What Is So Bad about Inventory?

So what’s so bad about inventory? Simple: Inventory costs a lot of money. First, there are the raw materials and operating expense it costs to produce it. Next, we must han- dle it, which means we need more people and machines like forklifts. Then we find ourselves moving the material around, usually more than once before it gets to its desired location. This in turn requires space and transportation and neither are free.

Next, we must keep track of it, which means people, computer programs, and reports galore—almost all of which are filled with errors. We then try to fix these errors. The way we try to fix the errors is to use things like cycle counts which then take more people, more time, more computers, and worst of all more reports and more meetings.

In addition, we must care for this inventory to make sure it does not get damaged. And finally, we must ship it before it becomes obsolete.

I have dealt with several firms who say their cost of inventory, obsolescence excluded, exceed 25 percent/yr of the product value. That is 2 percent per month, and if your company is operating on 12 percent earnings on sales—well, the impact is huge and you can see why many firms wanted to get rid of it. What else can be done to make such a huge bottom-line improvement? It’s no wonder many firms jumped on this band- wagon of inventory reduction in the name of JIT.

All of these liabilities of inventory are obvious bottom-line opportunities, and yet the greatest advantage of reduced inventory is not even mentioned here. In fact, it is often not even recognized. In just a minute, we will get to that crucial advantage which so few see and even fewer appreciate.

Question 1: “What Is the Basic Purpose of Inventory?”

What is the basic purpose of inventory? This is not a complicated question—indeed, it is a rather simple one actually, but it is asked by a scarce few, and answered by even fewer.

First, let’s make sure we are on the same sheet of music here. I am talking about the use of inventory in a classic for-profit business. The objective of those companies is generally to do just that: make a profit. In those businesses, the purpose of inventory is singular and simple: You should only hold the inventory you will need to protect your sales.

I see no other reason to hold inventory. Any amount beyond this is an expense that is not justified, yet to hold less undermines your ability to supply your customer—and nothing will hurt profits like failing to sell. It is a very simple concept. Well, it is pretty simple, anyway, and yet is still missed by many.

We only hold the inventory we need to protect sales. There is a relationship between the amount of inventory and the volume of sales. So in a nutshell, if we know the sales volume and can understand the relationship, we could calculate the inventory we need to protect those sales. The relationship is a sim-

ple mathematical calculation, but just how is that calculation made?

First, let’s address finished goods inventory. This inventory calculation has three parameters—and not surprisingly, there are three types of inventory. The three param- eters are:

• Stock replenishment volume (that is, the picked-up volume by the customer)

• External variations, usually demand fluctuations

• Internal variations, usually production issues

The total inventory is the sum of the three types of inventory, which are:

Cycle stocks

This is the volume you need on hand to take care of the normal demand pickups by your customer, often this is called stores.

• For example, if your customer picks up each Wednesday, you will need their ordered volume ready for pickup then—and not before. Unfortunately, the infor- mation handling system, production, and the delivery system are not instan- taneous, so we need some volume in cycle stock that is above the bare minimum the customer will pick up. So, to make sure you can achieve the customer’s needs, we will calculate the cycle stock’s volume to be the production rate multiplied by the replenishment time plus some arbitrary safety factor we will call Alpha (see the section “Finished Goods Inventory Calculations” later in this chapter). The stock replenishment time (see Fig. 3-1) is the sum of four variables:

P

oint of Clarity The only eco nomic purpose of inven- tory is to protect sales.

Replenishment time RT = t_plan+t_q +t_prod + t_del

Planning time, tplan

Kanban post

Customer Production

cell

Delivery time t_del Heijunka

Queue time, t_q Production time t_Prod FIGURE 3-1 Replenishment time.

Planning time This is the time that the order takes to be processed and sent to the pro- duction line.

Waiting time This is the time the order is waiting to be processed. This is sometimes referred to as queue time.

Production time This is the time it takes to produce the desired quantity.

Delivery time This is the time to get the lot from the production line to the storehouse.

Buffer stocks

This is the incremental volume of inventory, above the cycle stock’s inventory volume, which is held to account for external variations, and is calculated based on historical data of the variation of these external causes.

Safety stocks

This is the incremental volume of inventory currently held that is above both the cycle stock and buffer stocks. It is held to account for internal variations in supply to the storehouse.

Question 2: “Just What Is Causing the Need for Inventory?”

The need for each of the three types of inventory is caused by different factors. These factors are:

• For the cycle stock, the need for the inventory is caused by the size of the picked- up shipment, which, for a constant demand product, is a function of how frequently the shipment is picked up. In addition, some inventory is needed to cover the time it takes to plan the shipment, make the shipment, and move the shipment within the plant. This is the replenishment time calculation.

• For both the buffer and safety stocks, the need for inventory is one of the world’s best kept secrets. The need is caused by variation. When we have more variation in the system, we need more inventory. The buffer stock size is usually deter- mined by two variables: changes in customer demand, and variations in delivery conditions. Often, this is due to weather, or in the case of products that cross an international border, customs can be an issue. So, the sources of variation for this volume of buffer inventory are somewhat outside of the control of the plant.

• Regarding safety stock in particular, the large sources of variation are issues of supply to the storehouse. These sources of variation include such items as line outages due to machinery failure or stock outs. Poor cycle time performance can cause production to fall short of goals, and of course quality problems can also be a major cause of variation. All three of these issues, which happen to be the three aspects of OEE (Overall Equipment Effectiveness), are largely under the control of the plant.

• In the case of the buffer and safety stock inventories, there is a simple way to calculate the volumes needed. If the variation of the volume swings is calculated over a reasonable time frame and stated as a standard deviation, your variation is now converted to numbers so we can have a common understanding of it.

Now if you have a stable system and hold 2.33 standard deviations of inventory,

you will have enough inventory to cover about 99 percent of these deviations, presuming your data are normally distributed. Since, in reality, there are many possible sources of variation, assuming the normal algorithm is reasonable.

With weekly shipments, that would mean about one undersized or late shipment every two years.