Inventory is evil: the real cost of inventory ownership
Over the next few issues, AFDEC Chairman Adam Fletcher provides an overview of the inventory management methods and business models used by electronic component manufacturers and their franchised distributors.
Franchised distribution is a customer service business: franchised distributors must provide the goods and services their customers need at the right price, in the right quantity, to the right quality standard, at the right time and in the right place.
Franchised distributors only really have two assets: inventory and people.
Inventory is only an asset when it is 'turning and earning', the moment this stops inventory becomes a liability. As a result franchised distributors continue to invest heavily in inventory management software, automated systems, skilled people and processes in order to effectively manage this asset. Of equal importance is the warehouse environment and personnel responsible for the inventory QA inspection, location, retrieval, modification, packaging and dispatch.
Cost factors
Many distributors fail to fully understand the true cost of inventory holding to their organisations. Their assumption is that it is a simple calculation of inventory value and the cost of borrowing money. Whilst this is in part correct, it doesn't account for the warehouse facility, taxes, insurance, obsolescence/shrinkage and material handling factors that add significantly to the overall cost. This is all the more surprising, given that the operation of franchised distributors is relatively easy to financially model compared to that of a manufacturing organisation.
For franchised distributors the large proportion of activity (cost) is based around the management of inventory, making it possible to reasonably quickly and accurately determine the real cost of holding inventory.
Counting the cost
Let's examine each cost factor and determine a theoretical cost of ownership model for a UK based franchised distributor, 'ABC Distribution', see table.
This quick calculation shows that the cost of inventory ownership for ABC Distribution is 31% or £0.31 for every £1.00 of inventory over a 12-month period. In fact this is at the low end of the cost of ownership range, which is typically between 30% and 50%.
The increased use of 'lean manufacturing' programs by original equipment manufacturers (oems) and contract electronic manufacturers (cems) over the last twenty years has effectively pushed electronic component inventory back down the supply chain. This has resulted in cost saving benefits for the oems and cems who have been able to reduce their raw material inventory accordingly. In turn, many electronic component manufacturers have concluded that a direct engagement with these oems and cems, with their constant manipulation of a weekly material requirement, is much better served via their franchised distributor.
Swings and roundabouts
Whilst this has resulted in additional business for many franchised distributors, they now also have the responsibility of meeting their customers' production requirements with a 100% service level from their inventory. Oems and cems have significantly improved their manufacturing cycle times over the last ten years, reducing both their work in progress and finished good inventory, but they've struggled to accurately forecast their end-customer demand and therefore their manufacturing demand. This inability to forecast end-customer demand has led to significant oscillation in their material requirements with franchised distributors having to manage both large upside and downside demands.
For a franchised distributor, making the correct analysis of electronic component demand across their customer base (in close cooperation with the component manufacturer) is essential if favourable 'inventory turns' are to be achieved. If they get the analysis wrong, a lot of expensive inventory remains in their warehouse facility with the high cost of ownership described above and the capital invested in the wrong inventory mix may have an 'opportunity cost' if other sales opportunities have been missed.
This is cost penalty is compounded when additional investment has to be made in inventory in a bid to recover the situation, and if the 'slow turning inventory' has to be disposed of.
All parties in the supply network are attempting to optimise both their physical inventory and their inventory management procedures. Inventory reduction is a major contributor to improved financial performance, hence my title for this series of articles: 'Inventory is evil'.
