Finished Inventory is much too High!!

 

By Eli Schragenheim

This is a case study by Eli Schragenheim that he has allowed me to publish here. Your goal is to analyze the current situation, comment the proposals and develop what you believe are the best strategy and tactics for the company to pursue. The first post is the current situation. (If you are interested in such business cases and their analysis I recommend Eli's book, "Management Dilemmas". The book has many different case studies for you to work through. Eli gives his analysis which he does not claim to be the best possible - nevertheless they are thought provoking.

Lisbon Motor

Lisbon-Motor is a successful manufacturer of electric motors for washing machines and dishwashers.  Their annual sales are $120 million.  Net profit is quite low:  only $2.5 million, but in the market they are in this is considered a success.  The company has more than 100 clients located (almost) all over the globe.  Sales to US washing machine manufacturers represent more than 50% of Lisbon-Motor sales.  Sales to German factories add another 28%.  Other clients are located in Eastern Europe, South America and Asia.  Lisbon-Motor, located near Lisbon, Portugal, has about 11% of the world market share for the type of motors they produce.

According to Arturo Moriera-Lima, the energetic COO (Chief Operating Officer) of Lisbon-Motors, the huge finished goods inventory held at each client’s site is the most critical problem.  Here is how he describes the problem:

“The big washing machine manufacturers demand that (major) suppliers manage their inventory at the washing machine factory.  They call this VMI, Vendor Managed Inventory, and it is now essential for any important sale.  They give us a forecast for each model they plan to produce.  If we have to write-off our stock because they change models too quickly, then clients compensate us for up to 4 weeks of stock at their factories, based on their forecasts.  They demand 100% availability of motors whenever they need them.  If we fail – they can terminate their contract with us immediately.”

“Usually we can rely on their weekly MRP reports – but they are reliable only for the next two weeks requirements!  Beyond that there are always huge changes in demand.  Since we are responsible for 100% availability of the motors, it is essential for us to maintain huge stocks at our client’s sites.  We have almost $60M of motors in finished goods, (valued at the sales price) sitting at clients. If you take into account that just our raw materials are almost 50% of our selling price then it is easy to understand the size of our problem.  Add another about 10% for transportation cost and 8% direct labor for the complete picture. With the frequent model changes we are lucky if we have to write-off only 9% of the finished goods inventory we hold.  Clients compensate for only about half of this loss.  The problem is so big because the very long transportation times necessitate much more inventory than any client is willing to commit to.  However, lots of inventory is the only way we can compete with the local motor manufacturers.

“Our VP of Engineering, Ernesto Nazareth, came up with the following idea.  Let’s produce only 4 standard motors and store them in our factory warehouse.  Then, when we need to ship to a client we take the closest motor type and introduce the necessary changes to the motors and match them to the particular client’s model.  He demonstrated that every current motor requires just a minor 2% modification to transform it to client specifications from one of the four standard types.  He also showed how easy it is to modify each of those standard types to fit clients’ requirements exactly.  Ernesto claimed that this move would cut inventories and add capacity at our constraining work-centre.”

“This idea looks good to many people, but I simply do not understand it.  We have, at least, 20% excess capacity at what is considered to be our capacity constraint.  So, after this ‘fantastic idea’ we’ll have 30% excess capacity due to time saved on setups. So what?  And, what inventory levels can we reduce?  We still need to hold the same inventory levels at the client’s sites, because of the very long transportation time.  Ernesto speaks about production lead-time reduction however our production lead-time, because we use a DBR production system, is now two weeks at most!  Reducing it to one-week, or even to 3-4 days, won’t help much considering transportation to the US is 5 to 6 weeks.”

“On top of all that, the engineering change to our production lines would cost us $500,000.  Direct labor would increase by 10% as the changes require more work, and even material cost would increase by 3% due to a higher level of scrap.  Considering all this, where is the business advantage for Lisbon-Motors to justify such a move?”

We need to be careful with Arturo’s reservations.  Arturo is known as the conservative almost always against any proposed change.  This is certainly so if the idea comes from Ernesto, considered to be a possible future COO.  The story goes that Arturo was dead set against the introduction of the DBR planning, even though today he is all for it.

The other senior Lisbon-Motors executives point to the on-going price pressure as the major problem not the very high inventory levels.  In fact some of our long-term contracts with clients state very clearly that we are committed to lowering prices by an agreed percentage every year.  Most of our other clients constantly ask for bids from all possible suppliers to drive prices down further.

Is Arturo wrong in his criticism of Ernesto’s idea?  Assuming it is possible to implement Ernesto’s idea and Arturo’s numbers are correct, is there a way that makes Ernesto’s proposed engineering change profitable?

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