Smart Inventory Solutions. Phillip Slater
items will naturally have a high turnover and some will be low. The aim of the ratio is to measure the overall efficiency of the inventory investment.
In one recent case, an inventory manager tried to justify the size of his inventory by pointing out that one section of inventory had a stock turn of 5 (very good in his circumstance) and that another section had a stock turn of 0.2 (very bad). The justification was that insurance spares caused the low stock turn and, therefore, nothing further could be done. This analysis, however, ignored a large component of inventory that could be managed down and it ignored the possibility of consignment stock for the fast movers.
As mentioned above, stock turns is also a great measure to use when you have multiple sites or locations within the one company. As an internal benchmark, stock turns readily shows which sites have better control over their inventory.
Stock turns is an essential measure of inventory performance because it measures the inventory efficiency. When used in conjunction with other measures such as stockouts, the overall performance of your inventory investment can be determined.
The Financial Impact of Inventory
How often have you heard someone say, ‘Without this inventory, production will stop’ or ‘We are merchandisers; we need our inventory or we won’t make sales.’ These statements represent the typical view of inventory—more is better! It is true that without the right inventory some sales may be missed or a production line may stop. Both are outcomes that may result in lost revenue. It is also true that too much inventory costs a business even if it is the right type of inventory. It costs money to buy inventory, it costs money to store inventory, and it costs money to finance inventory.
Often people say that the real issue is one of balance—that is, balancing the cost of inventory investment with the potential gain (or loss) from not making the investment. However, this view is overly simplistic. It can be misleading if applied universally. The goal should be to ensure that you don’t overcompensate for uncertainty by stocking materials that you just won’t need and to avoid overinvesting in the inventory that you do need.
In many cases, the ongoing level of investment that companies make in their inventory just does not make sense. These are the cases where stock minimums are never reached. Perhaps months of supply are held when weeks (or days) will do. Or the inventory is just not needed, but is not sold off or otherwise removed from the system. These are the cases where the ongoing cost of the inventory just cannot be justified.
The Inventory Management Tension
The conflicting needs of meeting demand expectations and minimizing the financial investment in inventory sets up a tension between Operations and Financial Management. This inventory tension is shown in Figure 3-1.
Figure 3-1: The Traditional Inventory Tension
Financial managers such as Chief Financial Officers (CFOs) and accountants will typically seek to minimize the working capital that is tied up in a business. Working capital includes inventory. But if these managers take an approach that is based solely on the dollars invested, it is likely that the investment will end up being made in the wrong inventory. Why? Because the aim is to reduce the dollars invested, not to meet demand expectations.
The accountant’s approach will result in inventory being cut in any way possible to drive a working capital outcome. This approach is most likely going to be the case if the performance of the financial manager is measured solely by financial outcomes such as working capital, not operational or sales outcomes.
Conversely, operations managers typically seek to maintain a high level of investment in inventory. Their goal is to ensure that inventory will be available to meet demand. As a result, there is likely to be an overinvestment in inventory; there may be high levels of obsolescence, and, in some cases, high product spoilage. These outcomes occur because operations managers are typically measured by plant performance or Profit and Loss metrics (P&L — sometimes referred to as the Statement of Financial Performance) such as revenue, cost, and EBIT (Earnings Before Interest and Tax). Inventory is a balance sheet item (see below) and does not impact the P&L. Therefore, minimizing inventory is typically of little concern to operations managers.
Resolving this inventory tension requires an approach to materials and spares inventory management that strips away the excess and ensures that a company only stocks the right amount of the right inventory. The first step to achieving this is to understand the financial aspects of materials and inventory management.
There is an old saying in business that ‘Cash is King.’ What this means is that cash is the lifeblood of all business. No cash, no business. Spending money on materials that end up in inventory ties up cash and diverts it from other potentially revenue-generating or cost-saving uses. The aim, therefore, should be to minimize the inventory investment for a particular level of customer service. The approach taken should ensure that the target level of service is met while also minimizing the cash investment. In turn, this approach will maximize the overall benefit for the company.
A Simple Model of Business Economics
Understanding the importance of cash requires having a basic understanding of business economics. To help explain this, turn to Figure 3-2, which represents a simple cash flow cycle.
(1)Starting at (1), the 12 o’clock position, this business has some ‘Cash on Hand’ with which to operate. The cash might have come from investors or it might have been borrowed from the bank.
(2)In either case, the investors or the bank will want a return for making the money available. The return will be either interest for the bank or dividends for the investor. In a real business, some of this cash would be used for investment in plant, equipment, and buildings. But for simplicity, in this example we will assume that that type of investment is complete and requires no further funding.
(3)The business spends its cash on buying raw materials, spares, labor, and utilities so that it can make products.
(4)Typically the business will need to hold inventory of the raw materials and spares in order to be able to provide a buffer between supply of these materials and the demand from their production department. The buffer is necessary because the rate of demand is usually greater than the ability to supply. In order to accumulate inventory for this buffer, they need to buy more than they will actually need in the short term.
(5)The raw materials are then used to make product. After the product is made, it will be put into inventory, again to act as a buffer between supply and demand. Again, to accumulate the inventory for the buffer, the business must make more than is needed in the short term.
(6)When these products sell, the buyer pays the company; the payment provides an input, or receipt, of cash to enable the company to recommence the cycle.
While the cash flow cycle continues, the company will need to spend cash on overheads, new investment, interest on money borrowed, repayment of money borrowed, and dividends to shareholders.
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