Inventory Optimization: Five Steps to Improve Process Effectiveness

Inventory Optimization:

Five Steps to Improve Process Effectiveness

Structured approach to global inventory planning and control helps manufacturers maintain high customer-service levels and reduce variable costs.

Inventory Optimization: Five Steps to Improve Process Effectiveness

• 1.  Take a business assessment
• 2.  Develop the inventory plan
• 3.  Execute according to the plan 
• 4.  Measure performance against the plan
• 5.  Ensure continuous improvement 

Amidst the recent continued economic volatility, C-level executives’ focus has shifted from revenue growth to profitable growth, and hence global supply chain performance has gained a great deal of attention. As global supply chains are devising ways and means to respond to unpredictable customer demand and increased competition, one of the greatest challenges they face is achieving inventory optimization while maintaining higher customer service levels and reduced variable costs.

In my experience of working with a number of clients in the energy and chemicals market within manufacturing, in addition to some in the consumer packaged goods (CPG) and pharmaceutical markets, I have observed some common challenges facing these industries, including:

·Ineffective Master Data Management: Data definition and data quality are common pain areas across industries, driven by acquisitions (multiple disparate systems) and lack of data management practices. These organizations are sitting on a pile of data, without being able to use this data for effective decision making. For example, almost all of the clients I worked with had inaccurate procurement and manufacturing lead times in their transactional systems, leading to judgment-based inventory planning. Inaccurate planning leads to frequent expediting and de-expediting and the resources were constrained by available capacity. To free up capacity, each component in the value chain buffers the lead time component and this lead to excess ordering and stocking to meet customer service levels.

·Individual goals not aligned to overall objectives: While all of the clients I worked with believed that cycle time reduction would bring a competitive edge to their business, and had an overall objective of reduced order-to-delivery cycle time, individual elements of the overall cycle time did not have any goals around lead time adherence. Similarly, procurement and logistics functions were measured on cost savings only, while CXOs’ objective was to improve customer service levels and working capital. There were no processes around supplier or freight forwarder performance management on fulfillment or lead time adherence, or the processes were so ineffective that it didn’t drive any actions or behavior.

·Lack of communication and collaboration: Whether it’s within the organization or between supply chain partners (customers and suppliers), lack of communication and collaboration was one of the top three challenges across industries. Here’s a typical example: New product development or R&D developed a new product without involving procurement, which resulted in procurement of customized parts from specialized suppliers, resulting in higher total cost of ownership. In some cases procurement was involved during new product development, but quality control were not informed of the raw material testing requirements.  This resulted in material rejections and a poor supplier relationship.

To address these challenges, I recommend a five-step structured approach to set up an effective global inventory planning and control process, as follows:

1.  Take a business assessment

Assess business functions and processes in their current environment. Start with an understanding of the current order-to-delivery (OTD) process. Devising a future state while identifying gaps and improvement opportunities will set the momentum to accelerate change acceptance among the cross-functional teams involved, including sourcing, planning, commercial operations, stockroom and manufacturing. Key activities in this stage should include:

• Study “As-Is” planning and execution process within the OTD process. Aim to have an unbiased assessment of current processes and practices. Start by interviewing a representative set of stakeholders who perform the same job within each function of the OTD process. Follow up with brainstorming sessions that involve key stakeholders from each function, which will help them understand their upstream and downstream process and address any issues arising out of lack of clarity of roles and responsibilities. These stakeholders should also voice their opinion on the desired “As-Is” state to establish a baseline against which improvements can be measured, and to effectively manage change through shared responsibility among their teams. Organizations should also consider conducting lean workouts among a cross-functional team of subject matter and Six Sigma process experts to understand redundant and non-value-added steps in the process due to multiple hand-offs between various functions within the OTD process.
• Summarize findings and gaps in data, process and practices. One of the ways to effectively capture the gaps in material planning and execution practices is through self-evaluation score sheets. A score sheet typically enlists the various planning and execution categories, and asks the functional owners to score according to the importance and effectiveness of each practice. Typical scoring criteria used is 1 (low), 5 (medium) and 9 (high) to clearly differentiate high impact gaps from lesser ones.  For a more robust and objective view,  third party service provider can also assist with benchmarking current processes against some of the best run companies in the industry.
• Devise “To-Be” planning and execution OTD process. Resource and system limitations may warrant a “To-Be Intermediate” state before moving to the ideal state. The objective is to outline a streamlined, robust and sustainable process that is aligned to the overall objective of optimizing inventory, customer service levels and variable costs. Organizations then begin to migrate to ideal state once resource and system limitations are addressed.
• Communicate to the whole group the identified improvement opportunities and goals. One of the biggest challenges faced during assessment is change resistance. Data-based inferences and identification of change catalysts is the key to driving fast adoption of more easily implemented improvements. By seeing immediate results, stakeholders will be better engaged to support additional and more sweeping process changes.

