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Companies that manufacture products must manage their inventory to keep costs low but availability high.

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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. 

Instructions

  • 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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  • 00:03 >> Hi, I'm Ray Sheen.
  • 00:05 Let's now talk about some aspects of managing inventory cost.
  • 00:10 I'll start with a brief description of how inventory costs are analyzed.
  • 00:14 Inventory goes through a three-phase cycle as it is processed in a business.
  • 00:17 It starts out as raw material.
  • 00:19 That is the material and components that are received from suppliers.
  • 00:22 Based upon the manufacturing build schedule, the raw material is transferred
  • 00:26 to the production floor and the product begins to be fabricated or assembled.
  • 00:30 During this time, the inventory is called work in process inventory, or WIP.
  • 00:35 Once the product is complete, the inventory is now classified as finished
  • 00:38 goods inventory, which means it's ready to be sold to a customer.
  • 00:42 A good manager wants to manage and
  • 00:44 optimize the cost in each of these three phases.
  • 00:47 However, the best approach for that will vary based upon the phase.
  • 00:50 The principles that are being maintained are to reduce the cost as much
  • 00:53 as possible.
  • 00:55 The more inventory, the more money that is tied up in parts and products.
  • 00:59 Plus, the inventory must be managed.
  • 01:01 There are taxes, insurance, and facility costs to be addressed, not to mention
  • 01:05 that with lots of inventory, it's likely that some will become old and obsolete.
  • 01:10 But the reduction in inventory must be balanced by a need to serve customers.
  • 01:14 If there is no product available in a timely manner,
  • 01:17 customers will go to competitors or alternative solutions.
  • 01:20 If I go to a pizza shop and they say pizza will be ready in 15 minutes, I will wait.
  • 01:25 If they told me that they first had to make their prize pizza sauce and
  • 01:28 it will take two hours, I'm leaving.
  • 01:30 I'll go next door and get some sushi.
  • 01:33 So, let's take a closer look at each phase.
  • 01:36 I'll start with raw material.
  • 01:38 Raw material inventory is the stuff we get from our suppliers
  • 01:40 that we use in the products that we make.
  • 01:43 This remains in the category of raw material until it's distributed for
  • 01:46 use in the manufacturing process.
  • 01:49 Most of the time, the raw material is at the production facility in a stock room,
  • 01:52 or some other inventory storage facility.
  • 01:55 Although in some cases, the inventory may be owned by the company but
  • 01:58 held at the supplier due to storage or space restrictions.
  • 02:02 There are several optimizing approaches for raw material.
  • 02:05 One approach is to use standard materials.
  • 02:08 That is usually readily available, so you won't need to stock up.
  • 02:11 Also, if your company uses the same material in multiple products,
  • 02:14 you'll have more flexibility to quickly use the material.
  • 02:18 For low cost raw materials and
  • 02:19 components, buy in bulk if you can get a discount that way.
  • 02:22 Even if you have a lot, there's little cost.
  • 02:25 For high cost materials, schedule using the KanBan system.
  • 02:28 This will automatically reorder the material as it is used,
  • 02:31 ensuring there is always a small amount of high cost material available, but
  • 02:35 only a small amount.
  • 02:37 You can also negotiate with the supplier to set up just in time, or
  • 02:40 JIT systems, that deliver material at the point of use when scheduled to be used.
  • 02:45 Let's move now into the WIP inventory.
  • 02:48 Work in process inventory is the name for partially completed products.
  • 02:52 This is valued as an inventory asset on the company's books, although,
  • 02:56 in its current partially-completed state, it probably can't be sold to anyone.
  • 03:00 It is no longer raw material, because production has started, but it is not yet
  • 03:04 finished goods and ready for use by a customer.
  • 03:07 WIP is normally found at the manufacturing facility, or at suppliers who
  • 03:10 are conducting special processes, such as plating, on a partially complete product.
  • 03:15 The number one optimizing approach for
  • 03:17 this type of inventory is to apply LEAN principles.
  • 03:20 These were pioneered at Toyota, and have a goal of reducing waste in the production
  • 03:24 process by drastically reducing manufacturing cycle time.
  • 03:28 Two of the principles of LEAN that can be applied without the rest of the process
  • 03:32 are to reduce lot sizes so as to reduce queues and backlogs in the process.
  • 03:36 When that happens,
  • 03:37 a particular unit of production will flow faster through the process.
  • 03:41 A second technique is to use generic subassemblies
  • 03:44 that can be quickly put together in a plug and play style design approach.
  • 03:47 This allows the assembly to happen very quickly.
  • 03:50 An example is the Dell computer ordering process,
  • 03:53 where there are literally thousands of possible product configurations.
  • 03:56 You select the configuration you want, and Dell can build it and ship it in a day.
  • 04:01 Finally, let's look at finished goods.
  • 04:03 This is inventory that's completed the production process and
  • 04:05 is ready to be sold.
  • 04:07 In companies that make to order, there is very little inventory in this category.
  • 04:11 As soon as the product is built, it is shipped.
  • 04:13 But if your company is make to stock, you might have a lot.
  • 04:17 This inventory is often held in a production warehouse facility or
  • 04:19 distribution center to be shipped to the customer.
  • 04:22 In some cases, it is shipped to the customer to be on site, but
  • 04:25 is not bought by the customer until the customer selects it for use.
  • 04:29 Many retail chains work this way.
  • 04:31 The products on the shelve are still owned by the manufacturer and are not bought by
  • 04:34 the retail store until a customer goes to the checkout counter to buy the product.
  • 04:39 The optimizing approach for
  • 04:40 this will vary depending upon whether it is a custom product or commodity product.
  • 04:44 As I mentioned, with custom product, as soon as the product is produced, it ships.
  • 04:49 If the customer orders something far in advance of their needed ship date,
  • 04:53 delaying the start up production until there is just time to make the product
  • 04:56 will lower finished goods inventory costs.
  • 04:59 For standard commodity products, the amount of finished goods will depend upon
  • 05:03 the transportation time and logistics flow.
  • 05:05 There needs to be enough inventory in the pipeline to meet demand and
  • 05:08 refresh supplies without any extra.
  • 05:11 You can apply LEAN to logistics process to improve this.
  • 05:14 One thing to watch for, depending upon the product,
  • 05:16 there are seasonal variations in demand, so prepare for them.
  • 05:20 The takeaway from this discussion is that there are many ways
  • 05:24 to manage inventory costs.
  • 05:26 With some attention, costs can kept low, and yet service levels kept high.

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