Manufacturing Companies – Keys to Inventory Management
Holding inventory is required as a hedge against various external and internal factors, either as a precaution, an opportunity, or sometimes for speculative purposes. The basic reasons for investing in raw material and finished goods inventories are outlined below:
Raw Material Inventory
Most companies have raw material inventory warehouses attached to the production facilities where raw materials, consumables, and packing materials are stored and issued for production on an as needed basis. The primary reasons for holding raw material inventories are as follows:
- Meeting variations in production demand
- Catering to cyclical and seasonal demand
- Realizing economies of scale in procurement
- Avoiding price increases or realizing quantity discounts
- Reducing transit cost and transit times
- Addressing long lead time and high demand items
Finished Goods Inventory
Manufacturing companies hold finished goods inventories in many locations throughout the supply chain. Finished goods can move from the point of manufacturing to the end customer, based on a variety of sales and delivery models. Inventories may be owned and held by the company or by intermediaries associated with the company’s sales channels. Finished goods inventories are maintained for the following reasons:
- Market size, location and supply chain design
- Build-to-stock or build-to-order production strategy
- Transportation and physical barriers
- Local tax and customs regulations
- Production lead times
- Supply chain cost avoidance
- Speculative and hedging strategies
The cost of procurement, storage, and management of inventory in manufacturing environments can result in significant ongoing operating costs. These costs can be categorized as ordering costs, carrying costs, and shortage costs that include losses from pilferage, shrinkage, and/or obsolescence. The cost of procurement and inbound logistics are a part of ordering cost. Ordering cost varies based on two fundamental factors – the cost of ordering too little or too much inventory. Ordering too little inventory will result in the increase of replenishment and ordering costs; ordering excess quantity will result in incremental carrying costs.
A primary component of inventory carrying cost involves inventory storage and management either using in-house facilities or external warehouses owned and managed by third party vendors. In either case, inventory management and the related processes involve extensive use of storage facilities, material handling equipment, software applications, computer hardware and staff resources. The other component of carrying cost is the cost of capital. This includes the costs of interest on working capital, taxes on inventory paid, insurance costs and other costs associated with legal liabilities.
Inventory storage costs and the cost of capital are both dependent upon and will vary with the decisions of management to manage inventory in-house or through outsourced vendors and third-party service providers. The trend is increasingly in favor of outsourcing the inventory management function to third party service provides. Organizations find that managing inventory operations requires certain core competencies, which may not be in line with their business experience and focus. Also, in the case of large-scale warehouse operations, the scale of investments may be too large in terms of the cost of storage facilities and material handling equipment. Capital can then be utilized in other important areas such as research and development, expansion etc.
Inventory Management & Control
Inventory management and control is a critical function, especially in situations where multiple locations and service providers are involved. The efficiencies of inventory management are largely dependent upon the skills and knowledge of the inventory planners, the focus and involvement of management, and the management policies surrounding the inventory management system. Companies which identify supply chain and inventory policies to be of significant help in gaining an edge over competition will invest heavily in engineering efficient supply chain models and inventory management practices to meet their business goals. Efficient inventory management will mean carrying optimally balanced inventory as well as ensuring control over related inventory carrying costs. The following actions are involved in effective inventory management:
- Establish and outline standard operating procedures for all supply chain participants and service providers. This includes flow charting and documenting all inventory systems and warehouse operations. It is important to have ongoing process adherence within a clearly defined management structure which identifies decision making authorities.
- Create inventory visibility at every stocking location through information systems capabilities, and establish accountability for oversight and review of the data.
- Require inventory planners to analyze inventory status at all locations on a daily basis in order to highlight non-conformities and to drive timely issue resolution.
- Initiate daily and/or monthly cycle counting procedures to be carried out at all locations with results summarized and reported on a timely basis. Repetitive cycle counts will highlight ongoing location stock accuracy and will lead to continuous process improvements.
- Conduct periodic wall-to-wall inventory counts and audits at all locations and insist on one hundred percent adherence to established counting and reporting procedures. Wall-to-wall inventories should typically be scheduled at least twice a year.
- Confirm that inventories maintained by third-party logistics providers are accurate and properly interfaced with internal inventory systems.
- Visit major inventory sites with management present during physical stock counts and audits as scheduled.
