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CHAPTER 2

MODELS OF INVENTORY

Different types of inventory holdings require different types of management strategies. Each strategy gives us a management model. Part of the problem is that inventory is held for different reasons. Each inventory “makes” money for the company in a different way and should follow rules unique to that way. For example, people often have trouble seeing the distinction between traditional retail inventory and maintenance inventory.

There are four types of inventory, which includes distinguishing between finished goods and retail inventory. They are raw material, work in process, finished goods, and retail and resale. Each type is subject to different types of analysis. Sears and Roebuck (now simply Sears) was one of the first organizations to seriously study inventories. They were pioneers in making the management of a retail inventory a scientific endeavor.

Now after years of case studies and dissertations, we can observe that all four inventories are pretty well understood and well-studied in business schools. Table 2-1 on the following page summarizes these four types.

Each of these inventories has specific rules, KPIs (key performance indicators), other metrics, and challenges. The one thing in common is that apparently all these measures are directly related to sales. Profit flows from adding value.

Raw Material and Work in Process

Inventories for raw materials and work-in-process were not well studied until the 1970s. It took Toyota’s success and its revolutionary approach to manufacturing and inventory (TPS or Toyota Production System) to generate interest in raw materials and work-in-process inventories.

Table 2-1: Types of Inventory

Type of Inventory	What Is It?	How to Manage or Analyze
Raw Material	To be used to produce something (e.g., wood stocked for a furniture maker).	Delivered as needed, when needed, quantities needed. Tie vendor to production line MPR system.
Work in Process (WIP)	Similar to raw material, but some value has been added.	JIT (just in time) and daily or hourly delivery to next process, deliver to machine, no stock, and no buffer. Pull systems order parts.
Finished Goods	Completed products in warehouse.	Similar to retail inventory, but other issues such as build up for seasonal sales (e.g., candy canes), buffering supply disruptions (e.g., build up before strikes).
Retail and Resale	To be bought by customers (e.g., retail stores) or by dealers (e.g., distributors) from brick and motor stores or virtually from automated warehouses.	Turnover, sales per square foot; new: rack jobbing, consignment, cross docking (product never touches the ground). Logistics vendors cropping up (e.g., FedEx part bank).

Manufacturing has fundamentally and dramatically changed from the spread of TPS over the last 40 years. In the companies that survived, manufacturing is now a finely tuned, lean process taking raw materials and turning them into finished goods. Global manufacturers have moved from batch processing of parts to JIT (Just-in-Time) manufacturing, as prescribed by TPS. This evolution means it is now economical to produce smaller batch sizes.

For example, before JIT, motorcycle maker Harley-Davidson needed 17 weeks to turn a bar of steel into transmission gears, build the transmission, assemble the bike, and ship it out. When JIT was introduced, the time was reduced to 1 week. Batch sizes (size of the run for a single SKU) were reduced from thousands to what was needed for just one or two shifts (dozens or hundreds at the most). Lower batch sizes encourage lower economical order quantities from the OEM parts business.

Automobile manufacturer Henry Ford had a massive, although somewhat primitive Just-in-Time manufacturing system running at the River Rouge facility outside Detroit. He coordinated the delivery of rail cars of raw materials such as iron ore, coal, and sand, converting them into cars in one continuous process.

The Kingsford Company was formed by Henry Ford and E.G. Kingsford during the early 1920s. Charcoal was developed from Ford Motor Company’s factory waste wood scrap. Ford, who had a large plant in the Upper Peninsula of Michigan, was always looking for new ways to combine resources. One day as the Model T cars were coming off the assembly line, he noticed many wood scraps being discarded. He directed that all wood scraps were to be sent to his chemical building to be made into charcoal.

RETAIL AND RESALE INVENTORY MODEL (FINISHED GOODS, TOO)

In a retail inventory (stock items to sell), profit comes from the margin between the purchase price and the sales price, minus the costs of sales and stocking. Effectiveness is measured by how quickly the inventory turns over; sales/profits per square foot; and an absolute minimum of goods damaged, stolen, made obsolete, or otherwise left over and not sold.

