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DOWN WITH INVENTORY!

by Rene T. Domingo (email comments to rtd@aim.edu)

The third industrial revolution is taking place - the first started in 18th century England with The Industrial Revolution, the second in the early 1900's in America with Taylor's scientific management, and the current one in the early 1960's in Japan with Toyota's Just-in-Time (JIT) manufacturing system. JIT has gone beyond car manufacturing, beyond Toyota and even beyond Japan, and is now making companies worldwide review and rethink the way they design and manage their operations. JIT's two most radical principles are zero defect and zero inventory. While the Industrial Revolution centered on mechanization and speed, and Taylorism, efficiency and optimization, JIT is after perfection and minimization.

Zero defect may demand super-human efforts but this principle is easily integrated into existing corporate cultures because the idea of flawlessness is not something new. Perfection is the obsession and expectation of skilled craftsmen, Renaissance painters, and space missions. It is just a matter of adopting this objective in high volume manufacturing and service operations and making zero defect the duty and desire of all employees.

Zero inventory, another perfectionist goal, is ironically the most powerful JIT principle but the least understood and appreciated. The concept appears unprecedented, dangerous, and suicidal. Why should companies precariously operate without any stocks on hand, when business can proceed smoothly with at least some inventory? Most JIT literature focuses on how to eliminate inventory and much less on why it should be done. This article will explain why stockless operation is necessary for survival in this highly competitive environment by pointing out the common misconceptions about keeping inventory. I feel that an enlightened company would be so determined to get rid of inventory that it would find ways and means to do so by itself.

INVENTORY CAN WIPE OUT PROFITS

Inventory is not a harmless item in the balance sheet. It has invisible tentacles that reach the income statement and suck out profits. Companies usually see their hard-earned operating profits drastically diminished, if not eliminated, by non-operating interest expenses mostly due to funds tied up in unseen idle inventory. Inventory, though not a income statement item, also pushes up operating costs in a silent but no small way - rent, leases, energy, and insurance. Expensive manpower to maintain and handle inventories are safely hidden and embedded in direct and indirect labor costs. Defects and spoilage due to excessive inventory (explained below), can bloat material consumption and costs unnoticed. Most cash flow problems resulting in expensive borrowing and frantic juggling of funds come from failure to liquidate inventories. In short, inventory is not free.

INVENTORY IS NOT A BUFFER

Conventional wisdom dictates that inventory should be carried as buffer or safety stock to absorb sudden or abnormal rise in customer demand. But in case of sudden drop in demand, which is the more common occurrence in this highly competitive environment, inventory becomes a drag. Most inventory control systems are designed to cope with quantitative but not qualitative changes in demand. If you have adequate stocks of the wrong products, then your safety stock is unsafe. A more formidable challenge at present is adapting to changes in variety or product mix that the market wants, rather than changes in volume - a task that mere inventory management cannot effectively do.

A specific level of finished goods inventory is often maintained to provide a targeted customer service level - satisfying the customer, say, from 95% to 99% of the time. Increasing inventory may be the simplest way to increase service level, but it is also the most expensive; moreover, it is inflexible and cannot quickly adopt to high product variety situation. Reducing lead time or processing time is more effective and less expensive. The logic of the brisk fast food business is lead time management with minimum inventory and minimum space. This JIT principle was successfully applied by Toyota to car manufacturing. Short lead time, rather than huge inventories, is ideal for high variety, perishable, fashionable, and high obsolescence products that describe most of the consumers products of today and tomorrow.

In case of raw materials and supplies, these are often stockpiled to maintain a buffer or hedge against future price increases. True, prices go up, but they also go down; and in case prices continuously go up, no amount of inventory build-up will give you long term protection and advantages if you are in operation indefinitely. The main business of any business is business, not speculation. Unless you are in commodities trading, you are not an expert in speculation. In any speculative activity, gambling included, there are always more losers than winners. Any short-term gain from hoarding is windfall due to luck and not management.