2.  Develop the inventory plan

Complete and accurate data is fundamental to developing an inventory plan. Start with the data gaps identified during the assessment phase. Next, determine data availability and data quality along with their operational definitions for effective inventory planning and control. Having clear operational definitions is extremely important for process standardization and improvements, specifically if the business has grown through acquisitions and has multiple data sources and nomenclatures. Inventory planning is driven by accurate data pertaining to:

·         On-hand inventory

·         Open orders (sales, production and purchase)

·         Lead time

·         Standard or average cost

·         Bill of material (BOM)

Developing an overall inventory plan should involve the following steps:

·Classify parts into three segments: raw, work-in-process or sub-assembly, and finished goods.

·Categorize each segment into stock and non-stock categories (purchase to order or make to order).

·Plan for each segment, independent of the other others involved in the process.

·Classify raw material stock using multi-criteria inventory classification to lay a good foundation for success.

·Calculate safety stock and minimum order quantities by part to optimize inventory and transaction costs while achieving service targets. Develop a theoretical raw material inventory plan based on calculated safety stocks and order quantities.

·Repeat the exercise for other segments and come up with an overall inventory plan to meet the desired service levels.

·Identify initial inventory impact and planned inventory investment.

·Once a plan is developed, upload the planning parameters into transactional systems.

3.  Execute according to the plan 

Once the inventory plan is developed, it is important to execute to the set plan. Any exceptions to deviate from the set plan needs to be approved by management to ensure discipline. Executing to the plan involves the following steps:

·Ensure tight adherence to inventory planning and ordering policies at part level.

·Establish process controls to ensure data quality and consistency.

·Synchronize production schedules to the materials plan.

·Establish a robust supplier performance management process that captures effective contract management, performance measurement and metrics, performance review and control mechanisms, and recognition systems. Timely raw material availability is the key to optimal inventory planning, as poor quality of materials could lead to poor yields and costly reworks.

·Simplify, standardize and digitize the process globally to minimize efforts in routine execution.

·Set up a process around Delegation of Authority (DOA) to ensure disciplined and

4.  Measure performance against the plan

Organizations can’t improve what they don’t measure. Ongoing monitoring and control is key to sustain improvements, organizations should focus on near real time visibility into supply chain performance measures to proactively root cause for deviations from plan, and to take corrective actions. This step should involve:
* Establishing key performance indicators (KPIs) and metrics for each process. For example:

(a)    Planner metrics provide visibility into a planner’s performance on service levels: safety stock investment, ordering costs and total excess inventory value.

(b)    Supplier scorecards with delivery, costs, quality, responsiveness and reliability related metrics highlight top and poor performing suppliers.

(c)    Workforce productivity to drive “first time right” culture and to minimize rework and associated wastes that would consume quality time of workforce.

(d)    Production span measures overall production variations and identifies root cause variations in each work-center.

* Establishing process controls through periodic monitoring and reports.
* Empowering and encouraging people to document and share best practices and recognizing people delivering exceptional results.

5.  Ensure continuous improvement 

To meet complex and volatile customer demands, while ensuring profitable growth, organizations should focus on continuous improvements leading to faster movement of materials and information. This step should involve devising a mechanism or practice in order to:

·         Capture root causes for variations in the plan.

·         Conduct periodic reviews to discuss impact areas, assign ownership and establish timelines to facilitate resolution.

