4 Inventory

UNDERSTANDING INVENTORY WASTE

Mike Dixon, PhD

In modern operations management, inventory represents more than just stored materials and products- it often signifies inefficiency and waste. As one of the eight fundamental wastes identified in Lean principles, inventory waste occurs when organizations maintain excess materials, components, or products beyond what’s needed to meet current customer demand.

While some inventory is necessary for operations, excess inventory ties up capital, consumes space, and often masks underlying operational problems. Understanding inventory waste is crucial for improving operational efficiency and financial performance.

Types of Inventory

Organizations typically manage four distinct categories of inventory:

1. Raw Materials

Raw materials represent unprocessed inputs awaiting transformation in the production process. This includes everything from basic commodities to specialized components. For example, an automobile manufacturer maintains inventories of steel, glass, and electronic components.

2. Work-in-Process (WIP)

WIP consists of partially completed products moving through the production system. These items have received some processing but aren’t yet finished products. In a furniture factory, this might include partially assembled chairs or tables at various stages of completion.

3. Finished Goods

These are completed products ready for sale or distribution to customers. They represent the final stage of inventory before delivery to customers. For a clothing manufacturer, this would include packaged garments ready for shipment to retailers.

4. Maintenance, Repair, and Operations (MRO) Inventory

MRO items support production but don’t become part of the final product. This category includes spare parts, cleaning supplies, and tools. While often overlooked, MRO inventory can represent a significant investment and waste if not properly managed.

The Hidden Costs of Excess Inventory

Holding Costs

An inventory holding cost is the total annual expense of storing and maintaining inventory. Direct holding costs typically range from 20% to 30% of inventory value annually, meaning a company with $1 million in inventory likely spends $200,000-$300,000 just to maintain it. These costs include:

• Storage space costs: Monthly facility expenses averaging $5-15 per square foot, plus utilities running $1-3 per square foot and security systems costing $2,000-5,000 annually
• Insurance premiums: Typically 0.5-1% of inventory value annually for basic coverage
• Property taxes: Often 1-2% of inventory value annually in many jurisdictions
• Material handling equipment: Forklifts ($25,000-35,000 each), pallet jacks ($300-1,000each each), plus maintenance and operator labor
• Inventory tracking systems: Enterprise systems costing $10,000-100,000+ annually for software, hardware, and maintenance
• Climate control: Specialized environments can add $1-2 per square foot in utility costs

Opportunity Costs

When capital is tied up in inventory, companies lose potential returns from alternative investments:

Risk of Obsolescence and Spoilage

Inventory value can decline dramatically due to various risks:

• Technical obsolescence: Electronics losing 5-10% of value monthly
• Style changes: Fashion items typically marked down 30-50% at season’s end
• Expiration: Perishables facing 100% loss if not sold by expiration date
• Physical deterioration: Raw materials degrading by 2-5% annually in normal storage
• Market changes: Products requiring 20-40% discounts when market demand shifts

Impact on Cash Flow and Financial Performance

Excess inventory creates multiple financial impacts:

• Reduced working capital: Every $1 in inventory typically requires $0.25 in working capital
• Lower return on assets (ROA): Each 10% increase in inventory typically reduces ROA by 1-2%
• Increased borrowing: Inventory financing costs 6-12% annuallydepending on the costs of borrowing.
• Higher operating costs: Carrying costs reduce operating margins by 2-5%
• Reduced profitability: Every dollar of unnecessary inventory typically reduces net profit by $0.20-0.30

Note: These figures represent typical industry ranges and can vary significantly based on industry, location, and specific business circumstances. Companies should analyze their own data to determine their actual costs.

Understanding Work-in-Process (WIP)

WIP inventory represents products actively being transformed through the production process. In a service, WIP is often a person waiting or being served. While some WIP is necessary, excessive WIP often indicates process inefficiencies and creates several problems:

• Longer lead times
• Reduced flexibility
• Quality issues (problems hidden in WIP)
• Increased handling and damage
• Space consumption
• Production scheduling complexity

Little’s Law: A Fundamental Relationship

Little’s Law provides a powerful insight into the relationship between WIP, throughput rate, and flow time:

WIP = Throughput Rate × Flow Time (lead time)

OR

Flow Time = WIP ÷ Throughput Rate

OR

Throughput Rate = WIP ÷Flow Time

Let’s understand each component:

Throughput Rate

This is the average rate at which units complete the process, typically expressed as units per time period (e.g., 100 units per day, 10 per hour, 100 per minute). Throughput rate measures how fast a process can produce output under normal conditions.

For example:

• A coffee shop serving 20 customers per hour
• An assembly line completing 80 cars per day
• A document processing center handling 400 claims per week

Flow Time (also called Lead Time or Throughput Time)

This represents the average time a unit spends in the process from start to finish, including both processing and waiting time. Flow time includes:

• Actual processing time
• Queue time (waiting to be processed)
• Transport time•Inspection time
• Any other delays or waiting periods

For example, if a customer order takes 5 days from order placement to delivery, the flowtime is 5 days, even though actual processing might only be a few hours.

