In his immensely interesting book Basic Economics, storyteller, humorist, photographer, libertarian economist, and Hoover Institution Fellow Thomas Sowell makes an interesting and succinct observation about inventory: Inventory is a substitute for knowledge.
There are many misconceptions about Lean (and mass production, too) that can be cleared up by giving some serious thought to the meaning of this assertion.
As a general rule, the knowledge that is most important to maintaining proper levels of inventory is knowledge of the rate of customer demand — how much stuff your customers will buy or consume in a given time.
Knowing the rate of customer demand allows us to keep enough inventory on hand to meet peak demands, with but a small margin remaining to allow for our lack of complete knowledge about the rate of customer demand.
Too often inventory is set by a manager deciding he or she, for whatever reason, wants inventory at a certain level, this despite conventional business thinking that we should minimize inventory because it reduces capital requirements for the business. In plain language, capital translates to money. Reduced inventory means less money tied up in setting up and running the business.
Think about it like this: Suppose you go into a Home Depot store, but instead of all that stuff sitting on shelves waiting for you to buy, they have stacks of cash sitting on the shelf, each stack of cash representing the price Home Depot paid for each item.
Where the tape measures go, a stack of cash.
Where a gallon of paint goes, a stack of cash.
Where a toaster oven goes, a stack of cash.
Where a 2×4 goes, a stack of cash.
You’d probably think to yourself, “Man, they have a lot of cash lying around here. I don’t think I’d want that much cash lying around.”
In short, you’d wonder if they have too much inventory.
And they almost certainly do. In my experience most businesses maintain far too much inventory on many items most of the time. Reducing inventory to appropriate levels is where understanding the rate of customer demand comes into play.
By definition, the rate of customer demand involves a rate, a consideration of time. It’s crucial to understand the time factors that affect your inventory level — not just how quickly customers buy stuff, but how quickly and reliably you can get new stuff from your suppliers. Let me give an example.
I worked at a place that used about two or three cases of a particular box each week. Deliveries of new stock were reliably delivered twice a week, on Tuesday and Friday, so at a basic level we needed to keep a case or two of these boxes on hand, but certainly not much more than that.
Allowing for the possibility of a snowstorm or forest fire preventing a supply truck getting through (and, likewise, to some degree, preventing our customers from getting through), we might plan to have three or four cases on hand when the truck leaves.
Instead, we often had eight or ten cases.
This makes no sense. When you get deliveries twice a week, keeping enough stock on hand that you could go four or five weeks without resupply is simply foolish. I’ve never seen a business that had enough money lying around unused that the best use of that money was to buy stuff it didn’t need and put it on a shelf somewhere. Yet business people do this all the time because they lack any significant knowledge of the rate of customer demand for their products, and they ignore the ability of suppliers to quickly replenish supplies.
Financial experts will tell you that unused inventory is bad because it ties up capital. And that’s true. Excessive inventory requires greater cash infusion to the company than would otherwise be necessary. That cash infusion means that investment has been increased so, with the same earnings, the return on investment (ROI) is necessarily lower.
A few excess cases of boxes won’t make a noticeable difference on ROI but, cumulatively, many instances of excess cases of boxes certainly can, and that can start to put the business and jobs at risk.
But there is another, often hidden, factor associated with excess inventory that is very costly and, in many cases, affects ROI more than the excess inventory itself: the labor costs of handling excess inventory. Let me give an example.
I once worked at a place where we simply maintained too much inventory. Much of this inventory had expiration dates, so we had to practice a FIFO (First In, First Out) inventory system (though it’s a good idea anyway).
Because we were short of room, we often had to pull existing product off the back of the shelves, replace it with newly arrived product, then put the existing product either back on the front of the shelves, or in another holding area where it was more ready for use. This represented a great deal of unnecessary and complex (and, therefore, time consuming) labor.
By reducing inventory levels to more closely match the rate of customer demand (with some excess inventory to allow for our incomplete knowledge of that rate) we cut our inventory management labor in half, saving eight hours per week. This was worth a relatively modest amount — about $80 per week, or around $4,000 per year. Some days, when the truck was late, we could put the inventory away as the driver unloaded it, cutting labor significantly more, by perhaps 80%. This would have been impossible with the old, higher levels of inventory.
The additional inventory that we eliminated was worth perhaps $800. Spending $4,000 per year to maintain $800 in excess inventory makes no sense at all. Put another way, the return on eliminating that excess inventory was probably between $80 and $120, a mere rounding error on the labor savings. The labor savings played a far larger role in improving the bottom line (and, therefore, ROI) than did reducing the capital requirements.
There are many variables that affect whether the benefits of inventory reduction are derived mainly from reduced labor costs or from reduced direct inventory costs. However, it doesn’t really matter which predominates. Both have an effect.
That double effect is common in Lean improvements, and provides just that much greater incentive to gain knowledge about the rate of customer demand, and to stop randomly substituting inventory for our lack of knowledge.