How to get a handle on your inventory

Interest rates and inflation are climbing, price pressures are increasing, and energy costs are rising. Some Wall Street economists say a slowdown has already started, based on the lackluster first-quarter inflation-adjusted U.S. gross domestic product growth, which is almost 20 percent lower than originally predicted.

All these signs are pointing to the rising cost of carrying inventory. It is time once again to improve inventory turnover, reduce inventory investment, reduce cash demand, lower risks associated with obsolescence, reduce slow-moving inventory, and improve the inventory process drivers that contribute to high inventory levels.

Research shows that annual inventory carrying cost averages between 15 percent and 40 percent of the dollar value of the inventory. Well-managed companies have taken aggressive steps to reduce "at-rest" inventory by revamping their supply chains to support smaller, more frequent shipments.

Industry sources have reported that some of the best-performing stamping companies are turning inventory 28 times annually. Unfortunately, there is no magic number for an acceptable inventory turnover rate, considering how widely material type, availability, delivery, production lead-times, customer requirements, and industry practices can vary.

Trade organization and industry sources can provide average inventory turnover rates, which can be used as a guide for establishing inventory levels within specified industries. Another good starting point is to develop an inventory model based on the minimum length of time inventory is needed to support production requirements and customer service levels. '

Setting an Inventory Target

A very simple way to establish inventory levels at a stamping plant is to assess average weekly shipments.

Assuming that shipments are worth $1 million a week, and material represents 50 percent of sales, then $500,000 worth of material is required to meet weekly delivery requirements. If delivery lead-time is two weeks, the minimum inventory investment required is $1 million (two weeks for the production cycle time multiplied by the $500,000 in material required for weekly shipments). Two weeks of inventory investment factored over 52 weeks results in an annual turnover rate of 26 times.

Although other variables have to be factored into the equation, this is a quick way to determine an ideal inventory investment target. In all probability, there is a substantial difference between the target inventory turnover and the actual turnover. Assess inventory turns, and keep working the model until the constraints are removed to achieve the desired inventory turnover rate.

A Case Study—What Not to Do

Let's examine a real situation. We'll call the company Murphy Co. (as in Murphy's Law: Anything that can go wrong will go wrong.).

Murphy's operating executives concluded that a new enterprise resource planning (ERP) system was required to correct the company's inventory problem. They decided to make a large investment in software and employee training, figuring that would cure the inventory problem.

Shortly after the investment, a negative cash flow position developed, caused by spiraling inventory levels. The company blamed the ERP system, although the new system was only perpetuating the insidious practices that were causing the inventory issues in the first place. As a result, Murphy's inventory turnover dropped from six turns a year to 1.5. Ideally, it should have been turning about 16 times annually if the company had properly used the new system's sequence scheduling and sophisticated material requirements planning (MRP) applications.

Murphy engaged a consulting firm to help diagnose the causes of the inventory issues. The initial assumption was that several primary actions were contributing to unacceptable inventory levels. A deeper assessment revealed a number of practices collectively driving inventory to levels far higher than recommended.

Identifying Gaps in the Inventory Process. First, Murphy made an operating decision to build-to-stock and configure-to-order, with the goal of shortening delivery lead-times to enhance its competitive position. The company believed this approach would have an auxiliary benefit of leveling plant staffing requirements—build-to-stock until a firm order was received.

This decision created a higher inventory risk and built-in obsolescence. The execution of the process caused residual inventory resulting from customization, which occurred on almost all customer orders, creating a substantial inventory imbalance.

Second, the customizing required additional engineering effort coupled with the inherent revisions to bills-of-material. The combination of lead-time for engineering and the purchase of nonstock material offset any gains anticipated by this strategy.

The competition elected not to take the inherent inventory risk and, as a result, had greater flexibility and responsiveness with shorter lead-times. The problems caused by Murphy's decisions are evident: increased operating cost, higher inventory, and no competitive advantage.

