Step 6: Anticipating the costs of material inventory
June 28, 2013
In this sixth installment of columnist Gerald Davis' series on job estimating he reviews inventory management as it relates to the estimator’s prediction of expenses.
This edition of Precision Matters continues our detailed examination of estimating as a business process. Step 5 discussed the estimator’s labor and machine time study for each of the needed manufacturing steps. At this point the estimator has a clear idea of the sequence of operations and the time each requires. Knowing this time helps the estimator predict shop expense and the number of days required to produce finished goods.
We now turn our attention to raw material. As with labor, we need to predict both the required lead-time to obtain the inventory as well as the expense of obtaining the inventory.
For the sake of discussion, we’ve dissected the estimator’s job into a dozen tasks. In reality, these tasks may overlap or evolve in different sequences. As a review, here is a brief outline of how we’ve dissected an estimator’s job:
The estimator predicts how much and what kind of inventory can satisfy the customer’s request for quote (RFQ). Sometimes an RFQ specifies a delivery date, in which case the estimator has a known schedule and, therefore, cost structure. In other situations, the customer may not place an order for some time, if at all. So in these cases, the estimator must attempt to anticipate the inventory’s future availability and cost.
Inventory starts as raw material. As we add value—in other words, apply labor—the raw material transforms into work-in-process (WIP). When material finally matches all specifications on the production drawing, it becomes finished goods. For this discussion, we will consider finished goods as ready to ship but still owned by the shop.If a customer places an order, we might pull inventory from finished goods and ship it to the customer. If we don’t have any finished goods to ship, we trigger a production order to manufacture the finished goods so we can satisfy the customer.
Mismanaging inventory leads to waste, be it piles of unused inventory or idle employees waiting for material. Good inventory management prevents unexpected production delays and minimizes storage and floor space dedicated to inventory.A good business goal is to have smooth production with minimal operating capital frozen as inventory. An optimal inventory level will improve cash flow, shop throughput, and customer satisfaction.
(Note that we avoid using the term minimum inventory. Instead, we want to focus on just right—that is, having no more and no less than we need. It very well could be that, for your business, minimum inventory with no provision for scrap is just right.)
Throughout this series, we have compared and contrasted the estimator’s responsibilities with other job functions like inventory manager, purchasing agent, salesperson, production scheduler, and plant manager. The estimator focuses on possible schedules, whereas the other job functions deal with committed schedules. One method of developing estimating skill may be to take a sabbatical and temporarily serve in other job areas to gain cross-training.
From one perspective, inventory is just a business expense. A well-reputed business strategy is to avoid unneeded expense—and unneeded is the operative word.
To illustrate, let’s make some pancakes. The recipe calls for, among other ingredients, one cup of flour. We could procure exactly one cup of flour, though it would take some legwork and probably a special container. But since flour is commonly sold by the pound, we also could buy a pound, use what we need, and store the rest for later.
Still, our strategy remains to avoid unneeded expense, and this depends on expected demand. If there are no more batches of pancakes to be made, then the trouble and expense of buying just one cup of flour makes sense. On the other hand, if we might make more pancakes, or if we have another use for flour, then the convenience and savings gained from buying in bulk is the way to go.
The estimator manages future inventory. Inventory is an expense but also vital to success. It is a necessary blessing; you just don’t want too much blessing. Inventory spoils. It gets stolen, lost, misused; it rusts, rots, and even evaporates. When you have it, you want to keep it fresh. But you want it only for a short time. When you want it, you want it right now. An estimator considers all of this when predicting inventory expense.
To obtain inventory usually requires a sequence of events: the RFQ, purchase order, shipment, receiving inspection, receipt of invoice, and sending of payment. The overhead required to handle all this adds value to the inventory, and an estimator should not ignore this inventory overhead cost.
nlike an inventory manager, the estimator does not have a physical inventory of material. Instead, the estimator works with an imagined inventory based on what is on hand as well as what might be purchased. Often the estimator draws from a detailed history of previously ordered inventory.
Even though the estimator is working with a virtual inventory, most decisions that go into managing inventory apply equally well to physical inventory and virtual inventory. Where do we buy it? What is the normal lead-time? What is the unit of measure used when placing an order for it? Are there minimum quantities to consider? What does the material cost? How is it stored? Is this material a normally stocked item in the shop? Where is it stored? How much is allocated for current production? How much is available?
Consider a shop that has a bin containing finished goods. Often a happy customer retrieves as many items it needs, when it needs them. If the customer’s demand rate keeps the shop busy replenishing that bin with finished goods, the business plan is in harmony. But if the demand for finished goods is too low, the shop will sit idle waiting for the opportunity to build and replenish the inventory of finished goods. The alternative is to produce finished goods only when there is known customer demand. This means the customer has to wait and, quite often, be less happy.
Over the long term, your happiness is closely linked to your customers’ joy. If they don’t mind waiting for your excellent finished goods, you’ve got a plan that works. Still, even if the customer doesn’t mind waiting, you don’t want the customer to wait. That’s because you pay until the customer pays. You buy the raw inventory, hold it as WIP, and turn it into finished goods to satisfy customer demand. The faster the customer is satisfied, the sooner you will be paid.
