Inventory Reduction: Effectively Turning Excess Into Cash

  • Written By: R. Michael Donovan
  • Published On: May 16 2002



Introduction

In virtually all manufacturing companies, there is a direct correlation between inventory levels and overall business performance. According to Harold Geneen, the legendary financial genius and former chairman of ITT, "all the problems of business end up in inventory." Most knowledgeable executives would agree with Geneen. In fact, CEO's and CFO's believe that their companies consistently carry 25 to 40 percent or more inventory than is needed.

Assess Your Capabilities

Ask your material planning and operations team to answer the following four questions.

YES NO
1. Do you have effective, fact-based decision-support for identifying and prioritizing actions to stop unnecessary material inflow to inventory by dollar impact?
2. Does your decision-support system pinpoint undesirable inventory dollar movement by item?
3. Do you have decision-support capability that continuously assess specific items inventory reduction potential?
4. Does your decision-support system help you establish a baseline, set clear targets and provide on-going performance measurement for every item in your inventory?

 

What is likely to happen is that many individuals will skip over key words and, at first, answer the questions with a 'Yes'. However, when the key words are pointed out, the answers are almost always 'No' for not just some of the questions, but all four of them.

Finding out that your inventory planning and control system, even one based on modern ERP systems, does not have the depth and breadth of decision support capability needed to identify and prioritize preventative actions based upon their dollar impact can be a real eye-opener for senior management. A common misconception is that effective decision-support to reduce and prevent excess inventories from accumulating is part of the company's current system. To some extent, logic does exist in material planning systems to prevent inventory excesses. However, good prioritized separation of the vital few from the trivial many, especially by their dollar impact on inventory investment, is rarely part of the functionality in most ERP systems. The good news is that the functionality can be added quickly, at a modest cost. This can create an ROI like no other investment you can make.

Considering how much money may be unnecessarily flowing into inventory every year mandates that adding the capability to quickly answer the four assessment questions on page one is an absolute necessity.

Excess Inventory Is a Problem in Good Times, and Bad

Companies hit by a sharp decline in sales all too often experience a significant rise in inventories because of the considerable and unnecessary time that's usually needed to get incoming supply rebalanced with customer demand. When sales are declining, making the right adjustments in inventory levels becomes an exceedingly more important and difficult task. For some companies declining sales combined with a suddenly out of balance incoming supply of inventory have caused a massive cash outflow.

Coping with a rapid sales decline can easily cause companies to wait too long to make supply adjustments. The result is rapidly accumulating excess inventory. It's extremely important to have the capability to promptly take the right actions that are needed to prevent and reverse the accumulation of excess inventory. A healthy balance sheet depends on having a quick, precise inventory avoidance and reduction methodology. Most companies rely on their ERP systems for inventory accumulation avoidance and reduction only to be disappointed by the poor results.

Increasing Inventory excesses are often unnoticed by management until major reduction adjustments are needed. Some inventories go up significantly and surprisingly quickly. In fact, there are cases where a 20 percent to 30 percent rapid decline in sales has caused inventory turnover to be cut by 40% - 50% or more. In a sharp sales decline situation, it is common for inventory turnover to fall a lot before management gets the necessary information never mind early warning signals. The result can be a deep cut into cash balances.

Most organizations do not have really effective processes that provide early warning signals to make the specific adjustments to incoming material flow. Most of the time, ERP systems provide inventory planners with massive amounts of data that is poorly prioritized causing deferral actions to be late, ultimately resulting in a frantic, last minute scramble to make adjustments, which often cause more problems than they prevent.

A Sound Strategy Requires Using a Fact-based Approach

When the CEO or CFO finally gets the information that, in fact, inventory is rapidly piling up beyond what is needed, the typical reaction is to enforce an across-the-board clamp down on all new purchases. This 'shut-off-all-the-spigots' mentality can, however, cause even more financial damage. The across-the-board squeeze everything approach can create material shortages which in turn can cause missed shipments depressing revenue and customer service while increasing inventories and costs. As a result, these actions can lead to the very opposite of what management wants to happen.

Management needs to tackle the problem using a fact-based approach, allowing for accurate, careful adjusting of individual spigots to rebalance supply with demand. Finance, without the right information at hand, is often driven by a balance sheet view of the problem, is often the cheerleader for the "global squeeze" approach to cut inventories. The big problem with the across-the-board "global squeeze" is that it almost always reduces plant operating efficiency and decreases the customer service level. Worse, instead of improving financial performance, it often causes a sales decrease as a result of necessary materials being mistakenly squeezed out of inventory.

Often the senior management team assumes that inventory planning personnel will be able to easily handle the inventory problem because of the company's heavy investment in a state-of-the-art ERP system. This is a very dangerous assumption to make. Rarely have companies permanently solved their inventory problems with just an ERP system. In fact, ERP and other software tools can actually lead to a false sense of security. Inventory excesses, whether allowed to build up when times are good or when sales are falling, always result from ineffective inventory planning processes and effective monitoring.

Management should consider implementing an effective inventory monitoring methodology before installing an expensive ERP system. You want to get inventory under control before you introduce major new ERP and supply chain solutions-not afterwards. If you don't get the inventory on the right path first, today's bad inventory practices and policies are likely to be perpetuated tomorrow in the company's new Supply Chain Management system.

Rapid Inventory Reduction

A number of companies have used the Rapid Inventory Reduction Methodology as a way of quickly bringing their inventory levels down and into alignment with customer demand. International Game Technology, a casino gaming equipment manufacturer, achieved a 20 percent reduction in unneeded inventory in just three months and IGT was able to get that number up to 32% within just a five-month period, as they reported in the APICS International Conference Proceedings. IGT managed to save more than $16 million using the Rapid Inventory Reduction Methodology - dollars that looked better as cash rather than inventory on the balance sheet.

What's required for a Rapid Inventory Reduction program? An excellent way to start an inventory reduction program is by using computerized modeling and diagnostic tools that can quickly identify and quantify where to get the cash out. It's very important for management to have a factual basis to accurately quantify (item by item) how much inventory can be turned into cash and when. Also, pinpointing exactly where avoidable future inventory increases are going to occur so you can take the right actions to prevent unnecessary cash outflow is critical to success. It's a matter of assembling the right information in a way that causes the right, prioritized actions to be taken at the right time.

The first step in the Rapid Inventory Reduction Methodology is to use Inventory Quality Ratio (IQR) logic to classify each item's inventory dollar balances as active, excess, slow-moving or no moving according to predetermined inventory planning parameters. The IQR provides a fast and effective method for profiling an inventory both initially and on an on-going basis.

When an effective inventory monitoring methodology is put into place, management is much better prepared with the right information to reduce inventory including when dramatic declines in sales occur. That means a higher cash balance rather than a high inventory balance - which is what CEOs and CFO's want to make happen.


About the Author

R. Michael Donovan is a management consultant based in Framingham, Mass. He can be reached at (508)788-1100. Readers may obtain other educational material through the website www.rmdonovan.com and information on the Rapid Inventory Reduction Methodology can be obtained at the website www.inventoryinc.com.

 
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