- Continuously review all inventory related processes and ensure that required training is carried out regularly.
- Establish a process-oriented culture where all operating staff members understand the importance of managing inventory effectively.
Inventory Methods and Metrics
Every organization that is engaged in the production, sale or trading of products holds inventory in one form or the other form. Manufacturing organizations typically hold raw material, work-in-progress, and finished goods inventories. Each category of inventory should be actively managed using appropriate methods and metrics.
Order Quantity and Timing
Raw material inventory management essentially deals with two major functions: inventory planning and inventory tracking. Inventory planners analyze demand and decide when and how much to order. A traditional inventory management approach can consist of a combination of the following three replenishment methods:
- EOQ: Economic Order Quantity method determines the optimal order quantity that will minimize the total inventory cost.
- Continuous Order Model: works on fixed order quantity basis where a trigger for fixed quantity replenishment is released whenever the inventory level reaches the predetermined safety level and triggers reordering.
- Periodic System Model: This model works on the basis of placing an order after a fixed period of time.
Each of the above methods involves analyzing and coordinating delivery capacity, lead times and delivery schedules of suppliers, and logistical processes and transit timelines involved in transporting and warehousing raw materials before they are ready to be supplied to the production shop floor.
Inventory in any organization can involve thousands of part numbers and millions of parts in quantity. Therefore, inventory is required to be classified logically in order to prioritize and facilitate management. In many organizations, inventory is categorized according to the ABC Classification Method. This method is based on 80/20 principles involving the relative value of the inventory units on hand. An illustration of the classification follows:
- A-Category Items Comprise 20% of SKU & Contribute to 80% of the dollar usage.
- B-Category Items Comprise 30% of SKU & Contribute to 15% of the dollar usage.
- C-Category Items Comprise 50% of SKU & Contribute to 5% of the dollar usage.
This kind of categorization of inventory helps to manage the entire volume and assign relative priority to the right category. For example, A Class items are the high value items; therefore, companies should monitor the inventory of this category closely to ensure the inventory level is maintained at optimum levels. Any excess inventory can have a significant adverse financial impact.
While inventory classification of raw materials for inventory management purposes can apply the ABC Classification, finished goods inventory is classified under additional categories based on various attributes including sales volumes/patterns, functional attributes, and operational requirements. At the very basic level, finished goods are manufactured and stocked separately, depending upon unique business unit and sales channel requirements.
Inventory Turnover is calculated by taking the Total Cost of Goods Sold, divided by Average Inventory. Adding beginning and ending inventory and dividing by 2 calculates Average Inventory.
A higher inventory turnover generally suggests a healthy trend of increased sales and the need to maintain adequate inventory levels to avoid stock outs. Inadequate stock can result in the loss of business opportunities and is something that management must monitor closely. On the other hand, a lower inventory turnover shows that either sales of the targeted inventory are slowing down or that the unused inventory is building up within the system somewhere. A slow inventory turn can help an inventory manager focus on finding non-moving, obsolete and slow-moving inventory items, and steps can be taken proactively to deal with the issues appropriately.
Inventory turnover also reflects the carrying cost that is incurred in managing inventory. Increased inventory turns reduce the carrying costs. The costs, especially fixed costs like warehouse rent, get distributed over higher inventory throughput; therefore, the unit cost of inventory transactions is reduced.
Inventory turnover is also indicative of the health of inventory operations. When inventory turnover is higher, all inventory operating efficiencies must be elevated in order to be responsive to market demand and customer satisfaction.
Inventory management in manufacturing companies is an ongoing and dynamic process. Eliminating inventory related inefficiencies in physical operations, processes, and systems requires active management participation and continuous improvement in all areas of inventory management. Companies that do this successfully have a greater opportunity to achieve sustained growth and profitability.
Founded in 2001, FocusCFO is the leading onsite fractional CFO services provider in the Midwest and Southeast, with more than 100 CFOs and Area Presidents throughout Ohio, Indiana, Kentucky, Michigan, North Carolina Pennsylvania, South Carolina, West Virginia and Tennessee. FocusCFO works closely with small to medium sized businesses helping business owners gain control over three key financial and operational areas: increasing cash flow, reducing business risk, and creating a platform for scalable growth. This allows business owners to then realize full financial control and increased value in their businesses.