Applying Little’s Law:

Little’s Law is particularly powerful because it allows managers to calculate any one of the three variables (WIP, throughput rate, or flow time) when they know the other two. This flexibility makes it an invaluable tool for process analysis and improvement:

• To find Flow Time: If you know your WIP level and throughput rate, divide WIP by throughput rate
• To find WIP: If you know your throughput rate and desired flow time, multiply them together
• To find Throughput Rate: If you know your WIP and flow time, divide WIP by flow time

Here are two practical examples demonstrating how Little’s Law works in different settings:

Example 1: Manufacturing Process

• • If you observe 100 units in WIP (on average)
  • And your throughput rate is 20 units per day
  • Then: Flow Time = WIP ÷ Throughput Rate = 100 ÷ 20 = 5 days

Alternatively, if you wanted to achieve a 3-day flow time with the same throughput, you would need to reduce WIP to 60 units (3 days × 20 units/day).

Example 2: Service Process

• • A doctor’s office has 12 patients (WIP) in the system
  • They serve 3 patients per hour (throughput rate)
  • Therefore: Flow Time = 12 ÷ 3 = 4 hours per patient

If the office wanted to reduce patient wait time to 2 hours while maintaining the same throughput, they would need to reduce the number of patients in the system to 6 (2 hours × 3 patients/hour).

This mathematical relationship holds true in virtually any process, from manufacturing to services, making it a universal tool for process analysis and improvement.

Key Insights from Little’s Law:

1. Reducing WIP while maintaining throughput will reduce flow time
2. Increasing throughput while maintaining WIP will reduce flow time
3. If WIP increases but throughput stays constant, flow time must increase
4. The relationship is mathematical – it always holds true under steady conditions

This fundamental relationship helps managers understand how changes in one variable affect the others, making it a powerful tool for process improvement and inventory reduction efforts.

Then Why Hold Inventory at All?

Despite the significant costs and risks, there are several strategic reasons why companies maintain inventory:

Responsiveness to Customer Demand

In today’s competitive market, customers expect immediate availability. When a customer wants a product, having it immediately available can mean the difference between making a sale and losing it to a competitor. Inventory enables companies to meet customer expectations without delay. For example, a retail store needs to have products on shelves when customers arrive, and an auto parts distributor needs to fulfill urgent repair orders immediately.

• Allows immediate fulfillment of customer orders
• Maintains high service levels and customer satisfaction
• Prevents lost sales due to stockouts
• Critical for competitive advantage in many markets
• Especially important for retail and essential products

Economies of Scale

Buying or producing in larger quantities often reduces the per-unit cost significantly. These savings can outweigh holding costs when managed properly. For instance, a manufacturer might save 20% on raw materials by ordering full truckloads, or a production line might reduce setup costs by running larger batches. These cost advantages often make it economically sensible to hold more inventory.

• Volume discounts on larger purchases
• Lower transportation costs per unit
• Reduced ordering and setup costs
• More efficient production runs
• Bulk purchasing opportunities

Buffer Against Uncertainty

The business world is inherently unpredictable. Supply chains can be disrupted by weather, political events, or supplier issues. Demand can surge unexpectedly. Lead times can vary. Buffer inventory provides insurance against these uncertainties. Consider how grocery stores increased their buffer stocks after experiencing supply chain disruptions during the COVID-19 pandemic.

• Protection from supply chain disruptions
• Coverage for unexpected demand spikes
• Insurance against supplier delays
• Handling of seasonal variations
• Protection against price fluctuations

Safety Stock Requirements

While similar to buffers, safety stock specifically addresses known variability in supply and demand. It’s calculated based on service level requirements, lead time variability, and demand patterns. For example, a hospital must maintain certain levels of critical supplies to ensure patient care is never compromised, even if deliveries are delayed or usage spikes.

• Guards against stockouts
• Manages lead time variability
• Covers demand uncertainty
• Protects critical operations
• Maintains service level agreements

Operational Efficiency

Inventory can actually help reduce overall operational costs by enabling smoother, more efficient processes. Without adequate inventory, operations might suffer from frequent starts and stops, rush orders, and inefficient batch sizes. A furniture manufacturer, for instance, might hold more raw materials to avoid costly production line changeovers and maintain consistent output

• Reduces machine changeover frequency
• Allows for optimal batch sizes
• Smooths production schedules
• Enables consistent workflow
• Minimizes rush orders

Strategic Considerations

Sometimes, holding inventory is a deliberate strategic choice beyond immediate operational needs. Companies might stock up ahead of anticipated price increases, during periods of material scarcity, or to support major initiatives like new product launches. For example, electronics manufacturers often build up an inventory of critical components when shortages are anticipated.

• Takes advantage of anticipated price increases
• Secures scarce materials•Supports new product launches
• Maintains competitive position
• Enables quick market response

The key is finding the right balance between these benefits and the holding costs discussed earlier. This often involves sophisticated inventory optimization models and careful consideration of business strategy and market conditions.

Conclusion

Inventory waste, while sometimes necessary, represents a significant challenge in operations management. Understanding the various types of inventory, their associated costs, and the relationships between WIP, throughput, and flow time provides managers with the knowledge needed to make better inventory decisions. By recognizing inventory as a form of waste, organizations can work to reduce it systematically while maintaining or improving service levels.