·         Run continuous improvement programs such as Vendor Managed Inventory (VMI) and consignment stock agreements with key suppliers.

·         Reduce cycle times and lead times within the order to deliver cycle, to minimize forecasting errors.

·         Minimize the ordering quantities and safety stocks.

·         Establish a data-driven decision making process.

·         Enhance and retain workforce materials knowledge.

Important Techniques of Inventory Control System

Some of the most important techniques of inventory control system are: 

1. Setting up of various stock levels. 

2. Preparations of inventory budgets. 

3. Maintaining perpetual inventory system. 

4. Establishing proper purchase procedures. 

5. Inventory turnover ratios. and 

6. ABC analysis.

1. Setting up of various stock levels:

To avoid over-stocking and under stocking of materials, the management has to decide about the maximum level, minimum level, re-order level, danger level and average level of materials to be kept in the store. 

These terms are explained below:

(a) Re-ordering level:

It is also known as ‘ordering level’ or ‘ordering point’ or ‘ordering limit’. It is a point at which order for supply of material should be made.

This level is fixed somewhere between the maximum level and the minimum level in such a way that the quantity of materials represented by the difference between the re-ordering level and the minimum level will be sufficient to meet the demands of production till such time as the materials are replenished. Reorder level depends mainly on the maximum rate of consumption and order lead time. When this level is reached, the store keeper will initiate the purchase requisition.

Reordering level is calculated with the following formula:

Re-order level =Maximum Rate of consumption x maximum lead time

(b) Maximum Level:

Maximum level is the level above which stock should never reach. It is also known as ‘maximum limit’ or ‘maximum stock’. The function of maximum level is essential to avoid unnecessary blocking up of capital in inventories, losses on account of deterioration and obsolescence of materials, extra overheads and temptation to thefts etc. This level can be determined with the following formula. Maximum Stock level = Reordering level + Reordering quantity —(Minimum Consumption x Minimum re-ordering period)

(c) Minimum Level:

It represents the lowest quantity of a particular material below which stock should not be allowed to fall. This level must be maintained at every time so that production is not held up due to shortage of any material.

It is that level of inventories of which a fresh order must be placed to replenish the stock. This level is usually determined through the following formula:

Minimum Level = Re-ordering level — (Normal rate of consumption x Normal delivery period)

(d) Average Stock Level:

Average stock level is determined by averaging the minimum and maximum level of stock.

The formula for determination of the level is as follows:

Average level =1/2 (Minimum stock level + Maximum stock level)

This may also be expressed by minimum level + 1/2 of Re-ordering Quantity.

(e) Danger Level:

Danger level is that level below which the stock should under no circumstances be allowed to fall. Danger level is slightly below the minimum level and therefore the purchases manager should make special efforts to acquire required materials and stores.

This level can be calculated with the help of following formula:

Danger Level =Average rate of consumption x Emergency supply time.

(f) Economic Order Quantity (E.O.Q.):

One of the most important problems faced by the purchasing department is how much to order at a time. Purchasing in large quantities involve lesser purchasing cost. But cost of carrying them tends to be higher. Likewise if purchases are made in smaller quantities, holding costs are lower while purchasing costs tend to be higher.

Hence, the most economic buying quantity or the optimum quantity should be determined by the purchase department by considering the factors such as cost of ordering, holding or carrying.

This can be calculated by the following formula:

Q = √2AS/I

where Q stands for quantity per order ;

A stands for annual requirements of an item in terms of rupees;

S stands for cost of placement of an order in rupees; and

I stand for inventory carrying cost per unit per year in rupees.

2. Preparation of Inventory Budgets:

Organizations having huge material requirement normally prepare purchase budgets. The purchase budget should be prepared well in advance. The budget for production and consumable material and for capital and maintenance material should be separately prepared.

Sales budget generally provide the basis for preparation of production plans. Therefore, the first step in the preparation of a purchase budget is the establishment of sales budget.

As per the production plan, material schedule is prepared depending upon the amount and return contained in the plan. To determine the net quantities to be procured, necessary adjustments for the stock already held is to be made.

They are valued as standard rate or current market. In this way, material procurement budget is prepared. The budget so prepared should be communicated to all departments concerned so that the actual purchase commitments can be regulated as per budgets.

