by Peter Kingma, author of “CASH IS KING“
No matter what business you’re in, market demand for your company’s products will never be constant. That’s why managing inventory effectively is essential. Getting caught with too much or too little inventory can be disastrous. Too little inventory means that you can’t fill customers’ orders. On the other hand, if you have too much inventory, you may be creating a dangerous cash drain.
In my work advising clients, I often see leaders who understand the importance of cash for their businesses, but fail to pay attention to how inventory impacts cash flow. I recognize that inventory management can be complicated and can trip up even the best companies. But there are ways to simplify the process. In this article, I provide best practices for implementing a successful inventory management system. These concepts should be embraced by everyone in your organization.
Managing inventory wisely
Obviously, if you run a company that makes products, you need inventory. You need raw materials. You need spare parts to fix equipment, and you need finished goods to sell. However, inventory is very expensive and can tie up a lot of precious cash. It’s important to acknowledge that every dollar invested in inventory has equal value with unequal returns, meaning, investing in inventory that sells quickly and at a high margin produces more favorable returns on the investment than inventory that sits around unused.
Let’s start with some basic descriptions of inventory. There are essentially four categories:
Raw inventory. This consists of the materials that enter your plant, such as rolls of aluminum, plastic fasteners, circuit boards, and so on. These are components that will be used in the production process. Raw materials may arrive from suppliers all over the world. The receiving process varies greatly depending on the materials and your contractual arrangements.
Work in progress (WIP). This is the inventory within your plant as it flows through the production process. The amount of WIP varies greatly from company to company, depending on the process of production. Some products like batteries require a curing process after lead and acid are combined. Sometimes WIP can grow if there are shortages in raw materials. In the past few years, there was a global microchip shortage. Almost-finished automobiles piled up in lots outside factories, awaiting the installation of the critical chips. This is often referred to as trapped inventory. It can become a very costly problem, tying up precious cash at the same time as sales plunge because a company can’t sell half-finished goods.
Finished goods. These have completed the production process but remain in your plant and on the company books awaiting final distribution. Processes such as packaging and documentation requirements can cause this inventory to build up. But there might be intentional reasons to pile up finished goods inventory. Perhaps there is a known seasonal pickup in sales so you must prebuild in anticipation.
Maintenance, repair, and operations (MRO) MRO inventory is a classification for products such as spare parts for machinery in the factory. It also includes anything required for day-to-day maintenance and operations.
Material requirement planning (MRP) software can help calculate optimal inventory levels, taking into consideration all sorts of drivers such lead times, batch sizes, and so on. These applications are powerful tools, but they do require continuous updates and trust.
Inventory Stocking Categories
There are five key inventory stocking categories to monitor:
Cycle stock. This is the amount of inventory needed to meet current demand. For example, your forecast calls for you to produce 25 electric motors each day. You need 5 units of a certain type of fastener for each motor. So, every day the cycle stock for that fastener is 125 units. But do things hold constant? Are there no fluctuations in demand? No disruptions in supply and delivery? Hardly! So, you need to account for those scenarios by holding safety stock.
Safety stock. This is your hedge against fluctuations. Safety stock is calculated based on historic variations in factors such as demand and lead times. On most days you needed 125 units, but sometimes demand surged and you needed 150 units. Or your lead time fluctuated a day or two, so you didn’t always have the 125 units you needed on hand. Looking at those historic fluctuations you can then calculate how much you need, based on your desired service level.
Pipeline stock. This is the inventory that is in transit from the supplier to the plant. Delivery times, minimum order quantities, batch sizes, and so on can affect how much you need to have in transit to meet your cycle and safety stock requirements. Sourcing from low cost, yet distant countries might not always be the best option if it means you end up with more inventory (that you own) on boats trying to get to your plant. Understanding the economic trade-offs is very important.
Prebuild stock. You might elect to prebuild ahead of seasonal demand surges or in anticipation of plant shutdowns. Anticipating these periods, you would schedule some prebuilds to offset for the decreased production capacity.
Merchandising stock. This is the stock of finished goods required to meet sales demand. This can increase if service level commitments have been made with customers.
Seven Best Practices
With these categories in mind, here are seven best practices to follow:
Pay close attention to safety stock calculations. If you have invested in MRP tools, make sure your team is using the full capability. Avoid one-off calculations and deviations from established planning processes.
Examine pipeline stock and look for opportunities to shorten transportation windows while also decreasing minimum order requirements. A steady flow of material at a constant pace is easier to work with versus erratic schedules and large quantity requirements. Implement economic trade-off processes. Be sure to account for total costs including the cost of investing in extra inventory when considering sourcing.
Review prebuild assumptions. When possible, build up to the point of greatest flexibility. For example, if you know the Volt Minnie as a product family will increase in demand, but you are not yet sure of the demand for customized features, build to the base-level requirements and then add or modify later as needed.
For made-to-order inventory, there should be little to no merchandise stock on hand. If there is, challenge those assumptions and decisions that drives the need to hold that inventory.
Implement and follow standard planning processes such as monthly Sales & Operations Planning and weekly Sales & Operations Execution processes. Document the decisions made so that you can review add adjust as needed.
Pay close attention to maintenance schedules and be thoughtful about scheduling them, recognizing that each time a line goes down there will likely be a prebuild of inventory.
Treat inventory dollars invested as equal to dollars invested in capital equipment or research. This brings great clarity and forces good decisions. Tying up cash in slow-moving or excess inventory is wasteful and makes for poor investments.
Impact
Inventory can have a tremendous impact on a business. Make sure that everyone in your organization understands this and is willing to follow established processes that allow precious capital to be deployed to its best use. Sticking to these best practices will help ensure the success and longevity of your company.
Peter Kingma, author of “CASH IS KING“, is the Americas Working Capital Leader for EY Parthenon. Working across a variety of sectors including automotive, aerospace, defense, healthcare, retail, and consumer products, he advises business leaders on how to optimize the management of cash. His work has led to well over 25 billion dollars of value creation for his clients. You can learn more at peterkingma.com.