We have a lot of pressure to transform raw material into finished goods quickly. As a professional fabricator, you didn’t need me to tell you that. For estimating, the material planning requirements closely follow the business model that governs the shop. If your shop is dedicated to short lead-times, then material planning is extremely important to the estimator. If your shop operates on tight margins in a competitive market, then material planning is extremely important.
Notice a pattern? No matter what business model you are operating with, material planning is extremely important. Material planning relates directly to customer satisfaction and operating expenses. If you have lots of inventory on hand, you have lots of customer satisfaction, but also lots of operating expense.
Memo to estimator: Keep inventory stocking requirements to a minimum—high enough for quick response and customer satisfaction needed to succeed in the market, but low enough to minimize expenses.
Scrap was supposed to be a four-letter word, but somebody screwed it up. Everything about scrap is contrary to customer service. For an estimator, though, scrap is part of the plan.
In an ideal world, raw material would instantly convert to finished goods, sort of like the replicator on “Star Trek.” In the real world, raw material comes in sizes that leave skeletons and remnants (see Figure 1).
The estimator “owns” those remnants. Is that an expense to include in the price quotation? In some cases, other jobs can use those remnants, and this presents a competitive advantage that allows the shop to offer better prices to customers. When remnants are destined for the recycle bin, their cost must be passed on to the customer.
Each manufacturing operation has inventory going into it (raw stock) and inventory emerging from it (finished goods). The perfect manufacturer again would be like that “Star Trek” replicator—raw stock goes in, finished goods emerge, and no scrap is produced.
Of course, this isn’t a perfect world, so the estimator relies on the shop’s track record for workcell scrap rates. These include setup pieces, destructive testing pieces for welding or riveting, the occasional equipment malfunction, and other shop errors. Knowing this, the estimator then increases the amount of inventory going into each operation so that enough emerges for the next operation.
To calculate this, the estimator works backward through every fabricating step, each of which has a yield that allows for expected scrap. The goal is to cut just enough material to complete the desired amount of finished goods—and no more.Say shipping generally scratches or damages one part, coating usually messes up two, forming burns through three for setup, and the laser sometimes tilts a few parts. So if we need to ship nine, we’d better start with 17 to allow for yield through the production line.
Where scrap is produced matters. As the part progresses on the floor, it becomes more valuable—and so does scrap. Scrapping a raw billet is less expensive than scrapping something closer to a finished good. All the labor that goes into WIP scrap is an expense.
Software makes calculating these scrap expenses easier. If using a simple spreadsheet, though, an estimator may want to treat scrap using an overall yield rate rather than identify scrap expenses at each work center.
Consider a product made from an 8-foot length of 2x4 lumber. The part is to be sawn 47 inches long. Normally, all goes well and two parts get cut from each stick. Every now and then a trim cut goes bad or a stick comes in short, and only one part comes out of the stick. From a batch of 50 2x4s we typically get 96 finished parts. That’s 96 out of 100, or a 96 percent yield rate. So we add 4 percent to our starting inventory estimate to cover scrap.
Suppose we start a few extra parts and have a good day—100 percent yield for this batch of parts. Our customer demand is satisfied, and we still have finished goods. As with the remnants of raw material, the estimator “owns” the finished goods.
What to do with that expense? Another customer demanding the overrun inventory may cover the overrun expense. So could the same customer if it demands the item in the near future. This can work if the shop can handle the expense of storing the finished goods and retrieve them in good shape for shipping. But if the overrun inventory of finished goods is headed for the recycle bin, then the estimator needs to include that cost in the price quote.
It might make more sense to show the customer the cost behind that inventory buffer. The customer then might opt to accept a quantity range rather than a specific quantity of parts if that would reduce the price by, say, 4 percent.
If the customer will repeatedly order the same item in the future in exact quantities, then we might establish a buffer inventory of finished goods to account for those rare occasions when the scrap rate exceeds the predicted rate. Setting up a finished goods inventory buffer is easier to do when the customer is cooperative. This “cooperation” is often defined with long-term contract agreements. Clearly, the estimator needs to be aware of both the long- and short-term relationship with the customer.
When quoting, an estimator might allow a week or more to bring in raw inventory. When the purchase order finally arrives, though, the raw-stock inventory order may need to be expedited, which throws off the original cost estimate.
Even worse, the estimator might have presumed that, for a better price, the shop could order the material with similar stock to fill multiple orders. But what if there isn’t time for this convenience when a customer finally places the order? Placing a small-quantity rush order can make material price skyrocket. This is why the estimator must anticipate this during the material planning stage and, most important, communicate this to the sales team and customer.
The bottom line: A quoted price is based on a quoted lead-time. Expedited delivery changes everything.
Gerald would love to have you send him your comments and questions. You are not alone, and the problems you face often are shared by others. Share the grief, and perhaps we will all share in the joy of finding answers. Please send your questions and comments to firstname.lastname@example.org.