What Is the Cost Saving from the Reduced Inventory?

>If I reduce the inventory value from $1000 to $700, can I include that $300 in my cost saving?

At my company, we do allow our BBs to take the benefit of inventory value reductions in the cost savings, but only for the first year. After all, you can't go around taking credit for the rest of your career, now can you? (ha ha)

You did not mention how long before your next load of inventory arrives. If you are reducing inventory levels by $300 for example, you still need to replenish to keep your line running. If you ordered $1000 of inventory and are now changing to $500 twice per month, your savings would be the cost of money ($500 X .08 X .04) or $500 X 8 % cost of money X 2 weeks divided by 50 weeks. I hope this helps your quantifying of savings

Eric,

Claim the inventory carrying cost (e.g., 12%) times the $300 ($36) dollars as cost savings. The $300 is a cost saving as well. We can talk about it in more detail.

Tom
602-436-4852

At the very least, you should get the opportunity cost, or the cost to borrow that $300 if it was not available for another purpose. This is a soft-cost savings that some companies do not consider, only hard-cost savings.

If local suppliers are making more deliveries, is your client issueing more POs? If so, you have increased the ordering costs, which decreases your overall savings.

Your savings is calculated by the carring cost. Some companies finance their own inventory and some use bank money. Find out what interest your company is paying on the money and the inventory reduction times that percentage is your actual cost savings. Example; if you reduce inventory by $100,000 dollars per month and the bank loan is at 10% you are saving the company $10,000 dollars a month. The best way to measure inventory is by turns and aging. Ideally you want your inventory to be 8 turns a year. But this again demands on the company and product. I work for a managment consultant company and do this quite often so if you have any further questions please feel free to contact me.

On inventory reduction, some controllers allow the reduction in carrying cost of inventory. Depending on the interest rates and cost of capital, this calculates to about 1.5% of the inventory value per month.

I had a project very similar to what you described. I also inquired about taking credit for the actual amount of inventory reduced. The financial folks insisted that only the working capital interest(WCI) could be utilized as savings since the money saved in the inventory reduction was only "freed" to purchase more inventory. The money saved via WCI over a years realization added up to a nice sum however!

You need to be careful when calculating inventory savings. If the inventory can be reduced without sacrificing delivery performance or customer service, I recommend a savings of 12%-15% of the reduction as the savings. This is a conservative approach (the cost of money). Your savings is not $300, but .12x300 or $36 (maybe).

The objective of your project should be to "properly size with data" the inventory pipeline, not to reduce inventory. I've seen many organizations reduce their inventory too low and remove all their flexibility and responsiveness to changes in their marketplace. This is added cost, not an inventory savings.

Organizations such as APICS estimate the "all-in" cost of carrying inventory as 26%-30% but thats a little overstated - based on a 60s-70s Materials Management model.

Use 12%-15% and you won't get any arguments from anyone - especially your accountants.

Eric,
How did you define the problem for inventory reduction from the practical and the statistical perspective?

The saving in your case would be on the inventory carrying cost ,typically inv. carrying cost comprises of Interest cost ,cost of warehousing the inventory, insurance etc.

Lets say that you have reduced the inventory from $1000 to $700 and the annual rate of interest..i.e the interest that you would earn on the money bhad this been placed in the bank...is x% per annum.
Then the annual interest saving would be = $300*x/100
Now to this you may add your Warehouse cost reduction , material handling cost reduction etc.

In some cases it is worthwhile to develop a single Inv. Carrying Cost factor (say Y) which includes interest+warehousing cost+insurance cost etc . and then simply get the cost saving by multipling this factor with the inventory reduced amount. i.e $300*Y

Opportunity cost calculation is a little tricky affair it involves answering following questions:
1. Loss in sale due to nonavailability of the material

Here the loss = the net profit that would have been earned by the company on that order had the material been available, while calculating the net profit the Inv. Carrying cost would also have to be reduced for this order from the Gross profit earned on the order.

