Variation and Inventory

["John McConnell" <wysowl@msn.com.au>]

SOME NOTES ON VARIATION AND MANUFACTURING INVENTORY

A good approach to setting inventory levels that hails from operations
management is:

Inventory Target = Ave demand + 3?Sales + 3?Manufacturing Variance (+
perhaps some safety buffer).

Manufacturing Variance is defined as the difference between what we tried to
make and what we actually made.  The formula gives an inventory target that
all but guarantees customer service, but which holds inventory at as low as
possible a level without compromising that service.

What the formula shows is that inventory is a function of variation.  If
variation in sales or manufacturing variance is reduced, Inventories can
also be reduced for a given customer service level.

If there were no variation, there would be no need for inventory, provided
short lead times were not a problem.  In fact, the only reasons for holding
inventory are to absorb variation, to provide product to lead times shorter
than normal manufacturing cycle times and to provide a buffer against
strikes and significant plant failures.

In practice, most companies aim for 95% (or thereabouts) of this inventory
target.  Generally, the cost of holding the last 5% is indeed significant.

ANOTHER APPROACH
Another approach is to make to order, say on a daily basis.  In this case,
only the manufacturing variance need be considered.  However, one needs to
have a manufacturing process that can be turned on and off like a tap,
without taking a hit in costs, and which have cycle times much shorter than
desired sales lead times.  Only a few processes can behave in such a manner
without creating significant cost increases.  Usually, the processes that
make to order in this way are assemblers rather than manufacturers.

COST OF INVENTORY
Essentially, there are three ways to cost inventories of finished goods:
1.	Selling Price
2.	Cost Price (sometimes fully absorbed, sometimes not)
3.	Variable costs only.  (Essentially the cost of raw material, the energy
costs to convert this into product and perhaps some wear and tear costs.)
This is the additional cost over and above that which would have been
incurred if the inventory had not been made.

I prefer the latter approach.  For example, if I look at a balance sheet for
last month and then rework the sheet to show what it would have looked like
if half the current inventory had not been made, the difference between
these balance sheets is the actual cost of that inventory to me.  In the
short term, labor is a fixed cost.  By my reckoning,  fixed costs must be
paid for whether or not the inventory is created, and that to include them
in inventory carrying costs may be applicable in some reporting situations,
but not for month to month management of a manufacturer.  Matters are
somewhat different if I am an assembler or a distribution outfit.  There is
no “right way”.  We must think things through for each application.

Remember the 15th Point!

John McConnell
Wysowl Pty Ltd
Ph: intl+61 7 3882 1822
Fax: intl+61 7 3882 1800