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Strategy for Deriving Maximum Profits by Inventory Minimization
Marjorie Green & Mischa Dick
Six Sigma Systems, Inc.
Phoenix, AZ

Option three requires some fundamental change of the operational systems and potentially the customer behaviors. Techniques like Lean and Six Sigma are most useful to drive the kind of change required to fundamentally improve process performance and alleviate or lessen the need for inventory as a buffering mechanism. From an inventory standpoint, Lean will improve flow thus moving towards production of product just in time. By producing product on demand, the fundamental issue of non-synchronous production is addressed. Six Sigma will aid this process by removing variation form the process, again aiding in the synchronization of supply and demand.

In practice both option two and option three should be executed. In many organizations step one is the implementation of a structured, analytical inventory management method using operations management techniques. Initially this step can result in inventory reductions of up to 50% without any negative impact on service levels. In order to continue along a path of continuous improvement, Lean and Six Sigma techniques should be applied to improve the product delivery system. In some cases technology can also be used to aid in this process.

In recent years IT providers substantially increased their product offering to better ‘coordinate’ supply chain activity and to improve inventory positions. Some cautions have to be kept in mind for those organizations looking to IT solutions as the primary method to improve inventory positions. In many cases IT solutions do not fundamentally change the business process. If they do, it usually requires modeling the business process around an IT solution, versus implementing an IT solution to support the best possible business process. If not planned carefully, IT solutions can “automate” a fundamentally flawed process – hardly in the best interest of the implementing firm. Secondly, IT solutions assume educated users. While new technology software has the capability of applying a vast number of analytical models, the usefulness of those models will be determined by the correct application. IT providers often supply basic training, however, the workforce must be educated in regards to available models in the context of the exiting business. Lastly, IT solutions are time consuming and resource intensive. Initially, substantial gains can often be achieved much faster and cheaper by implementing the framework below.

The Value of Placing Inventory
As stated previously, the value of placing inventory is to have product on hand when it is required. The requirement for product can originate at a customer seeking product as well as an internal need for product, such as the requirement for piece parts at the assembly line. As such, the value of inventory can be found in the following:

  • Making a sale immediately, preventing either a lost sale or a delay in cash flow (in the case of backorders being acceptable)
  • Ability to produce product as planned

Instead of listing the value of inventory, we can also express the value as a cost of not having inventory. Since this inverse view of the value of inventory will prove to be advantageous in the derivation of inventory models later, we will continue considering the cost of not having inventory. In detail they are:

  • Cost of a lost sale
  • Cost of capital in the case of a delayed sale
  • Cost of a line shutdown, line changeover, etc. due to parts unavailability etc.
  • Delivery penalties
  • Overtime charges

The Cost of Placing Inventory
Placing inventory is costly and is a cash flow drain, which is the reason for the attention it usually gets. The following is a brief list of the type of costs that should be considered when deciding on the appropriate amount of inventory to be held:

  • Cost of capital. Any cash used to purchase inventory is not returned to shareholders or reinvested in economic value added (EVA) activities. Therefore there is a real cost to the firm of placing inventory for purposes of supply and demand synchronization. A good indicator for the cost of capital is the weighted average cost of capital (WACC).
  • Cost of obsolescence. In markets with high rates of product innovation and customer expectations for product innovation, product placed as inventory can become obsolete. At best this inventory can be sold at a discount once it has become obsolete, however, in some cases it must be removed and written off entirely. If it is sold as obsolete product the firm may encounter an additional cost if cannibalization of its own product portfolio occurs
  • Cost of management. Managing inventory requires resources in the form of individuals managing the administrative and physical aspects. Additionally IT resources are consumed in the process of managing the inventory
  • Cost of physical storage
  • Cost of ordering. The order process typically requires administrative resources to complete the ordering transactions. Even in highly automated B2B situations, auditing personnel will be required
  • Cost of setup. The physical setup of production should be considered in cases where batch manufacturing is still applicable. This cost can be substantial in those organizations with large equipment, such as injection molding etc.
  • Shipping cost

First published in IPC proceedings, April 2002.

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