Inventory Reduction

Inventory Reduction
The fundamental techniques

By Mike Rauch

Inventory is the largest single asset that most companies have. Unfortunately, it consumes space, gets damaged, and sometimes becomes obsolete. Inventory itself does not create value for customers. Yet for most companies, inventory is a necessary component of the business cycle and must be carefully managed.

Many businesses underestimate the carrying cost of inventory. They calculate carrying cost based on the borrowing cost of money alone. Other factors can outweigh this cost.

Major costs of high inventory include increased rent expense and handling costs, greater product damage, more frequent product obsolescence, and longer delay in noticing quality errors. For most products, the annual carrying cost of inventory is an astounding 20 percent to 40 percent of the materials cost.

Top Five Inventory Reduction Techniques

The most effective way for businesses to reduce inventory is by reducing the supply lead time. Lead time can be defined as the time it takes from when you first determine a need for a product until it arrives on your doorstep. If lead time was zero, inventory could be zero.

Imagine how simple business would be if lead time was zero and orders were filled instantly. A customer could walk through your door, order whatever they want, and walk out happy with no delay. There would be no warehouse space, no order follow-up, no inventory counting, no forecasting, no product damage, no obsolete inventory, fewer employees, less risk of theft, and less cost overall.

Obviously this is not possible, but the shorter the lead times, the less complex our inventory management will be. In general, you can expect the following reductions in inventory as lead times are reduced:

Note that lead time can be separated into three components: review time, manufacture time and transit time. Review time is the time it takes for your company to generate an order. Changing your order frequency from twice a month to once a week or even daily can cut total effective lead times substantially.

Keep in mind that lead time reliability is just as important as lead time itself. Short lead times with a high degree of uncertainty can force necessary inventories upward; something to keep in mind when selecting suppliers.

Most business operations involve many inventory items. It is not appropriate to give the same attention to each item. To establish the appropriate degree of control, use an ABC classification scheme to divide inventory items into three categories based on sales volumes: high dollar volume (A), moderate dollar volume (B) and low dollar volume (C).

By ranking your parts according to dollar volume, you can create an inventory management plan that puts emphasis on the most important items. A Parts should comprise the top 80 percent of dollar volume, B Parts about 15 percent, and C Parts about 5 percent. You should find that this will represent about 20 percent, 30 percent and 50 percent of your part numbers (or Stock Keeping Units—SKUs) respectively. If category B and C items consume too much of your inventory, work with your suppliers to reduce minimum order sizes or lead times for these items.

Dollar volume is a measure of importance. Category A items should be monitored closely through more frequent cycle counts and shorter time periods between reviews. Note that in some cases, lower ranked parts may be of special importance to your business process and may deserve to be pushed into a higher category of importance as a result. The ABC classification system is a tool that will help you employ your inventory control efforts efficiently.

Don’t be a collector. Many business owners have difficulty throwing away products they paid good money for. But holding on to obsolete products just burns up even more cash. Rid your company of obsolete stock promptly, and use the cash and space you save for something more profitable.

To eliminate obsolete stock, create a “red tag” program to identify old inventory. Tag old inventory with large red stickers. Note on the sticker the date tagged, person doing the tagging and a review date. Move these products into a quarantined area of your warehouse. If you haven’t used the products by the review date, cut your losses and liquidate the merchandise. If you just can’t bear to part with your beloved inventory, you can always renew your review date and clear out the items the second time around.

Red tagging of obsolete items is something that originated with Japanese automakers. Examples such as Toyota’s Red Tag sales events are common. These companies are just moving out old stock to make room for newer, more profitable inventories. Many companies empower employees to red tag items themselves. Red tagging works for anything in your warehouse, not just consumable inventories.

Gather a small group of employees and do a one-hour red tag “blitz” in an area. Items that appear as though they don’t belong in the work area are placed in a pile. This might include items such as jigs and fixtures, tools or personal belongings. Next, items in the pile are offered back to the employees in an auction-style format. Unclaimed items are tagged and moved to the red tag quarantine area and then discarded if not claimed by the review date.

Plan a red tag blitz in a different area at least once a month. Don’t forget to blitz your office space as well. You’ll be amazed at the additional space and positive energy this will create for your organization.

Many businesses carry excess inventory because they don’t understand the needs of their customers. Does your customer really need the entire order right away? Perhaps supplying half of the order this week and half next week will be adequate or even preferred by your customer.

Some companies give volume discounts to their customers for large orders. Is this really beneficial for your company? Build-to-order manufacturers might benefit from large orders by reducing setup costs, but stocking manufacturers, dealers or wholesalers may require less inventory if they ship smaller orders more frequently. Whatever the case, understanding your customer’s needs is fundamental to your inventory management success.

Consumers today have more choices and are less patient. Gone are the days of four TV channels and telephones with busy signals. Today, gratification is instant. For example, if you don’t want to wait for the 10 news, no problem, just watch it on satellite in a different time zone. Better yet, record it on TiVo, watch it any time and skip the commercials. With cell phones, ipods, e-mail and Fedex, consumers these days can get what they want, when they want it.

As a result, consumer demand for instant gratification is forcing companies to be more flexible in what they offer. Proliferation of SKU numbers is the unfortunate consequence. Garage door companies are carrying a much wider variety of products than ever before. One way to counteract this problem is by using a technique called delayed differentiation.

With delayed differentiation, you push customization of your product until the last possible moment. You store base items only, and customize them when there is an order for that item. For example, rather than having windows installed at the manufacturing plant and stocking glazed and unglazed sections at your distribution center, you save on inventory if you glaze sections at the distribution point or wholesale operation. To take it one step further, you might only stock common colors, and paint the colors that are less common only at the time you have an order for that color.

You will have to work closely with your sales and marketing staff to identify where SKUs can be consolidated without negatively affecting your customers. To avoid inventory proliferation, make sales suggestions to customers based on items that you already stock or can easily customize. Make sure your customers know that by ordering common items they will receive better service levels.

A Word of Caution

Inventory reduction programs are frequently implemented without a solid understanding of supply-chain implications. Whenever adjusting your inventory levels, do so gradually. Document your minimum and maximum goal inventories for each item and then move only 25 percent toward your goal each quarter. By using the techniques above, you can develop a proper strategy for sustainable and appropriate inventory reduction.