Best Practices for Inventory Reduction

A survey of best practices for inventory reduction is conducted annually by the Inventory Reduction Report, a subscription newsletter for "Improving Logistics and Supply Chain Management." According to the inventory managers responding to the 2001 survey, their top inventory reduction practice for the eighth consecutive year is the periodic review. Over 65% cited "periodic reviews to determine ways to reduce inventory" as one of their top five practices. The survey went on to rank the twenty most favored practices. All of the following top-ten practices were employed by at least 20% of the respondents.

One major conclusion of the survey is that inventory managers are using an increasing number of analytical approaches for reducing inventories. These include reviewing usage, safety stocks, lot sizes and order quantities more frequently, and using ABC classifications to manage their inventory levels and investments more effectively. Their comments also confirm that it often takes more than one practice to achieve and maintain inventory reductions.

MRP, DRP and ERP systems generally do a good job of planning requirements and getting inventories on the shelf. But they don't do a very good job of helping us deal effectively with the excess, slow moving and obsolete inventories that accumulate over time. The proliferation of various practices for inventory reduction is a clear sign that we should be doing more to monitor inventory performance, to avoid the build up of these inventories in the first place, and to fine tune our MRP systems to keep them current and effective.

The Inventory Quality Ratio

Seven of the top-ten best practices being used by inventory managers today are incorporated in one comprehensive inventory management technique. The Inventory Quality Ratio (IQR) is a simple, straightforward way of measuring inventory performance, managing inventory dollars and identifying inventory reduction opportunities. The IQR logic was developed collectively by the materials managers of 35 companies. It was used by them to reduce inventories a total of $500 million (25% average reduction) while improving on-time deliveries. It has since been used by planners and buyers in manufacturing and distribution companies worldwide to reduce inventories 20% to 40%.

Using the data from any existing MRP system, the IQR logic first divides inventory into three groups: items with future requirements, items with no future requirements but with recent past usage, and items with neither. The items in these groups are then stratified into typical ABC-type classifications based on their future dollar requirements, their past dollar usage, or their current dollar balances, respectively. A target inventory level expressed in days' supply is set for each item based on its classification. The balance on hand of each item is compared to the target, and the dollars of each item are categorized as either Active, Excess, Slow Moving or Obsolete. These are called the inventory quality categories. The Inventory Quality Ratio is the ratio of the active inventory dollars to total inventory dollars. In a theoretically perfect situation (i.e., with no excess, slow moving or obsolete inventories) the IQR would be 100%.

IQR incorporates the best practices of periodic reviews and ABC analysis with forward-looking days' supply and user-defined parameters. It provides inventory managers with a dynamic methodology to review and reassess lead times, safety stocks, order quantities and replenishment cycles on a weekly or monthly basis. IQR also enhances existing MRP systems by adding a dollar focus to prioritize current reduction opportunities.

Reducing Excess Inventories

The figure below is an example of how the IQR methodology identifies the segments of inventory with the greatest reduction potential. The dollars are divided into the following quality categories: Active, Excess, Slow Moving and Obsolete. The IQR% is Active inventory dollars divided by Total inventory dollars. This example shows inventory dollars for make parts and buy parts. Other IQR breakouts show these inventory dollars by product line, stock type, planner, vendor, commodity, account number, ABC class, order policy code, storeroom and plant location.

Most manufacturing companies have an IQR of about 40%, meaning that 60% of their inventory dollars are non-active. Approximately 50% of their inventories are Excess and 10% are Slow Moving or Obsolete. As indicated above, Excess inventories offer not only the largest but also the best opportunities to reduce inventories. This is because deferring incoming purchases until the Excess inventory is consumed not only increases inventory turns but also improves cash flow and avoids future write-offs.

Planners and inventory managers can drill down on any cell to see all of the items that make up those inventory dollars. They can also drill down on any item to see all of the detailed information for a given part number, including past usage, future requirements, days' supply, open orders, safety stocks, lead times, and the order policy codes that are driving the MRP system.

Keeping MRP Current

All MRP systems contain order policies and quantities that should be reviewed and revised and conditions change. Many of the best practices noted earlier involve ad hoc analyses of the various order parameters coded in our MRP systems. These include safety stock, lead time, order quantity, lot sizes, past usage and replenishment cycles. Rather than conducting separate analyses of these parameters, the IQR logic combines them in a simple exercise that actually calculates the potential for inventory reduction. Planners and buyers can use this information to set realistic inventory reduction objectives for different segments of their inventory. Once the appropriate material ordering guidelines have been determined for each segment and/or class of inventory, they can be uploaded to bring the MRP order policy codes and quantities in line with the desired inventory levels. This will fine tune MRP and allow it to generate replenishment orders that are consistent with the overall inventory objectives.

Using Continuous Improvement

Although the "periodic review" is a favored practice, continuous reviews and exception reporting are much more timely and effective in managing inventories. Until recently the limiting factor has been the time required to monitor and evaluate inventory performance.

We all know that inventory reduction is a two-step process - getting the inventories down and then keeping them down. Done properly, the second step never ends. The IQR methodology combines best practices in a continuous improvement process to address inventory reduction in several ways. First, to reduce excess inventories, avoid shortages and improve cash flow. Second, to clean house of slow moving and obsolete inventories. And third, to routinely evaluate and revise the MRP ordering rules so they remain in synch with current demand and consistent with company inventory policies.

Consultants use the IQR logic as a diagnostic tool to assess inventory performance and identify opportunities for improvement. Its wider use, however, is as a continuous improvement program for inventory reduction. One world-class company was already turning inventories 30 times when it started using IQR. Within six months they increased to 40 turns and later to 42 turns. Whatever a company's current inventory performance may be, there are improvements that can be made by focusing on the dollars.

Companies in a variety of manufacturing and distribution environments have implemented the IQR methodology as their own best practice for inventory reduction. Perhaps one of the greatest benefits of the IQR logic is showing planners and inventory managers exactly where they can have the biggest impact on inventory performance and company profits.

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Gary Gossard is President of IQR International.
He can be reached at 949-487-5400 or www.iqr.com. Gary Gossard, IQR International