The first is to increase sales so a greater turnover is made, resulting in more profit. For example, if a company generates R10 million profit out of R50 million turnover (20% of turnover), then R40 million is cost. If turnover is increased to R75 million, the profit will be expected to be R15 million, an increase of R5 million. To increase turnover by 50% is not easy - ask the sales force!

The other alternative to increase profit is to reduce costs. For example, if we go back to the company with a turnover of R50 million, of which R40 million is cost, any reduction in cost gives an equal amount of increased profitability. If the cost reduces by R5 million, now down to R35 million, then profitability increases by R5 million up to R15 million. In relation to turnover, if costs go from 80% down to 70% of cost, then profit goes up from 20% to 30%

This suggests that if we want increased profit, we need to get our costs down. In most manufacturing and distribution companies, the biggest individual cost is inventory, usually somewhere between 50% and 90% of cost of sales, depending upon the industry. This therefore is the first cost to attack. There are actually two elements to consider, the price of the inventory we buy, and the amount of inventory we hold which incurs holding cost at about 35% per annum.

To decrease the cost of the inventory we need, we need to be working to a plan and set up long term contracts. Today the trend is for the buyer to negotiate an annual or longer contract, based on estimated quantities. The customer's material planner talks direct to the planner at the supplier to arrange the material call-off's to match the build schedule.

The second element is the holding cost on the inventory we hold. Finished goods stock is made up of safety stock, cycle stock and transportation stock. Safety stock, which we do not plan to use, is there to provide the desired service level to our customers. Using the statistical safety stock calculation, the amount we need is based on the replacement lead time, the demand variability, and the service level. The only one of these that we can change at will is the service level. As a company, a decision must be made as to the level of service to be provided to the customers. The hard facts are, the higher the service level, the more safety stock required, and therefore a higher investment.

Cycle stock is there to meet the planned or forecast demand.
 
 

The holding cost incurred at 35% per annum is directly related to the amount of inventory held. The average inventory is calculated as "half the order quantity plus safety stock". Safety stock we have already discussed. The average cycle stock is calculated as half the order quantity. At any point in time the cycle stock is somewhere between zero and just about to be replenished, and at a maximum level when it has just been replenished. On average, it is half way between the two limits.

To get the average inventory value lower, we need to reduce the amount received and not issued shortly afterwards. To do this we need to reduce the order quantity of the 'A' items (items with a high annual spend) so smaller quantities are received more frequently.

From a practical point of view, due to the cost of placing and processing a supply order, the low annual spend items (C items) can be received infrequently with higher order quantities. It has less impact on the inventory level.

Transportation stock is that stock that either is being moved from the central warehouse to a branch, or from a branch to a customer. The more we can streamline and speed up this process the less inventory we will hold, resulting in less holding cost.

As can be seen, by managing our inventory better, our costs can be reduced, whilst maintaining the same or better customer service. The costs saved now result in an ongoing equal amount of extra profit from the same level of turnover.
 
 

October 1999