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Inventory - Cash or Carry? |
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Free Feature Article
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There is an old saying in business that ‘Cash is King’. Inventory, no matter what type, ties up cash and diverts it from other uses. Therefore the aim of inventory management should be to minimize the inventory investment for a particular customer service level. The approach taken should ensure that the target level of service is met while also minimising the cash investment. In turn this will maximize the overall benefit for the company.
To achieve this many companies adopt supply chain techniques for managing their inventory without realising that the effectiveness of these techniques is limited to only a certain type of inventory. That is direct inventory. These companies don’t realise, that for their indirect inventory such as parts and components, finished goods, OEM spares, engineering spares, MRO inventory and industrial supplies, a more complete approach is required. As a result, the opportunity for cash release with this type of inventory is often disproportionately large for the inventory investment.
Some companies take a completely different view, they treat inventory as an expense and this is particularly the case with MRO inventories. You might expect this with companies that don’t carry other types of inventory (such as utilities) but in fact it is the case with many types of companies, even those in manufacturing. For many engineers inventory isn’t a serious business topic; inventory is something that accountants count and storemen store. For the average maintenance engineer the issues are uptime and reliability. Spares don’t improve reliability and they only improve uptime by being available when needed. Hence their issue is availability and not inventory reduction. However, whether they realise this or not, their purchase of MRO inventory is an investment of the company’s cash. It represents a use of cash that may, or may not, be better used in either a capital purchase or elsewhere in the company.
In an environment where downtime is costly, and relatively speaking the cost of individual spares is cheap, it is easy to justify carrying any number of spares. In this case MRO inventory is viewed as insurance. This perspective almost invariably results in the over purchase of MRO inventory and subsequently an over investment in inventory. In this case MRO inventory is the forgotten investment.
If, however, we view MRO inventory as an investment then logically we will manage the inventory differently. Our goal will be to maximise the return on investment. That does not mean risking our operational outcomes but it does mean ensuring that there is no excess or unnecessary inventory investment. It does mean consciously managing the cash investment. The challenge with MRO inventory, as with all inventory, is whether to free the cash or carry the inventory.
Why MRO Inventory Is Different
Most people can identify at least three different type of inventory: raw materials, work in progress (WIP) and finished goods. Depending on how one views the supply chain, we can classify most inventory in one of these categories. But the author proposes an alternative view. That is, that there are only two inventory types: direct and indirect inventory. Direct inventory is all the inventory created along the supply chain. This is the main inventory focus for manufacturing companies. Indirect inventory is the inventory that supports the main supply chain and this includes the MRO inventory. There are a number of reasons why indirect inventory is different to direct inventory:
Inventory As An Investment
To really understand the role of inventory and the importance of cash management we need a basic understanding of business economics. Figure 1 represents a simple cash flow cycle and will help explain the concept of cash flow.
Figure 1: Cash Flow Diagram
The business spends its cash on buying raw materials and engineering spares so that it can make products. Typically it will need to have inventory of these items so that there is a buffer between supply of these materials and the demand from their production department. This buffer is necessary because the rate of demand is usually greater than the ability to supply. In order to accumulate this inventory they need to buy more than they will actually need in the short term.
The raw materials are then used to make product. In doing so cash is spent on utilities and labour. After the product is made it will be ‘put into inventory’. Again to act as a buffer between supply and demand. And again to accumulate this inventory they must make more than they need in the short term. When these products sell, the buyer pays the company and this provides an input, or receipt, of cash to enable the company to recommence the cycle. While this cycle continues the company will need to spend cash on overheads, new investment, interest on money borrowed, paying back money borrowed and paying dividends to shareholders.
A company’s cash flow is the difference between all the cash that goes out (buying raw materials, engineering spares, utilities, labour, overheads, investment, dividends, interest and loan payments) and the money that comes in (receipts from customers). If the cash flow is negative, that is, the ‘cash in’ is less than the ‘cash out’, the company will need to borrow more money or it will be unable to buy supplies, labour, utilities etc. In short, no cash, no business.
The investment in inventory is an interruption to this cash flow cycle. While raw materials will eventually be turned into products, many purchases of MRO inventory are never put to any use (in which case they get ‘written down’ over time and may eventually be declared obsolete). This means that the company has spent its cash but gets no return on that expenditure. In many cases it is not overstating the situation to say that this cash has been wasted. However, if a company is able to reduce the level of MRO inventory it carries, it can free up the cash that is invested in that inventory. This cash can then be used for other purposes such as for further capital investment.
Why Hold Inventory?
MRO inventory includes all the maintenance spares carried for responding to both breakdowns and scheduled maintenance, it covers all the operating supplies carried to keep the process running, it covers all the inventory held by OEMs (Original Equipment Manufacturers) to service the equipment they sell, it covers all the inventory held by suppliers that becomes your inventory (such as bearing suppliers). It is a very wide field.
Despite this, there are only three reasons why you purchase and hold onto inventory:
1. To enable supply in a timely manner. This means that when you need the part you need it faster than it can be supplied from your suppliers. You need the part and you need it now!
2. Project or shutdown work. With project work and shutdowns you have the uncertainty of what might be needed, perhaps the timing of when it might be needed and a workforce and timelines that can’t wait. You must hold some inventory.
3. Purchasing and manufacturing efficiencies. Sometimes it is just not economic to buy spares on a piece-by-piece basis. Therefore you buy the minimum economic quantity and have a spares inventory investment.
In the first two cases the inventory is held as an insurance against other loses and in the last case the inventory is held as a means of trying to minimize the cost per item (but not the inventory investment). It is clear that that each of these reasons will lead us to holding too much inventory if we do not value the cash that is invested.
