Reducing inventory to speed cash flow

Electrical Apparatus, Apr 1998 by Wiersema, William H

Managing by the 80-20 rule20% of your stock makes up 80% of your volume

MOST COMPANIES WOULD be better off with less inventory. Expenses to finance, store, handle, and insure inventory cripple cash flow. Every dollar of inventory costs at least 25 cents per year to support. It may easily cost more in obsolescence, lost efficiency, and shrinkage. Vendor quantity discounts pale in comparison.

The cause of bloated inventory is often the lack of records. When records are out of control, so is ordering. Placing orders when quantities look low never works well. Frequent stockouts cause buyers to order more. Parts may sit for years only to be thrown away. To make things worse, stockouts continue no matter how big inventory gets. Without control, companies lose orders and ultimately, customers.

When inventory grows, warehouse performance declines as space runs out. Unfortunately, too many warehouses evolve without much thought. The logic of an initial design is lost over time. The most accessible storage winds up less than half filled with infrequently used items. Arranging parts alphabetically, for example, signifies inefficiency.

Turnover, or the ratio of usage to average amount of inventory on hand, reveals problems. Distributors' inventories often turn less than four times and manufacturers' less than eight. These numbers are unacceptably low.

The bottom line is this: Inventory should equal needs. It exists mainly because of lead time, which is how long the customer can wait versus how long it takes to obtain and process the material. If the customer can wait two weeks and the vendor can deliver in one, why carry inventory at all? Similarly, an item used infrequently should be cut from stock.

80-20 rule revisited

You need a place to start, to make sense out of the data mess. Even Superman can't solve all problems at once. Chances of success improve when you focus attention on what's most significant. Then, you'll change things that maximize bang for the buck.

Remember the 80-20 rule? It says 20% of your customers provide 80% of the sales volume, for example. Or, that 20% of your customers or vendors cause 80% of the problems. With so many applications, the idea loses its meaning. Inventory, however, remains an ideal way to use it.

Here's how to apply the rule: Classify inventory into A, B, and C categories. "A" items are the 20% of items that make up 80% of annual usage dollar volume. "B" items comprise the next 30% of items, and "C" items are the remainder. Dead stock or "D" items, having minimal usage relative to inventory on hand, are separate from the normal categories. (More about "D" items later.)

To implement ABC analysis, prepare a spreadsheet containing part numbers and annual dollars used. Newer software allows you to download this from your computer without having to re-key. Sort the data by usage dollars in descending value order. Remove "D" items. Then, count the first 20% and the next 30% of items. Usage dollars for the first 20% should be about 80% of the total. (See Table I, next page, for illustration.)

"A" items

Focusing on "A" items can improve profits dramatically because they impact turns the most. To improve turns, target levels of "A" items in inventory and compare to actual each month. As turns increase, carrying costs fade into insignificance. Say total turns are four, meaning three months' supply on hand. If just "A" items increase to eight times, overall turns improve to over seven. Inventory decreases more than 40%, with substantial savings. It's the power of the 80-20 rule.

"A" items deserve priority in control, ordering, and storage. Control is the basis for improving inventory management. It requires perpetual records that cover all transactions and balances on hand. They optimally are maintained on computer and updated daily in real time so that current data are always accessible. Automation is no panacea, however. Computers compound errors, sometimes making problems even worse.

Keeping records accurate means frequent testing through cycle counting, up to monthly for "A" items. Cycle counts compare inventory on hand to records on a rotating basis. To be effective, differences in counts should be followed up to find causes and correct for them.

How accurate is accurate enough? Improving accuracy, like anything else, needs a target. You can measure it by comparing accurate as a percentage to total cycle counts. Try for 98% for "A" items. That doesn't mean 98% of counts must be identical to recorded balances, but within a tolerance of one or two pieces for every 100. Graphs are preferred ways for communicating results.

Accuracy is a crucial first step; ordering is the next one. Ordering "A" items is much more important than most companies make it. Accountability should reflect dollars involved. Orders for "A" items should be reviewed and approved by top executives.

Select vendors carefully and track their performance. For "A" items especially, low price costs you in other areas. Poor delivery and bad quality prevent you from completing orders. Long lead times force you to keep larger quantities on hand. To maintain service while holding down costs, enter blanket orders that allow frequent deliveries. To minimize effects of uncertainty, shorten lead time.