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How Do We Educate Customers About Reducing Inventory? EOQ vs. MOQ

Ask the Expert: Lean Leadership:  Have a question about lean leadership? Let Larry Fast tackle it for you.

QUESTION: For materials that are controlled by the customer, and customers that don’t mind holding excess inventory, what are the key lessons we could use to educate customers about reducing inventory? Has EOQ (Economic Order Quantity) been a successful methodology when selling the strategies to the customer as opposed to the MOQ (Minimum Order Quantity) concept?

ANSWER: This question is a follow up to my last article on inventory. EOQ is a term I first heard when my company was installing its first MRP (material requirements planning) system on an IBM 360 computer back in the day. EOQ was a financially driven number, not a customer service number, and was tied to the ABC inventory model discussed in Are You Overlooking Inventory as a Focus for Process Improvement?

“A” items, for example, because of their high volume might be scheduled to run every week or two based on average weekly demand numbers. These meant nice long runs for equipment and every operator in the factory loved them.

A “B” item might run once a month and a “C” item maybe once a quarter. Again, the thinking behind this is that we don’t want short runs in the factory that negatively affect efficiency and often scrap as well.

In my view, this is thinking that is representative of the 1970s, not 2015.

Our focus for the last two decades or so right up to today has been on reducing our cycle times, using quick-change thinking and technology to achieve close to theoretical minimums on set-up times, working with suppliers to compress their cycle times, and yes, working with customers on improving their use of statistical analysis to improve their forecasting a la great S&OP planning. (Sorry, but the forecast done with a wet thumb in the wind doesn’t work for me.)

In my view, this is thinking that is representative of the 1970s, not 2015.

The MOQ was/is typically used when the cost involved in the set-up is excessive and/or the process is one that simply cannot be stabilized soon enough to get a good product on a short order without excessive scrap. These are typically special ordered products that have to be priced at very high margins in order to justify the inefficiencies created by the order size. In the wire and cable industry a continuous vulcanizer and/or a large plastic extruder were the operations most affected.

Another example is if the order is for a product that takes a non-standard/special raw material and one for which your supplier has a MOQ. In these cases the customer normally has the option of buying any leftovers of the special raw material or else can ask the maker of their final product to manufacture a sufficient quantity that will consume all of the raw material.

The MOQ in my mind is still a valid issue even after all of the improvements in our set-ups and cycle times. It is absolutely critical that the product is priced at a premium and captures all of the additional costs associated with these kinds of orders. Be sure your pricing of “A” items isn’t subsidizing these kinds of orders.

There are two important business decisions that go with inventory:  1) It is important to providing customer service and 2) It is a consumer of cash. Our challenge as manufacturers is to optimize this outcome, i.e., have a record of customer service near perfection with the minimum amount of inventory.

But No. 1 has to happen first.

So is it EOQ or MOQ that is the better methodology of selling the strategy of lower inventory to customers? The short answer is neither.

The first considerations are these:

  • Is your manufacturing organization capable of processing orders on much shorter set-ups and cycle times?
  • Are your suppliers already supplying raw materials to your shop floor on cycle times that meet your needs as their customer?
  • Are your processes stable with process capabilities that consistently meet the needs of your customers?
  • Are on-time deliveries to your customers consistently above 98%?
  • Do your suppliers and your factory have adequate capacity to support the growing needs of your customers?

If any of these questions get a “NO” answer, then I’d argue you aren’t ready to start a discussion with customers about reducing inventory. Your supplier and/or manufacturing capabilities simply aren’t yet good enough to get into inventory-reduction discussions with your customers. One of the primary drivers of answering the question, “How much inventory do I need?” is how reliable the plant’s shop floor execution is. Got to fix that first.

It isn’t clear from the reader’s question how much finished goods inventory is being held for the customer and where it’s being warehoused. As factory performance approaches the goal line, it’s appropriate to get to the “how much cash” discussion. How much cash is tied up in inventory being held in the company warehouse? How much cash is tied up in inventory in the customer’s warehouse? Is it their cash or yours (consigned inventory)? What’s the total cash for all items being held in inventory for this customer if there is more than one part number?

Once the factory has established it can meet the customer’s expectations on service, then it’s appropriate to broach the subject with the customer of how --  together -- we can minimize the negative cash impact caused by having excessive inventory. Based on their pattern of orders and forecast variation and based on your plant’s performance, what is the legitimate calculated safety stock necessary to sustain the service level? How can we move toward that number? Here’s where the financial implications, i.e. positive impact on cash flow, become apparent.

When you go to meet with your customer to celebrate your company’s improvement and next steps to expand your relationship, be sure to take your fact-based data that demonstrate your ongoing capabilities and sell your performance now being at levels where extra inventory simply is no longer required.

Educate them on the work that’s been done to improve process capabilities and to reduce set-up and overall cycle times. Further, assure your customer that you won’t be going from current inventory levels down to safety stock levels immediately.

Rather, you’ll be stepping down the inventory levels in a controlled manner to confirm your customer’s confidence that extra inventory is no longer required.

If you have inventory at your warehouse as well as your customer’s, take yours out first while the customer retains their “Charlie Brown blanket” for a few more weeks. Once your inventory is consumed, then go to work with them to phase it down to safety stock levels. Then go right ahead with discussions about how to move from a make-to-stock relationship to how you can get to a make-to-order scheme.

If your production signals are currently based on shipments out of your warehouse, then suggest you’d like to move your production signals to shipments from the customer’s warehouse. This is a great way to bridge the gap from where you are to the ultimate objective of responding to your customer’s orders.

And don’t forget to have your salesperson close the meeting by asking for more business: “Based on our performance record, let’s discuss how we can help with a greater share of your business. Oh, and by the way, the carrying cost of the inventory we’ve been holding for you has been $x,xxx/month. Since that expense is no longer required, we’ve reduced your price on all products we provide with the new process by $x or by x%.

It’s a win-win. Cha-Ching!

“Those that say it can’t be done need to get out of the way of the people who are already doing it.” -- Joel Barker, Futurist and Author

Larry Fast is founder and president of Pathways to Manufacturing Excellence and a veteran of 35 years in the wire and cable industry. He is the author of "The 12 Principles of Manufacturing Excellence: A Leader's Guide to Achieving and Sustaining Excellence." A second edition is planned for release in 2015. As Belden’s VP of manufacturing Fast led a transformation of Belden plants in the late '80s and early '90s that included cellularizing about 80% of the company’s equipment around common products and routing, and the use of what is now know as lean tools. Fast is retired from General Cable Corp., which he joined in 1997. As General Cable's senior vice president of operations, Fast launched a manufacturing excellence strategy in 1999. Since the launch of the strategy, there have been 34 General Cable IndustryWeek “Best Plants Finalist awards, including 12 IW Best Plants winners. Fast holds a bachelor's degree in management and administration from Indiana University and is a graduate from Earlham College’s Institute for Executive Growth. He also completed the program for management development at the Harvard University School of Business.

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