Many of my clients have achieved dramatic improvements in inventory levels. Here’s why that’s so important: inventory is one of the top consumers of cash, so improving turns can increase the amount of cash available and reduce the working capital necessary to fund growth.
One client had inventory turns of 17, even though they imported some things from China and had highly variable sales. Another had turns of 22 in a commodity, high freight cost environment. Two others reduced inventory by over 70% in less than a year.
Many CEOs and CFOs of middle market companies consider going from four turns to eight to be good improvement. While those numbers might beat industry average in benchmark studies, who strives to be average?
Inventory turns represent the number of times inventory turns over in a year, compared to the cost of the inventory. If a company has cost of goods sold for the year of $15 million and inventory of $5 million, turns would be three. Companies often make mistakes in this calculation that cause them to think they’re doing better than they are. Some companies use revenue divided by inventory to calculate the number, but revenue includes profit, which falsely pads the result. Some companies also use average inventory for the year, which is technically correct, but I prefer to use ending inventory as it gives you a better view of how your current inventory is performing.
Making Dramatic Changes
In order to improve inventory turns, companies need to think outside the box, or get rid of the box all together. Trying to do the things they are already doing, but better, will tend to only pick up a couple of turns improvement. You have to do things much differently to achieve high turns.
I’ve identified three areas to dramatically reduce inventory in both manufacturing and distribution environments:
- Being intentional
Step one in any improvement process is to get rid of what you don’t need. Rationalization helps identify things that are superfluous and inconsistent. There are several areas where you can apply rationalization. The first (and often easiest) is supplier rationalization. In a recent newsletter, I mentioned the supplier year-to-date payments report as a tool to help reduce the number of suppliers you use. Having more than two or at most three suppliers for any item is waste. I’ve seen companies reduce their total supplier base by up to 70% by developing solid partnerships with a few excellent suppliers, which not only reduces inventory, but usually cuts costs through better volume discounts.
The second place to apply rationalization is in SKU (stock keeping unit, or part numbers) management. Why have seven parts that do the same thing, when you could have two or three? Why use ten parts to make something when a redesign could reduce that to one or two? Next time you tape a package shut, look at the plastic dispenser that holds the tape. Those used to be made of metal and had up to a dozen parts, but now they’re injection molded and have two parts at most. Rationalization in action!
One distribution client had over 4,000 parts in their warehouse, but only 36 accounted for 50% of revenue. Another 250 parts accounted for 40% of revenue and the remaining parts only brought in 10% of revenue. It was easy to cut the inventory in half initially, and then a bit later, they had brought it down by over 70%.
Being intentional is the process of doing things in a certain way with discipline. I often refer to it as “call shot pool.” You take the shot, well practiced and disciplined, and the ball goes exactly where you intend it to go. The same thing should happen in inventory management. Being intentional involves having exactly what you need, when you need it, at the lowest possible total cost. The first step, which most companies overlook, is to know your cost of holding inventory, which allows you to evaluate when you should take volume discounts, whether you should take truck load quantities, whether you should hold inventory for customers, and so on. The cost is made up of a number of elements including cost of capital, cost of warehousing, cost of handling, obsolescence, adjustments and more. Having calculated it for many clients, I’ve seen costs of 3% per month or even more. A quantity discount from a supplier is quickly eaten up by the cost of holding inventory.
Another part of being intentional is to have predictable lead times. Many of my clients used to hold excess inventory because their supplier lead times were so long. But if those lead-times were consistent, they wouldn’t need to order such high volumes. It’s much more important that lead times are predictable than that they’re short. Short certainly helps, but long can work as well. Calculating the cost of holding and evaluating predictability of lead-times can help you determine, for instance, if it’s really cheaper to buy parts from China rather than from the company down the street.
Think of flow as a state of being. Companies can achieve flow through auto-replenishment systems such as Vendor Managed Inventory or Kanban, which are more reliable and predictable than many MRP systems. Well managed auto-replenishment has always been a part of dramatic inventory improvement for my clients. One implemented VMI in a construction-related warehouse and reduced inventory from $17 million to $5 million while projects were expanding, and at the same time improved service to the field teams, in which improved productivity by over $20 million.
Supplier partnerships, more frequent smaller orders, blanket purchase orders, and well-designed distribution networks can all contribute to flow. My book 1+1=100, Achieving Breakthrough Results Through Partnerships discusses these topics in more detail.
The Take Away
The actions needed to reduce inventory aren’t new, but they do require a tenacious leader, well-designed performance measures, and a carefully crafted implementation plan to produce extraordinary results. Over the years I’ve seen many companies exceed their expectations for inventory performance, achieving inventory turns, labor productivity, improved cash flow and profit improvement. I encourage you to go way beyond industry average when looking at inventory turns.
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