Inventory management.
What is inventory management, and what is the basis for inventory management excellence?
Inventory management…. Everybody does it!
Well, almost everybody!
Manufacturing companies do it. Retailers do it.
Webshops do it. Restaurants do it.
Fast moving customer goods companies do it.
And freight/logistics companies do it.
What is the definition of inventory management?
Having the right inventory, at the right time, in the right place.
There is an element of recordkeeping in here:
is what our system says is there, really physically there?
The other element is the flow of goods: from suppliers to manufacturers to warehouses to
points of sale to customers.
Everyone in the company has a stake in inventory management.
If you ask the sourcing department, they will probably propose to buy in bulk from suppliers
to get maximum volume discounts.
If you ask manufacturing, they will want to make big production runs of the same product,
before changing over to produce another product,
for maximum efficiency, and lowest cost per unit.
If you ask warehousing, they will tell you they don’t have space for all this stuff.
After all, a warehouse has similar properties as storage space in your house:
somehow it magically fills up!
Sourcing, manufacturing and warehousing might be the departments physically handling the
inventory, but there are others that have their own opinion about inventory management:
marketing and sales, finance and accounting, and legal.
What? Even the legal department has an opinion about inventory management?
You bet!
Let me walk you through their viewpoints.
Marketing and sales will argue that we need to have plenty of inventory available when
the order from the customer comes in.
Finance and accounting will say that the biggest priorities for inventory management are to
manage cash flow, and avoid inventory obsolescence.
Obsolescence is a fancy word for inventory that is outdated and no longer used, and may
have to be written off as a loss.
And lastly, legal has gone through the fine print of the contract with a customer, and
found that there is a paragraph specifying that in case of a factory outage on the side
of the customer, certain critical spare parts need to be delivered to them within one day.
If these parts are not delivered on time, there is a severe financial penalty which
the company would obviously like to avoid.
To decide on what is the right inventory, at the right time, in the right place, let’s
ask a question to each department: would you like more or less inventory?
Sourcing, manufacturing, marketing and sales, and legal, each having their own reasons,
say “More”.
Only warehousing, and finance and accounting, say “Less”.
I hereby proclaim that the outcome of the vote is 4 in favor of “More”, and 2 in
favor of “Less”.
But wait! We have someone that might change their mind.
Warehousing will vote “More” as well if they get to build a bigger warehouse!
I hereby proclaim that the outcome of the vote is 5 in favor of “More”, and 1 in
favor of “Less”.
But wait! It turns out that the finance vote
has more weight than that of anybody else, 10X as a
matter of fact, tilting the balance in favor of less inventory by 10 to 5 votes!
Why is the viewpoint of finance, to keep inventory as low as possible, so dominant in most companies?
Financial goals and results often drive a lot of the operational behavior in a company,
so let’s see how inventory shows up in the financial statements.
Here it is!
On the balance sheet, the overview of what a company owns and what a company owes.
Inventory is one of the assets on a company’s balance sheet.
The balance sheet always balances, so if you want inventory to increase, then either some
other category on the same side of the balance sheet (like cash, for example) has to decrease,
or one or more items on the liabilities and equity side of the balance sheet has to increase.
The options to choose from are clear and logical: do we want the excess inventory to eat into
our cash balance, do we negotiate longer payment terms with our suppliers to increase accounts
payable, or do we raise capital through borrowings or equity?
Inventory also affects the income statement, or profit and loss statement.
But wait, the word inventory is not mentioned here, is it?
Well…. Revenue is the number of units sold times the selling price, and cost of goods sold
is the number of units sold times the cost per unit, so you can say that the sale of
inventory to customers affects the income statement.
Here’s where finance agrees with marketing and sales: if you are out of stock while there
is customer demand, you can’t earn revenue and margin on the products you weren’t able
to supply, so you are limiting Gross Profit growth!
Here’s where finance agrees with warehousing: if you are overstocked, you might run into
inventory obsolescence, which hits the Cost Of Goods Sold line.
Or you might pursue low-margin clearance sales where the price per unit is hardly any higher
than the cost per unit.
Inventory also affects the cash flow statement,
right here in the line Cash From Operating Activities or CFOA.
The logic is very simple.
If inventory goes up, then CFOA goes down.
If inventory goes down, then CFOA goes up.
Basically the same story that we saw on the balance sheet: inventory up, cash down.
Inventory down, cash up.
What is the basis for inventory management excellence?
There is one word that needs to connect all departments: trust.
Let’s zoom into three specific examples.
If manufacturing trusts sourcing to deliver raw materials just-in-time, with predictable
lead-times, then raw material inventory levels can be low,
and inventory management can be optimized.
If manufacturing does not trust sourcing, then there is an incentive to build raw material
safety stock.
Same thing with trust between marketing and sales on one side,
and manufacturing on the other side.
If marketing and sales trust manufacturing to produce on time and on spec, then finished
goods inventory levels can be low, and inventory management can be optimized.
If marketing and sales does not trust manufacturing,
then there is an incentive to build finished goods safety stock.
A different type of trust is built between finance and accounting, as well as marketing
and sales, on one side, and warehousing on the other side.
The main question around trust in this case:
is what our system says is there, really physically there?
Both for account reconciliation purposes in finance, as well as product availability for
the customer!
Trust is the basis for inventory management excellence.
How is that trust built, and what is the payoff?
Trust is earned by delivering on commitments.
If trust is high, inventory levels can be low.
To build trust, investments need to be made!
To achieve inventory management excellence,
a company MUST invest in systems as well as processes.
Data and information, as well as the right human actions.
In most cases, those investments pay off big time!
You can learn a lot from reading books or watching videos on inventory management, but
the only way to truly make it come alive is to see inventory management in action.
Go visit a company with a complex supply chain, that is well known for its inventory management:
an e-commerce retailer, or a car manufacturer.
You’ll be amazed by what you’ll see and learn!