In my previous blog on effective inventory management, I discussed some of the possible pitfalls when using inventory turnover as a measurement for effective inventory management. In this post, I’ll describe a simple technique for measuring inventory effectiveness.

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Measuring Inventory Effectiveness

  1. To measure inventory effectiveness, total the product inventory (in equivalent units and dollars) in any of the seven categories listed below, or any other similar categories that would make sense to the business, including:
    • Damaged: Product not fit for use due to material handling, storage, etc.
    • Recall: Material suspected to be out of specification
    • Rework: Material partially defective, yet repairable
    • Outdated: Product beyond its date of expiration (may still function, but can be shipped only in specific cases)
    • Short-dated: Product soon to reach expiration (may soon become outdated)
    • Obsolete: Product superseded by new product (last year’s style, model, etc.)
    • Non-Moving: Product with very minimal order demand for a period significant to the business
  2. Then, express the “drag” inventory as a ratio of the total inventory and subtract the ratio from 1 as shown below:

Inventory Effectiveness = 1.0 – Drag Inventory/Total Inventory

This measurement gives a simple, overall view of the inventory working for the business. Published lists of the “drag” inventory can then be used to drive action plans to reduce it to zero. It becomes especially effective when this “drag” inventory is expressed in the language of management – dollars.

Eliminating the “drag” dramatically increases the velocity of inventory and improves the inventory turnover ratio. Measuring the inventory effectiveness focuses attention on the waste inherent in the system. Removing this waste increases competitiveness and lowers costs.

Segmenting Your Inventory Data for Best Results

Using this index effectively requires some savvy customization. Applying it to all inventory may prove interesting but fail to point out areas for action. Consider segmenting the index and analyzing by category:

    • Product Lines: Looking at each product line points to the specific area for improvement. If this analysis points to a multitude of areas for improvement, use the Pareto principle to isolate the major opportunities. Consider differences between old and new product lines.
    • Inventory Category: Measure the index for raw materials, work-in-process, intermediates, finished goods, or even spare parts (for equipment manufacturers). Perhaps the index can be used to identify wasteful business practices in any of the “value adding” steps of the supply chain.
    • Suppliers: Contract manufacturers should also be included, especially if the raw material or work-in-process inventory is owned by the business.
    • Age of Inventory: Isolate the amount of inventory in the seven categories that were created in the last three months, six months, etc.
    • Demand Manager / Distribution Planner / Master Production Scheduler: The index measured by those responsible focuses directly on performance. This may lead to direct preventive action or a more in-depth understanding of the inventory.

Once the index measurements have been made and established on an ongoing basis, set aside realistic goals for directing the business. This may be accomplished through competitive benchmarking or by emulating a respected leader in the field. At the very least, a percentage factor would be used to judge performance.

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Action Steps for Improving Inventory Management

Once areas of improvement are identified with the index, it’s time to take action. At this point, the drag inventory has been identified, and it’s visible for addressing in two ways:

  1. Move the damaged, recalled re-worked, outdated, short-dated, obsolete, and non-moving inventory. Consider price incentives, untested markets, recycling back into the manufacturing process, alternative uses, etc. Make a list available to the sales department, and encourage the sales staff to be creative in moving the product. Ask R&D if it is possible to recycle “drag” inventory into the manufacturing process. For non-process industries, consider modifying parts to make them useful. Lastly, consider donations to universities, learning centers, or trade schools before writing off the product.
  2. Prevent these categories of inventory from entering the system. Conduct a cause analysis to isolate problems. This will lead to continuous improvements in the process. These improvements could come from many areas of the business and will involve changes in the way one operates. Marketing could improve forecast accuracy and manufacturing could reduce lead times to allow a make-to-order business and greatly minimize forecast errors.

To begin this improvement process, you’ll need to involve various members of the business.

  • Managers of assets need to review this index on a routine basis and understand the impact on costs. For their needs, it may be wise to express this inventory in dollars.
  • Sales managers should become aware of the role they play in cost improvements by promoting the sale of this inventory.
  • Those involved in planning and scheduling should understand the impact of their work in creating this inventory.

Presenting to these groups the effectiveness/ineffectiveness of the inventory will change nothing. Pointing out opportunities for improvements will not lead to action in itself. One must find support in the organization from senior management to drive action toward improvement.

The inventory effectiveness index provides a simple tool for identifying areas of potential improvement in the business related to the physical nature of inventory. These physical reminders of what’s gone wrong can easily be measured and can easily be understood by all levels of management. The simple nature of the index makes it easy to customize, which renders it all the more useful. It can uncover areas of inventory that are convertible to cash in the short -term.

[Read More: My Biggest Mistake: Inventory Levels are the Thermometer for the Management of the Company]  
These action steps can be used to deal with short-term problems and can focus on preventing inventory build-up with long-term improvements in mind. Perhaps the most valued attribute of the inventory effectiveness index is the further refinement of the true costs associated with inventories. It engenders a more widespread understanding of the nature of inventory and fosters action to prevent the buildup of non-value adding drag.

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