How inventory errors lose money at metal fabrication shops

How much inventory does your metal fabrication facility carry? The more accurately the answer, the more profitable your manufacturing business can be. Getty Images

For every dollar of error in your inventory, there is a dollar of direct impact on your profitability. It’s hard to believe, but it’s true.

How is this so? Profit is calculated by taking your total sales less the cost to produce, manage, and sell your product. When you value your inventory (known as book value) and you count your inventory (known as count value), every dollar you write up or down to match these two values directly affects your profitability. For instance, if your book value is $250,000 and your count value is $225,000, that inventory error just cost you $25,000 in profit.

We all know inventory accuracy is important for so many reasons that affect profit indirectly. What many don’t often consider is how the accuracy of inventory affects profit directly. Let’s drill into this further to uncover why inventory accuracy is such a critical part of any manufacturing business.

Inventory Accuracy

Inventory accuracy is defined as any inconsistency between your recorded and actual inventory, including its quantity, location, and value. Many sources claim that 97% inventory accuracy is a good benchmark for most companies. Depending on how much inventory your company carries, each percentage of improved accuracy also improves profitability; conversely, each percentage decrease in inventory accuracy can, when not managed effectively, subtract from the bottom line.

To calculate inventory, you first count the number of items. If the count equals the on-hand value in the system, it is a hit. If it does not equal the on-hand value, it is a miss. Divide the total number of items counted by the number of hits and you get your record accuracy. This pure number does not account for inventory value or categorization techniques like the ABC analysis (with A items having very tight inventory control, B items less tightly controlled, and C items with the simplest inventory control).

You also need to consider inventory accuracy from a value perspective. To calculate this, take the value of the inventory in your business system and compare it to the value of the counted inventory. If the value is a low number it can be more misleading than the record-accuracy measurement described previously. One of the reasons it can be misleading is that your errors are occurring on items of similar value or the count for low-value items is off but might have little impact on your inventory’s overall value. Many accounting people will be satisfied if the value of the inventory is highly accurate even when the count is not.

If the number is high, you need to spend the time researching the parts with the bad counts. Is it the system or process you use? Look for the root cause. (We will discuss cycle counting and root cause later.) High value differences are ones that accountants are going to insist be reconciled.

Other Benefits of Accurate Inventory

Increased profitability isn’t the only benefit of inventory accuracy, of course. Consider the impact on customer service. Customers might call and request certain parts; you think you have them and promise to ship them. However, when you try to ship the parts, you find the inventory is not there. Disappointed customers are now left in the lurch. This is not good customer service. Will they talk poorly about your company? Will they buy from you again?

Accurate inventory improves customer service, allowing you to confidently make and deliver on promises. Fabricators work in competitive markets where maintaining customer satisfaction is crucial.

Improved inventory accuracy also allows you to reduce the amount of inventory you keep. If you are confident that you have what your records indicate, you do not need spare inventory. Money previously tied up in inventory now can be used for other purposes, such as employee education and benefits, research and development, and market acquisitions.

Better inventory accuracy also improves return on investment (ROI). Companies count on ROI to stay in business. It’s the reason people invest in and start businesses in the first place. If they don’t receive a good return, they might choose to sell or even close the business. A good ROI benefits the whole company and keeps people employed.

Maintaining high inventory accuracy also means you can eliminate the expense of doing a physical inventory. The act of physically counting an entire inventory usually introduces more errors than it fixes. Moreover, doing a physical inventory can be extremely expensive. You often have to pay people overtime to do it, and you might even need to halt production. By maintaining an accurate inventory count, you can stop doing annual physical inventory counts.

Inventory accuracy also affects downtime. Say you receive an order and your (inaccurate) records show you have the inventory to run it. You release the order to the shop floor—and the excess downtime commences. First, material handlers spend time looking for inventory that isn’t there. Next, they contact their supervisor for help. When that doesn’t work, they go to people in purchasing to see if they ordered the material. If not, they need to expedite a purchase order and pay extra for the material and delivery. Finally, customer service needs to get involved to call the customer and explain why the order will be late.