I would writr more on this subject later.
Till then
Bye

This is a Lean project, not a Six Sigma project.

Your $300 is a one time increase to cash flow. Your savings are the cost of capital for that $300.

Make sure your management values the cash flow contribution, it gains them flexibility.

You should ask for your next project to be one that will utilize the Six Sigma tools.

Let’s say I was spending $100 per month for 100 widgets I need to build Product X. Widget Supply Company (WSC) comes to my receiving dock and delivers 100 widgets. They sit on a shelf and I use approximately 5 per day. On the morning of day 20, I have five left on the shelf, WSC comes, gives me 100 widgets and I pay them $100.
Now I decide to reduce the amount of inventory I carry at any given time. The next month, WSC delivers 100 widgets but I only buy 50. I keep $50 in my pocket. I tell WSC to come again in two weeks and I will but 50 more widgets from them then. (Note that I am still going to buy, handle and store 100 widgets per month). I take the $50 and invest it for two weeks and (hopefully) make a profit on it. That is my benefit.
In two weeks, WSC comes and I purchase 50 more widgets with the $50 I had invested but, I get to keep the interest.
Marc W. Richardson
Sr. Quality Assurance Engineer

The most commonly accepted industry metric for reduced inventory is Carrying Cost. Most organizations agree that 12% is a good number because it represents a reasonable opportunity cost of money.

To calculate savings take the inventory reduction (BI-EI) and multiply by 12%. This is a reasonable cash flow savings.

Reducing inventory also provides other benefits such as increased flexibility and responsiveness (On-Time Delivery Performance, and quicker exposure to problems (COPQ cost avoidance)when they occur.

Take my word for it - use the 12% and even your accountants will agree with your savings from inventory reductions.

Hi Allen,

In the inventory reduction project, I only applied some basic tools to show the improvement between "before" and "after" situation... not many six sigma tools used.

So is there any standard to judge if a project is a six sigma project? Do we have to use many tools in a six sigma project? and lots of statistics involved?

Thanks...

Eric

You would be well advised to speak to someone in your finance/accounting department at the front end to determine how they measure these costs. Since most companies have to borrow money to support piles of inventory, lower inventory means saving interest on what would otherwise have been borrowed. Another major component of carrying costs is sometimes Ad Valorem Tax. Additional costs that might offset your savings are increased shipping costs and internal handling costs of these smaller more frequent deliveries from your suppliers.

Someone suggested that you could invest the excess "inventory allowance" money you had from purchasing smaller amounts. Not likely! Inventory is paid off of an invoice. No Company is going to give Supply Management a bundle of cash to procure goods and allow them to bet on horses with any excess money on hand. Nor will the actual inventory value reduced be considered savings. No, the legitamate savings will be reduced inventory carrying costs (the determination having been worked out in advance with acct. & finance) minus increased costs to achieve this. Also, since piles of goods are usually fluctuating up and down in size, the reduction should be the "average" on hand before vs. after.

I'm researching a similar problem right now at my company, and I believe this analysis, although from 7 months ago, is a little shortsighted.  In handling 50 widgets at a time instead of 100, were you able to keep from adding additional space to your factory, or can now take on new business.  Did you need a Forklift to unload the widgets, or now with smaller deliveries can you get by with a pallet jack?  Do you have to work any overtime when the large shipment was delivered, but now that the shipments are smaller, you can get by with less receiving workers?  Do your Inventory Control workers save time because there are less widgets to count?  There are a lot of additional saving to be had in inventory reduction.  Some may be soft costs, but they are valid for six sigma project work.

I know this discussion is old, but in my current research, I found that the carrying costs of inventory can vary by company between 18-40%.  Even with todays low interest rates, the cost of capital alone is 5.5-7%.  This would account for Half of your 12% figure.  The other factors that go into carrying costs are Receiving and Put-Away Labor, Building Rent, Building Utilities, Inventory Control Labor, any Taxes on inventory or building, Building Maintenence, Inventory Shrinkage and Obsolescence, Insurance on the Inventory, and the costs of any security guards/equipment to help protect the inventory.