Expansion or increase in sales volume is another grand excuse to let go of inventory and seek its own level. It is always easy, (and requires no effort nor talent), to increase inventory levels as sales increase. But the ultimate objective of JIT companies is to forever increase inventory turnover - by maintaining current inventory levels or reducing them further during times of high sales growth.

INVENTORY IS NOT AN ASSET

What makes most managers treat inventory indifferently or favorably is its accounting treatment as a "current asset". More often than not, inventories are neither current nor assets; and to further complicate things and multiply the illusion, many companies use the current ratio (current assets/current liabilities) to gauge their liquidity position. Current liabilities are usually more current than current assets. It is often much harder to liquidate current assets - inventory and its sister, accounts receivable - than it is to postpone payment of current liabilities. One company tried to borrow a $50,000 working capital loan from a bank which refused to give it after examining its balance sheet and discovering that it had $1,000,000 in inventories. The company hesitated to explain that the bulk was made of up old stock, slow-moving and never-moving obsolete items which were carried over in the books for years.

The primary accounting basis for classifying an item an asset is cost, because cost is objective and documented, rather than market value which is subjective and unrealized. But cost does not necessarily confer value to an asset. The fact that the company incurred cost in purchasing or producing an asset does that mean it can be sold. Fixed assets like land retain and increase in value over time, but inventories are subject to high degree of obsolescence and spoilage and therefore their costs seldom reflect their true market value. In case of drop (but not increase) in market value, accounting practice allows the devaluation of inventories. But this painful task is rarely done since it would drastically reduce the company's asset base and serve to expose the negligence and incompetence of the current management.

Accounting practice tends to favor objectivity (cost) over relevance (market value) which is what managers must have to control inventories. As such accounting records and financial statements do not tell the whole truth about these assets. Your production people know better the actual condition of inventory to say whether or not they can be sold. Your marketing people know better the marketability of saleable inventory to say whether or not it would be bought and at what price. But only top management has the power and personality to extract and squeeze the truth out of production and marketing staff. It would not be unusual to deflate the book inventory value by 50% if management gets the right information.

INVENTORY IS NEVER OPTIMIZED

Most literature on production and inventory management subscribes to the traditional view that the level of inventory can be optimized by ordering an economic order quantity (EOQ). The EOQ formula states that the optimum order or production quantity is the amount at which the total inventory cost is minimum. Using calculus, this is the amount at which the carrying costs (insurance, interest, etc.) equals the ordering or set-up costs (paperwork, machine-set-up time, etc.). The principle says that any amount below or above this EOQ will tend to increase total costs. The theory is correct, simple, beautiful, but seldom applied in practice.

Why is the EOQ approach a failure? One reason is its utter simplicity - it is limited to unrealistic single-product, steady demand and static costs assumptions. The academe and operations research specialists have come up with more sophisticated EOQ models that claim to handle some product variety and changes in costs and demand over time. But these highly theoretical models using advanced calculus lack appeal to and beyond the comprehension of practitioners and decision-makers in the company.

The EOQ principle also requires lots of accurate information as inputs, carrying costs, set-up cost, unit costs, and demand for each product. Most companies do not possess, update, nor monitor these information consistently or accurately. Most would not be willing to invest in manpower and information systems to track these down just to get EOQ's for each item carried. The business tasks of purchasing and production can proceed without these bothersome EOQ's. In fact, many companies just use rules of thumb, experience, and gut-feel to set the number of days, weeks - or months supply of each product or item they carry.

