Welcome to Business Management
Thursday, March 22, 2007
Inventory - Cash Or Carry
There is an old saying in business that ‘Cash is King’. Inventory, no matter what type, ties up cash and diverts it from other uses. Therefore the aim of inventory management should be to minimize the inventory investment for a particular customer service level. The approach taken should ensure that the target level of service is met while also minimising the cash investment. In turn this will maximize the overall benefit for the company.
To achieve this many companies adopt supply chain techniques for managing their inventory without realising that the effectiveness of these techniques is limited to only a certain type of inventory. That is direct inventory. These companies don’t realise, that for their indirect inventory such as parts and components, finished goods, OEM spares, engineering spares, MRO inventory and industrial supplies, a more complete approach is required. As a result, the opportunity for cash release with this type of inventory is often disproportionately large for the inventory investment.
Some companies take a completely different view, they treat inventory as an expense and this is particularly the case with MRO inventories. You might expect this with companies that don’t carry other types of inventory (such as utilities) but in fact it is the case with many types of companies, even those in manufacturing. For many engineers inventory isn’t a serious business topic; inventory is something that accountants count and storemen store. For the average maintenance engineer the issues are uptime and reliability. Spares don’t improve reliability and they only improve uptime by being available when needed. Hence their issue is availability and not inventory reduction. However, whether they realise this or not, their purchase of MRO inventory is an investment of the company’s cash. It represents a use of cash that may, or may not, be better used in either a capital purchase or elsewhere in the company.
In an environment where downtime is costly, and relatively speaking the cost of individual spares is cheap, it is easy to justify carrying any number of spares. In this case MRO inventory is viewed as insurance. This perspective almost invariably results in the over purchase of MRO inventory and subsequently an over investment in inventory. In this case MRO inventory is the forgotten investment.
If, however, we view MRO inventory as an investment then logically we will manage the inventory differently. Our goal will be to maximise the return on investment. That does not mean risking our operational outcomes but it does mean ensuring that there is no excess or unnecessary inventory investment. It does mean consciously managing the cash investment. The challenge with MRO inventory, as with all inventory, is whether to free the cash or carry the inventory.
Comparison of Investment Measures
So far we have explained that MRO inventory is an investment of the company’s cash and that the ‘insurance’ approach will lead to over investment. What is needed is a way to compare that investment to other investments such as fixed capital. The two most common approaches for comparing different investments are ‘Payback’ and Return on Investment (ROI).
Payback measures how long it takes for the investment to ‘payback’ the original funds invested. So, if we purchase a machine for (say) $1,000,000 and the machine reduces costs in some way by $500,000 per year then the ‘payback’ is 2 years ($1,000,000 / $500,000).
Return on investment (ROI) measures the percentage return that the investment generates per year. So, in the above example, the investment of $1,000,000 returns $500,000 per year, which is 50%.
These types of measures provide a means of comparing different uses of cash and help us to prioritise the use of that cash. For example, if we can achieve a $500,000 return by investing $750,000 (an ROI of 66%) then because of the superior ROI we may redirect our cash into that investment rather than the $1,000,000 investment above.
However, MRO inventory is not quite so easy to evaluate and this is why the investment is so easily over looked. We cannot so easily identify the return on investment with MRO inventory because the benefit of MRO inventory is the prevention of loss through reduced downtime.
We can though, use our understanding of cash management and investment measures to lead us to a better understanding of inventory management and the impact of safely reducing inventory. So, while it is difficult to quantify the benefit of holding inventory we can most definitely quantify the investment and we know that if we can reduce the level of the investment (without impacting our downtime) not only will we increase the ROI but we will also free up cash and improve the company cash flow.
In addition, if we hold too much inventory of an item and that excess adds no value because it is never used, then the ROI is zero. In effect we would be better off putting this money into the bank at zero interest than holding the inventory – at least we would still have the original capital! This excess inventory uses up the cash and can be removed with no risk to the business.
We can also use the investment approach as a means of determining the ROI from applying resources to reducing that inventory. If, for example, we spend $100,000 identifying and taking action to reduce inventory and we achieve a reduction of $1,000,000 then the ‘payback’ on that investment is 1.2 months and the ROI is 1000%. Now wouldn’t we like that return on our other investments! That $100,000 might, from a pure business perspective, be the best investment that a company can make.
