By ALAN NICHOL, Executive Member, AlanNicolSolutions LLC
A lesson I learned from one of the Six Sigma masters is to dig into the enterprise resource planning (ERP) system of a business and plot out the sales vs. inventory numbers of various products. We have ERP and MRP systems to help make it easy to mine the data of our daily or yearly productions, but it’s amazing how few of us know how to do so or use these systems for such purposes.
When we map out the sales of our products over a period, such as the last two years, for example, we can build a histogram or bar graph of our sales per product. I suggest doing this by high-level stock keeping unit (SKU) numbers if you have multiple options (such as color) for a single product. Now look at the bottom 5 percent of your sales chart.
How many of the items at the low-sales end of your chart have you sold in the last two years? How many do you have in inventory? How long have they been in inventory?
Congratulations! You have just identified your dead weight items. Now for the hard part: You must decide what to do with them.
I call these your dead weight items because, chances are, they cost you more to have them on-hand and advertise in your catalog than they can produce in the way of revenue or profit. I have yet to meet two accountants or CPAs that can agree on how to calculate the true burden of product inventory, so I’ll give you a very simple way to look at the lost opportunity of these items and a way to argue for their elimination.
Go to the middle or opposite end of the same bar graph. Identify those products that produce the most profit. Look for margin or profit, not just most sales. Now, how many of those items could you have produced and sold with the cost that went into the inventoried products you are keeping but not selling? That is your lost opportunity.
I used this logic with a friend who deals in antiques, particularly antique jewelry. She has an inventory of items that she has acquired that are not easily turned around, nor easily scrapped for monetary value. I asked her how much she can make on her items that are easily turned or scrapped. She said that it averages out to about $7 for every dollar that she spends on those items, not counting the items she is sometimes forced to also buy that turn into useless inventory, nor her time and energy.
Wow! That’s pretty good! So I asked her how much she thought she could unload her useless inventory for if she did a garage sale or put it up for auction on-line. She estimated it to be about $1,000. Can you see where this is going?
If she were to unload her useless inventory for $1,000 and use that money to buy more products that she could turn, she could reasonably make $7,000 for that effort. In other words, the inventory isn’t $1,000 of assets collecting dust; it’s a loss of a potential $7,000.
If you have read a book, any book, on Lean, then you have probably already read a similar example and argument. Understanding that inventory that isn’t turning is a liability instead of an asset isn’t too hard. The trick is identifying it and then doing something about it.
My friend with the antique business still dreads the effort of unloading her useless inventory, but at least she now knows to avoid collecting it or get rid of it as soon as she does.
How do we get into these “useless inventory” messes in the first place? It’s easier than you think. Some times it starts with a special order, some times with voice-of-the-customer data. A customer wants to order a kit or collection of products, but needs or expects one particular item in order to make the package complete. So you design and produce that particular item.
The problem comes when that particular item turns out to be something that only a very few customers desire or expect. Also, in order to acquire the manufactured components for that item, your purchasing department may have been compelled to buy several items’ worth of components. Your own manufacturing may have decided to run many of the items, instead of just a few in order to justify the setup or changeover of tooling and assembly assets.
Some times it is because of your own built-in defenses against this sort of thing. Imagine that your production planner wants to build three specialty items. Your production priorities probably take order and keep shoving your order of three to the bottom because of the apparent value of fulfilling that order. So, to work around the priority problem, your planner places a larger order.
There are numerous ways to end up with unwanted inventory. So, once you have identified it, what do you do about it?
The first, and usually best, option is often the one least well-received. Scrap it. That’s right. Stop wasting overhead and resources keeping it — turn it into cash if possible and use that cash to build something that sells.
If you can eliminate it from your catalog so that you don’t build any more, that is also probably best. Your sales and marketing folks will usually have something to say about this plan. Usually, the need for it is so that they can “pull through” orders for related products by completing a rare customer’s needs with the useless inventory.
