Mark S. Miller, C.P.M., CIRM
Mark S. Miller, C.P.M., CIRM, Purchasing Manager, Case Corporation, Racine, Wi. 53404, 414/636-6565, email@example.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
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|
|Change in Inventory||0||(10)|
|Gross profit from sales||110||120|
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)
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:
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:
Purchasing should work with suppliers to reduce the number of items carried. The number of parts can be reduced by:
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.
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:
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.
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 Frequency||New 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.
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:
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:
Supplier stocking - The supplier carries safety stock and ships Just-in-Time.
Inventory reduction has a direct impact to your company's financial success. Recognize the importance of inventory reduction by:
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:
Cavinato, Jo.,& Kauffman, Ralph G., Purchasing Handbook Sixth Edition, New York: McGraw-Hill, 2000, Chapter 26 "Inventory Management" , edited by Miller, Mark S.