Finished Inventory is much too High!! - Analysis II

 

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.

Analysis of Ernesto’s Proposal:

Advantages:

• Lower inventory due to a 1-week cut in replenishment time.

1. Significant for the German market as inventories there can be reduced by a considerable amount without jeopardizing availability.
2. For all the rest (the majority of clients) the inventory saving is small – only 1 week out of 8 saved.
3. Bottom line Lisbon Motors saves some of the 30m$ of cash tied up in inventory plus a small amount of the 3m$ of scrap costs.

• Is it worth it?

1. 10% added labour costs an additional 960k$ (10% of 9.6m$).
2. The additional materials cost comes to about 2m$ (3% of 60m$ of materials cost)
3. There is an initial investment of 500k$
4. Lisbon Motors would not realize a reduction in cost, and
5. No additional value is created for clients – so price pressure would continue and there is no real reason for new clients to buy from Lisbon Motors.

• Can we improve upon Ernesto’s good start?

Sources of Ideas for an Improved Proposal:

A. From the Story:

1. The threat that a client can terminate a contract immediately if there is a failure in availability indicates how important this is to washing machine manufacturers. They probably have a similar situation with their customers!
2. That clients will compensate for 4 weeks of motor supply when they change models is a further indication of the first point AND probably a huge expense item for washing machine manufacturers. 1-month supply of motors is about 8% of a years demand, a motor may be 20% of the sales value of a washing machine – so 1 model change takes 1.5% of sales of profits (15% of profits if profits are10% of sales!). That is just 1 model change – it doesn’t say how many model changes there are, but there are many. (If model changes did not cost so much in motor compensation a washing machine manufacturer could increase the rate of changes and possible gain a marketing advantage. 
   All in all this compensation for motor supply at model changes is very expensive – for both parties. (Somehow clients will eventually carry the cost of motor write-offs by suppliers.)
3. Ernesto’s idea reduces the need for stock dramatically because only 4 basic models (to be finished when demand is known) need to be held.
4. The US is far from Portugal in terms of shipping time. The number of motors “on the way” cannot really be reduced, but the 4 basic motors stocked in the US would achieve a major reduction in inventory and opens the possibility (by finishing locally) of very short lead-times to clients (from a local stock). Clients need to hold much, much less to ensure availability as the local warehouse (because it covers all the US demand) can respond quickly to any local client demand fluctuations. The penalty of inventory write-offs (or rework) when a client changes models could practically disappear.
5. Germany and the rest of Europe are close enough to Portugal that they can be supplied in the same way as the US – but directly from Germany – great for clients.
6. Asia remains a problem because it might be too small (for now) and to far flung to apply the same idea of local finishing.
7. We know that if Lisbon Motors margins are squeezed all other competitors will be in the same boat. If a sizeable penalty is offered for late delivery most (maybe all) competitors will be afraid to copy such an offer. We just need to be sure that we can guarantee availability to very near 100%.

B. From the Theory of Constraints - Distribution:

1. We know that aggregating centrally (in the US and in Portugal for Europe) will reduce the relative size of demand fluctuations so that together with the need to store only 4 products Lisbon Motors will need much less stock vs. what is being held at clients today; and Lisbon Motors will (if clients cooperate) be quite sure of being able to meet 100% availability.
2. If Lisbon Motors’ clients supply their inventory levels of motors, Lisbon Motors can replenish frequently based on what was just consumed. 1-weeks supply is likely to be sufficient, because the 1st week’s forecasts are accurate.
3. The local US (and Portugal) stocks of almost finished motors can be replenished in the same way, and with the same level of security.
4. The Theory of Constraints Replenishment method gives early warning of an impending stock-out, manages inventory target levels up and down as demand changes - to always have about the right amount of stock on hand and it provides the knowledge to deal with model changes and other discontinuities in demand.

Technorati Tags: Case Study, Continual Improvement, Cost, Costing, Effectiveness, Policy, Reliability, Risk Management, Speed, Theory of Constraints, TOC, WIP

iv>