# Six Sigma and Inventory Carrying Costs

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• #28465

john beaudoin
Participant

Our location has about \$50 million in Inventory and uses an Outside Storage location as well, with about \$8 million in inventory.  We have several projects underway that are designed to reduce lead times, etc. to reduce the amount of inventory we carry, and yet maintain our customer service level for repair parts.
We are trying to compute the 6-Sigma savings we can get by reducing inventory.  Let’s say \$3,000,000 for instance.  We don’t think we can say that our project savings is the \$3,000,000 because you would eventually buy and sell the inventory, you just carry \$3M less.  We also understand that figures that go into inventory carrying cost are:  Building costs, equipment expenses and depreciation, labor to check-in, receive, and put-away the inventory, security and insurance to protect the inventory, losses due to pilferage, obsolete inventory, labor to cycle count inventory, interest/cost of capital to purchase inventory, applicable taxes paid, etc. Let’s say that all of this adds up (the going range is 18-40% of the value of the inventory can be in carrying costs).  Does this mean that our project savings would be to multiply the carrying cost percentage times the dollar value of inventory reduction?
We have some here that think the only savings we can claim is the hard savings in any Outside Storage Costs we can reduce in addition to a 6% cost of capital, since we will still have the same building, personell, equipment, etc.  Are they correct?

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#70972

Jim Johnson
Participant

John:
I think that you have a good grasp of the components that go into the costs associated with carrying excess inventory. In terms of which of these you can say that you saved and which you did not, the answer is quite simple (in my mind) – If you can abolish the component (i.e., defer the full-time equivalent (FTE or headcount) to check-in, receive, and put-away the inventory; Taxes; Security and Insurance) then you can claim the savings. If these don’t go away, then you can’t claim the savings.
Supposedly your Management Accountants have some basis for the costs associated with carrying this inventory. Perhaps you should meet with them and see what comprises this basis and then see what components or percentages of components of that basis you are abolishing with your project.Now, I have a question for you. What did you consider a defect in your project? If you are using dollars as your defect then you will have some trouble in building a suitable control mechanism to monitor your improved process. This is what I was taught in Black Belt school and it seems to make sense. If there is anyone who has successfully counted defects in terms of dollars saved, I am interested in hearing how the accomplished it.I hope that this helps. If you would like to discuss this more directly, please contact me at [email protected] .Jim Johnson

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#70978

Matthews
Participant

I agree with Jim , your savings should not consist of the monetary value of the actual inventory but the cost of storage and maintenance associated with the stock, therefore your strategy should be to exit your outside storage facility.Your defect in that instance should not be monetary but cubic metres space that is being used outside. By understanding the demand for or need for the inventory and reducing internally the cubic metres associated with the stock outside would allow you to exit the facility. You should then look into the process of maintaining your stock internally and see if you can reduce your overheads by processing quicker thusfore reducing the amount of manpower needed aswell as how the stock is stored , could better racking utilize ceiling space for instance?
Regards,
John. (Six Sigma Blackbelt)

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#70980

john beaudoin
Participant

Thank you for the input Jim.  To answer your question, for example if our project is to reduce the lead time of parts from our suppliers from 16 weeks to 6 weeks, we would call a defect any item with more than a 6 week lead time and a non-defect would be any item with 6 weeks or less lead time.  This would be the basis for our sigma level and possibly tracking.  This being a Transactional project, we would come up with some average cost basis number to get a savings per defect.
I like your analysis, and our Finance Department would most likely agree with you, as what you are referring to is all hard cost savings.  We are wondering if we could claim the other portion of carrying costs as a soft cost savings.  It would be up to the managagement of the warehouse to determine if the change showed a slowdown in Inventory and Receiving functions, reduced overtime worked, reduced need for temporary employees, etc.  Is it legitamate to claim the soft savings?

