Managing Inventory Obsolescence for Improved Performance

In this article we will discuss managing obsolescence from an inventory management perspective only. There is much more to managing obsolescence if you address the matter from a product lifecycle point of view. We will not directly address lifecycle management in the present discussion. However, you will learn how an Inventory Management Review Team can help get you started on the path to world-class performance as a manufacturer or distributor.

Why manage obsolescence at all?

The old proverb about “hindsight is 20/20” rings true here. If all your company does is “clean house” when you begin to run out of storage space in your warehouse or some other contingency forces you to do so, then your organization is not – by definition – “managing” obsolescence. Actual management would imply taking some proactive measure that would tend to reduce losses from the accumulation of obsolete product.

When obsolete product accumulates your organization may experience any of several negative effects:

• Your assets will be overstated on your financial reports
• Inventory carrying costs increase
• Increased carrying costs lead to increased operating expenses
• Money may be spent on excess labor to handle warehouse activities such as bin-to-bin moves and cycle counts
• Excess labor costs contribute to increased operating expenses
• Increased operating expenses lead, inevitably, to lower profits
• Lower profits mean less money is available for reinvestment in company growth, new product development, sales, marketing and other forward-looking activities
• Reduced spending on forward-looking activities may lead to lower growth

Defining obsolescence for your business

Some organizations never get around to defining obsolescence. One of the reasons for notmust defining obsolescence is that the firm is willing to take an order for any product – even one that they quit manufacturing or selling a decade ago – because they feel they somehow that they take that next order.

If you find yourself in this position, it may be because your enterprise has never actually calculated the true cost of fulfilling such an order. How much has it cost you to carry the components, tooling, and other essentials over the last several years in order to fulfill your customer’s request? If you are under the mistaken impression that your only cost for carrying otherwise obsolete merchandise is the pittance you pay to the bank in interest, you are likely widely mistaken.

That aside, there are some general rules that may be applied to define “obsolete” product in your warehouse:

• Items for which your organization has had no customer-facing demand for n months may be obsolete. “Customer-facing demand would be indicated if the item has been sold, shipped as a complementary item in conjunction with another sale, or used as a component in the production of a finished good item sold to a customer. Other kinds of transactions are likely not customer-facing.
• Items that are not essential for the support of other sales (e.g., repair parts) and have had no customer-facing demand for x months.
• Raw materials or subassemblies that are not presently on any active or planned routing or bill of materials.

Actions to take

After your organization has settled on the criteria that define obsolescence, the next steps should be:

1. Get together a list of all the items in your inventories that meet the criteria you have established
2. Review the list to determine why each item appears on the list. (Which of the established criteria did a particular item meet to end up on the “obsolete” list?). Some of the reasons that may lead to items being on the “obsolete” list might be:
   1. Inventory recording errors
   2. Unrealistic forecasts
   3. Engineering changes
   4. Excessive supplier lead times or other supplier reliability issues
   5. Policies or lack of policies governing inventory stocking
   6. Existing performance metrics

1. Do a Pareto analysis of the results to help you plan your attack on the issues presented

In this example, the firm had slightly less than 600 items of its more than 31,000 SKUs (< 2%) that met its obsolescence criteria when it kicked off its obsolescence management program. When assessed based on the number of occurrences (items), the issues align as follows (largest causes first):

1. Vendor reliability issues (189)
2. Performance metrics issues (143)
3. Inventory recording errors (122)
4. Engineering changes (99)

Forecasting failures (33)

1. Policy issues (13)

However, when viewed from a dollars perspective, the issues rank as follows (highest first):

1. Forecasting failures ($46,328)
2. Engineering changes ($26,328)
3. Vendor reliability issues ($22,822)
4. Performance metrics issues ($7,066)
5. Inventory recording errors ($3,718)
6. Policy issues ($3,657)

Having both of these Pareto analyses in hand, the team may wish to deal with the highest dollars first from an inventory “liquidation” aspect. This will free up cash for the organization. However, from a policy and procedure perspective, the team should turn to the “occurrences” Pareto and deal with “Vendor reliability issues” driving nearly one-third of the affected SKUs into an obsolete status.

Why might these discrepancies to exist between the “Inventory Dollars” and “Number of Occurrences” Pareto analyses? Consider the following:

• “Forecasting failures” and “Engineering changes” are likely driving obsolescence in finished goods. Since finished goods have a higher per-unit cost, it would make sense that a smaller number of occurrences results in a higher dollar-value effect.
• “Inventory recording errors” are more likely to occur on small components that may have a relatively small unit cost, but inventory transaction recording errors occur on a large number of these items

Next Steps

Here are some ways that our team (from the example data) might take action regarding some of these issues:

• Liquidate obsolete inventory in descending dollar-value order to free up cash that is presently tied up needlessly in this inventory.
• Vendor reliability issues may be addressed in a number of ways; however, it is important to recognize that the “Vendor reliability issues” may be cross-linked to “Performance metrics” or “Policy” issues. If the organization has policies (written or unwritten) or performance metrics that drive buyers to the lowest-cost vendor or lowest-cost purchase, then these policies or metrics may be contributing to the “Vendor reliability issues” thus causing the buyers to over buy. The team should be certain to review all of these issues in concert. Policies and performance metrics should be changed to take vendor performance into consideration in determining the value to the organization. The team might also be able to work with some vendors to help them improve their reliability as a supplier.
• Performance metrics may, like “policies,” may be written or unwritten. In one organization with which I worked several years ago, there was no “performance metric” – strictly speaking – with regard to inventory stocking levels or dollars. However, the buyer responsible for the bags in which the finished goods were packaged for sale had been “beaten up” by management often enough that he knew the “performance metric” was: “You don’t run out of these bags, no matter what!” The result was huge inventories of these bags taking up the better half of one of the warehouse buildings. If a product changed and the change made the product information printed on the bag obsolete, there were also large quantities of obsolete product that required disposition. The team should check the performance metrics that are driving inventory levels on items that end up obsolete and require liquidation, then seek revisions to those metrics as necessary. They should look at both purchasing and production metrics.
• Inventory recording errors can be tricky problems to resolve. The team in our example company should seek to discover what kinds of transactions (e.g., cycle counts, bin moves, receipts of goods, production entries) most often lead to inventory recording errors. Then the team may be able to make recommendations that they believe would help reduce the number of errors that occur and the severity of the discrepancies, as well.
• The inventory obsolescence stemming from Engineering changes may be reduced or eliminated by instituting a “use up” plan whenever an engineering change is introduced. The team from our example company might also consider moving toward more product standardization around components and subassemblies. This could lead to fewer obsolete SKUs. This approach also offers side benefits, such as potentially reducing the number of SKUs that must be purchased and maintained, as well.
• Forecasting failures may be inevitable since that is the nature of forecasts. However, having a team that closely monitors purchasing, production and stocking levels that are predicated on fresh forecasts could lead to reduced obsolescence in the long run. Our example company team might consider such a specialized inventory team since $46,000 is no small amount for many small to mid-sized businesses to write off in obsolescence. Also, the team could consider a recommendation to regularly monitor, measure and report on forecast accuracy with the goal of improving forecasting methods over the long term.
• When considering Policy Issues, our team (from the example company) should be sure to consider the policies that drive inventory matters such as:
  • Purchasing: Vendor selection, price negotiation, purchase terms and purchase quantities
  • Stocking: Setting safety stock quantities, approved warehouse “stock lists,” reorder points and line points
  • Production: Establishing batch sizes, sizes of production runs, overrun allowances and so forth

Establishing an Inventory Management Review Team

By way of example, we have discussed some of what an Inventory Management Review Team (IMRT) can do for you in terms of getting control of your obsolescence. Now let us consider what an IMRT looks like and what it can do for your organization if instituted as a process of ongoing improvement.

The role that an Inventory Management Review Team (IMRT) plays can be critical to an organization’s ability to manage a variety of inventory issues. The IMRT should be assigned the responsibility to:

• Determine authorized stocking lists (i.e., what SKUs may be stocked in each logical or physical warehouse);
• Set and modify inventory management parameters used to govern stock quantities including:
  • Lead times / formulas,
  • Safety stock quantities / formulas,
  • Calculated / forecast demand,
  • Cost of Carrying Inventory (by Warehouse),
  • Cost of Replenishment (by Warehouse),
  • Economic order quantities (EOQ) / formulas,
  • Min/Max quantities, and/or
  • Replenishment methods (e.g., Max stock, Min/Max, EOQ, manual);
• Review and adjust sales / consumption forecasts;
• Recommend product standardization / diversification efforts;
• Review and make recommendations regarding long-term production planning and requirements planning standards;
• Review engineering changes prior to final release (except emergency changes);
• Review and recommend changes for all policies and procedures (formal and informal) affecting purchasing, stocking, movement, consumption and disposition of inventory; and
• Review and recommend changes for all performance metrics (written or unwritten) affecting purchasing, stocking, movement, consumption and disposition of inventory

Depending upon the nature of your organization, the make-up of your particular version of the Inventory Management Review Team will vary. However, most organizations should consider having members from the following areas or departments on their IMRT:

1. Inventory / Warehouse Management
2. Product / Manufacturing Engineering
3. Purchasing
4. Sales / Marketing
5. Accounting

Requirements differ from organization to organization, but it is likely that you will want to set up a routine schedule for your IMRT to meet. If monthly is too frequently, consider bi-monthly or quarterly meetings of the IMRT to handle its business. However, give the team adequate time to review all of the pertinent data and to hammer out responsible decisions. Generally, you will find that a half-day is the minimum time required. For large and complex operations, a full day may be required.

If you find that a full day is becoming insufficient to handle all of the IMRT’s required duties, think first about having the team meet more frequently. This is probably a better solution than extending the meetings beyond one full day at a time.

Long-term Goals

Your IMRT’s efforts should lead to lower inventories. In turn, lower inventories will likely have many positive long-term positive effects on your organization including:

1) Improved cash flows,

2) Reduced operating expenses,

3) Accelerated throughput,

4) Increased profits, and

5) Improved return on investment.

Therefore, the closer your IMRT can bring the operations for which they are responsible to JIT (just-in-time) inventory positions, the more improvement they will see in overall operations – provided the effort is undertaken wisely. JIT should also dramatically reduce losses due to obsolescence.

Other long-term goals for the IMRT might include:

• Improved sales forecasting through a process of ongoing improvement;
• A more disciplined approach to engineering change orders (ECOs) through thoughtful efforts at component standardization and use-up methods;
• Reductions in lead-times for both purchased and manufactured goods; and
• Improved inventory accuracy and system-wide data reliability and visibility

Summary

Getting control of your obsolescence and a better handle on slow-moving inventory is an important first step toward getting more “lean” in your operations. Starting on this journey can be rewarding by making your organization better in a number of ways. Establishing your IMRT (Inventory Management Review Team) could be an initial step in a journey leading to world-class manufacturing or distribution for your organization.