John, Do you have any specific articles where you found the 18%-40% for inventory carrying costs. I am trying to find the industry average for carrying cost in the aerospace industry. I have been using between 20% - 30%.

I am doing a business case for a visibility tool and focusing on inventory reduction because this is where I feel is the most low hanging fruit.

I found this from the web.  http://www.effectiveinventory.com/article38.html

They had some articles posted.  One, article 35, provided a questionaire for company's to fill out and have their Carrying Costs calculated for them.  There data was kept annonymous and consolidated.  What they found was a range of 18-42%. There is a Rule-of-Thumb of the Prime Interest Rate + 20%.

The point is that every company is different, and I'm not sure you could even group the aerospace industry together (I have an Aeronautical and Astronautical Engineering Degree from Purdue) as they can be very diverse in scope as well.  Real data, if it can be obtained, is the best way to go.

It is not so difficult to compute, see:

http://www.effectiveinventory.com/article35.html

I was able to get the actual carrying cost % from our Financial Management folks.  I was able to provide more reliable cost information for my project that way. 

Eric, In your situation you loosing only the ' Opportunity Cost " but in other hands you have to classified the $ 300K as items ( i.e . ABC classification) Fast , slow or dead moving items  for your project.

Opprtunity Cost means ( other investment , Interest of CD , capital Investment etc. )

However, you have to decide which method are you using in Accounting ( just In time inventory , fish method.....etc. )

I need some help, i am a final year MBA student at IIT madras, for my project work i need some information on how six sigma can be applied to the warehousing activities to improve their efficiency. I would be happy if some person would give me some websites or white papers as references, where they have mapped the warehouse processes.

thank you

regards

MR Sriram

This is not necessarily true.  Yes it is a lean project but you can use six sigma tools to obtain your goals.  They work very well for it actually.  The savings from inventory reduction is not the same as the amount of inventory reduced.  You use a cost estimate for inventory.  For instance, my company believes that carrying cost of inventoy is 18% of the inventory's value.  This covers assets tied up in inventory, markdowns, age-outs, rent on warehouse, etc.  Some companies use 10% and some use 15%.  This is a number that needs to be calculated by your IEs.

Hi Tom,

Last time I met you we both worked for Honeywell - so where are you nowadays as your attached ph no says that you have moved on.

Let me know.  adam.bowdenfirstdatacorp.com

Regards,

Adam

I Believe the whole lot of you need to take a look at the bigger picture.  You can only assume that you can reduce the inventory by that amount if the demand can be consistantly met at that inventory level.  That means that inventory levels are driven by plant floor Operational Equipment Effectiveness (OEE), which incorporates such thinks as parts supply repeatability, machine and process efficiency, quality issues and scrap losses, and machine running speeds.  That is why people are beginning to come to the conclusion that there is a $1 for $1 savings for permanent inventory reduction, not just an interest rate savings.  Oh yeah, it's an annuity, not a one time savings...  A final thought to really blow your minds; if you use an increase in OEE to reduce inventory, then you just lost the opportunity to make the profit off of all the additional sales you could have made.  The reality is inventory should always only be large enough to compensate for process variations.

If you are reducing obsolete/excess inventory and receive credit back from a the original supplier or a resaler, the credit amount should be used.  If it is inventory that has not yet arrived on site (cost avoidance), then you should use carrying costs (including cost of capital).  Your cost of capital should be whatever your company (on average is earning on it's investments).  These investments are generally projects that they are contemplating, but could also include their stock portfolio, etc.  In addition you should consider the other carrying costs including (devaluation of inventory, costs of cycle counts, storage space, 'shrinkage', etc.)

*I did a similar project and calculated the savings received in credit from the vendor or resalers.  When cash is critical, this may be a priority metric for your company.

Hey Dcolvin,

nice to see you on the boards again...it's been awhile.   Say hi to chris C for me.

