2005 Articles

Inventory reduction does not always mean better profitability, let alone customer satisfaction.

Don’t let the ghosts of inventory past scare you into reduced profits. Inventories in the late ’90s grew to unsustainably high levels and when the bubble burst few companies came away unscathed. Unfortunately, many have reacted by reducing inventory and commitment levels to unsustainably low levels. While inventory management is critical, tradeoffs are made when squeezing inventory. The most prominent tradeoffs are responsiveness to customer demand and profitability.

Whether your company is an OEM or EMS, you are well aware of delivery pressures. The electronics business is about being fast and flexible. By the time someone sends you a P.O., they need the product yesterday. Failure or inability to deliver an order quickly can be the difference between life or death for a product – and sometimes a company.

Accurate sales forecasts are critical to getting a jump on filling hard orders. Unfortunately, forecasting demand is an inexact science (OK, I’m being generous here). A solid sales department should be able to forecast most annual demand within 25%, with some exceptions. The forecast is critical to how you fill the material pipeline and how quickly you can respond to hard orders. It also determines the size of the company’s required credit lines.

Demand visibility has dropped dramatically for all of us since the inventory bubble burst. Demand windows that used to cover months are now measured in weeks. I believe this is driven in large part by an understandably high level of risk aversion. The problem with this elevated risk aversion is that it not only leads to missed opportunities, it also reduces the profitability of every order.

In the past several years we have seen average order sizes reduced drastically. However, for many parts, annual usage has stayed almost the same. This change in buying behavior has pushed up the unit costs by reducing the build quantities. To illustrate this point, let’s look at a real world example.

This specific example regards bare PCBs but could be anything from plastics to cables to sheet metal. An EMS company has been buying a specific PCB from us for several years at an annual use of about 2,500 pieces. Once a year, the EMS company receives a forecast from their OEM customer. Before the inventory crash, the EMS company was allowed to buy based upon the forecast, and was allowed to commit to 100% of the forecast. The cost savings of building higher quantities far outweighed the costs of carrying inventory, so they typically ordered 2,500 pieces to be built in one run. They then released from inventory per their assembly demand.

The EMS company now buys the same amount of boards but has reduced the commit quantity to about 625 pieces per build. When they started doing this, they said that their customer demanded that they reduce their inventory risk. We explained the piece cost of a 625-piece build is $8.13 and at 2,500 pieces the cost is $4.65. The reply was that they would rather pay more per piece and reduce the inventory than pay less per piece but risk taking an inventory hit. Over the course of the next year, they again used about 2,500 pieces. This reduced their profitability by $8,700!

What if they missed their number by 25% because the product died or was re-engineered? They could have scrapped 625 pieces and still come out ahead by $1,548.

At the same time that they were reducing their profitability, they also reduced their flexibility. With a standard lead-time of three weeks, they were no longer able to fill demand spikes as in the past, and this led to some unhappiness on the part of their customers.

The point here is that what is good for inventory reduction is not necessarily good for profitability or customer satisfaction. There is a happy medium between the dangerously high levels of several years ago and the risk-averse low levels of today. To find that happy medium requires a knowledgeable and disciplined sales force, a high level of communication between customers and suppliers, and a basic understanding of simple mathematics.

The bottom line: It is possible to increase profitability by increasing inventory levels, and you can make customers happier in the process.

David Wolff is president of P.D. Circuits (pdcircuits.com); dwolff@pdcircuits.com.

• Prev
• Next