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#70981

john beaudoin
Participant

I’m not sure that removing our Outside Storage should be the top priority, as our hard expenses for its use amount to \$200K/Year to handle \$8M in inventory (2.5% carrying cost).  The carrying cost in our own facility, which has much higher labor, security, rent, etc. is much higher.  The only parts we maintain in Outside Storage are Full Pallet Quantities of Parts.  (About 700 of our available 130,000 SKUs).  Because we have so many SKU’s, most of our internal warehouse space is for Receiving, Picking, Packing, and Shipping as well as for Bin Boxes to store parts as small as a sesame seed to big screen TV cabinet backs.  Our pallet racking aisles are reserved for such large parts or parts with full pallet quantities.  They are already configured to Very Narrow Aisle (4 feet) and run to the ceiling of the faciltiy.  While we have some projects looking at focussing on the reduction of inventory in Outside Storage (OSS), we have others that are looking at reducing the overall value of our inventory.  My current data shows that my average pallet in OSS has a value of \$3000.  My costs internally for preparing and receiving that pallet are \$5 Soft costs and my hard costs paid to our OSS vendor are \$60 over the life of the pallet on average.  16% of my total \$ value of inventory is in OSS.  If we have a project that allows us to carry \$48M in inventory over the course of a year instead of \$50M, and I am not specifically targeting the 700 parts in OSS for the reduction, then my OSS savings would be the \$2M x 16% = \$320,000 @ \$3,000/skid or 107 pallets saved x \$60/plt for \$6,400 + \$533 internal labor.  Surely I’ve got to be saving the company more money than that.  I think there has got to be some carrying costs associated with the warehouse itself that would also be saved.  We have 150,000 part locations in the warehouse, and only 2,500 have the ability of holding a pallet from OSS, so I’m not sure that internal inventory reduction will allow many more pallets to be returned from OSS (Currently have almost 3,000 pallet locations out there – charged by the pallet, not for the space).

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#70983

Barry Davis
Participant

As worldwide asset manager for our corporation, I can assure you there are many HARD costs associated with inventory.  The more you have, the more it costs to stock, count, move and store, and the longer it sits the greater risk you run of obsolescence and shrinkage.  Lets say you are in a low margin business and your net/net bottom line is 5%. For every \$5000 in inventory you have to write off, your sales team has to generate \$100,000 of revenue to offset. You also always have the lost opportunity cost of capital tied up in inventory that could be working somewhere else for you.  A conservative figure to use for real hard savings would be 18% carrying cost.  The best measure for the effectiveness of your project is turnover improvement or average days of supply improvement.  The problem with measuring just leadtime is you will rarely execute to the exact leadtime. Turnover is the best way to really measure the effectiveness of inventory management.
Barry Davis, Black Belt

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#70985

john beaudoin
Participant

Thank you for the response.  Since we are in the repair part business, I would classify us as a high margin business.  Also, we must carry inventory to last for some models for 5 years or more.  As a result, half of our inventory (SKU’s not \$) is stuff we may only sell one of a year, and usually the quantities are kept small as well (Most parts business’s are like this, and because of the carrying costs, thus the “high” markup of parts).  If our current inventory turns were 6 months, and with a project could get that to 5.5 months. (Sales constant, but inventory value now \$45.8 M instead of \$50 M.)  What is this really telling me in terms of project tracking, sigma level, etc?  From month to month, the sales may not remain constant, inventory purchases can be cyclic, etc.  For tracking purposes, there would be a lot of variables.  It is a number that we currently measure, but is it the number I can use to track project savings, if the project deals with how inventory is purchased and not sales?

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#70986

Jim Johnson
Participant

I think that I would focus on the hard savings that we discussed earlier in terms of closing the project initially.  Then place the process into sustainment (i.e., monitor the new process for a period of days or months) and see what the true results are for your “soft” savings.
One of the criticisms of Six Sigma is that we tend to “make up” the savings.  In this case, since you have some resistance to the inventory basis of the savings, claim the hard savings that everyone is in agreement with and then let the process run for a period of time (determined by your business cycle).  During that time, monitor the actual costs and compare them to previous experience from the same time period.  This will validate the “soft” savings for you.
Does this make sense?
Jim

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#70987

Participant

Your analysis of inventory carying cost is RIGHT ON.
Make life simple for your-self – get with your Finance Director/CFO and let them decide on the correct rate then, as you rightly point out, multiply the % by the \$ value and record this as a saving. In terms of the saving category you need to consider the following;
– Hard saving/bottom line – a portion of your savings will reduce the companies expenditure on resource, heating, lighting etc
– Cost avoidance – typically the value of money portion is considered a cost avoidance as it does not appear on someones budget and thus would not fall into the hard savings bucket.If you really want to translate the cost avoidance numbers into hard savings perhaps consider the fact that the, say, \$3m released from inventory will enable increased sales and thus increased margin – which is bottom line.If you would like to discuss further feel free to e-mail me at [email protected] regards,Adam

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#70996

Barry Davis
Participant

Turnover is a function of inventory and sales.  If sales remain steady and inventory goes down, your turnover goes up.  So from your example lets assume you reduced inventory by \$4.2M in one quarter and your sales were say \$100M for the quarter.  Your turnover is 100/45.8*4(annualized) = 8.73 turns.  Using your old inventory level of \$50M yours turns would be = 8.0.  So you saw a .73 or 9% turns improvement.  Hard savings using a conservative 12% carrying charge for the quarter would be \$126,000(12%*\$4.2M/4).  Turnover is the best measure for effective asset management and there is nothing complex about it.  Improve turnover and you improve cash flow and bottom line profits, period.

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