-Heebee

Hi Mark,

I like your thoughts on the capability/stability of the process as this is a measure most people don't take !  Also, from my experience, most people don't use statistics when calculating Kanbans based upon demand & supply variation.

Best regards,

Adam

The way I see it. A one-time deduction using the total cost of the parts is a good practice. However, if I save my company from ordering the same excess inventory the next years, I at least should get credit for the interest and opportunity percentage of that money over the next years. I am freeing money that can be invested or just saved at a bank to gain interest. 

Purchasing strategy needs to take into account the total inventory system and all purchases must be made with understanding of the impact to the total system and the impact on the business's key financial measures (cash flows, inventory turns, receivables, payables, contras, and borrowing) and operational measures (total warehouse space available at all sites, labor/overtime, inventory aging, obsolescence, & customer generated part changes/revisions/engineering changes).  To accomplish this improvement to the purchasing strategy to a total system focus versus a silo-focus, the Purchasing Manager or designee should utilize the following information to make all future purchasing decisions for the business: 1) customer forecasts, 2) shipping histories, 3) part velocity - dynamic versus static, 4) part life cycle/date of future obsolescence

Mr.Eric, seems you have worked a lot on Inventory reduction through Six Sigma which exactly I m intending to do a project on. Can you pl give me (rao.vijendarmahindra.com) more details or how exactly your project went on? I will be grateful if you can share your efforts & results. Thanks & Regards

Hi,

I am working on a paper where I reduce the setup cost with investment.

The setup cost equation is

S(I)= b Tie(I) + c Ti(I) - a I

b is the labor cost

Tie is the sum of internal and external setup times and is a function of the investment=Ti +Te

c is the opportunity cost

Ti is the internal setup time and is a function of the investment

a is the slope of S(I) vs. I

I is the investment

In the paper I have assumed that the relation between S(I) vs. I, Tie (I) vs. I, Ti(I) vs. I and Te(I) vs. I are all decreasing straight line graphs.

Tie= d -xI

Ti= f-yI

Te=g-zI

I wanted to know how i could calculate the different cost and slopes, more importantly the opportunity cost

You are treating a reduced setup time as a productivity gain due to lower total labor costs.  All you are doing is reallocating waste.  You should consider whether you are reducing a constraint with the setup reduction.  If no, find a constraint and remove it.  If yes, determine the improvement in gross output provided by the reduction in cycle time.

http://software.isixsigma.com/forum/showmessage.asp?messageID=32716

Am I not reducing the total setup cost by investing "I"? If not could you pls help me do this right?

I didn't completely understand your formulae.  I'm suggesting you decide if you are really saving money;  if so, choose the appropriate cost model.

You are definitely freeing up labor, but does that increase the overall efficiency of your factory?

What Is the Cost Saving from the Reduced Inventory

in need more information and i wish to Six Segma

hello friends

i am a hard-core operations management guy and i deal with inventory reduction and inbound logistics, well i guess after so much research i feel that knowledge must be shared so here i am avalable for any further discussions on this topic to SHARE..feel happy to mail me on kedar_symbiosisrediffmail.com

kedar,

Just a thought.

iSixSigma posts a lot of articles from practitioners on the home page. You might want to speak to them about writing an article.

Good luck.

Kedar,

Thanks for the invitation, but the idea of the forum is so MANY of us can learn from each posting.  Private emailings would make it one-to-one learning and leave some out of the loop of learning from you.  Wouldn't it be better if you posted some of this knowledge on the forum so that several of us can see it at one time?

Kedar,

Welcome and thanks for being willing to share your vast knowledge.

Please tell me everything I need to know, but please keep it short.

To Mike, Rubberdude, etc.

Did you guys restart this thread to help me out?

If so...thanks!

A lot of great reading with this thread.

-batman

batman,

Not me. You must have some good karma going on.

Regards

HE did it!!  (points finger at Stan....)

