Materials management
There are many advocates of inventory reduction and we wholly support this as being fundamental to long term business improvement. We differ from many others because our experience has led us to the necessity of recognising real world limitations and adopting pragmatic approaches to stock management and inventory reduction. Our focus is on profitable operation and we have developed an approach to materials management which is based on a bottom up analysis employing first principles thinking. We look at the factors that are both encouraging and discouraging the holding of stock and seek to establish an economic balance between them. The whole process flows sequentially through three steps:-
- Understand your Total Stock Holding Costs
- Define the Economic Order Quantities
- Establish Stock Management Parameters
Obviously all situations are unique and can be analysed in detail. However, the generic information on this site provides a useful starting point for effective stock management. In parallel with the effective management of stock it is important to consider inventory reduction. The two main reasons for holding stock also hold the clues to its effective reduction. Essentially we need to hold a minimum amount of stock in order to continue satisfying customer demand whilst waiting for new units to arrive, whether from our in house processes or an outside supplier.
Supply Side Delays
Knowing the supply side delay, or re-order lead time is crucial to the minimisation of stock levels. Setting a correct re-order point, or re-order level requires both a knowledge of the future demand and the delay until new stocks arrive. Even if an item could be instantly obtained, inventory will still arise if we buy or make more than we require at the moment. This is often necessary to achieve acceptable:-
Order Handling Costs
Often the bulk of the inventory arises as a result of Economic Order Quantities or economic batch sizes. Batching is employed in recognition of the costs associated with initiating, organising, delivering and closing an order. When these costs are high relative to the cost of fulfilment it becomes uneconomic to source items individually. A manufacturing example is when a component can be made in minutes once some hours have been spent to set a machine. In this situation, processing large quantities both lowers unit costs and increases manufacturing capacity. Whilst it is important to explore improvement actions such as process re-engineering, it is also necessary to manage the operation effectively in the short term. Most businesses will never be free of such considerations, for example where fixed delivery charges are applied (irrespective of the number of items ordered) or minimum order values are applied. In reality, there are economies of scale in all forms of processing, including office environments, and whilst we may strive to eliminate the reasons for them, we still need to manage their impact on our profits.
You may use the calculators provided on this site to understand the impact of inventory on your business. Recognition of costs and cost drivers is the first step towards cost reduction.
If you are contemplating a cost reduction exercise or would like a customised calculator please contact us for a free initial consultation.
Consultancies working in this field are not permitted to use these calculators which are copyright protected, please contact us to discuss opportunities.
Total Stocking Costs
There are significant costs associated with holding inventory and these arise from three main areas:-
Financing costs
Don't be misled by low bank base rates, financing is still expensive for most businesses. And most businesses have limited availability of funds. Hence the financing cost will be either the borrowing cost or the opportunity cost (profits lost because another opportunity could not be funded). A simple example would be when an additional product line can not be offered because there are no funds to stock it; here the opportunity cost would be the lost sales margin perhaps 35% on each stock turn.
Storage costs
There are real costs associated with the storage of any item. In addition to the floor space required (plus heating and lighting) there is an administration overhead for receiving, tracking and despatching items. These costs, unlike financing costs, will not be a simple percentage of the value and will in fact vary widely. It is relatively inexpensive to store small items of high value, whereas the converse is equally true, Examples might be top of the range mobile telephones compared to pre-formed cardboard boxes. The value density or cost per cubic metre of the item provides an indication of its storage costs.
Obsolescence risks
For all items in storage there is a risk that they will be rendered unsaleable, either due to deterioration or a lack of demand. Examples might be food that goes past its sell by date, fashion items like top of the range mobile phones that no-one wants to buy or spare parts for products that are no longer manufactured. The real obsolescence cost will vary widely, but an estimate should take into account the product's shelf life and the robustness of the sales projection. Some mitigation against loss may be derived from reduced price offerings or sales and this should be factored into the cost figures.
Total Costs of Holding Stock
The costs derived under each of the headings above can be aggregated to provide a composite stock financing cost. The link will load a simple estimator that you can use to derive your own figure. This tool will provide a useful insight into the real costs of holding your stock. It is an approximation because it uses generic numbers. Whilst more precise answers can be calculated they require a lot of effort to achieve. We recommend that you start with this, and contact us if and when you can see value in a more precise approach.
Economic Order QuantitiesFor almost every task or job that is done, there is an overhead associated with starting and finishing the task and this is unproductive time. This might be retrieving a file and putting it away again, finding your place in a book (or marking it) or setting a complex manufacturing process.
These losses are often a significant part of the total cost (or time) of the process. Reduction and/or elimination of these losses (waste) lies at the heart of lean or flow methods which are highly successful in reducing costs and stock holdings in volume manufacturing. However all of us on occasions have to accept the realities of low volume or infrequent demand. In these situations, the normal response is batch processing. The advantage of batch processing is that the expensive overhead that has been incurred in creating the first unit can be spread across a number of items instead of just one. This has the benefits of not only reducing the unit cost, but also increasing efficiency and consequently capacity.
The unit cost reduction will continue as numbers increase and although the benefit diminishes, there is no level at which the benefit ceases. At some point however the unit cost benefit is out-weighed by other factors. This could be a variety of things, but for a physical item, each extra unit produced will need to be paid for and stocked until required. If these stocking issues are expressed financially, they can be used to calculate an optimum batch size.
These behaviours are not restricted to manufacturing, but apply to all operations in your business. It is extremely difficult to eliminate all of the issues that encourage batching behaviours, particularly in purchasing, where bulk discounts, fixed delivery charges and minimum order values are the norm.
Stock ManagementWhilst holding stock has undesirable implications, it is too simplistic to say that it should be removed. Consideration of the reasons why you are holding stock and working to improve the factors which are driving the stock holding requirements will inevitably reward you with a stock reduction. This is particularly easy to achieve in large volume manufacture where flow principles can be employed to good effect. Most of us however have to survive in the real world where there is one overriding reason for holding stock:-
SUPPLY SIDE DELAYS
We need to hold a minimum amount of stock in order to continue to meet customer demand whilst waiting for new units to arrive. Whether these come from in house manufacture or an outside supplier, knowing the supply side delay, or re-order lead time is crucial to the minimisation of stock levels. Setting a correct re-order point, or re-order level requires both a knowledge of the delay until new stocks arrive and the forward demand for the item.
FORWARD DEMAND
If there are delays involved in re-supply then stock levels can only be minimised with a good understanding of future needs. If the re-order level is set too low, stocks will run out, if set too high, unnecessarily high stock levels will result. For example if the delay is four weeks and the demand is for two units a week the re-order level will need to be set at eight units.
In reality forward demand levels are projections and suffer from a level of uncertainty requiring an additional stock allowance for safety. These combined considerations will allow you to decide on a re-order level (when stock is depleted to this quantity a new order will be raised).
RE-ORDER QUANTITIES
The re-order level tells us when to re-order, but we also need to understand the quantity to re-order. This will usually be determined by economic considerations rather than demand projections. In the real world, most stock arises as a result of the economics of supply.