At periodical intervals actuals are compared with the budgeted figures and reported to management which provide a suitable basis for controlling the purchase of materials,

3. Maintaining Perpetual Inventory System:

This is another technique to exercise control over inventory. It is also known as automatic inventory system. The basic objective of this system is to make available details about the quantity and value of stock of each item at all times. Thus, this system provides a rigid control over stock of materials as physical stock can be regularly verified with the stock records kept in the stores and the cost office.

4. Establishing Proper Purchase Procedures:

A proper purchase procedure has to be established and adopted to ensure necessary inventory control. The following steps are involved.

(a) Purchase Requisition:

It is the requisition made by the various departmental heads or storekeeper for their various material requirements. The initiation of purchase begins with the receipts of a purchase requisition by the purchase department.

(b) Inviting Quotations:

The purchase department will invite quotations for supply of goods on the receipt of purchase requisition.

(c) Schedule of Quotations:

The schedule of quotations will be prepared by the purchase department on the basis of quotations received.

(d) Approving the supplier:

The schedule of quotations is put before the purchase committee who selects the supplier by considering factors like price, quality of materials, terms of payment, delivery schedule etc.

(e) Purchase Order:

It is the last step and the purchase order is prepared by the purchase department. It is a written authorization to the supplier to supply a specified quality and quantity of material at the specified time and place mentioned at the stipulated terms.

5. Inventory Turnover Ratio:

These are calculated to minimize the inventory by the use of the following formula:

Inventory Turnover Ratio

= Cost of goods consumed/sold during the period/Average inventory held during the period

The ratio indicates how quickly the inventory is used for production. Higher the ratio, shorter will be the duration of inventory at the factory. It is the index of efficiency of material management.

The comparison of various inventory turnover ratios at different items with those of previous years may reveal the following four types of inventories:

(a) Slow moving Inventories:

These inventories have a very low turnover ratio. Management should take all possible steps to keep such inventories at the lowest levels.

(b) Dormant Inventories:

These inventories have no demand. The finance manager has to take a decision whether such inventories should be retained or scrapped based upon the current market price, conditions etc.

(c) Obsolete Inventories:

These inventories are no longer in demand due to their becoming out of demand. Such inventories should be immediately scrapped.

(d) Fast moving inventories:

These inventories are in hot demand. Proper and special care should be taken in respect of these inventories so that the manufacturing process does not suffer due to shortage of such inventories.

Perpetual inventory control system:

In a large b essential to have information about continuous availability of different types of materials and stores purchased, issued and their balance in hand. The perpetual inventory control system enables the manufacturer to know about the availability of these materials and stores without undergoing the cumbersome process of physical stock taking.

Under this method, proper information relating to receipt, issue and materials in hand is kept. The main objective of this system is to have accurate information about the stock level of every item at any time.

Perpetual inventory control system cannot-be successful unless and until it is accompanied by a system of continuous stock taking i.e., checking the total stock of the concern 3/4 times a year by picking 10/15 items daily (as against physical stock taking which takes place once a year).

The items are taken in rotation. In order to have more effective control, the process of continuous stock taking is usually undertaken by a person other than the storekeeper. This will check the functioning of storekeeper also. The items may be selected at random to have a surprise check. The success of the system of perpetual inventory control depends upon the proper implementation of the system of continuous stock taking.

6. ABC analysis:

In order to exercise effective control over materials, A.B.C. (Always Better Control) method is of immense use. Under this method materials are classified into three categories in accordance with their respective values. Group ‘A’ constitutes costly items which may be only 10 to 20% of the total items but account for about 50% of the total value of the stores.

A greater degree of control is exercised to preserve these items. Group ‘B’ consists of items which constitutes 20 to 30% of the store items and represent about 30% of the total value of stores.

A reasonable degree of care may be taken in order to control these items. In the last category i.e. group ‘Q’ about 70 to 80% of the items is covered costing about 20% of the total value. This can be referred to as residuary category. A routine type of care may be taken in the case of third category.

This method is also known as ‘stock control according to value method’, ‘selective value approach’ and ‘proportional parts value approach’.