To stay ahead of competition, Murphy's top management embarked on an aggressive new-product development program. Its products were so innovative that sales outpaced its ability to meet demand.

While that seems like an enviable position, the company gave no consideration to designing the new products in a manner to consume the extensive residual inventory created by the build-to-stock and configure-to-order policy. Furthermore, no consideration was given to consuming the excessive stock parts in inventory to support spares, repairs, and other replacement requirements for existing products to a reasonable level. Murphy made almost its entire inventory obsolete by virtue of the innovative new products, except for the inventory needed for maintaining services levels and warranty requirements for existing products.

In its rush to market, Murphy never completely tested the new products, resulting in extensive engineering changes orders (ECOs), which averaged an astonishing level of 40 per week for more than a year. Purchased parts and components became obsolete faster than replacement parts could be acquired. Products delivered required a certain set of spares and repair parts that were different in each situation, because of product revisions driven by ECOs.

In hindsight, when introducing the new products, Murphy should have considered the number of units of the existing design that would have to be sold to consume inventory subject to obsolescence.

Configuration management was another major issue. The large numbers of ECOs put a considerable strain on the organization's ability to maintain current bills of material. As new parts were added to the bills of material, obsolete parts were not being deleted in a timely manner. When a new customer order arrived, bills of material were released for the purchase of material and components.

Murphy was purchasing material for obsolete parts that were never removed from the bills of material. When it completed building a new unit, there were residual parts left over that were returned to inventory — with no demand.

For laughs and giggles, an employee generated a computer report to identify the open purchase orders for parts with no demand and slow-moving inventory. It revealed that purchase orders worth several hundred thousand dollars were placed for parts and components that were not required now or in the future. The MRP system updated nightly, and the next day a whole new set of requisitions were generated for parts and materials with little or no demand, perpetuating the reordering of slow-moving inventory.

Another problem was that Murphy's engineers were designing and specifying different parts for every new application, rather than designing products from a standardized parts/vendor listing. This practice substantially increased the part numbers in the system and correspondingly increased the number of parts required in inventory. A purchased parts index or item master file would enable the engineers to increase the reuse of parts and components, thereby standardizing designs and minimizing the number of parts in the system.

Murphy had more than $4 million worth of slow-moving inventory, defined as any part that had no activity for six months. Several causes for this high level were:

• The safety stock and reorder quantities were not established on several inventory items.
• Demand requirements were not updated, causing the system to generate requisitions for parts based on higher usage levels.
• Inventory adjustments from cycle counts, which adjusted on-hand quantities below the reorder point, automatically triggered a requisition regardless of demand.

Rising Inventory = Rising Costs. Murphy's costs were going up along with inventory levels. The profit margin was eroding as a result of the high numbers of changes required for the new products. When all of the return material resulting from ECO activity arrived at the plant, it was already obsolete.

Company management decided to sacrifice the balance sheet for the profit and loss statement. The returned obsolete inventory was placed into inventory at the original purchase value, rather than facing an inventory write-off or establishing a reserve on the balance sheet for obsolescence beyond what was historically experienced.

Over the course of the year, this act alone increased Murphy's inventory by more than $2 million. Since it is a private company, Murphy doesn't have to meet the corporate governance requirements imposed by the Sarbanes-Oxley Act, so it ended up with overstated revenues and pumped-up assets on the balance sheet. Of course, this further jeopardized the company's ability to achieve some reasonable rate of inventory turnover, in conjunction with all of its other inventory sins.

Management realized that they had to reduce material cost. The conclusion was to buy material at prices lower than standard cost to gain a favorable purchase parts price variance, which would favorably impact profitability.

Murphy decided to provide an incentive to the purchasing department to achieve this objective faster. The buyers would get a bonus based on the savings generated for all purchases below the standard cost. The buyers learned quickly that purchasing larger quantities offered substantial price concessions from suppliers, enabling them to earn larger bonuses.

