Strategy for Deriving Maximum Profits by Inventory Minimization
Marjorie Green & Mischa Dick
Six Sigma Systems, Inc.
Inventory in Distress Situations
In addition to the costs mentioned above, inventory may also play a vital role for a firm in distress. If the inventory is saleable, management may decide to utilize the inventory as a cash generator regardless of the impact on some of the costs stated above. While non-profitable sell-offs may seem irrational to some, it in fact can represent very sound business action. If the firm is close to default and the continuing operation is in the shareholders interest, the unprofitable liquidation of inventory may generate sufficient cash to implement other changes for survival. The potential cost incurred in this situation, the cost of default, may also be incorporated, but is beyond the scope of the discussions of this paper. The methods discussed here are useful primarily for those organizations with sufficient cash flow to sustain operations. Along the similar lines, inventory can be useful during the initial stages of an economic downturn. During this stage, the company has a fixed cost structure to support strong product demand. As demand drops in the economic downturn, the associated fixed cost structure of the firm lags behind in adjustment, thus creating serious cash flow drains. Inventory sell-offs may be used to bridge this transition period.
Inventory for Profit Maximization
The goal of any inventory policy is quite easy to state: Minimize the sum of all costs associated with inventory. The question of the ‘correct’ amount of inventory can now be expressed as a cost minimization problem that needs to be solved. We will demonstrate the mechanics of this shortly.
The Operations Management Approach
To implement an operations management approach to inventory optimization, we must first and foremost understand the cost structure associated with the parts under scrutiny. Depending on the primary players contributing to the overall cost of having and not having inventory available, the application of different inventory models and management methods will be appropriate.
Furthermore, since the operational purpose of inventory is to buffer a mismatch of supply and demand, we must understand the supply and demand behavior we are attempting to buffer.
Typically we need to understand supply lead-time from order placement to receipt into inventory along the following parameters:
- Average lead time
- Variation of lead time
- Stability of lead time
With regard to product demand, we subsequently need to understand:
- Average demand (daily, if available)
- Variation of demand (daily, if available)
- Stability of demand
In order to characterize the supply lead-time and demand, statistical tools such as Statistical Process Control (SPC) have proven to be quite useful.
Once all these elements have been determined, it is most useful to collect the information in a matrix to get a quick overview of all the primary cost drivers as well as the supply and demand behavior. From the matrix a standard model can either be chosen, or a custom model can be derived.