When demand sags, inventory can all
too easily pile up, putting pressure on the financial performance of the
organization. The procurement team can do much to relieve the situation—and in
the process exert a powerful impact on overall business performance. The six
action steps outlined here can help supply management executives make that
difference.
By Justin Reaume
There has been plenty of discussion
over the years about how to reduce inventory. Generally, the perspective is
from the office of the material planning manager or supply chain manager, since
inventory performance is usually thought of as a production metric.
However, there are many aspects of
inventory management that are directly influenced by decisions made in the
procurement department. Many of the variables that are tied to the reliability
of the logistics network are directly related to the locations of the suppliers
and to their delivery performance. In addition, contractual agreements that
specify high minimum order quantities or long lead times—or both—can prevent
the materials organization from making the necessary adjustments to raw
material inputs when demand does not merit high volumes.
It may seem obvious to say that
procurement managers must understand the impact of their decisions and strive
to accommodate the goals of each operating unit in sourcing arrangements that
are effective for all parties. The decisions made within the procurement
department have lasting effects on the rest of the organization; they become
part of legally binding contracts that govern the way a company conducts
business with its supply base. Unfortunately, it is still common practice to
optimize the effectiveness of one function, such as procurement, at the expense
of the effectiveness of others.
This article presents six checklist
actions to help procurement professionals play more integrated roles in the
management of inventory. Managed well, these actions can help improve profitability.
Collectively, they can have as great a financial impact on an organization as
does a reduction in purchased cost.
1.
Reduce Minimum Order Requirements
Many suppliers specify a minimum
order quantity (MOQ)—that is, the minimum amount of material that can be
ordered at any given time. Determination of the MOQ is a balancing act between
allowing the supplier to make long production runs in order to realize
economies of scale and ordering the minimum amount of material required to
sustain production and maintain low inventory levels. When there's a drop in
demand, previous minimum order quantities that met material planning
requirements no longer meet those objectives. In short, the MOQ is now
excessive.
Here's a quick example. Imagine an
MOQ of 10,000 units for a product with a yearly volume of 120,000 units; that
translates as one shipment per month. Now imagine that annual demand drops to
60,000 units. Under the current MOQ arrangement, there would then be six
shipments a year, or one every two months. Then, since two months of material
is shipped to the customer at a time, the amount of ongoing inventory is
doubled, as seen in Exhibit 1.
Essentially, low MOQs allow an
organization to make more flexible adjustments to component shipments; the
result is that the material planning organization can more effectively match
material flow to customer demand reductions. Prohibitive MOQs, such as the one
described above, will result in increased inventory levels in any scenario—and
especially in a declining market.
Contractual adjustments offer the
most straightforward way of addressing excessive minimum order quantities.
However, renegotiation of supplier contracts will almost always have cost
implications; it's common for purchasers to hear about price increases since
the suppliers' economies of scale will be affected by the cutbacks in demand.
A widely used method to avoid paying
price increases is to authorize the supplier to make longer production runs.
Part of that authorization must include an agreement to ship only what is
immediately required by the customer. The purchasers require the supplier to
hold the remaining inventory. In turn, that requirement usually triggers a
request from the supplier for a guarantee that the excess material will be
purchased. Naturally, the supplier also needs to maintain the lowest inventory
levels possible in order to achieve an acceptable cash flow. The supplier may
request that all material must be purchased within a specific period of time to
ensure some level of inventory turnover in case of a significant drop in
demand.
Another approach is to work with
minimum order values (MOVs). This option is usually used by suppliers that sell
standard components through a wide range of part numbers or stock keeping units
(SKUs). The MOV is predicated upon the total value of all part numbers shipped
to a single customer. In this scenario, production volumes are based on the
demand of many customers, so production scheduling does not normally fluctuate
to match the needs of one particular customer.
An alternative is to consolidate
multiple SKUs with a few strategic suppliers in order to more easily achieve
the minimum-order-value requirement. This approach allows for more flexible
ordering; because the overall spend at each supplier is larger, lower volumes
of each part number can be purchased while still achieving each supplier's
total order value minimum.
Here's a quick example: Let's say
that Company A buys six SKUs from four suppliers, each of which has a $100 MOV
requirement. That means Company A must buy $400 worth of product in total. Yet
it needs only $50 worth of each part, so it should be spending only $300 for
them. But Company B buys its six SKUs from two suppliers, each with the same
$100 MOV. Like Company A, Company B needs $50 worth of each per part. But in
B's case the $300 total requirement translates into $150 to be spent at each
supplier, easily meeting their MOV stipulations.
2.
Improve the Reliability of the Supply Chain
In an ideal world, there is no need
for safety stock because the buying organization is guaranteed that it will
always receive the requested amount of material at the scheduled time. But this
guarantee is almost impossible to make. The practical approach is to carry out
a risk analysis to determine how much stock should be maintained to cover a
potential interruption in supply. The less reliable the supply chain, the
higher the risk and the more safety stock is required.