Show them the sales records and your analysis of the lost profits by having your money tied up in inventory. Bring you production or operations leaders into the conversation for extra leverage. If you still can’t get through the barrier, negotiate to force the item to be a build-to-order item, and set your system to refuse to order components or complete assemblies for more than one, so that it refuses to inventory the item.
For the latter solution, you will now need to battle it out with your order entry folks who don’t want their response times on orders affected by build-to-order specialty items. So, now you may need to go back to your sales folks and convince them to change the information on your Web page and/or catalog to inform a customer that it is a build-to-order item and will take longer to arrive.
It’s not easy to go through all of these arguments and negotiations. But if you run the numbers over several products, you may be surprised just how much lost opportunity can be captured. For one business to which I showed my analysis and proposed the change, the estimate was over $500,000.
This exercise also explains why the Lean methodology is so compelling. When everything is build-to-order and inventory is the enemy, the above problems generally go away and the waste doesn’t occur.
I want to give one more observation along the lines of eliminating dead weight offerings. Some times the dead weight shows up in our services, not just our products.
If you have the means, track or dig through your existing records of how much time you spend addressing the demands of your various customers. You may find that you have less than 5 percent of your customers that require more than their fair share of your time.
These are often the ones that don’t follow instructions or make frequent mistakes or demand things be done their way instead of how you have asked them to do it. Now consider how many other customers can be served with the same number of man-hours, and what the potential revenues or profits may be. (If you can’t, simply calculate the cost or burden of your problem customers.)
If you can get the numbers to make sense, fire your problem customers. If you explain it to them politely, they may just come around and start paying attention in order to keep their favorite service provider. If not, let them go to your competition. Let your competition carry the dead weight, while you make more money for having dumped it.
Lastly, let me make a concession. Yes, using a calculation of how much profit could be made by shedding your dead weight, and turning its cash value into profitable products or services assumes that there is more to sell than you are currently selling, and does not account for the fact that you may be already producing your full possible quota. Such is the fallacy of every simple business calculation. Nothing is ever simple.
If your business won’t accept the simple ideas and concepts, then you will need to go through the exercise of calculating how much those parts or services really cost you and compare that with how much they generate in revenues. I urge you to save yourself the trouble. You will just come to the same conclusion.
Some times the simple examples make a point, but don’t convince the beholder of the complex problem. Let me use an example of a complex problem we can probably all identify with — airline travel.
Have you noticed that the direct flight costs you three to five times as much as the itinerary with three legs and two layovers? Again, simplifying things for the sake of brevity, the airlines are encouraging customers to consume more resources for less airline revenue. Why would anyone do this?
I know the argument is that the resources are already committed, so it’s a matter of basic economic supply and demand, and any added income to cover the expense of those resources, to fill a seat, is a good thing. I don’t really think that logic passes the common sense test.
First, some customers are already committed to traveling. They have a choice of taking a direct flight for $500 or an indirect for $200. If that customer chooses the latter, the airline just agreed to take them to their destinations for twice the customer service interaction, twice the fuel, twice the wear and tear, etc. for less than half of the revenues. Oops.
Second, if the airline is hoping to lure a customer away from a competitor by offering a two-leg flight instead of their one-leg flight for a lower price, if the revenues from that lured customer don’t cover the expense, the airline just lost money. Unless that airline is so stellar in performance that it wins the customer’s future loyalty, the operation was a complete loss. I’ve seen little evidence of customer loyalty victories.
Obviously the airline industry is very complex. It’s also perpetually on the brink of bankruptcy. Don’t be like the airlines. Keep it simple. If it costs more to provide it than you can get for selling it, don’t sell it, don’t produce it, and by all means, don’t put it in inventory.
Take some time this week and get one of your ERP/MRP support experts to help you run the data dump of your sales by product SKU. Make a chart of it and see what you learn. Start tracking which of your customers monopolize your customer service resources. Make the effort to identify and shed the dead weight. You may just be the hero of the day for finding the lost profits your business needs.
Stay wise, friends.
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