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Cutting Inventory Costs

Inventory remains a largely misunderstood part of manufacturing businesses, but it becomes even more critical to engineering related businesses, where often payment cycles are long and significant materials costs are incurred up front.   Whilst many businesses find their total inventory value is only a small percentage of their overall costs, it is the rate at which inventory moves that can kill off cash flow.

In engineering businesses where sales are often lumpy and cash flow is either feast or famine, the cash tied up in holding inventory can be the difference in meeting your short-term obligations or having to raise extra credit facilities.

Inventory incurs a range of costs including:
  • Carrying value of stock
  • Storage space costs
  • Handling and management costs
It also impacts gross profit in any particular reporting period, as stock is usually brought to account at the end of each reporting period, reducing gross profits.   In other words, if it has been on the shelf for 12 months it cuts into your net profits.

But the biggest impact inventory has on a business is the loss of cash for the period the items are sitting on your shelves.   Cash is king in any business, and cash tied up in inventory simply reduces your opportunities to expand sales in other areas or require you to have increased short term finance requirements.

Cutting inventory costs needs to be part of your everyday management systems, and requires a systematic approach.   It is something you continually manage, and as such need management reports to facilitate the key areas that generate costs for your business.

SME’s often ignore the need for inventory systems because they are too complex to handle within the usual accounting software, and they feel they can’t justify the costs of an enterprise software package that takes time to implement, learn and tailor to their business.

Step 1: Know Your Inventory & Prioritise

You can’t do anything without knowing what you have in inventory and ideally how long it has been there.   A simple inventory system can track what you have in stock, its carrying value and the trends of movement in stock value.   A system then allows for easy prioritising of what are your fastest and slowest moving items and what value is locked away in your inventory.   By the way – this also means a stocktake is required!   When was your last stocktake?

No improvements can be sustained unless you have a system for managing what you have on your shelves.   This system is not just software, but procedures and policies for managing inventory – but more about this in step 5. 

Step 2: Reduce Supplier Lead Time

The basic premise of inventory is to provide a buffer to allow variation in either customer requests or manufacturing.   If there is no lead-time in getting inventory then you just simply pick what you want and use or sell it.   So looking at ways to reduce lead-time can also reduce demands to carry stock.   

Ideas to consider include identifying the suppliers that can assist with fast turn-around or provide consignment stock.   Lead time reduction is also assisted by understanding when you need items and what is the history of usage on key items.   This forms part of projecting demand for inventory items – the next step. 

Step 3: Project Inventory Demand

Having a system for monitoring and tracking inventory should also allow you to predict what will happen in the future.   Usually demand projection is reviewed for the next 3-6 months, but even regular projection over a 4-week period allows for improvements in inventory control.   Projecting demand is not meant to be exact, it is meant to give you a guide of your future requirements.   This information helps your suppliers to reduce lead times as well as allow you to plan your cash flow and prevent un-necessary cash-shortage surprises.

Demand projection also goes hand-in-hand with reducing manufacturing cycle times.   Although this is another topic altogether, reduced cycle times managed correctly can also allow reduction in inventory levels, as a result of greater flexibility. 

Step 4: Eliminate Stock-Outs

Quite simply stock-outs can cost you big dollars.   When a customer wants a product that you can’t supply you run the risk of losing the sale.   In manufacturing, raw material stock outs can hold up machinery, meaning reduced capacity and less coverage of your fixed costs.   It can also mean you pay more to get the items urgently in both delivery charges and spot pricing rather than negotiated supply agreements.  

In a service business, stock-outs can grind a business to a halt.   A cleaning business cannot clean if the right materials and chemicals are not available.   So this either means the client doesn’t get the service, a catastrophic result, or the cleaning business incurs significant extra costs in securing the items required. 

Step 5: Systemise control

A system for inventory management is not just about cost control.   It is about managing information that impacts the cash flow of your business.   Inventory systems must include:
  1. Policies and procedures that spell out how people within the organisation utilise inventory and how it must be accounted for
  2. System for recording and tracking stock and usage.
  3. Regular management reviews of stock levels, trends and key financial performance indicators.   These should include:
    1. Stock value (current and moving totals)
    2. Inventory turnover
    3. Number of stock-outs
    4. Breakdown of inventory items
  4. Regular action plans to extract the best value add to the business from inventory
Inventory systems also allow other people within the business to make correct decisions when it comes to meeting customer requirements.   In an engineering business inventory systems support accurate and profitable quoting by indicating to managers what is in stock, how long it will take to deliver and what has been used for similar jobs in the past.   The more accurate your quotation system is the more likely you are of winning work and making a profit.  

Within a manufacturing environment, inventory systems form part of the entire supply chain making sure raw materials are always available.   For the customer, inventory usually means the finished products they buy.   In this case inventory management is all about being able to meet customer demands and respond to market changes.

Inventory is something that everyone in a business “shares” in some form, and hence everyone must be involved in managing it.   Inventory management is not just keeping a list of what is on the shelf, but encouraging everyone to find ways of adding value to the business through better use of an asset already paid for.
What Next? 

Effectively managing cash flow is all about working capital and finding innovative ways to reduce it, without sacrificing efficiency or customer service.  The only way a business can improve their working capital is by first understanding what contributes to the working capital and then implementing programs to measure and reduce it.

Nothing happens unless you decide it will happen, and unless you change something you will always get the same result.  What decision do you need to make NOW?

Maxell Consulting has helped many businesses identify the value in their business and empower the owners to develop plans to crystallise that value.  

We offer a free assessment of your situation and review what potential value exists within your business.