Are Your Inventories Under Control?

Management consultant, R. Michael Donovan says "In virtually all manufacturing companies, there is a direct correlation between inventory levels and overall business performance." According to Harold Geneen, the legendary former chairman of ITT, "all the problems of business end up in inventory." Most knowledgeable executives would agree with Geneen. In fact, CEO's and CFO's believe that their companies consistently carry 25 percent to 40 percent or more inventory than is needed.

Excess Inventory Is a Problem in Good Times, and Bad

However, excess inventory isn't just a problem when times are good. Companies hit by a sharp decline in sales all too often experience a significant rise in inventories because of the considerable and unnecessary time that's usually needed to get incoming supply rebalanced with customer demand. When sales are declining making the right adjustments in inventory levels becomes an exceedingly more important and difficult task. Some companies have been caught with declining sales and the out of balance incoming supply of inventory has caused a massive cash outflow.

According to R. Michael Donovan, an authority on supply chain management, "coping with a rapid sales decline can easily cause companies to wait too long to make supply adjustments and inventory excesses rapidly accumulate. It's extremely important to have the capability to promptly take the right actions that are needed to prevent the accumulation of excess inventory. Most companies rely on their ERP systems for inventory accumulation avoidance and reduction only to be disappointed by the poor results. A healthy balance sheet depends on having a quick, precise inventory avoidance and reduction methodology" Donovan adds.

Most companies do not have really effective processes in place that provide early warning signals for management to make the specific adjustments to incoming material flow. Most of the time, ERP systems provide inventory planners with massive amounts of poorly prioritized information causing deferral actions to be late ultimately resulting in a mad, last minute scramble to make adjustments which often cause more problems than they prevent.

Inventory excesses are often increasing yet go unnoticed by management until major reduction adjustments are needed. Some inventories go up significantly and surprisingly quickly. Donovan explains, "In fact, there are cases where a 20 percent to 30 percent rapid decline in sales has caused inventory turnover to be cut by 40% - 50%." In a sharp sales decline situation, it is common for inventory turnover to fall a lot and before management gets the necessary information never mind early warning signals. The result is a deep cut into cash balances.

A Sound Strategy Requires Using a Fact-based Approach

When the CEO or CFO finally gets the information that, in fact, inventory is rapidly piling up beyond what is needed, the typical reaction is to enforce an across-the-board clamp down on all new purchases. "This 'shut-off-all-the-spigots' mentality can, however, cause even more financial damage," Donovan points out. "The across-the-board squeeze everything approach can depress revenue and customer service while increasing costs, leading to the very opposite of what management wants to happen," Donovan adds.

Management needs to tackle the problem using a fact-based approach, allowing for accurately adjusting and carefully adjusting individual spigots to rebalance supply with demand." Finance, without the right information at hand, is often driven by a balance-sheet view of the problem, is often the cheerleader for the "global squeeze" approach to cut inventories. "The big problem with across-the-board "global squeeze" is that it almost always reduces plant operating efficiency and decreases the customer service level," says Donovan. "Worse, instead of improving financial performance, it often causes a sales decrease as a result of the right materials not being in inventory because they were mistakenly squeezed out by the global approach to managing inventories".

Often the senior management team assumes that inventory planning personnel will be able to easily handle the inventory problem because of the company's heavy investment in a state-of-the-art ERP system. "This is a very dangerous assumption to make," Donovan emphasizes. "Rarely have companies permanently solved their inventory problems with just an ERP system" In fact, ERP and other software tools can actually lead to a false sense of security. According to Donovan, excess inventory - whether allowed to build up when times are good or when sales are falling - almost always results from ineffective inventory processes, policies, monitoring and practices.

Donovan thinks management should consider implementing an effective inventory monitoring methodology before installing an expensive ERP system. "You want to get inventory under control before you introduce major new ERP and supply chain solutions-not afterwards. If you don't get the inventory on the right path first, today's bad inventory practices and policies are likely to be perpetuated tomorrow in the company's new ERP system."

The Rapid Inventory Reduction Solution

A number of companies have used Donovan's Rapid Inventory Reduction Methodology (www.inventoryinc.com) as a way of quickly bringing their inventory levels down and into alignment with customer demand. "International Game Technology, a casino gaming equipment manufacturer, achieved a 20 percent reduction in unneeded inventory in just three months and IGT was able to get that number up to 32% within just a five month period," notes Donovan. "IGT managed to save more than $16 million using the Rapid Inventory Reduction Methodology - dollars that looked better as cash rather than inventory on the balance sheet," adds Donovan.

What's required for a Rapid Inventory Reduction program? According to Donovan, his firm initially starts an inventory reduction program by using computerized modeling and diagnostic tools that can quickly identify and quantify where to get the cash out. Donovan stresses, "it's very important for management to have a factual basis to accurately quantify (item by item) how much inventory you can turn into cash and when. Also, pinpointing exactly where avoidable future inventory increases are going to occur so you can take the right actions to prevent unnecessary cash outflow is critical to success". It's a matter of assembling the right information in a way that causes the right, prioritized actions to be taken at the right time.

When an effective inventory monitoring methodology is put into place, management is much better prepared with the right information to reduce inventory including when dramatic declines in sales occur," Donovan notes. "That means a higher cash balance rather than a high inventory balance - which is what CEOs and CFO's want to make happen."

For further information on the Rapid Inventory Reduction Methodology click on http://www.inventoryinc.com .

Many more articles in The CFO Refresher, Logistics & Supply Chain Management and Performance Improvement in The CEO Refresher Archives

   


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