Education and training in inventory management focus on inventory functions, which include cycle stock to balance carrying and ordering costs, safety stock for variances in demand and supply, transit stock for movement of goods, anticipation stock for seasonality and forecasted shortages, and hedge stock to reduce the impact of price changes.

In reality, all businesses have "dysfunctional" inventories that erode profits and increase working capital. A formal approach to measuring, analyzing, and controlling these inventories is required. These items can be grouped into the following four categories:

1. Excess inventories for active products--quantities beyond those needed to meet objectives of having inventory.
2. Aged/obsolete inventories--inactive products with little or no sales or consumption.
3. Less-than-prime inventories--inventories restricted due to quality problems.
4. Make-to-order candidates--inventories for items that are sold in such small quantities they should be produced against orders.

Every business needs a formal process to identify and control those inventories that do not function to support customer service or help to optimize costs. The ratio of functional-to-dysfunctional inventory varies significantly with the nature of the business. On the demand side, such factors as product life cycle, volume per product, customers buying the product, and demand pattern influence the ratio. On the supply side, quality performance, manufacturing flexibility, and order quantity economics contribute to the ratio.

The first step in controlling dysfunctional inventories is to develop a definition for each category that is specific to the business. For example, "excess" is much different for a highly seasonal product where pre-building is the norm versus a short life-cycle, hi-tech product. Economic order quantity (EOQ) is a key factor in determining what is excess. For example, assume the EOQ for a product is 10,000 units and demand is 2,000 units per month. The month's on-hand at replenishment would be 5 (10,000/2,000). Assume the safety stock has been set at one month's supply. Then, inventory beyond a six months' supply is excess.

The significance of "aging" also varies with the business environment. The normal demand pattern must be understood. For example, a firm that produces agriculture fertilizer would not be concerned about slow movements in December. On the other hand, a company that sells toys would be concerned about slow movement during this same time frame.

The key criterion for identifying "obsolete" items is the "number of days since last sell or consumption." The correct number of days to use varies with the business environment. For example, a maker of high-tech electronics may expect some sales every week; whereas, the producer of specialty chemicals may have many items with no sales in a particular month.

The inputs to establishing policies include the normal demand pattern, number of customers purchasing the item (if raw material the number of end items using the product), and expected product life. The report should list items in descending order in terms of days since last sale or consumption and should include reference to the last customer who purchased the product. Each month, items with no sales or consumption should be reported and reviewed.

The "less-than-prime" category includes scrap and any inventory that is restricted to specific end uses or specific customers. There are a variety of techniques for identifying and segregating these inventories. Most enterprise resources planning systems provide flags to restrict distribution unless overrides occur. Many firms develop batch or lot number techniques designed to help planners identify and report these quantities. In some instances, special item or material codes are used to identify less-than-prime items.

The make-to-order (MTO) versus make-to-stock decision has to be made on an item-by-item basis. A periodic analysis should be performed to identify candidates for MTO strategy. The criteria used to do the analysis will vary with business. Items sold to only one customer should be identified and reviewed by marketing and sales. Collaborative planning with the customer is one way to ensure such items do not become obsolete inventory.

Other criteria that might be used to identify MTO candidates include the following:

1. Items sold to three or less ship-to locations
2. Items with more than 60 days between outputs (sales or consumptions)
3. Items with average inventories of more than 180 days of supply

Each report should be designed to focus on a group of items that relate primarily to one category. For example, the data filter for the obsolete report should include prime products only. It is expected that less-than-prime products will age; however, the root cause is not a change in the market but, rather, inability to produce what the market wants. Each exception report should facilitate the assignment of action to a specific function when feasible. Otherwise, the tool becomes just another piece of information that gets lost in the maze.

Once baseline performance has been identified, improvement goals should be established. For example, if dysfunctional items represent 15 percent of total current inventory, the goal might be to reduce this number to 10 percent of total within 12 months. Some of the actions that can be taken to reduce the level of dysfunctional inventory include:

1. Offering a discount to customers
2. Reworking or recycling
3. Selling to scrap or waste dealers
4. Developing new markets.

The analyses should be used to develop preventive measures--not just identify problem inventories. Actions that can be taken to avoid further build-up of dysfunctional inventories include collaborative planning for single customer items; MTO strategy for low volume, high risk items; better demand-supply balancing; and improved performance against customer requirements.

Including dysfunctional inventories in the formal inventory control approach ensures problem inventories--and the associated root causes--are highlighted for action. It also eliminates the confusion caused when these inventories are included in analyses designed to help control functional inventory levels. Addressing dysfunctional inventories in this manner results in more effective inventory management.

Alan L. Milliken, CFPIM, CIRM, CSCP, is business process education manager for BASF Corporation. He can be reached at (973) 978-5239 or via e-mail at alan.milliken@BASF.com.
Join Milliken for the APICS Webinar, "How to Optimize Inventory Through Process Improvement," on Friday, June 6, at 2 p.m. ET.
http://www.apics.org