sure the supplier understands - Talk to suppliers and make sure they  are aware how you measure their delivery performance. Some of the items  to clarify include: the window used, ship date or receipt date, how  calculated and how short-lead-time orders are counted.

    • Set supplier goals- Set on-time delivery goals with supplier. Make delivery  one of the key measures in your supplier rating program.

    • Reward superior performance - Recognize supplier who achieve their on-time  goals. Give annual awards for suppliers who exhibit world class  performance.
  8. Set up a supplier managed inventory program.

    Purchasing has the opportunity with work with key suppliers to develop a program to manage and hold inventory for you. The idea is to reduce the amount of total inventory not just transfer inventory to the supplier. There are many popular programs used today including:

    • Vendor managed inventory (VMI) - The supplier performs the inventory function for the customer.

    • Point of sale (POS) - The supplier reacts to customer demand and replenishes the inventory level.

    • Consignment stocking - The supplier owns the inventory when it is in your facility. Payment is made when the inventory is used.

    Supplier stocking - The supplier carries safety stock and ships Just-in-Time.

  9. Give credit for inventory reduction.

    Inventory reduction has a direct impact to your company's financial success. Recognize the importance of inventory reduction by:

    • Get everyone involved - Teach the impact inventory has on the bottom line.  Form a team to focus on inventory reduction projects. Get suppliers,  engineering, manufacturing, finance, and marketing involved in the team.
    • Count inventory reduction as a cost reduction - In many companies, inventory  reduction is not counted as a cost reduction. Inventory reduction is  important and should be recognized as a cost reduction.

Summary

Purchasing can make a major impact on the amount of inventory invested. The Japanese have taught us well that it is evil to tie up cash in inventory. Every dollar saved in inventory has a direct impact to the bottom line profits of our companies. Use these ten inventory management techniques to save your company money:

  • Work with suppliers to improve communications in the supply chain.
  • Negotiate lower lead times with suppliers.
  • Reduce the number of part numbers carried.
  • Find ways to reduce surplus and obsolete inventory.
  • Improve supplier's quality to reduce costs.
  • Challenge and reduce minimum order quantities and price quantity breaks.
  • Have high impact parts delivered more frequently.
  • Improve suppliers on time delivery performance.
  • Set up a supplier managed inventory program.
  • Take credit and track your efforts to reduce inventory.

REFERENCE

Cavinato, Jo.,& Kauffman, Ralph G., Purchasing Handbook Sixth Edition, New York: McGraw-Hill, 2000, Chapter 26 "Inventory Management" , edited by Miller, Mark S.


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