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Understanding The Inventory Drivers



Why have practices such as lean manufacturing and six-sigma process improvement tools had such a profound impact on inventories? And how does e-commerce enable even more exploitation of these advances? The basic idea of these practices is to continuously reduce all the waste and non-value-added elements of a process, leaving only those that actually provide value to the customer. Inventory is greatly affected by these processes and by the improvements companies have made. To understand this phenomenon, consider the source of demand for production and therefore the source of inventory requirements, the final customer.

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Determining what the customer will want, before there is a commitment to buy, varies greatly from industry to industry. It would be easy to manage a business if we know exactly what, when and how much the customer will purchase. When this occurs, supply and demand are in balance. But the reality is that in most circumstances, we do not know far enough in advance to be able to convert “raw material” to “finished goods” within the time frame the customer would like.

Example: suppose the customer leadtime for ordering a piece of industrial machinery is 90 days from order to shipment. The supplier of the gear assembly needed to produce the machinery has a leadtime of 120 days to produce and assemble the gear set. To ensure gear supply, orders are placed 120 days in advance, based upon the forecast of machinery sales. Then the customer orders a configuration not in the forecast. The gear sets ordered earlier are received but have no use, adding to inventory. The correct gear set is ordered in less than supplier leadtime and must be expedited to meet customer needs, possibly with added cost.


The manufacturer that can reduce the time between customer commitment to buy, and time of delivery, will have a distinct advantage in the marketplace, as in Dell’s build-to-order system for personal computers.

All the processes required to create the final product potentially contribute to this time interval. These include the mining and refining of raw materials, ordering and receiving of materials, shipping of materials and manufacturing processes themselves. Whenever one of these processes is performed in anticipation of demand rather than in response to actual demand, inventory is created that may or may not ultimately prove to be of value.

The farther we are downstream in the manufacturing cycle, the less flexibility there is to make what the customer will want. In the case of a personal computer, a microprocessor may be usable in any number of configurations to suit the customer, but once that microprocessor is assembled into a circuit board and is installed in a laptop case, it can no longer be used to make a desktop machine. So, the objective is to convert the raw material inventory to a specific configuration no sooner than absolutely necessary, maintaining the most options to meet future customer needs.

Lean manufacturing and Just In Time attempt to deal with the unusable inventory dilemma, and are based upon the principle of making only that for which there is a known demand. The lean manufacturing and six-sigma methods not only seek to eliminate production of unwanted goods leading to excess inventory; they also are intolerant of errors, forcing the identification and removal of the root cause of the error.


Quality and Lot Size

The lean and six-sigma methods require sound discipline to implement, but once deployed, they are powerful cost reduction tools. An important aspect of the pull or on-demand approach is the elimination of quality problems, document errors and forecast inaccuracies as sources of excess inventory.

The following example demonstrates how a “bill-of-material (BOM) error” leads to inventory build-up. The design bill-of-material entered into the “MRP system indicates that 25 fasteners are required for the assembly, but the assembler has learned to accomplish the task using only 22. Each assembly scheduled triggers an order for 3 extra fasteners. Unless the bill-of-material is corrected, over a period of time there will be a large excess inventory of fasteners, and no one will understand why!.

In another actual example of quality adversely impacting inventory, the ordering system for a supplier of steel sheet to a manufacturing operation requires the identification of nearly 200 parameters to complete the order;

The supplier’s experience shows that because of the large number of data fields, 81% of the orders have at least one error. Only 19% of the inventory delivered to the customer was exactly as ordered. This condition causes inventory to be present that was not required by MRP and at the same time will show balances on hand are short of actual MRP requirements. These will again cause an excess of the wrong material and a shortage of the correct material in inventory. Correcting the condition requires that the order entry process be made error-proof and will probably be aided by reducing the number of order variables.

The “pull approach“, besides requiring near perfect quality, demands smaller lot sizes, approaching one piece. The primary determinant of lot size is set-up tune and cost. In order to absorb the cost of setting up a particular operation (plating and heat-treating are good examples) it makes sense to make as many pieces as possible (batch or lot size) during the process cycle so that the portion of set-up cost allocated to each piece is small. Thus; the larger the lot size, the smaller the set-up cost allocated to each piece, and the lower the total cost per piece. Any lot size greater than actual demand builds unnecessary inventory, so reducing set-up cost will reduce unit cost, lot size and inventory.


Information (Information Technology)

In addition to limiting production to actual customer demand by adopting lean manufacturing, there are other techniques in practice today to limit unnecessary inventory investment. The Internet provides a high-speed communication channel to better align customer demand and manufacturing supply.

Example: When customers pay for their purchases at the cashier of a Wal-Mart store, a record of the transaction is transmitted directly to the suppliers, triggering a replenishment cycle. In effect, immediately upon completion of the sale, an order is initiated to replace the item sold. This process, repeated across all Wal-Mart stores simultaneously allows the supply chain to respond to actual demand on a site-by-site basis. The result of this information flow is shorter replenishment cycle-time, lower systemwide inventory, and lower cost throughout the supply chain.


Similarly, system interconnection enabled by the Internet (information flow in real time) can reduce inventories carried in the distribution channel. By having on-line access to inventory information at the manufacturer or a central warehouse, distributors find it possible to hold smaller quantities locally and still provide the same level of service to their customers. This visibility up and down the supply chain allows buyers and suppliers to better align their stocks to varying customer demand, and uses information to remove excess inventory and cost from the chain.

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