Inventory Cost Management
Companies that manufacture products must manage their inventory to keep costs low but availability high.
When to Use Inventory Cost Management
Those individuals responsible for inventory management, whether in manufacturing, logistics, or sales, will need to know the current status of value of inventory and the accounting principles used.
- There are three phases in the inventory cycle, raw material, work-in-process (WIP), and finished goods.
- There are different optimizing approaches that can be used in each phase. The optimal level is one that is the lowest cost that still provides needed availability to meet customer demand. This level is ultimately a business decision, but operational managers can make that decision easier by reducing the cycle time through each phase.
- High levels of inventory require high levels of cash to pay for the inventory and may require high costs to store and manager the inventory. In addition, most companies must pay property tax on the value of the inventory that is on hand and carry insurance for the value of the inventory. An additional problem is that a long inventory cycle will often mean that some inventory gets stranded along the way by becoming obsolete due to design or customer changes.
- Insufficient inventory in the inventory cycle can lead to the loss of sales. When a spike in demand occurs, if the company is unable to provide product to potential customers, they will go to a competitor or an alternative solution to their issue.
- Raw Material is the first phase in the inventory cycle. This is the material purchased from suppliers but not yet in use in the production process. This may have been delivered to the company’s production facility or it may be held and stored at the supplier’s facility.
- Raw material is optimized so that production has on hand what it needs to meet the build schedule, but very little extra raw material is in the stockroom.
- Use standard materials and components when possible. Lower cost and more flexible for use in multiple products.
- Low cost items can be bought in bulk for significant savings without adding significantly to the inventory costs. High cost items normally should not be bought in bulk.
- High cost items use a KanBan (scheduling system that orders a replacement for an item when it is pulled from raw material inventory and placed into production). This minimizes the quantity on hand, but still ensures there is some on hand.
- Negotiate with suppliers to deliver inventory “just in time” (JIT) which reduces the costs of managing the inventory onsite.
- Work In Process (WPI) is the second phase of the inventory cycle. This is partially manufactured product. It is no longer raw material, but it is not yet finished goods ready for sale to a customer. This is typically inventory that is moving through the factory process but can include the value of inventory going to supplier who provides a special process in the middle of the manufacturing process, such as adding a special coating.
- WIP inventory is optimized by reducing the manufacturing cycle time so that the product can be built is as little time as possible.
- The most common approach is to apply LEAN manufacturing methods that were pioneered by Toyota and focus on reducing the cycle of the production value stream.
- Minimize queues, storage locations and reduce lot sizes so the WIP inventory goes directly from work station to work station and does not sit on a cart or a shelf waiting for its turn to be worked on.
- Use generic subassemblies that can be used in multiple product lines whenever possible. Then if there is a slow down on one line the subassemblies can still be used on another.
- Finished Goods Inventory is manufactured products that are ready for sale to a customer. They may be held at the manufacturing plants, in distribution centers and retail outlets, or at the customer’s facility.
- The optimizing approach for Finished Goods inventory varies depending upon whether the product is a custom product or a commodity.
- Custom products should focus on product designs that allow the product to be near completion in a generic mode and can then be customized quickly at the last step of production. Or it should be designed so that the customer can select from many different options that are pre-determined to be allowable options – think of the process of ordering a computer from Dell.
- Standard commodity products should maintain inventory at the appropriate places in the logistics process to meet demand and allow time for restocking.
- In either case there may be seasonal adjustments (sales go up for the holidays) that could require some “build ahead” of finished goods.
Hints and Tips
- The optimal level of inventory will change frequently so it should be re-evaluated on a periodic basis. I recommend quarterly.
- It is often possible to negotiate a long term contract with suppliers that requires regular shipments (daily, weekly, etc.) and allows the company to vary the quantity in each shipment based upon the current inventory needs (KanBan approach). Using this approach the required quantities can change with each shipment without getting purchasing, contracts and negotiations involved.
- Lean can be applied to the order processing and logistics flow as well as to the manufacturing process. Reduction in cycle time in these areas can reduce the amount of inventory required in the system.
- It is almost impossible to be fast in production. Continually look for ways to reduce cycle times without driving up costs.
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