Hello, my name is Jim Tompkins. I'm the CEO of Tompkins Associates and Tompkins International.
I am pleased to be with you today to present our sixth part of our third series of the Global Supply Chain Podcast. In this third series on the topic of Supply Chain Cost Reduction, we've been working our way through the major costs of the supply chain, and today we turn our attention to inventory cost reduction.
To help us out here, I am pleased to welcome back the Tompkins Associates thought leader on inventory cost reduction, Ralph Cox. Hi, Ralph.
Ralph, many of our clients are interested in reducing inventory as a way to reduce costs.
But first, please help our audience understand how inventory can be both an asset and a liability.
Ralph:
Inventory represents what's called an approach / avoidance conflict in psychology -- like birthday cake ... you want it but you don't want it. Inventory is similar, and there are several interesting aspects to this paradox.
Salable inventory is an asset from a financial point of view, and is reflected as such on balance sheets. Inventory is also an asset from an operations point of view in that it provides prompt product availability for customers and, for manufacturers, buffers production from numerous short runs.
Inventory is also a liability from a financial point of view, in that the funds tied up in inventory are not liquid and cannot readily used for other purposes.
Above and beyond liquidity, inventory can be a liability if it cannot be sold in the near term at full price. Also, as long as you keep it on-hand, other types of costs are incurred. Ideally, a firm would operate with little or no inventory, but as long are there are lead times for acquiring product, manufacturing capacity limitations, purchase transaction and manufacturing changeover costs, and as long as forecasts are not perfect, on-hand inventory is needed to provide good customer service.
The primary issue in inventory cost reduction is to keep the appropriate level of customer service while minimizing the cost.
Jim:
Great, kinda related to this is the fact that inventories have both capital and expense costs. Please explain this to our audience, because I really think it's important that they understand it.
Ralph:
Inventory requires an investment which, although it cannot be depreciated like other capital investments, and cannot be deducted from income like an expense, is quite real. In other words, it requires working capital. Above and beyond the capital required to fund the acquisition of the inventory, whether it's purchased or manufactured, there are ongoing costs which are incurred as long as the inventory is held.
These ongoing costs, which are referred to as inventory holding or carrying costs, fall into three groups -- storage, risk and opportunity. The storage and risk costs are included in operating budgets, and are reflected in monthly expense statements, while the opportunity costs are not commonly included. Some more advanced firms, however, do make "below-the-line" entries for opportunity costs so as to be able to see the whole cost picture.
In the storage area, ongoing expenses are incurred for space, that is - depreciation if the facilities are owned and leases if they are rented -- as well as for lighting, heating and cooling, security, insurance, taxes and other items. All of these are incurred continuously and, while we haven't had much for awhile, they do escalate as a result of inflation. While a lot of inventory is stored in warehouses and distribution centers, inventory is also stored in tanks, pressure vessels, silos, stockpiles, railroad cars and other facilities, each of which has its associated storage costs. Storage-related expenses are also incurred for counting the inventory, repackaging it when required, sweeping around it, straightening it up and a myriad of other seemingly innocuous tasks which would not be required if the inventory weren't on hand.
In the risk area, the ongoing costs are related to losses in value. These costs are incurred when products in inventory become non-salable because of product expiration dates, shelf life, supercession by another product, damage, loss, theft or simply when there is no longer any demand for the product. Accordingly, depending on the situation, the loss in value may be reflected as the loss of the original cost when the product can no longer be sold, or as a loss in future gross margin when it can still be sold, but only at a lower price.
The opportunity cost often represents the so-called "lost" return which could have been made if the funds had been invested. Opportunity cost can also reflect the reduction in interest expense, which would have been recognized if debt were reduced. Regardless of whether debt is involved or not, the opportunity cost is often valued at the firm's capital investment hurdle rate inasmuch as internal capital investments could have been made at that rate of return or higher if additional funds had been available; that is, if the money hadn't been tied up in inventory.
Jim:
Ralph, many financial managers look at inventory working capital as a source of cash which could be more effectively used in some other way. Do you agree with this?
Ralph:
Yes, working capital can be removed from all but the very best-managed inventories and put to better use without impacting customer service. The potential customer service impact could be in terms of declining fill rates or in terms of increasing customer lead times.
There are a quite a number of different ways to accomplish this. Of course, you can also reduce inventory by reducing fill rates, but only if that is desirable and usually it's done for less important SKUs. When beginning to consider this question, it's helpful to understand the cash breakdown of the inventory -- that is, to what extent the inventory is actually tying up cash as opposed to being merely balances in accounts payable.
This understanding can serve as a starting point for improvement as we'll discuss in a moment. We're not suggesting that a way to get cash out of inventory is to violate payment agreements with suppliers for past purchases. Renegotiating payment terms for future purchases is always a possibility, but there are more effective approaches.
Jim:
Great, thank you. Now for the heart of the matter. How can inventory be reduced?
Ralph:
It's helpful to recognize that three different aspects of inventory: safety stock, cycle stock, and stocking policy -- that is, whether the SKU is acquired to inventory or acquired after a customer order is received -- can all be part of the solution.
The most direct way to remove cash from inventories is to reduce cycle stock by purchasing or manufacturing smaller quantities more frequently. This approach increases purchase transaction costs or production changeover costs, but in many cases at least some of these costs are not truly variable, so there is little or no actual cost increase.
For example, if the number of purchasing, receiving and accounting personnel is essentially fixed, then the cycle stock could be reduced by, say, 25%, if purchase order quantities are reduced and the number of receipts increased by about 25%. This approach can be used for virtually all inventory locations, however, for purchased items stored at the location to which the supplier ships, supplier minimum order quantities may need to be re-negotiated at the PO-level, as opposed to the SKU-level. The second most direct way, when multiple distribution centers are involved, is to stock the SKU at fewer locations.
This approach does not impact fill rates, but does increase customer lead times, in that the SKU would be shipped from a location further from the customer, and potentially at higher transportation cost as well. The same result can be accomplished by shipping from locations which have overstock to avoid replenishing other locations which do not.
The third, more advanced, approach is to optimize safety stock levels. Safety stocks for different classes of SKUs need to be fine-tuned to provide the optimum balance between working capital and "lost" gross margin. The statistics are well understood and take into account demand variability, lead time variability and forecast error. The resulting product availability, whether measured by order fill rates or retail SKU in-stock ratios, needs to reflect management's priorities and the inherent economics.
There are numerous additional approaches to reducing inventory depending on the circumstances -- improving forecasting for both existing and new SKUs, reducing lead times, converting to vendor-managed inventories (VMI), converting to vendor stocking programs (VSPs), using reverse logistics to position the inventory for faster workoff, donations, and returns of overstock to suppliers -- ideally under previously negotiated annual return allowances with no restocking cost; and others.
Ralph, how do you know that you're not reducing the inventory too much?
Ralph:
Potential changes need to be prioritized and phased-in, so that the results - and any downsides - can be well understood and communicated clearly to management, both before and after implementation. For dormant inventory there's little or no risk, but, for active inventory, order fill rates and out-of-stock SKU situations and their underlying drivers -- under-forecasting, lengthening lead times, falling supplier inbound order fill rates, and others -- all need to be carefully monitored. This is especially true for long lead time SKUs.
Jim:
Thank you, Ralph. I'm really excited about this series, and I really appreciate your input today.
I look forward to our next segment in this global supply chain series on cost reduction, as we welcome Matt Wilkerson, to talk to us about supply chain technologies and how we can reduce costs through these technologies. Until then, have a good one.
