Inventory Investment vs Customer Service

INVENTORY INVESTMENT Vs CUSTOMER SERVICE
by
Brian Willcox CFPIM CIRM
of
ACTION MRPII

What is the cost of good service? Our sales force will quickly tell you that for good service you need plenty of stock. They seem to consider that the cost of the stock is the problem of the accountants and nothing to do with them. Before we get into an argument about who pays the bill for holding stock, lets look at what must be included in the cost of stock.

Cost of Holding Inventory

There are two basic elements that constitute this cost. Inventory holding cost percentage and the average stock held.
Inventory holding cost includes the cost of capital, which is often considered as the lost opportunity cost, currently at about 25%. In addition there is the cost of insurance, obsolescence, losses and damage, and the stores cost which add up to another 10% giving 35% in total. It is this percentage which is then multiplied by the average stock value to give us the cost of keeping that stock. Therefore if we have on average R1,000,000 in stock at any point in time, it costs us R350,000 a year to keep it there. A pretty daunting figure. It would appear therefore, to provide a high level of service to our customers means that it is going to cost us a tremendous amount of money. Yes it is, but there are ways of reducing that cost whilst still providing the required service level. The holding cost percentage is effectively out of our control, but the other element is the average amount of stock we hold which we can control.

Average Inventory

Average inventory consists of two parts, cycle stock and safety stock. Cycle stock is the active part which is there to meet sales. Safety stock is there to protect against demand variation and is not planned to be used.

Safety Stock

The amount of safety stock we keep should be calculated using the statistical safety stock formula and not just a number of weeks cover. Safety stock should consider three elements, the first of which is the demand variation which is measured in terms of standard deviations. This measures the variation between forecast and actual sales, period by period. Although over several periods the sales might equal the forecast, it is the difference in each period that gives the stock out problems and it is that which we need to protect against. The second point to consider is the replenishment lead time. The longer it takes to replenish the stock the more serious it is if you run out, therefore the more protection you need. The last point is the customer service level which you as a company decide you require. The higher the service level you want, the more protection you need. It is these three points that statistical safety stock considers and of the three, we have some control of two of them, lead time and customer service level. This means that if we want to reduce our investment whilst maintaining the same service level we need to tackle our manufacturing lead time. Lead times are very much a function of load against capacity. The actual process time is only a minor part of the total manufacturing lead time. Lead time is often stated to be a function of the orders priority. This is true up to a point. Priority sequencing will organise the flow of work to ensure the right parts come together in the right sequence for assembly but it will not magically get rid of the work in process, only extra capacity will do that. What have we just said. To reduce our inventory investment we may need more capacity. Perhaps it is time we did our sums and see if it is less costly to have more, less utilised machines, or to carry more safety stock.

Cycle Stock

Cycle stock is the product we put into stock to meet the sales forecast. The quantity we hold at any point in time is only slightly related to the sales forecast. It is directly related to the replenishment order quantity. In fact, it is on average half the order quantity if sales occur on an even basis. This tells us therefore that if we replenish our stock twice as often with half the quantity, our average cycle stock will also halve. This means that again we have found a way to reduce our investment without reducing our customer service. In fact we are now more flexible to meet our customers needs which is another benefit for free. The big question is of course, what does it cost us to halve our manufacturing batch size? If you ask manufacturing why they make in the quantities they do, you get a variety of reasons from, because we always have, its easier and more economical to make in large batches due to the cost of set up. Another argument is that they are short of capacity and set-up consumes capacity for no productive output. What we have just concluded is that our set up time determines our inventory investment. Thus if we want to reduce our investment we need to reduce our set up times. Many companies consider set up time as fixed. The amazing fact of life is that when you actually set out to reduce set up it is not that difficult. One of my colleagues say's that he can reduce a set up by half with only minimum expense if it has not been previously worked on. People are finding it is not all that difficult once they try.

Conclusion

To reduce our investment in inventory, whilst still maintaining the same service level, we need to do two things; reduce our manufacturing lead time and reduce our set up so we can reduce our order quantity. Just as a final thought, if we reorganise our production facility in line with the Just in Time principles a normal saving is a manufacturing lead time reduction of 75% to 80%.
If the realisation of what has been put forward is now sinking in and the thought frightens you, hide this from your financial director who might find it interesting.