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Large Savings Through Optimizing Inventory


Large Savings Through Optimizing Inventory

Companies can increase working capital by improving inventory practices. By improving one turn, a typical company can save hundreds of thousands of dollars. In the example below, ABC Company has a Cost of Goods Sold of $40M and may be able save over $500,000 annually by optimizing their inventory with an improvement of one turn.

ABC Company Information:
Cost of Goods Sold (annual) $40,000,000    
Total Inventory Value (average) $7,575,000    
Days in Inventory 69    
Your Inventory Turns equal 5    
Your Annual Cost of Carrying Inventory to the current expense to maintain inventory $2,045,250 to $3,484,500
Cash tied up in Inventory $7,575,000    
If ABC increased their Inventory Turns by 1:
Your Inventory Turns would equal 6    
Days in Inventory 58    
Annual Cost of Carrying Inventory would be $1,719,601 to $2,929,690
Annual Savings would be $325,649 to $554,810
Cash tied up in Inventory would be $6,368,891    
One time cash savings would be $1,206,109    

* The first table shows current inventory turns and annual inventory carrying costs which is where the company’s performance is today. The second table shows what the company could save if they increased their inventory turns by 1.

Inventory Carrying Costs

  • Facility costs
  • Utilities
  • Insurance & taxes
  • Labor
  • Physical counting of inventories, cycle counting
  • Obsolescence
  • Lost opportunity costs
  • Interest on debt
  • Deterioration
Inventory Carrying Costs Elements Cost Percentage
Interest/Opportunity Cost 10% to 15%
Handling & Storage (People & Space)
Damage & Shrinkage (Scrap & Obsolescence)
4% to 8%
Taxes & Insurance
Redistribution Cost (in the wrong location)
3% to 6%
Transactions (Counting, Moving, Planning, Issuing, Reconciling) 5% to 10%
Gen. &; Admin. Staff (Managers, Planners, Physical Mgmt.) 5% to 7%
TOTAL 27% to 46%

Source SC Council, APICS, Best Practices and Industry Experience
* This table shows the annual carrying costs elements add up to a large number when you calculate the total effect of each category. The annual negative effect on the company’s bottom line can run between 27 percent and 46 percent of the inventory value.

Find the Triggers and Rules Within Your Supply Chain

  1. Customer calls and places an order (trigger)
  2. The order triggers the procurement process and production schedule
  3. Purchasing department orders the item

When a trigger occurs, most companies make a variety of adjustments, following rules that have been established over the years. For example, if the customer order is for 100 widgets due February 1, customer service may have a rule to set the due date as Jan. 25 to ensure timely delivery. Purchasing may have a rule to order 105 percent of the materials needed to ensure sufficient materials. Production scheduling now sets a schedule to meet the Jan. 25 date, but also may have its own rule to start early to meet that date.

Such rules generally have evolved over time and may not have been reevaluated in many years because “we’ve always done things this way.” Yet such rules, many of which are established to cover flawed processes, can lead to excess inventory, excess inventory carrying times, or both. Triggers and Rules must change to optimize inventory on a sustained basis.

Where Should You Focus in the Process?

Select the areas of your supply chain with the most significant issues. Overall, there are nine areas in your supply chain that you need to address to optimize your inventory. Each area has its own challenges to analyze triggers and rules.

  1. Sales Order Process – Formalize the business process improvement by mapping the process from beginning to end, noting any triggers. The goal is to challenge and improve on the rules. While there are many others, some considerations include:
    1. Whether your products are make to stock, make to order, or engineer to order
    2. Order entry or order releases practices
    3. lead-times,
    4. percentages over order quantity, to name a few.
  2. Procurement Process – Formalize the business process improvement by mapping the process from beginning to end, noting any triggers and rules. Consideration include using blanket orders, ordering by releases, key sources, lead-times, distance to suppliers, percentage over order and receiving dates rules.
  3. Demand drivers – Review forecasting methods, innovative and functional products, sales forecasts, historical forecasts, economy by industry, seasonality, min/max rules, service level goals, customer’s industries and customer plans (furloughs, shutdowns).
  4. Standardize material usage – Review usage, analyze on hand inventory, review material substitutions, and review standards for identifying similarities (size, type, commodity families).
  5. Eliminate Obsolete Inventory – Review slow moving inventory, analyze inventory tied to specific customers, utilize substitutions and sell or dispose of obsolete inventory. Review of obsolete inventory should include dates of actual usage, not inventory moves; volume review; customers’ future plans for usage; industry outlook for customers; and bill of material accuracy.
  6. Improve Supply Chain Strategy – Analyze stages of interaction within the supply chain, assess collaboration building blocks and tie supply chain strategy to business strategy. Considerations are supplier and information technology constraints, information exchange, organizational design, key performance indicators, processes, systems & technology and people.
  7. Improve Technology – Evaluate ERP modules to ensure that reporting needs are met and consider aligning business needs, processes and people.
  8. Improve Communication – Assess level/type of communication within the supply chain and degree of collaboration between customers, suppliers and your company.
  9. Improve Data Integrity – Investigate cycle count accuracy, large write-ups or write downs, unexplained errors in data, incorrect bill of material and inventory evaluation problems.

It Doesn’t Happen without Responsibility

Calculate the opportunity your company is missing by not improving your inventory by at least one turn, and establish a one turn initial goal for your company. Start by optimizing your inventory and keep in mind that improvements will not happen without a plan (including a timeline), an executive responsible for the program and an agreed upon way to measure improvement. It took many years to create your triggers and rules, and it will also take time to implement changes to improve them.

Dale Billet is a director with McGladrey. For more information, contact Dale at dale.billet@McGladreyus.com