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| Consultant's Corner |
by
Scott A. Holter, CPIM |
| The Great Recession of 2008-09 has presented the greatest challenge to manufacturers and their supply chain management professionals in several decades. Very few manufacturers have escaped the recession’s demand destruction with many experiencing volume reductions in the range of 20-50%. |
| Companies with agile and lean supply chain processes have been able to respond to the drop in volume quickly and avoid an unnecessary build up of inventory. Others, despite the use of technology and lean manufacturing techniques, kept the production, outbound, and inbound supply pipelines flowing at pre-recession rates and are now being forced to work off excess raw material, work-in-process, and finished goods inventory. |
| M&M Business Solutions has been working with a range of companies during this period, and we’ve identified three (3) key practices that, if in place, enabled companies to quickly reduce their supply rates and inventories while others built up costly, excess inventory. |
| 1. Future-Looking Demand Forecasting Process with Management Approval |
| Many of our client manufacturers produce semi-finished or finished goods to stock. Even job shops that manufacture products to order procure some components or raw materials to stock, and some of these companies maintain a safety stock of semi-finished or finished goods. In fact, M&M Business Solutions’ research shows that most manufacturers procure or produce some products in advance of real order demand for them. |
| We have observed that most companies utilize sales history as the basis for calculating expected demand and target inventory levels, whether in the form of sales forecasts for Material Requirements Planning (MRP), Reorder Point or Min/Max levels, or the number of kanbans in a demand-pull system. Absent any other data, this is a reasonable practice but it relies on the assumption that the future will resemble the past. The sharp drop in demand in 2008-09 caused history-based forecasts and target inventory levels to be overstated by 20-50% and, thus, resulted in the production and procurement of excess inventory. |
| Companies that avoided this inventory utilize a forward-looking demand forecasting process. In these companies, sales history serves as a basis for proposing an initial product or product line sales forecast, but a best-practice forecasting process must include a Marketing, Sales, and/or Executive Management review and adjustment of the proposed forecasts. |
| In practice, our clients have not found it to be practical to expect a Marketing, Sales, or General Executive review and adjust each item’s sales history and forecast proposed by a software system. To make this practice practical, we recommend that companies apply across-the-board expected percentage increases or decreases to groups of related products. In practice, this simple approach enables executives to influence up or down the demands that the supply chain planning team work with in a systematic way. |
| 2. Regular Assessment of Planning Parameters (such as Safety Stocks, Reorder Points, and Number of Kanbans) |
| Safety Stock levels are set and fixed for each product in a forecast-driven, MRP-based or Reorder Point supply chain planning system to protect against stock-outs given variability and uncertainty in demand and lead times. In practice, M&M Business Solutions has found that many of its clients apply a “weeks’ supply” formula to establish Safety Stock. In a period of demand destruction, a previously set, fixed Safety Stock quantity actually represents many more weeks’ supply than intended, and 2008-09, fixed safety stocks resulted in excess inventory. |
| One best-practice model for Safety Stock management includes a monthly recalculation of Safety Stocks based on changes in demand. An even better model uses the approved, forward-looking forecast with past forecast accuracy factors to compute appropriate, go-forward Safety Stock quantities. The Great Recession has shown old assumptions used to compute Safety Stock levels can generate excess inventory in a hurry and that the “set it and forget it” approach is a dangerous way to manage inventory assets. |
| The forecasting practice described earlier has always been a best practice in the classic, traditional use of forecast-driven Material Requirements Planning (MRP) model, but is not limited to that application. For example, one client that was utilizing the simpler Reorder Point (or Min/Max) method benefitted just as much. |
| We showed this client that the Reorder Point for a product is, in essence, nothing but a fixed forecast. The Reorder Point is set at the Demand During Lead Time (DDLT) plus a Safety Stock factor. In this client’s case, we identified that the DDLT component of the Reorder Point was determined using overly optimistic sales history data as future demand and that by revising those factors down to reflect the current economy, the Reorder Points and corresponding inventory were quickly reduced by about 10%. |
| And, the demand component of DDLT wasn’t the only factor needing reduction. Faced with lower production volumes, we found that this client actually could produce products in much shorter lead times, and we found that its suppliers could also deliver in shorter lead times. By reducing the assumed lead times to match the new reality, we were able to help the client reduce inventory another 10%. |
