A manufacturer may turnover inventory 3.6 times, a retailer can have 4.1 turns and a wholesaler or distributor can show turns of 4.4. What these companies, albeit, in different types of industries, have in common? TOO MUCH Inventory! Where they may carry it – raw materials, work-in-process or in finished goods – is not necessarily the point. The point is they have too much money tied up in inventory.
From an accounting outlook, inventory is an asset – a buffer against uncertainty. The complete cycle time of inventory, when needed, when received, sold and sales payment is received is vital to a company’s success. The longer the cycle time, the larger the amount of inventory will be carried against that uncertainty.
Inventory turns are important. While the turns mentioned in the opening paragraph look good on the surface it is important to understand that turns should be compared to rate of days paid. In other words, when the company receives payment for the goods. The above firms are getting paid every 90 days. Would you like to get paid only every 90 days? This leads to a large capital investment of inventory earning nothing at a large carrying interest rate. Why do many companies still operate in this manner and accept this kind of performance?
In addition to the capital or carrying issue, excess inventory influences service and operations. Unnecessary freight costs were incurred to bring products into facility. Other costs like manpower hours, warehouse put-away and larger warehouse space than is needed are increased. A cycle count program, which is based on Pareto’s Law and ABC analysis, will continually count these items to the company’s detriment.
A business does not automatically or deliberately decide to have too much inventory on-hand as part of their forecasting plan. The reasons for excess inventory are many but some of the more common ones are the following:
1 Loss of sales fear: this is the fear of not having an item to sell as opposed to not being able to sell the item. This is where companies will put in a hedge factor into their inventories.
2 Price deals: Many companies purchase due to “great” price deals. Buy in excess of what is needed or will deplete in a reasonable time frame due to a price they could not pass up. Is it still a good deal when it sits in your inventory forever?
3 Write-offs: Firms are hesitant to write off the inventory and take a hit to their profit and loss for the year.
4 Metrics to measure: there are no metrics or key performance indicators implemented to measure and manage inventory – inventory turns, days in inventory, inventory aging and inventory velocity and no “ABC” analysis.
5 Supplier performance: suppliers are not managed even the ones who fail to ship on time or less than a pre-arranged percentage of the purchase orders. Extra time and extra inventory are built into the system to compensate for delivery issues.
These are only a few of the reasons for excess inventory. Inventory buildup is not the result of one cause but many create the overabundance of inventory. These causes reflect the lack of priority, processes and control of the inventory.
Excess inventory is not an acceptable situation and needs to be eliminated as quickly as possible. There are some options to carry this out:
1 Strategy and process: develop a process and procedures to manage inventory. Sustainability for this must come from the C-level management, otherwise a frustrating endeavor. Included in this, is the development of performance metrics for inventory (some mentioned above), implement lean to add value-added processes, study the entire supply chain from inbound to outbound and make inventory part of the company direction as it pertains to customers, sales and profits.
2 Distribution network: determine the optimal number of DC’s for today’s business.
3 Supplier performance: ensure it is a key part of the inventory management and sourcing strategy. There is more to vendor selection than just low prices.
4 Effect of global sourcing: long transit times across the oceans affect the inventories – in costs – that companies carry.
Increasing inventory turns and controlling lead or cycle time is vital to a firm’s profitability and long term growth. However, reducing inventory and preventing excess inventory does not happen overnight. It took a while to realize the inventory overage, so it will take a fair amount of time to correct. This action will require focus and diligence.