While inventory is often thought of as an asset, being one of the 7 wastes suggests that may be wrong-headed. In fact, as a waste, inventory can actually represent tremendous loss. Not only can inventory cost 40 percent or more of its direct cost to carry, it ties up precious cash that could better be used elsewhere in the business.
A simple definition of the waste of inventory is any on-hand material other than what is needed right now to satisfy customer demand. Inventory can be categorized in various ways.
- Direct Materials (Production consumables)
- Indirect Materials (Maintenance, Repair, Overhaul)
- Production Stage
- Raw materials
- Work in process
- Finished products
Physical materials aren’t the only type of inventory either. Other forms of inventory in include excess documentation, unread email in inboxes, and pending tasks. However, regardless of the specific inventory in question, all inventory is the result of over producing or over purchasing more than what is required.
Inventory may exist unintentionally or intentionally. For example, an unexpected disruption may slow down production and create a backlog, or we may intentionally order more to ensure we can deliver to our customers. Intentional or not, by definition, all inventory is more than what’s needed now, so it’s a waste, until it is needed.
Regardless, inventory directly impacts cash flow so even when inventory is high, as long as it is turning, it may feel as if everything is fine. Of course, the moment things slow down, that inventory can be a big problem, fast, since it’s tying up precious cash that could be used to invest elsewhere in the business.
3 Key Components of Inventory
- Cycle Stock:
Inventory needed to cover normal demand. Average daily demands and the replenishment lead time are the factors that impact the amount of cycle stock. This is calculated by multiplying average daily demand by lead time days.
- Buffer Stock:
Inventory needed to cover demand variation. Demand variation is expressed as a % of cycle stock. Historical forecasting errors and demand swings are some factors that influence the amount of buffer stock required.
- Safety Stock:
Inventory needed to cover internal or supplier related risk. This number is calculated based on the factors you select and measure over a period of time sufficient to give you an idea of the maximum loss such as scrap, rework, downtime and late deliveries. As a general rule, all internal and supplier related safety stock should be considered deviant. That is, it should not be usual. Internal and supplier processes should be reliable enough to not require additional inventory.
To truly account for the waste of inventory, we must first accurately account for the cost of inventory. Sadly, a common mistake that many manufacturers make is underestimating the cost of inventory.
A common cause of this mistake is confusing and conflating various terms and concepts related to inventory cost. Many people define carrying cost as synonymous with holding cost. Others define these two terms differently. Some, further define possession cost yet another way. Sadly, quite a few assume all of these terms are synonymous with capital cost. In fact, conflating total inventory cost with capital cost is the single most common inventory accounting mistake that the Falcon team sees manufacturers make.
Unfortunately, there isn’t a single definitive authority on the subject of inventory cost. However, what’s most important to know is how you define it, why you define it that way, and how your definition informs decision making, and drives improvement.
How should you define inventory cost? While there may not be a single authoritative definition of these terms, there is a great degree of commonality across various definitions. For example, many reputable sources see carrying cost, holding cost, and possession cost, as synonymous, and ultimately define them as the comprehensive cost of having inventory (i.e. having cost), which accounts for various factors such as capital cost, cost of storage, opportunity cost, material handling cost, cost of errors, shrinkage, taxes, inventory insurance, price erosion, and the cost of planning, procuring, and controlling inventory.
Now, if you’re an inventory, procurement, or supply chain manager and that sounds like overkill then the odds are extremely high that your company is currently underestimating carrying costs. By the way, most companies grossly underestimate inventory carrying costs. Are you?
It’s important to recognize that carrying costs can easily be 40% or more of the direct purchase value of inventory, are often between 20% and 30%, are unlikely to be less than 15% (very conservative), and nearly never less than 8%, even among world-class manufacturers. Yet, many manufactures routinely throw around carrying cost percentages between 2% to 5%. Unfortunately, the Falcon team has found that many of those same manufacturers can’t share how they come to that number, and more importantly, have no comprehensive measure of the total cost of having inventory. By the way, there is no benefit to low-balling this number. It does not aide supplier negotiations and undermines lean improvement.
With all that said, it’s also important to recognize that some inventory experts (including the Falcon team) will occasionally, intentionally break out certain factors and account for them separately, for some specific reason. So that it’s clear, there’s no rule that says you can’t do this. Just don’t lose sight of the true cost inventory.
When separately accounting for specific factors, you simply want to ensure that is clearly communicated in all relevant reporting, along with the rationale. So, you may wish to account for all inventory-related transportation costs separately from the rest of your “carrying cost” factors, but you should still clearly account for inventory-related transportation costs elsewhere and communicate why you have chosen to break this factor out (e.g. for lean analysis).
Regardless, don’t get hung-up on semantics. Coming to agreement with your colleagues, suppliers, and other supply chain partners on how to properly define these terms can take time, feel tedious and be exhausting, but the clarity gained is well worth the effort.
As mentioned earlier, inventory and cash flow are directly related. Not managed correctly, inventory can have a detrimental impact on cash flow.
There are also additional costs associated with keeping and managing inventory.
For many, the greatest cost of inventory is all of the other wastes that inventory often obscures from view. The more inventory we carry, the bigger the problems that are buried below the surface, such as unreliable processes or suppliers, unresponsive production, excessive movement, unreasonably long changeover times, etc. To achieve operational excellence, we must tackle these challenges head-on. Yet, we can’t even begin to resolve these problems, if we don’t even know they exist or recognize their impact.
What Causes Inventory Waste?
One cause of inventory waste in companies produce extra parts in case of scrap. This means that they are hiding things like quality concerns or careless manufacturing mistakes.
Another common cause of inventory waste happens when employees are measured and rewarded based on the number of units they produce regardless if they are producing well over the customer demand.
Unleveled production schedules also make it a challenge to maintain consistent inventory levels.
Finally, building to forecast is also a hurdle. The reason behind this is that forecasting is prone to mistakes and this is a common problem.
Lean Tools and Techniques to Prevent Inventory
There are some tools and techniques that can be adopted to battle this waste. Here are some of them:
- SMED – Single Minute Exchange of Dies
This is also known as quick change over. The way SMED works is to do as much of the work as possible while a machine is still running so that when the machine comes to a halt, we minimize the time necessary to become ready to produce the next batch.
- Once Piece Flow
This is also referred to as make one, move one. The way this works is in a production line, each worker produces one piece and passes it on to the next process only when needed. The workload is balanced to takt time and each operator is completely aware of all activities downstream and upstream.
The use of kanban is a powerful means to decrease the amount of inventory in any operation. Kanban’s power is in streamlining the scheduling process so that each production step only produces what has just been consumed at the rate that it is consumed.
- Supplier Management
As powerful as kanban is in reducing inventory and its many associated costs, vendor managed inventory solutions can even further reduce your inventory cost and even completely eliminate all supply related waste in some cases. Consider a JIT consignment solution where you only pay for what you use and only use a week or two of storage at point-of-use.
Hopefully, this article has helped your organization to gain a better appreciation of the true costs of inventory. In the next part in this series, we explore the waste of over processing.