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May 04, 2010
Eliminate, Simplify, Integrate
BY JOVY J. JADER
Developing the right inventory policy
Some years ago, I was asked to assess the operations of a major furniture exporter. Inventories at the company were estimated at 90 days, unacceptably high for a business of its kind.
At the same time, the firm was chronically late in delivering finished products to its foreign customers, with orders-to-deliveries sometimes taking up to six months.
I and my consulting team identified several major opportunities, few of which involved no major investment or lengthy implementation. One of them was the development of an inventory policy. An inventory policy is a statement that provides a guiding course of action for managing a firm’s materials, work-in-process, and finished product stock.
Many companies we’ve consulted with do not have a formal inventory policy; the ones that do have policies that were either too generalized or incoherent. Either way, these fail to provide a clear course of action for the materials and goods that flowed through the firm.
To be effective, an inventory policy must at least consider the following:
Basis for Action. The inventory policy sets the bases for how much to produce, how much materials to order, and how much to stock up for different time periods. Management will set these guidelines for all the firm’s operating departments to consult and abide by. Purchasers should need no clarification on how much to requisition from suppliers and production planners on how much of an item should be lined up for manufacturing. An inventory policy would also put forth procedures for the logistics division, such as a first-in first-out policy for materials and in-process items.
Strategic Direction. An inventory policy must be consistent with a firm’s overall strategy. If the company is pushing to lower its working capital, an inventory policy must be consistent with that end; if it wants to improve customer service, the policy should be focused on ensuring that finished goods are readily available for purchase.
Specific. An inventory policy must not be sweeping; it must be specific to each item that the firm is selling. These may involve classifying products by their value and selling behavior, which would mean a different measure for each item class: fast-moving items, for instance would have a different stocking policy from slow-moving ones.
Flexible & Responsive. Finally, an inventory policy shouldn’t be so rigid or slow to change. All products have life cycles, and inventory policies should correspond to the particular stage that the product is in.
For the furniture exporter, we found that most of its materials had inventory fluctuations that ranged from three weeks to four months: Items were being purchased at either very low or high quantities regardless of what was on hand, and without consideration for what product was still in-process.
We also discovered that in-process inventory levels were so high that some of the items had been sitting on the shop floor for six months. The firm was constantly reacting to rush orders from the sales department to the extent that material orders were being made based on projected demand. This inefficiency caused items in-process to be pulled aside and displaced to make way for higher priority products.
We recommended that the firm define an inventory policy at least for the items with the highest value. Through demonstrations, we showed how this would reduce inventories for just these items by as much as US$10 million, translating to capital interest that is lower by some US$1 million per annum—savings that would be immediately realized upon the policy’s execution. The measure required no additional investments in warehouse space or information technology: benefits would practically be at zero significant cost.
Other firms we’ve worked with have presented inventory policies that simply stated “we will keep stocks at no more than the equivalent of 30 days of sales.” The furniture exporter had no formal policy to start with, but this is only as bad as having one that is sweeping and vague.
An inventory policy should direct how materials and merchandise are managed within the firm and set the stage for how efficient and effective customer deliveries should be. A policy that sounds more like a management mandate would likely not be helpful in this regard. Managers need to understand that an inventory policy is not a target or standard but a guide for everyone in the supply chain to do their jobs at the most productive level.
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