To achieve this many companies adopt supply chain techniques for managing their inventory without realising that the effectiveness of these techniques is limited to only a certain type of inventory. That is direct inventory. These companies don’t realise, that for their indirect inventory such as parts and components, finished goods, OEM spares, engineering spares, MRO inventory and industrial supplies, a more complete approach is required. As a result, the opportunity for cash release with this type of inventory is often disproportionately large for the inventory investment.
Some companies take a completely different view, they treat inventory as an expense and this is particularly the case with MRO inventories. You might expect this with companies that don’t carry other types of inventory (such as utilities) but in fact it is the case with many types of companies, even those in manufacturing. For many engineers inventory isn’t a serious business topic; inventory is something that accountants count and storemen store. For the average maintenance engineer the issues are uptime and reliability. Spares don’t improve reliability and they only improve uptime by being available when needed. Hence their issue is availability and not inventory reduction. However, whether they realise this or not, their purchase of MRO inventory is an investment of the company’s cash. It represents a use of cash that may, or may not, be better used in either a capital purchase or elsewhere in the company.
In an environment where downtime is costly, and relatively speaking the cost of individual spares is cheap, it is easy to justify carrying any number of spares. In this case MRO inventory is viewed as insurance. This perspective almost invariably results in the over purchase of MRO inventory and subsequently an over investment in inventory. In this case MRO inventory is the forgotten investment.
If, however, we view MRO inventory as an investment then logically we will manage the inventory differently. Our goal will be to maximise the return on investment. That does not mean risking our operational outcomes but it does mean ensuring that there is no excess or unnecessary inventory investment. It does mean consciously managing the cash investment. The challenge with MRO inventory, as with all inventory, is whether to free the cash or carry the inventory.
Comparison of Investment Measures
So far we have explained that MRO inventory is an investment of the company’s cash and that the ‘insurance’ approach will lead to over investment. What is needed is a way to compare that investment to other investments such as fixed capital. The two most common approaches for comparing different investments are ‘Payback’ and Return on Investment (ROI).
Payback measures how long it takes for the investment to ‘payback’ the original funds invested. So, if we purchase a machine for (say) $1,000,000 and the machine reduces costs in some way by $500,000 per year then the ‘payback’ is 2 years ($1,000,000 / $500,000).
Return on investment (ROI) measures the percentage return that the investment generates per year. So, in the above example, the investment of $1,000,000 returns $500,000 per year, which is 50%.
These types of measures provide a means of comparing different uses of cash and help us to prioritise the use of that cash. For example, if we can achieve a $500,000 return by investing $750,000 (an ROI of 66%) then because of the superior ROI we may redirect our cash into that investment rather than the $1,000,000 investment above.
However, MRO inventory is not quite so easy to evaluate and this is why the investment is so easily over looked. We cannot so easily identify the return on investment with MRO inventory because the benefit of MRO inventory is the prevention of loss through reduced downtime.
We can though, use our understanding of cash management and investment measures to lead us to a better understanding of inventory management and the impact of safely reducing inventory. So, while it is difficult to quantify the benefit of holding inventory we can most definitely quantify the investment and we know that if we can reduce the level of the investment (without impacting our downtime) not only will we increase the ROI but we will also free up cash and improve the company cash flow.
In addition, if we hold too much inventory of an item and that excess adds no value because it is never used, then the ROI is zero. In effect we would be better off putting this money into the bank at zero interest than holding the inventory – at least we would still have the original capital! This excess inventory uses up the cash and can be removed with no risk to the business.
We can also use the investment approach as a means of determining the ROI from applying resources to reducing that inventory. If, for example, we spend $100,000 identifying and taking action to reduce inventory and we achieve a reduction of $1,000,000 then the ‘payback’ on that investment is 1.2 months and the ROI is 1000%. Now wouldn’t we like that return on our other investments! That $100,000 might, from a pure business perspective, be the best investment that a company can make.
# posted by gopi @ 7:37 AM 
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