Controlling inventory

Systematic ways to reduce carrying costs

WHEN YOU think about all of the money that companies invest in their inventories, you could compare it to covering the racks and warehouse floor with dollar bills. The spending is in response to customer needs to have products sooner. It arises from lead-times and other constraints involved in purchasing or manufacturing goods. If the constraints were reduced, less inventory would have to be carried, with fewer dollars tied up.

Even though the economy is on the upswing, you still want to keep inventory down, to conserve cash. A balance is needed to get to the minimum investment to satisfy your customer base. So a review of best practices for improving control over inventory seems in order.

Analyze needs

Benchmarks exist to gauge whether inventory levels are proper. Inventory turnover is measured by dividing cost of sales by average inventory levels. For distributors, a normal level of turns is four. For manufacturers, on the other hand, the normal level is eight.

However, management resources are insufficient to scrutinize every inventory item. Rather, inventory "ABC" classification can determine priorities. "A" items are the most important, in that they comprise the top 20% of inventory items that typically account for 80% of the annual usage dollars. When focused on these items, efforts to reduce inventory can be done in a manner that maximizes bang for the buck. "B" items are the next 30% of items, which comprise approximately 15% of usage dollars. "C" items are the bottom 50% of items at only 5% of usage dollars. An additional category is for "D" items, also known as "dead" or slowmoving stock.

The acceptable months' supply of product varies. Targets for A, B, and C, are 1, 2, and 4 months, equating to 12, 6, and 3 turns per year, respectiveIy. This is based on orders per year of 24, 12, and 6, respectively.

Parts can be benchmarked individually with reference to their reorder point patterns. In particular, this means that an average level should fall halfway between the low point of safety stock and the high point of reorder quantity plus safety stock. A reasonable safety stock is one half of usage during lead-time.

Eliminate excess inventory

Factors leading to excess inventory include: Vendor quantity minimums or discounts; poor controls; unreliable inventory records; overly complex product lines; obsolescence; and unpredictable vendor lead times or quality.

Excess inventory costs a company in space, financing, handling, insurance, personal property taxes, shrinkage, and pure waste.

The first step in managing inventory is assuring adequate controls are in place, as summarized in the accompanying box. Perpetual inventory records are the critical starting point, for "A" items particularly. Perpetual records track inventory balances item by item, reflecting current quantities and maintaining a permanent record of transactions. They assist not only in controlling inventory but also in detecting the level of shrinkage or other unrecorded activity that may be occurring. With the availability of these records even on accounting software for the smallest businesses, there is little reason to not use them.

Another approach is to obtain better terms from vendors. Vendors that consign their products or drop ship directly to end customers make it possible to operate without any inventory. The next most desirable terms would be ordering in small quantities from niche suppliers, so that less inventory would be carried. Lead-time could be dealt with by negotiating for vendors to store reserve stock. Title to goods purchased internationally could pass at destination or port of entry, so that inventory is not owned while intransit and payment terms commence only upon receipt.

Cutting the number of parts can also reduce inventory. Improved design can minimize components, simplify options, standardize raw materials, and group parts together. With the right design, a single subassembly can become the main component of one-hundred or more products, reducing inventory substantially. Low-volume items may be dropped altogether. Likewise, new product introductions can be limited to only those with sufficient market potential.

Removing uncertainty also helps. Ideally, vendors would deliver the right items immediately, in excellent condition and quality, only in quantities needed. Barring that, the need to carry items in stock should be limited to what is truly necessary. For stocked items, perpetual records allow the use of ordering techniques, including re-order points, min-max parameters, and material requirements planning systems. Likewise, science can be applied to lot sizes through economic order quantity computations. As records and purchasing decisions become more reliable, there is less margin for error, and safety stocks can be reduced.

Improved forecasting accuracy can be a win-win. As Melissa Basa of the Illinois Manufacturing Excellence Center comments, "One of the biggest challenges to inventory management is accurate sales forecasting. I have a colleague who often jokes that there are only two kinds of forecasts-lucky and wrong. But it is my firm belief that both supplier and customer have a vested interest in improving forecasting accuracy and that an incentive-based program that shares the value of the supplier's inventory cost savings based on better forecasting accuracy with the customer is a very viable solution."

Improve records

The proof of the accuracy of inventory records comes with the physical count. Considerations in taking a full physical count are in the accompanying box. Planning, preparation, methods, and cross-checks are key to success.

Between full physicals, cycle counting programs detect and correct errors. In order to do so, perpetual records and related procedures for recording transactions must be in place. The book quantity on hand must reflect transactions in a timely manner, including purchases and issues. Daily paperwork must be entered into the system prior to counts, and cannot wait until the next morning.