Let's touch on the external and
internal variables that contribute to the reliability of supply. External
variables—those over which the supplier has little or no direct control—include
customs delays, port strikes, lost shipments, damaged shipments, and so forth.
The simplest way to reduce the number of external variables is to reduce the
distance of each inbound shipment. Shipping product from across the Pacific
certainly carries more risk of delay shipping from state to state or province
to province. Safety stock levels can be drastically reduced when the logistics
channel is cut from six weeks to six hours.
Internal variables, which deserve
significant scrutiny from purchasing teams, include poor delivery performance,
defective product, mislabeled boxes, incomplete customs forms, and so forth.
The selection of a supplier that performs unacceptably on one or more of those
variables will create big swings in supply chain performance and may
precipitate the need for additional safety stock.
In such cases, companies can address
the reliability of supply by using a disciplined set of supplier performance
improvement activities. (See also the article in this issue of
SCMR
on “Creating the Ideal Supplier
Scorecard.”) One of the earliest activities is formal notification to the
supplier that its performance is substandard and must be improved if it is to
continue to do business with you. And one of the most important follow-on
activities: tracking the supplier's fixes and its subsequent performance in
enough detail to be able to take action quickly and decisively if necessary.
Ultimately, if the supplier's performance does not improve, the procurement
department must find a suitable replacement.
3.
Increase Material Ordering Flexibility
A common material planning practice
is to order material through a schedule of future requirements, sometimes known
as a release. The release authorizes production for deliveries to occur in the
coming weeks. The longer it takes to build and deliver product, the more
material needs to be released for production. If end-user demand drops
suddenly, the manufacturer can be left with excess inventory.
One approach is to negotiate for
lead times that have some flexibility. This is not easy: Lead times are not
generally an area of significant focus for the procurement organization, and
the lead time accepted by the buyer is likely to be what the supplier
requested. The approach begins with development of a standard lead time matrix.
The matrix is segmented by commodity and indicates an acceptable lead time for
each type of component—for example, 10 weeks for plastics, or six weeks for
stamped steel parts. (See Exhibit 2.) It takes suppliers' locations into
consideration because delivery times will vary.
Once reasonable lead times have been
decided, they should be communicated to the supply base with the intention that
outlying lead times will be renegotiated. Also, future requests for quotes will
specify acceptable lead times, and those numbers will be built into
negotiations.
Another means by which to address
long lead components is to purchase product through a distributor. The
distributor will maintain an inventory level that can handle fluctuations in
customer demand, and will act as the buffer between supplier lead times and
variability in the customer's ordering patterns. As demand drops, the
distributor is typically more agreeable to delaying shipments or can transfer
that inventory to support another customer's requirements. Conversely, the
distributor can generally provide product quickly when demand ramps up.
Any supply contract should be
designed to allow some flexibility in how and when the customer receives its
material. However, the contract must also be fair to the supplier. A maximum
period of shipment delay should be negotiated and included in the contract.
Items to consider include the material's shelf life, payment terms, warehouse
space, and specificity of product—that is, whether it can be sold to other
customers, and if so, how easily.
4.
Make More Use of Local Warehousing and Local Production
As discussed earlier, one of the primary
benefits of using suppliers that are physically closer to your receiving point
is that supply chain risk is reduced. In addition, local sourcing arrangements
typically involve more frequent shipments, further lowering inventories and
supporting just-in-time (JIT) manufacturing.
Overseas production is fraught with
inventory challenges, as supply chain managers have been learning to their
disadvantage in recent years. Before foreign producers actually ship, they
often stockpile product at consolidation facilities until a container can be
filled. In some cases, suppliers are asked to ship larger volumes in order to
spread shipping costs across more units. Not only do these actions increase the
quantity of product in the supply chain, they also reduce the frequency of
shipments. The result: an increase in the organization's perpetual inventory.
The following example clearly shows
the problem of perpetual inventory. (See Exhibit 3.) An organization receiving
monthly shipments to meet weekly demand for 10,000 units will hold 17,500 more
units in perpetual inventory because it is incurring additional safety stock
levels and receiving higher per-shipment quantities. Its safety stock levels
were increased to accommodate the fact that the monthly shipments were coming
from an overseas supplier.
One proven localization practice is
vendor managed inventory (VMI), also known as consignment. With VMI, the
supplier maintains its finished goods inventory on-site, at or near the
customer's facility. The customer is responsible for the material only when it
is pulled from the warehouse for production. Usually, the VMI supplier is
allowed to ship into the warehouse in whatever quantities it wants to ship. As
a result, the supplier bears the burden of analyzing the customer's production
efficiencies in the context of its own inventory-carrying costs.
VMI also has the advantage of no
out-of-pocket costs for warehousing or floor space and quick access to material
in case of unforeseen shortages. Delivery times are minimal; the material is
right there, ready to be pulled. And of course, customer-owned inventory is
eliminated. VMI agreements are initiated and negotiated within the procurement
group. The typical topics of conversation will be payment terms, insurance
responsibility, maximum shelf time, and increases in piece price to support the
additional service provided by the supplier.