The company repurposedMaterials serves as the marketplace between sellers (who have retired, decommissioned, and scrap products and materials) and buyers (who are looking for materials that they can convert, or repurpose, into other uses.) The company’s web site is http://www.repurposedmaterialsinc.com and we will look at them again when discussing the purchase of excess inventory.

In their company newsletter, Larry Kirchner writes about repurposing during the early days of Ford Motor Company:

More fun Ford facts: When Ford Motor Company ordered heavy items like transmissions and axles, they specified wood boxes be used for shipping. They further specified that each board of each box be prepared by drilling holes that were unnecessary for shipping the object. When the transmissions were delivered to Ford, the crates would be disassembled, and, due to the pre-drilled holes, the boards were immediately usable as floorboards in the automobiles (Figure 2-1).

Clearly without inventory on the shelf there is nothing to sell. So the goal is usually not to push the inventory to zero, but rather to have enough stock so that every customer that wants an item can get it, with no additional goods in stock.

FINISHED GOODS

One fairly recent change in the inventory of finished goods is the development of built-to-order products. Look at the Amazon print-on-demand (POD) model where you order a book, after which it is produced, packaged, and shipped (and makes Amazon a profit). This process allows Amazon to store millions of books virtually, making one at a time, and making money on that. The key is that there is no cost for storing the inventory. The only revenue to be made comes from getting the product in the customer’s hands in a reasonable time.

Figure 2-1: Converting shipping crates into floorboards

In the convenience store business, sandwiches have traditionally been delivered or made in the morning in anticipation for the day’s demand. As a result, there is sometimes waste from sandwiches left over in the evening and lost revenue from stock outs of sandwiches that are particularly popular. Wawa, an East Coast chain, pioneered a completely automated POS (Point of Sale) system. It allows customers to design their own sandwiches. A small crew behind the counter makes each custom sandwich in about the same time it takes the customer to pay.

The Exception that Caused a Breakthrough

The exception to ownership of the inventory is the proliferation of rack jobbing models invented by the milk, bread, soft drink, and snack companies, where the inventory is owned by the manufacturer until it is sold by the distributor.

Now retailers like Walmart own virtually none of the inventory in their stores. Although this model changes the magnitude of some key performance indicators (KPI), it does not change the measures needed for efficiency and profit. You still have to turn over stock and attain certain sales per square foot to succeed and thrive.

The metric of interest to the parts user is service level. In this usage, service level is the probability the SKU ordered is in stock and available for shipment to the customer. Service level is both an input to the stocking system and a measure of the stocking system’s effectiveness. In these retail inventories, the service level is a parameter that is used to determine the quantity on hand.

ORPHAN INVENTORY: COMPANIES WITH PHYSICAL ASSETS THAT WEAR OUT

Maintenance inventory is different from the other types and requires different tools for analysis. For example, you might stock a $25 part for years to avoid a $1,000,000 downtime incident. The part is orphan because there’s no immediate or pending demand for it. However, the maintenance inventory of spare parts makes it possible for the maintenance function to do its job, which includes enabling the company’s capacity (Table 2-2). But there is no outside reason or driver to have the parts.

Table 2-2: Orphan Inventory

Orphan’s Name	What Is It?	How to Manage or Analyze
Maintenance	Used to provide the capacity of an asset (not sold or converted). Generally not a consumable like ink or labels.	Downtime due to spare parts, cost and amount of downtime, dollars per asset value, dollars on shelf, insurance policy stock, how to insure having the part in 24 hours.

It is a supposition of this book that maintenance inventory is not an inventory at all and shouldn’t be treated like one. In fact, treating the storeroom as an inventory is a fundamental business mistake that costs your organization money and results in unnecessary and, possibly, excessive downtime.

Is the Orphan Maintenance Inventory a Completely Different Kind of Entity?

Inventories are assets that are on the financial books. Certainly the inventory costs money, but is it primarily a financial asset? Second, should the inventory be managed as a financial asset (like cash, raw material inventory, etc.)?

When we look at the operational use of spare parts, we see something entirely different. We stock parts as a method of risk management. There is a risk (downtime) that has certain financial and other consequences that we, as a business, are unwilling to take. Risk management has many ways of managing the risks of downtime.