The company achieved the desired result: the profit and loss statement showed a very favorable purchase price variance and higher-than-expected profitability. At the time of the assessment, Murphy's open purchase orders totaled more than $18 million, with a current inventory of raw materials and purchased parts of another $19 million for a company consuming approximately $3 million to meet monthly production requirements.

What is wrong with this picture?

Other "moving parts" were affecting Murphy's inventory levels adversely. Floor stock material such as wire, labels, and fasteners was not relieved from inventory when consumed unless specified on the bills of material. In most cases, the bills of material were either silent or inaccurate regarding quantities of floor stock required.

The inventory became artificially overstated as floor stock was not deleted when consumed. In addition, material shortages were not known, since floor stock was not controlled by the inventory system, always creating an emergency purchase situation.

The assessment also identified about $750,000 worth of material in inventory for completed jobs. Production control's lack of timely inventory transactions caused a material misstatement in financial reporting.

Specifically, revenue was posted at the time of shipment without a corresponding transaction, which moved inventory to cost of goods sold, thereby overstating profitability. Inventory was inflated on the balance sheet, while accounts receivable increased without a corresponding decrease in inventory. This resulted in accounting errors, which had an adverse and material effect on the financial statements.

Murphy's CEO concluded that the managers who got him into this mess were not the people who could get him out of the situation. He subsequently reorganized his management team and hired a new material manager with a professional supply chain management background. Murphy is in the process of fixing the mistakes and is working its way down the list of "lessons learned." It is implementing these solutions, which are the quickest to fix and will produce immediate results. Murphy plans to implement longer-term solutions within the next 6 to 12 months.

Lessons Learned

Companies can take several steps to avoid making the mistakes Murphy Co. did:

• Identify the true inventory drivers before investing in a new ERP system. The drivers may be erroneous past practices rather than system-related.
• Synchronize supply with demand. Invest in inventory based on firm orders.
• Build flexibility and responsiveness in the organization and external supply chain to meet demand requirements quickly.
• Reassess policy decisions regarding inventory investment for long-lead items.
• Develop a forecast of monthly usage for spare, repair, and warranty parts stocking requirements.
• Logically group excess parts in inventory into spare parts kits and offer them at a discount to customers to reduce slow-moving inventory.
• Establish partnering relationships with suppliers to fill parts orders with little or no inventory investment.
• Standardize designs based on common parts to minimize the number of parts in the system. Select them from preferred vendors, and formalize a configuration control program.
• Use the item master in the MRP application, and ensure continued maintenance occurs with current and specific product and demand information.
• Minimize the number of suppliers to gain purchasing leverage for more effective implementation of just-in-time deliveries.
• Coordinate the introduction of new products with inventory consumption of existing parts and materials. The same applies to ECO releases.
• Test new products thoroughly before market introduction to substantially reduce ECOs during production.
• Handle returned material quickly by returning defective parts to suppliers before warranty periods expire.
• Verify that bill of material requirements correspond to material actually required for production.
• Decide either to expense floor stock or specify all requirements on the bills of material, and maintain appropriate accounting for these inventory items.
• Make a concerted effort to maintain inventory accuracy.
• Take minutes of all master scheduling meetings, which affect purchase commitments and inventory levels.
• Tie purchasing department incentives (to reduce standard costs) to inventory levels.
• Base purchase quantities on the quantity required to fill orders, not on quantity price breaks.
• Maintain safety stock and reorder quantities on a continuing basis.
• Validate automatic purchase quantities generated by MRP applications before making purchase commitments.
• Develop a demand forecast for service parts, and conform MRP reorder points to projected requirements.
• Verify routers set in MRP applications to synchronized material arrivals with demand.
• Establish a weekly input/output inventory measurement. Validate that increases in inventory are the result of a higher level of customer orders.
• Provide inventory management and the ERP interface training to employees.

Frank G. Rubury is president of The Rubury Company, P.O. Box 1240, Dover, NJ 07802, 973-726-9007, fax 973-726-9490, ruburyco@ptd.net.