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Inventory management can mean trading time against money
Monday, October 20, 2003
At the University of British Columbia, Garland Chow is associate professor of logistics and transportation in the Sauder School of Business. He has taught supply-chain management for 20 years.
He says, in response to those who think inventory management dull, "this is one of the most important areas to concentrate on for any business. It's where, much of the time, a business of any size can save enough money to stay alive."
When companies, small or large, don't plan well enough, they can find themselves having to make tough decisions to shut down production facilities. That's what happened in Fort Saskatchewan, Alta., when, in June, 2001, Agrium Inc. closed a fertilizer plant when inventories of finished product lay unsold. As customer demand in Western Canada fell because of depressed crop prices that reduced planting, Agrium had no choice but to close shop.
"This is a case of poor demand forecasting," Prof. Chow says. "When the company had more output than it could sell, the plant had to be shut down. While fertilizer should have a long life in storage, there's a cost to keeping the stuff in warehouses. Making more than you sell soon leads to the growth of a mountain of the stuff and eventually to the producer running out of storage space."
A business that makes something from something else has to forecast the quantity of the output it can sell. Building unsold inventory is obviously not profitable and, should market tastes or competitive products change or become cheaper, that accumulated inventory will be obsolete and have to be written off.
Economic forecasting is part of the solution, Prof. Chow says. "Forecasting is important, but traditional forecasting that is based on orders from existing customers is inadequate as a planning tool. That's because orders from existing customers that are farther downstream in the production process may not indicate demand from final consumers.
"The solution is to get information on final consumer demand."
This is where new concepts of sharing information come into play. If parts suppliers and manufacturers get data on what's being sold every time the cash register rings, they will have as current an indication as possible of what's moving, he says. And if retailers share their promotional plans with upstream suppliers, those companies can target their production more accurately. Even when companies have good forecasts, they can still mismanage their inventories.
Determining the proper level of inventory is based on balancing various costs, Prof. Chow says. He explains that "ordering too much runs up a company's carrying costs. If you order too little, you may wind up spending too much on the administrative costs of pushing all the paper that is involved in buying inputs."
Some companies can reduce their ordering costs if they install enterprise-wide computers that handle inventory management and the ordering process with only one data entry, Prof. Chow adds. Many companies haven't automated their input ordering, and even those that have may not realize that more frequent ordering can reduce their raw-materials carrying costs, he says.
The problem that has to be solved by machine or by sweat is recognizing the tradeoff in costs between having so much raw material that any order can be filled and having so little that any losses of breakage or sudden surges in orders for final products cause production interruptions. Another cost of inventory is the risk of running out of supplies, called "stockouts," in the logistics industry. "You look at the cost of a stockout and if the result of not having something is huge or critical, then it may be worthwhile to carry a level of parts or raw materials for any foreseeable demand."
The starting point for this kind of inventory analysis is to know the costs of ordering and carrying and the costs of stockouts. All that can be reduced to a simple equation, in which the quantity and frequency of ordering is a function of the known cost of placing an order plus the cost per day or month of holding the raw materials in inventory adjusted for the risk of stocking out. Every day or week or month that inventory is carried adds to the carrying cost. So the longer raw materials are held and the larger the investment sitting on the shelf, the higher the cost of carrying inventory.
A few years ago, Rolls-Royce's gas turbine manufacturing unit in Montreal found itself without active management of its inventories from raw materials to finished products. After the company installed an enterprise resource planning system, it could consolidate inventory information. It found what inventory it held and where it was held.
This is the kind of case in which active intervention in inventory management should be able to reduce costs significantly. It also is a case in which the company wanted to be sure it had enough inventory to meet production demands for engines on the market and those in development, Prof. Chow says. "This is as true for a small to medium-sized business as it is for a large company."
Accountants are occupied with reporting on the value of a company's assets and net worth and, of course, its income.
But inventory managers focus on having the right quantity of raw materials for all scenarios the company might face.
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