Programs should assure that each item is counted at least twice per year. A wall-towall program takes total inventory locations, such as racks or bins, and selects a quantity to be counted each period. For example, a company with 52 inventory locations might count two per week. Wall-to-wall presumes that perpetual inventory records are set up in enough detail to track inventory by location. On the other hand, "ABC" analysis is a more common basis for cycle counting programs. The frequency of counts is determined by item class. "A" items are counted at least monthly, "B" items quarterly, and "C" items every six months. "D" items are disposed.

There must also be a means of tracking and summarizing results of the program, including explanations for errors located. This should include a reconciliation format completed for each count, as well as a summary report of all counts indicating error rates by inventory category. The error rates are expected to be high initially and come under control over time. The American Production and Inventory Control Society recommends error tolerance levels of 0.2% for "A" items, 1 % for "B," and 5% for "C."

Controls over inventory

* Implement perpetual records: Perpetual records are essential to accountability in providing a trail of inventory transactions. Bar coding facilitates data capture and reduces input errors. An additional step is to integrate perpetual records with the general ledger, so that all transactions are recognized, and shrinkage cannot be covered by simply changing quantities in the perpetual.

* Control ordering: Items that are stocked need to be controlled through budgets and ordering techniques. Non-stocked items should be supported by written requisitions from operations managers. A purchasing function, separate from requisitioning, receiving, authorization, and payment, should select the vendors and place numerically-controlled purchase orders.

* Reconcile cost of goods sold: In whatever manner derived, from manual costing out of orders or through back flushing, a cost of goods sold per system is useful for comparison with cost of goods derived from purchases adjusted for the change in inventory levels. This provides control at an aggregate level. In a job cost system, variances between estimates and actual should likewise be tracked and investigated.

* Use receiving procedures: The receiving function must be taken seriously. The role of receiving is to provide an independent record of the on-order status, quantity, description, and quality of goods received in a pre-numbered receiving report. These records should be routed directly to accounting for comparison to vendor invoices.

* Issue raw materials: Documented authorization and recording of issues of raw materials provide a more accurate accounting for their usage. This procedure forms the basis for what should be an extremely accurate record of what is on hand, for comparison to actual.

* Limit access: Access to inventory areas must be restricted in order to maintain accountability. If salespeople are allowed to pull samples or supervisors to obtain extra parts, the stock keeper cannot be held responsible for shrinkage.

* Physical count: Inventory records must be periodically reconciled to physical assets, through either complete or cycle counts.

Considerations for physical inventory

Planning

* Determine what will be included in the count: Un-owned items, such as consignments in from vendors or customersupplied materials, must be identified as such to assure that they are not counted. Owned scrap and obsolete inventory may be excluded and should be stored in a separate area. Owned supplies are also frequently omitted. Inventory is not concerned with equipment or hand tools.

* Project personnel requirements: Depending on the type of inventory counted, total time commitment may be as high as five or six minutes per stock keeping unit (SKU).

* Provide for proper equipment: Low-value items can be weigh-counted. Proper equipment should be made available. Specialized devices may also be useful, such as an ohmmeter for measuring the length of wire, or a specialized measuring stick for estimating the weight of metal coils.

Preparation

* Organize for count: Items should be staged to facilitate counting and verification. Items stored in inaccessible areas should be placed on the floor. Items inadequately identified must be properly labeled.

* Designate counting areas: If locations are not identified already, chalk marks on the floor should do so. This is the basis for count team assignments and for monitoring the progress of the inventory.

* Minimize movement: Ideally, operations should cease completely for the count. If that is not possible, at least the movement of material should be minimized and well-documented, to assure that items are not double-counted or conversely, omitted altogether. Vendors should be notified not to deliver during the count.

Methods

* Specify counting approach: Most companies use pre-numbered tags, but many are able to use sheets effectively.

* Select receiving cut-off. Items delivered after a certain cut-off date may be set aside for receiving once the inventory is complete. Copies of vendor packing slips for these items must be retained for follow-up.

* Process counts: Completed tags must be input as quickly as possible, to allow for timely cross-checking.

Cross-checks

* Segregate functions: Counters should not be responsible for inventory custody or for maintaining records.

* Control tags or sheets: A log of tags or sheets issued, returned, and voided must be maintained.

* Select recounts: Counters should not know perpetual record quantities. Quantities outside of a predetermined tolerance from perpetual records must be recounted.

By William H. Wiersema, CPA, EA Contributing Editor