VMI can produce some striking
benefits. At one company, the procurement organization allowed a 4-percent
increase in purchase price in exchange for placing 15 percent of a supplier's
inventory in VMI. The supplier benefited from the immediate price hike; the
customer was able to immediately reduce inventory value by $500,000.
5.
Manage the Accretion of Value Using Postponement Strategies
The value added to materials at each
stage of production also increases the cost of holding the evolving product in
inventory. As the supplier continues to produce material that the customer does
not require immediately, inventory exposure increases. Eventually, the supplier
will pressure the customer to buy product that has not been procured as
originally planned.
Therefore, it is imperative to
communicate production requirements to the supplier using a partial release in
order to minimize the amount of material in the supply chain. When components
are ordered under an ongoing release schedule, the customer does not always
order in finished goods quantities. A partial release will authorize the
supplier to procure raw material in preparation for production, but it does not
necessarily authorize it to add further value to the components. This
arrangement allows the supplier to procure the material required to meet
production timing, and reduces the amount of the customer's exposure. (See
example of exposure in partial vs. full authorization in Exhibit 4.)
A partial authorization can be
managed in much the same way that overall lead times are negotiated, since a
standard authorization by commodity can be developed. However, such levels of
detail require the buyer to understand how much value is added to the component
at each step.
When production is cut back, the
cutbacks should be immediately communicated to suppliers so they too can halt
additional processing of the product. A firm contract with a clear ordering
schedule will prevent further processing of material when orders have
diminished.
In situations where product is
ordered from an internal supplier, such as another division in the same
company, the postponement approach can also work well. When a drop in demand leaves
a division with excess raw material and idle production lines, managers may be
inclined to utilize the material to keep the equipment running. However, given
that value is added to the product during each stage of its manufacture, the
value of the finished goods becomes progressively greater than the original
inventory cost of the raw goods. The determination should be whether the
increase in assembled-product inventory cost is worth the benefit gained in
making otherwise idle machinery productive.
6.
Adjust Payment Terms
An increase in supplier payment
terms can be considered a blanket approach to inventory cost reduction. While
this approach does not directly reduce the amount of inventory on hand, it does
delay the amount of cash tied up in carrying inventory. Some questions to ask
when discussing the subject with the supply base include: What should be
offered in exchange for the extension? What effect will it have on a supplier's
financial stability? Will this send the wrong signal about your company's
financial stability? Will it damage supplier relationships so that the cash
gain is offset by less cooperation from the supply base?
Extended supplier payment terms can
also become a profit center for an organization. Imagine, for example, that
Company A pays its suppliers 90 days after receipt of product, and is paid by
its customers 60 days after delivery. If that product is processed quickly and
shipped to the customer with minimal time spent in process or finished goods
inventory, Company A will receive payment for its product before it makes
payment to its suppliers. (See Exhibit 5.)
In this example, Company A holds its
cash from the customer for 24 days before a portion is used to pay its supply
base. The benefits of these 24 days are twofold: (1) overall cash flow is
improved and (2) there is no need for an open credit account with a lender to
bridge the gap between supplier payments and customer receipts. The improved
profitability stems from the value of holding cash that otherwise would have not
been available. The incremental profitability is generally computed as 1
percent of the cash held for a given month.
Of course, the reverse applies; even
the most efficient supply chain cannot recover from unfavorable terms. A
company that enjoys 60-day customer payment terms is forced to use its own cash
or acquire loan capital if its suppliers must be paid within 30 days of when
material is received.
During the recent recession, payment
terms have certainly garnered plenty of scrutiny throughout the manufacturing
sector. Prior to the downturn, one forward-thinking organization was able to
re-negotiate its supplier payment terms for both production and maintenance and
repair components. The company's average days paid increased from 35 to 52
days. With a yearly spend of $70 million, this 17-day improvement yielded $3.2
million in additional cash flow.
Procurement
as Path to Success
Because suppliers become more rigid
in the concessions they are willing to give during downturns—agreements such as
the extension of payment terms or participation in a vendor managed inventory
program, for example—it is imperative to address each of these expectations at
the outset of the relationship. In fact, they need to be written directly into
the supply agreement in order to avoid difficult negotiations after production
has commenced.
At the same time, it is essential to
compare apples to apples. If one supplier is part of a VMI program and another
is not, the VMI supplier's prices will likely be higher. Thus, an analysis on
price alone may disadvantage that supplier—and rob the customer of a valuable
opportunity to reduce inventory.
However, proactive communication and
strong contracts are only part of the solution because a chosen supplier can
add peripheral costs that cannot be contained by a legal agreement. It has been
shown that the peripheral costs associated with supplier selection can have a
far greater financial impact on an organization than does the achievement of a
purchased cost objective. The best practice is to use a total acquisition
cost analysis. The ultimate goal of a total cost analysis is equal
consideration for each variable that may add cost.
The creation of a world-class supply
chain is heavily dependent upon the procurement organization's understanding of
the total cost associated with each supplier and its contracts. With the full
support of the purchasing group, the material supply chain can become a source
of profitability as well as a competitive advantage.
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