Comparison of Investment Measures
So far we have explained that MRO inventory is an investment of the company’s cash and that the ‘insurance’ approach will lead to over investment. What is needed is a way to compare that investment to other investments such as fixed capital. The two most common approaches for comparing different investments are ‘Payback’ and Return on Investment (ROI).
Payback measures how long it takes for the investment to ‘payback’ the original funds invested. So, if we purchase a machine for (say) $1,000,000 and the machine reduces costs in some way by $500,000 per year then the ‘payback’ is 2 years ($1,000,000 / $500,000).
Return on investment (ROI) measures the percentage return that the investment generates per year. So, in the above example, the investment of $1,000,000 returns $500,000 per year, which is 50%.
These types of measures provide a means of comparing different uses of cash and help us to prioritise the use of that cash. For example, if we can achieve a $500,000 return by investing $750,000 (an ROI of 66%) then because of the superior ROI we may redirect our cash into that investment rather than the $1,000,000 investment above.
However, MRO inventory is not quite so easy to evaluate and this is why the investment is so easily over looked. We cannot so easily identify the return on investment with MRO inventory because the benefit of MRO inventory is the prevention of loss through reduced downtime. (As mentioned in Part 1, MRO inventory does not improve reliability it only reduces the downtime through parts availability.)
We can though, use our understanding of cash management and investment measures to lead us to a better understanding of inventory management and the impact of safely reducing inventory. So, while it is difficult to quantify the benefit of holding inventory we can most definitely quantify the investment and we know that if we can reduce the level of the investment (without impacting our downtime) not only will we increase the ROI but we will also free up cash and improve the company cash flow.
In addition, if we hold too much inventory of an item and that excess adds no value because it is never used, then the ROI is zero. In effect we would be better off putting this money into the bank at zero interest than holding the inventory – at least we would still have the original capital! This excess inventory uses up the cash and can be removed with no risk to the business.
We can also use the investment approach as a means of determining the ROI from applying resources to reducing that inventory. If, for example, we spend $100,000 identifying and taking action to reduce inventory and we achieve a reduction of $1,000,000 then the ‘payback’ on that investment is 1.2 months and the ROI is 1000%. Now wouldn’t we like that return on our other investments! That $100,000 might, from a pure business perspective, be the best investment that a company can make.
A Real Life Example
Recently, one of our clients managed to achieve an inventory reduction of more than $10M in just 18 months. The estimated expenditure (including their staff time) to achieve this was $300,000. This is an ROI of 3,333% (no, this is not a printing error!) In addition, because the cost of carrying inventory there was an additional benefit of approximately $2M per year. In this case there was not one other project of any kind in that business that returned a one off $10M cash and an additional $2M per year with zero capital investment.
A program of inventory reduction may be the best business investment that any company can make.
How This Understanding Helps Us Reduce Inventory
We now have three ways to view MRO inventory:
These different perspectives guide us in the options that we have for managing the inventory investment.
For example, if the perspective is availability then the goal is likely to be maximising availability. In this case the so-called ‘inventory optimisation’ approach is likely to be used to justify holding more inventory not reducing our inventory.
If the perspective is cost then supplier negotiation (to reduce cost) is the most likely approach.
However, if the perspective is investment then we can use all seven of the possible ways for reducing the inventory investment. This encompasses the quantity we hold, the price we pay and the time for which we hold the inventory.
The ‘7 Actions For Inventory Reduction’
Having now freed ourselves of the constraints created by not viewing inventory as an investment we now have many more ‘levers to pull’ for inventory reduction. Fortunately, however, there are only seven ways to reduce inventory so the approach is quite manageable.
Action #1: Have Someone Else Hold it and/or Pay For It Action #2: Sell Excess and Obsolete Stock Action #3: Eliminate Duplication Action #4: Change the Factors That Drive Safety Stock Action #5: Reduce Reorder Stock Action #6: More Closely Match Delivery with Usage Action #7: Reduce the Value of Items Held
Conclusion
No matter how it is viewed, MRO inventory is an expenditure of a company’s cash. This expenditure is different to raw material, WIP or finished goods inventory because there is no intent to resell the items in order to recover the cash spent. The inventory is purchased to either act as insurance against other losses in production or to enable a lower cost per item purchased (i.e. volume purchasing).
This makes MRO inventory the worst kind of investment because any cash spent over and above the bare minimum required has a zero return on investment. This is only clear, however, when MRO inventory is viewed as an investment.
The investment perspective also helps in justifying the use of cash to conduct an inventory reduction program. In fact, this type of program can be the best use of funds available to a company with examples where the ROI for this activity can exceed 3,000%!
The investment perspective also means that the options for reducing inventory are not just limited to optimization and price negotiation. In fact there are seven actions that can be taken. With this higher level of understanding it is clear that every potential purchase of inventory represents a choice to be made by the company, and that choice is: invest the cash or carry the inventory?
About The Author
Phillip Slater is the author of the book Smart Inventory Solutions and the developer of the Inventory Cash ReleaseTM System - ICR®06, a world’s best practice approach to inventory management and reduction. For more information visit his website at http://www.InitiateAction.com.
Note: You are welcome to reprint this article online on the condition that it remains complete and unaltered (including the ‘About the author’ info at the end) and you send a reprint to enquiries@InitiateAction.com |
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Initiate Action Pty Ltd 49 Vida Street, Aberfeldie Vic 3040 Australia phone: +61 3 9331 3181 fax: +61 3 9331 3180 USA and Canada Free Call 800-581-7678
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