| Companies employing kanbans, or pull signals, in a lean or flow environment can also benefit from a forward-looking and executive-adjusted forecast. In practice, manufacturers use a variety of formulas to calculate the optimum number of kanbans in a pull-based replenishment system, but all of the different formulas consider demand as an essential factor. By using a set of management-approved forecasts, a more appropriate number of kanbans in the system for the recessionary conditions can be computed and established. |
| 3. Regular Assessment of Make and Buy Quantities (such as Economic Order Quantities and Kanban Sizes) |
| Four factors influence the determination of an optimal manufacturing or procurement lot/batch sizes: demand, setup/order cost, unit cost, and inventory holding cost. Heading into the Great Recession, M&M Business Solutions found that many companies applied the same “set it and forget it” approach to lot/batch size parameters as demand and lead times for manufacturing and procurement. As a result, production and procurement lot sizes were out of sync with the new reality. |
| Among the clients we examined, we found several consistent trends that, if corrected, the companies could have avoided an inventory build-up going into the Great Recession. |
| First, the demand factors used in determining lot sizes were virtually all too high, by 20-40%, and a reduction to a realistic level enabled the companies to reduce production and procurement lot sizes by a commensurate amount. |
| Second, the setup costs (for manufactured products) occasionally did not take into account the results of their lean setup reduction efforts. In one client’s case, setup times had been reduced by 1/3, but the EOQs were still being determined using old, pre-lean setup times. |
| Third, and perhaps most importantly, many companies have experienced wide swings in unit costs in the past 18 months. Commodity prices spiked in mid-2008, then fell in late 2008, and have since started to recover. These dramatic commodity prices changes need to be included in the EOQ calculations for both raw material and production lot sizes, but we found that many companies were slow to adjust lot sizes in response to cost changes. |
| The fourth component of lot size determination is inventory carrying cost, and a key element of this factor is financing cost. During the credit crunch of the last year, it has become more difficult and expensive to finance inventory. In response, companies should have raised the inventory carrying cost factor in its lot size calculations to as high as 40%. |
| Conclusion |
| Some economists refer to the Great Recession of 2008-09 as a once-in-a-century, “Black Swan” event. Whether true or not, it has revealed vast differences in the abilities of companies’ supply chains to quickly respond to drops in demand. Without correcting the underlying processes and management parameters, these companies probably continue to produce and procure excess inventory during this period of reduced demand. |
| Worse yet, without a responsive supply chain planning system that’s sensitive to demand changes, these companies will most likely respond too late to an upturn in volume when the economy begins to recover. The result will be material shortages, work load in excess of capacity, excessive overtime costs, and backorders and lost sales. |
| M&M Business Solutions has APICS-certified supply chain and manufacturing management experts that have helped dozens of clients implement better planning and control practices and systems. If you would like additional information or an assessment of your supply chain planning process, please contact Lori Burt or Scott Holter at 216-241-3272. |
| About the Author |
| Scott has spent more than 22 years in manufacturing and materials management as well as management and systems consulting. His 12 years of pre-consulting industry experience includes a Fortune 50 conglomerate, a Fortune 500 global chemical manufacturer, a $30MM division of Berkshire Hathaway, and small, privately-held manufacturer. These companies cross the defense electronics, precision machining, chemicals, compressed gas, medical device, lighting, and consumer goods manufacturing industries.
In 1999, Scott entered the field of management consulting, principally offering his manufacturing and materials management knowledge to clients seeking to optimize their supply chain and manufacturing processes. Frequently, this work has entailed extensive involvement with their Enterprise Resource Planning software infrastructure, from evaluation to package selection to implementation. Just as common, however, this work has involved the development and deployment of best practices and procedures in demand management, production planning, inventory management, and procurement.
Scott’s consulting experiences include over eighty clients. All but five are considered Small Manufacturing Enterprises (SMEs) under $250MM in annual revenue, and these companies cover a wide array of industries, including: aerospace; automotive, truck, and bus; capital equipment; chemicals and coatings; consumer packaged goods; forging; furniture; instrumentation; medical devices; metal fabrication and machining; plastic and rubber molding; electronics; printing and bookbinding, and others.
With an undergraduate degree in Industrial Engineering, an MBA, APICS Certification, and enough accounting credits to sit for the CPA exam in Ohio, Scott brings a unique blend of academic credentials to his clients. Scott has been teaching APICS Certification and College-Level Operations Management principles since 1996. |
M&M Business Solutions |
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