If this method is applied with care, it ensures considerable reduction in the storage expenses and it is also greatly helpful in preserving costly items

ABC Classification / Analysis of Inventory

The ABC classification process is an analysis of a range of objects, such as finished products ,items lying in inventory or customers into three categories. It's a system of categorization, with similarities to Pareto analysis, and the method usually categorizes inventory into three classes with each class having a different management control associated :  A - outstandingly important; B - of average importance; C - relatively unimportant as a basis for a control scheme. Each category can and sometimes should be handled in a different way, with more attention being devoted to category A, less to B, and still less to C. Popularly known as the "80/20" rule ABC concept is applied to inventory management as a rule-of-thumb. It says that about 80% of the Rupee value, consumption wise, of an inventory remains in about 20% of the items. This rule , in general , applies well and is frequently used by inventory managers to put their efforts where greatest benefits , in terms of cost reduction as well as maintaining a  smooth availability of stock, are attained. The ABC concept is derived from the Pareto's 80/20 rule curve. It is also known as the 80-20 concept. Here, Rupee / Dollar value of each individual inventory item is calculated on annual consumption basis. Thus, applied in the context of inventory, it's a determination of the relative ratios between the number of items and the currency value of the items purchased / consumed on a repetitive basis : 10-20% of the items ('A' class) account for 70-80% of the consumption the next 15-25% ('B' class) account for 10-20% of the consumption and the balance 65-75% ('C' class) account for 5-10% of the consumption 'A' class items are closely monitored because of the value involved (70-80% !). High value (A), Low value (C) , intermediary value (B)   20% of the items account for 80% of total inventory consumption value (Qty consumed X unit rate) Specific items on which efforts can be concentrated profitably Provides a sound basis on which to allocate funds and time A,B & C , all have a purchasing / storage policy - "A", most critically reviewed , "B" little less while "C" still less with greater results. ABC Analysis is the basis for material management processes and helps define how stock is managed. It can form the basis of various activity including leading plans on alternative stocking arrangements (consignment stock), reorder calculations and can help determine at what intervals inventory checks are carried out (for example A class items may be required to be checked more frequently than c class stores Inventory Control Application: The ABC classification system is to grouping items according to annual issue value, (in terms of money), in an attempt to identify the small number of items that will account for most of the issue value and that are the most important ones to control for effective inventory management. The emphasis is on putting effort where it will have the most effect. All the items of inventories are put in three categories, as below : A Items : These Items are seen to be of high Rupee consumption volume. "A" items usually include 10-20% of all inventory items, and account for 50-60% of the total Rupee consumption volume. B Items : "B" items are those that are 30-40% of all inventory items, and account for 30-40% of the total Rupee consumption volume of the inventory. These are important, but not critical, and don't  pose sourcing difficulties. C Items : "C" items account for 40-50% of all inventory items, but only 5-10% of the total   Rupee consumption volume. Characteristically, these are standard, low-cost and readily available items. ABC classifications allow the inventory manager to assign priorities for inventory control. Strict control needs to be kept on A and B items, with preferably low safety stock level. Taking a lenient view, the C class items can be maintained with looser control and  with high safety stock level. The ABC concept puts emphasis on the fact  that every item of inventory is critical and has the potential of affecting ,adversely, production, or sales to a customer or operations. The categorization helps in better  control on A and B items. In addition to other management procedures, ABC classifications can be used to design cycle counting schemes. For example, A items may be counted 3 times per year, B items 1 to 2 times, and C items only once, or not at all Suggested policy guidelines for A , B & C classes of items A items (High cons. Val)        B items (Moderate cons.Val)          C item (Low cons. Val) Very strict cons. control     Moderate control Loose control No or very low safety stock Low safety stock High safety stock Phased delivery (Weekly) Once in three months Once in 6 months Weekly control report Monthly control report Quarterly report Maximum follow up Periodic follow up Exceptional As many sources as possible Two or more reliable Two reliable Accurate forecasts Estimates on past data Rough estimate Central purchasing /storage Combination purchasing Decentralised Max.efforts to control LT Moderate Min.clerical efforts To be handled by Sr.officers Middle level  Can be delegated