The Trouble with Excess Inventory – a Quick Primer
Is excess inventory the root of all evil? In this article, Melissa Connolly explains how excess inventory weakens a business’ competitiveness by increasing operating cost and decreasing margin.
Editor’s note: this article elaborates on some of the concepts expressed in Melissa Connolly’s case study – Using Six Sigma to Reduce Excess Inventory – published earlier this year.
Why Excess Inventory Is "Root of All Evil"
Excess inventory is any supply in excess of demand. Supply consists of raw material, purchased components, WIP, and finished goods. Demand is defined as a requirement for the next step in a manufacturing process or a finished good to fulfill a customer order (Imants BVBA, 2008). Because supply and demand change on a regular basis, most businesses determine excess inventory by comparing the amount of supply to demand for a bounded period of time.
Using the above definition, excess inventory can be further broken down into three categories: live (raw), sleeping (WIP), and dead (obsolete). Live inventory is actively being utilized in the manufacturing process. Sleeping inventory is waiting to be worked on. This wait is typically due to missing requirements or capacity conflicts. Dead inventory is obsolete inventory due to demand changes (order cancellations, reduction in quantity, etc.) or engineering design changes (Excess, n.d.). Dead inventory is the least desirable type of excess inventory because there is no realistic expectation it can ever be consumed by future demand.
The Criticality of Excess Inventory
A state of zero excess inventory is not realistic for most manufacturing operations. However, as a rule of thumb, any excess above one percent of annual sales is considered troublesome (GXS, Inc., 2009). W.W. Grainger Inc., a Maintenance, Repair, and Operating (MRO) business provides insight to why a business would consider inventory levels a business critical metric. Based in Lake Forest, Illinois, Grainger has gained attention for increased supply chain performance. This performance is credited to the business’ internal metric system. One of Grainger’s five KPI metrics is quantification of excess inventory. Grainger’s V.P. of logistics, Rick Adams, explained that inventory is considered a big company asset. As such the inventory metric is closely monitored as a vital measure on Grainger’s return on invested capital (Cooke, 2001).
Grainger’s principle regarding inventory is tied to the concept that once a business builds up inventory, there is a limited amount of time to utilize and sell the inventory for maximum profit. After this optimal time passes, the dollar value of the inventory is reduced and capital returns are not maximized. Furthermore, carrying large amounts of inventory prevents a business from being able to quickly respond to changes in the marketplace without absorbing costs. Excess inventory reaches beyond capital issues and also negatively impacts services and operations. Extra inventory complicates warehouse layouts and can require much larger distribution facilities than are actually needed. These larger facilities and poor layouts increase the time employees require to pull inventory. Increased pull times lowers service levels, responsiveness to customer orders, which in turn have a long-term negative impact on a business (iEntry Network, 2010).
Toyota had an even harsher view on inventory, considering all inventories as evil. This seemingly drastic position is based on the premises that there is a direct relationship between financial health and inventory levels. Inventory cost money to purchase and "carry." Carrying cost included transportation, receiving, stocking, storing, insuring, and monitoring. Total carrying costs averaged 15% to 30% of the inventory value. For an average manufacturing business, total inventory cost could account for up to one half of total assets (Excess, n.d.). Inventory costs also decreased working capital interest; impaired employee productivity; and increased material obsolescence (dead inventory) (Imants BVBA, 2008). Consequentially, excess inventory weakens a business’ competitiveness by increasing operating cost and decreasing margin. All of these reasons are why inventory, especially excess inventory, is often considered evil.
Cooke, J. A. (2001). Can measurements help your company improve distribution? Retrieved from http://www.scvisions.com/articles/metric2.pdf.
GXS, Inc. (2009). Reducing supply chain waste with demand driven strategies. (n.d.). Retrieved from http://www.greensupplychain.com/case-reducing_supply_waste.html.
iEntry Network. (2010). Are you inventory rich and cash poor? Retrieved from http://www.webpronews.com/expertarticles/2006/12/20/are-you-inventory-rich-and-cash-poor.
Imants BVBA. (2008). Manufacturing, Chain and Maintenance Management Newsletter: Excess Inventory. Retrieved from http://www.managementsupport.com/nl/7excess_inventory.htm