Below is an excerpt from our whitepaper, “You’ve Been Charged with Reducing Inventory. Now What?”, which provides a detailed look at various methodologies and ideas related to inventory reduction.
APICS and college-level classes teach us the Economic Order Quantity (EOQ) formula, which approximates the proper make or buy quantity per item that balances ordering costs with inventory carrying costs.
EOQ = √(2AS/iC)
A = annual demand, S = fixed cost per order (ordinarily total setup cost for a manufactured item or total procure-to-pay costs for a purchased item), i = carrying cost as a decimal (often the company’s “hurdle rate”), and C = the item’s unit cost.
The supply chain professional charged with reducing his or her company’s inventory has little to no control over A, annual demand, or i, the company’s internal rate of return.
The supply chain professional can, for one, work to reduce an item’s cost. Using the EOQ formula above, reducing an item’s unit cost reduces inventory carrying costs and, therefore, safety stock costs. Inventory cost reduction approaches can include any or all of the following:
1. Use less expensive raw materials and components.
2. Improve labor and machine efficiency.
3. Reduce overhead costs attributable to the item.
All three inventory cost reduction approaches are feasible, but none is a short-term fix. Approach 1 requires an extensive effort that involves working with suppliers, marketing, engineering, quality assurance, and, often, customers. In some cases, customers specify particular raw materials that prevent a supplier from using alternate materials. For example, many OEMs have instituted a Made in America policy that prevents suppliers from using less-expensive, imported steel.
Labor and machine efficiency can often be improved through time and motion studies, automation and, potentially, subcontracting; however, these approaches do not offer overnight inventory value reductions.
Reducing a product’s overhead can offer some hope, but only if real, hard-dollar overhead reductions are pursued. Changing the current overhead application procedures merely shifts the costs from some products to others. In the short term, most overhead is fixed, so improvement efforts in this area take significant time and effort.
So, in summary, reducing products’ unit costs should be part of ongoing, continuous improvement efforts, but is unlikely to deliver necessary, short-term reductions in inventory.
The other, more practical tactic for a supply chain professional is to work on reducing ordering costs, the variable S in the EOQ formula:
- For manufactured items, this means reducing setup times for each operation on an item’s routing.
- For purchased items, this means reducing the transaction processing costs required to recognize the need for replenishment, authorize the purchase, receive the product, inspect and validate the item’s fitness for use, and process and pay the supplier’s invoice.
That’s it. That’s all a supply chain professional can do from the order-quantity perspective of APICS’ average inventory formula. For even more information on inventory reduction, our firm, or our services, contact us today.