JIT's zero inventory has none of the EOQ's drawbacks. It is easy and simple to formulate, understand, instruct, follow, and execute. Under zero inventory, minimum is optimum. The object is to minimize all inventory and order quantities until these reach zero levels. It is not deriving some vague magic number from other vague numbers. Zero inventory can be applied in the most static or dynamic situation even with the most imperfect or incomplete information. The zero targets stay even when products, costs, or demand pattern change, and whether or not you know all about your costs and products. EOQ defenders would say that minimizing inventory may reduce carrying costs (since there's practically nothing to carry), but it will bloat set-up or ordering costs, and total costs as well, since placing orders and/or setting up would have to be done much more frequently to maintain minimum stock levels. Under JIT, set-up time and costs are not constant, immovable assumptions - and they too shall be minimized just like inventory. JIT companies have the most advanced technology in reducing set-up time - for instance a 6-hour die exchange is reduced to 30 seconds. Long set-up time is not allowed to get in the way of inventory minimization. One good thing leads to another under JIT : reduced set-up time and costs not only make low inventories economical and feasible, but also allow shorter production runs and the scheduling of more types or varieties of product in a day. This production mix flexibility enables the company to cope with sudden and unpredictable changes in demand and consumer preferences.

INVENTORY AFFECTS QUALITY

Perhaps what is heretofore the most unrecognized adverse effect of inventory is its encouragement of bad quality and sloppy workmanship. The mere sight of abundant supply and stocks make most workers very careless in handling parts and products because it makes them think that there is a second or another chance to undo, rework, hide, or cover up first-time mistakes. Inventories, looked upon as buffer or back-up, make it very difficult for employees to "do it right the first time" - the dictum of the Total Quality Control philosophy.

In JIT companies, the output of one station immediately becomes the input of the next, and not thrown into a heap of buffer of work-in-process. With little stocks (ideally one piece), between them, JIT work stations are effectively coupled; defects are easily spotted and solved since the receiving station rejects them right away and returns them to the issuing station that just produced them. This instantaneous feedback on quality is not possible under the conventional JIC (Just-in-case) systems in which molehills of buffer separate or "decouple" work stations that tend to mind their own business -- until disaster suddenly strikes and goes beyond control. Since the entire JIT production line would stop if any work station stops, the workers and managers make sure no problem occurs anywhere in the line.

"Nature abhors a vacuum." Therefore, remove the vacuum, not by filling it, but by not creating it in the first place. JIT companies strictly and meticulously review and question all requisitions for additional space in the form of racks, shelves, stockrooms, and warehouses, and the people to guard and maintain these. With very little space to hide inventories, the problem changes from where to keep them to how to get rid of them and prevent their build-up in the future.

Companies should assess not only the financial impact of inventories on operations, but also the more dangerous psychological impact on workers and managers alike. Recognize that inventories occupy both space and the subconscious - a case of matter over mind. Managers are usually the first to be deceived by inventories - they would squirm or raise hell upon discovering a pile of unreported scrap, rework, or defects, but would glance with indifference at a pile of perfectly-made, non-moving, unsalable products called inventory.

CONCLUSION

Minimizing inventory or corporate fat requires drastic changes in lifestyle, work style, and management style. True JIT companies have mounted a sustained hate campaign against all kinds of wastes - foremost among which are the overproduction, overbuying, and oversupplying of anything to anybody. Instead of raising inventory levels to service customers as most run-of-the-mill companies do, JIT companies achieve the same objective more effectively and economically in the long run by shortening lead times and set-up times, and enhancing the capacity and flexibility of their people and processes. One company started conversion to JIT by splitting big orders and batches into smaller ones to improve manageability and monitoring of each batch. There are always ways and means to get started and succeed if there is a will. But never accept a manager's excuse for failure to reduce inventory levels as having inherited the problem from his predecessor (who may have been fired for giving the same excuse).

Bloated inventories is a symptom of a bigger malady that is systematic in nature: lack of a strong corporate will and poor leadership that lacks the zest to innovate and excel. The usual practice has been to touch inventory with a ten-foot pole and attend to more exciting, short-term problems. Many companies even delegate its solution to low-ranking supervisors who may not have the enthusiasm, skill, and power to even get started. Inventory management may not be as exciting as marketing and cash management. Business can go on indefinitely and painlessly without minding inventory -- until it is too late like cancer, which is discovered when it is chronic and beyond cure.


 

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