Many businesses have several factories in different parts of the country. If one of them goes down, the product can be made at another plant. The consequence of one plant temporarily going down is not particularly catastrophic.

• Some plant designers add in redundant equipment so that, if the main unit goes down due to a breakdown, the operators can shift to a back-up that is already in-line and ready to go.

• Carry spare parts and have maintenance people on staff who can repair the equipment.

• Contract with the OEM or a third party to maintain the asset to insure capacity.

• Rent the service from the OEM (such as renting an air separation plant from Air Products).

• Purchase business interruption insurance that covers breakdowns (if it is available).

• Borrow techniques from the risk management field to help manage production risks. Life Cycle Engineering, in Charleston, SC, calls this RBAM (Risk-Based Asset Management).

MAINTENANCE INVENTORY USAGES

Within the storeroom there are three usages of maintenance inventory: wear parts, paperwork and projects, and insurance policy or capital spares (Table 2-3). Each usage has a unique impact. However, the same part might have usage in two categories.

Table 2-3 Usages of Maintenance Inventory – Why It is Held

Type	Description and function	Analysis and management strategies
Wear parts	These parts are used up or consumed. Their usage can be predicted based on past usage. Common parts such as bearings, seals, belts, wear parts, supplies, and bolts are part of this group.	This inventory is closest to a retail inventory and can be analyzed the same way by using turnover, when last used, rack jobbing, and consignment.
Paperwork and project parts	The usage of these parts is regulated by paperwork. This group includes preventive maintenance (PM), projects, and construction. If the PM says to change the belt monthly, then the usage of that belt will jump to 12.	Not over-ordering (minimize leftovers). Standardization (not introducing new vendors without good reason). Blanket ordering with monthly releases.
Insurance policy or capital spares	Expensive, hard-to-get parts for critical assets; these parts move slowly (if at all).	Risk management: rigorous analysis of need. Reliability engineering, share parts, supply contracts.

If we break the maintenance inventory even further, we find several sub-types of parts. Table 2-4 shows another view of usage based on the driver or the reason for the usage — the basic usage of different spare parts.

Table 2-4: Detailed Usage of Spare Parts

Type of part	Explanation
Critical spares	Two names for the same kind of part. Be very careful with these. If you need them and don’t have them, you could be in serious trouble (excessive downtime). You have them for the expressed purpose to NOT use them. Called RUKI (Rarely Used Key Items).
Insurance policy spares
Standard replacement parts, stock items	The bulk of the items in your storeroom. They wear out and need to be replaced
Hardware	Nuts and bolts, can sometimes be consignment stock (owned, replenished, and managed by a vendor).
Consumables	Held in storeroom for production, like ink for labelers.

ANOTHER VIEW BASED ON THE CONSUMPTION RATE OF THE PART

Another way to evaluate maintenance inventory is to consider how quickly the parts move.

Fast-Moving Parts

Fast-moving parts are typically used in quantity with high frequency of issues. Because they are used regularly, you can forecast their usage. Furthermore, because you are interacting with that vendor regularly, it is easier to track changes to lead time. Typically, these parts are available from several vendors; management expects high service levels and decent pricing. The fast-moving parts are most likely to respond well to statistical inventory control processes.

Slow-Moving parts

Use, stock level, order point, and order quantity are difficult to calculate for slow-moving parts due to a lack of input data. These parts are difficult to predict. According to Moncrief et al. (Production Spare Parts), there are three statements of “fact” about these parts:

• Assume you have no idea when a slow-moving part will be needed because you generally don’t know.

• No amount of inventory will guarantee you won’t have to backorder this item under all conditions.

• No amount of inventory reduction can save enough money to compensate for a lack of a critical spare.

These slow-moving parts make up most of the value of a maintenance spare parts inventory for which you cannot forecast usage. As time goes on, the lead time is either long or unknown (and companies go out of business), and they often have a high per part cost.

Figure 2-2 provides a comparison of slow moving and fast moving parts.

Figure 2-2: Parts tree