These cascading problems show how poor inventory accuracy consumes so many resources, which in turn affects employee satisfaction. Employees want to do satisfying work, not waste time looking for nonexistent inventory.

Why Manage Inventory?

Expensive to carry and maintain, inventory is typically the largest asset manufacturers have. Carrying too much makes the out-of-pocket investment associated with that inventory too high. Carrying too little can lead to poor customer experiences with long-lasting, even irreversible effects.

Inventory management also affects cash flow. The more inventory turns you have, the more cash and related inventory-control expenses you free. Say your annual cost of sales is $2 million and your average inventory level is $500,000. Divide average inventory into annual cost of sales, and you have four turns. If you reduce your average inventory level to $400,000, you get five turns. One extra turn frees up $100,000 cash and eliminates the related expenses associated with that inventory. Typically, those related expenses are 25% or, in this example, another $25,000.

Some costs associated with carrying inventory are obvious, others less so. You have the cost of inventory, of course, along with the indirect labor that goes into managing it, including material handling and computer data entry and scanning. Then you have the storage space along with the property taxes, electricity, heating, and cooling costs. You might incur the freight costs of moving inventory between plants or warehouses.

There’s the risk of damage and pilferage, and the increased insurance costs that go with both. When you have more inventory, you also increase the chance of inventory errors like inventory shrink, when your actual inventory is lower than your recorded inventory. You also increase the risk of obsolescence.

Perhaps the least obvious and most overlooked cost has to do with lost opportunities—that is, the opportunity cost of inventory. If you can’t sell or use the inventory you have, you lose the opportunity to use the money elsewhere.

Ways to Minimize Your Inventory Investment

Cycle counting—an excellent way to increase accuracy and reduce your inventory investment—can help you correct inventory errors in a timely way. Catching errors early helps you pinpoint what caused them in the first place. With insight into the cause, you can implement corrective actions right away instead of being under pressure at year-end to get a good physical inventory, so you can move on and close out the books.

Frequent cycle counting is much more effective than a full-blown physical inventory count. You can do a root cause analysis and correct mistakes immediately. Frequent counts help you find record errors and correct your statement of assets right away instead of taking a big hit at year-end.

Make sure to educate the whole company as to why inventory is so important. Many might not understand their role or impact on the process. Set cycle counts at a specific time of day. Everyone should know when they occur and how to process transactions around them. Better yet, don’t count during production hours if possible. Count when few or (ideally) no transactions take place.

Also, don’t forget the purchasing department. How do you incentivize them? If you incentivize based on material cost reductions, are they buying more than you need just to get the lowest cost per pound? They may feel they are getting a good deal on that metal when in fact the cost to keep the inventory in stock is much higher than they realize. The cost of metal is always in a state of flux. Buying in larger quantities than needed is not a good practice.

Purchasing uses the information provided them. Review the bill of materials for the proper material quantity needed as well as the correct material. You don’t want them to buy too much, too little, or the incorrect gauge or size.

Finally, look at the production side of inventory control. What metrics have you given them? Production metrics generally include efficiency, yield, and productivity—but know that these can work against your efforts to reduce inventory costs.

Are they nesting more parts than you need to get a better yield? Are they running more parts to fill a sheet and keep the machine running? If they are, they’re using valuable resources that would be better spent producing items that your customers actually need and will use now—not later. Making them ahead will certainly cost more in the long run. Hold excess finished goods and you increase the risk of damaging them. Moreover, customers might send revisions that make those parts obsolete. These are all good reasons not to run extra parts just to increase your material yields.

Making material yield a metric can give you valuable improvement insights. But working to improve the yield metric without considering the use of other valuable resources (the laser, shear, inventory, people) can make matters worse.

Remember that each dollar of inventory error is a dollar of lost profit. Evaluate your turns. If your turns are low and you are holding more inventory than you need, either because you bought or made too much, educate your employees on best practices. Implement policies that allow workers to be idle and machines not to be scheduled to 100% capacity. In the end, you will be more productive, more nimble, less reactive, and more profitable.