And you are humoring the poster Kedar because?????  Any Stan blaming must be specific.  It can't be the collective Stan.

Humoring Kedar?  I think not..... I'm humoring Batman.......

And I specifically pointed at one particular Stan....... and if you couldn't see which one I was pointing at.... well... you're just SOL....

humor me! I'm an SS newbie!

-batman

OK Batman.....

A MBB, BB, GB, and a Boy Scout are on a cargo plane flying at 30,000 ft.  The pilot and co-pilot come out of the cockpit and announce the plane is crashing, there are five parachutes, and grab two parachutes from a corner, and jump out.  The remaining passengers realize there are only three parachutes left.  The MBB announces he is the smartest MBB ever, in the middle of a SS project that will save his organization $20 million over the next year and must be saved, so he grabs a ‘chute and jumps out.  The BB says he’s a part of the same organization and is responsible for over half that savings, so he grabs the next ‘chute and jumps out.  The GB looks at the scout and says, “I hate to tell you, but I am working with the BB and am critical to the project he’s speaking of…. So I’m taking the last ‘chute.”

The Boy Scout grins and says, “That’s OK…. The MBB that’s so smart?  The parachute he took?  That was my backpack.”

Holy humor RD!!!!

-batman

Hi all,

I will be thankful to you if you can help me out to know how to apply six in inventory turns project.

Eagerly waiting for response from all of you

TIA

Nilesh

No, just because you've reduced the cost does not mean that there is a savings. In the accounting world, just reducing the cost of an item does not reduce the over-all liability for that product. You need to reduce the cost of goods sold for example reduce your labor costs. The item will remain the same unless you are depreciating it.

how do you apply six sigma to logistics

sir please give more information about inventary managmant in easy way <thank you>

wnat is inventary management please tell in easy way

dear Qasim

                    inventory management is basically to maintain EOQ (Economic Order Quantity) in stores so there may exists no holding or carrying costs. There are different EOQ models you can study.

Another aspect of inventory management is towards MRP (material requirement planning) where accessories arrival times, order lead time are adjusted so there may not stockouts.

thanks

Ahsan

The benefit/cost saving of inventory reduction in my company count only interest saving since these materials are still usable. If reduction of obsolete items they can count full cost of materials, plus interest.

Tony, you can only count as inventory cost savings the value of creating a method of AVOIDING obsolete inventory.

Existing obsolete inventory is an expense already incurred. So you can only "save" money if you figure out a way to "predict" inventory that will become obsolete and therefore not purchase it.

You could count the savings from identifying existing obsolete inventory AND get rid of it only to the extent you eliminate moving costs and can put the storage space (usually a fixed cost) to better use.

Brandon and Tony,

The value attained from reducing FG inventory or WIP is only the "cost of holding inventory" i.e if it was your money tied up in inventory then you would lose the opportunity of getting investment benefits and also you are having to heat, light and count it etc which is typical carrying costs. The finance folks will typically quote you a % of any where from "base plus 2" upto 25% that you can count as a bottom line benefit. The whole avoidance costs of reducing the opportunity of producing future obsolete inventory will not go far.

Regards,

Adam

Adam, I agree with the holding cost portion - in fact I wrote that already.

However, if one figures out how to produce something in a manner that does not lead to obsolete inventory then mngt. had better pay attention. If they don't, they are not doing their job.

That was one of Dell's major strenghts early in their life. They didn't stock excess stuff since the state of the art was changing so rapidly. Avoidance of inventory that goes stale is absolutely a cost avoidance practice.

However, I will allow it is difficult to demonstrate.

I tend to use 5 primary categories when looking at inventory. New, fast moving, slow moving, sunset and finally obsolete.

Each category has a different process. By doing it this way and applying a subtle combination of Lean and Six Sigma it is possible to reduce inventory easily by 50 % and from experience upto 95% reduction.

Inventory is an indicator of waste. It is an easy hit and provides for a "big bang for the buck".

Regards,

Adam