in this issue
Improving the Bottom Line in Chemicals
4:57 AM MDT | May 4, 2011 | By JANE LEE
By Jane Lee, v.p./Supply Chain Consultants
Every chemical company in 2011 would love to either a) increase revenue or b) reduce costs. Increasing revenue depends on many factors too broad for this paper. Reducing costs, as well, can mean anything from firing people to closing plants. For a less drastic solution, though, the first place people often look is to reduce costs in the supply chain by reducing inventory.
It is important to remember that there are two basic types of inventory:
Demand Planning plays a big role in both types of stock. Academics frequently focus on the role of forecast accuracy in reducing safety stock – yet safety stock is often a very small portion of overall inventory. In real life, it is best to examine the big picture and then tackle the areas which will provide the most bang for the improvement buck.
Let’s first talk about the origins of unplanned inventory and why it can be so difficult to get rid of. Unplanned inventory can be the result of any number of problems:
Lack of visibility
The first rule of reducing inventory should be never to make more of something you already have plenty of. Sounds simple, but if the planners do not have full visibility of all inventory by location, precisely this situation can and does happen. An easy example of this is the loss of visibility of material in-transit around the world. Where this is still being tracked manually, it is easy to lose count of what is on its way and to order it again, resulting in duplication. In other cases, simple inventory inaccuracies between what’s physically on the floor and what shows up in the inventory system can have the same result. In extreme overstock situations, inventory may be stored in non-standard locations which do not even exist in the ERP system – a perfect formula for losing track of what’s on-hand.
Poorly controlled production processes, unexpected fluctuations in raw materials, even foreign objects (like squirrels) falling into production facilities can result in production which does not meet all specs for the product scheduled. Often, operators’ incentives lead them to try to get first-quality “credit” for such production as a broader-spec product, but one for which no more inventory is needed. At worst, this results in overstocking of the broader-spec product (which is probably produced in quantities larger than demand would call for anyway). At best, the negotiations keep this material in inventory longer than it should be. If the target inventory level is already met or surpassed for the broader-spec product, the off-spec lots should be downgraded to second quality and disposed of.
High Second Quality Inventory
From a balance sheet point of view, inventory counts as an asset. Once it is disposed of or sold as a loss, however, it generates a “hit” (loss) to the earnings statement. For this reason, those responsible for earnings – usually not the same organization responsible for working capital – are reluctant to downgrade or dispose of “bad” inventory for fear of reducing earnings. In point of fact, second quality material takes up warehouse space, working capital, and “days’ supply” better spent on product we can in fact sell at a profit.
In the chemical industries, which are by their nature continuous processes, it is almost uniformly true that in moving from Product A to Product B, material is generated which meets the full specs for neither A nor B. Since the amount of transition material is sequence dependent, this can be minimized by careful planning and campaign sizing. Nonetheless, some amount of transition material is almost always generated at some point during a full production wheel cycle.
Sometimes, a new grade AB can be defined with broad enough specs that most of the transition material meets them, and a new market can be developed for this grade. This is a best-case scenario, and even then it is frequently true that demand is less than the unavoidable production of this material. When this is the case, if positive action is not taken, then inventory of AB will simply pile up and up. Businesses who want the biggest payback for their inventory investment must carefully limit the amount of AB and dispose of any excess that cannot be sold before more is bound to be made.
If there is no demand for the transition material, then of course it should be disposed of immediately.
Production that Does Not Match the Demand Plan
Another frequent occurrence in chemicals is that demand is high for a very difficult-to-meet specification. Production, despite the best available process control, may result in a bell curve of output, where only the smallest tail at one end meets specs for the highest demand. When this is the case, there is little that can be done other than to find lower-margin outlets for the lower spec production. Obviously, continuous efforts will be made to move the high point of the bell toward the desirable spec, but in the meantime the other inventory cannot be allowed to pile up.
Another cause of production that does not match the demand plan may be lack of agreement within the organization to a single demand forecast. If the plant insists on using history to predict how much of its usual products it will need – in spite of the fact that Demand Planning may have good reason to know that Product X is dying and Product Y is taking its place – then the inevitable result will be too much of X and too little of Y.
In extreme cases, the Demand Planner may have taken his eye off the ball and failed to monitor the rate of even a planned and expected conversion from X to Y. In this case, the plant may be making exactly what it was asked to make, but the forecast for X and Y are wrong. In such a situation, care must be taken to provide incentives for the last few customers to use up the inventory of X before converting to Y. This problem is seen over and over again when planners are not cognizant of how many customers – as well as what volume – are buying each product. The fewer the customers, the larger the danger of being “stuck” with obsolete inventory.
Inaccurate Demand Plans
The instance above is just a special example of inventory resulting from an inaccurate demand plan. The importance of forecast accuracy to managing inventory can hardly be overstated. An inaccurate forecast leads to too little of some things and too much of others, or to product in the wrong places to match demand. In addition to the implications for slow-moving inventory, lost sales, and increased transportation costs, such inaccuracy wastes precious line time that, in a sold-out situation, cannot be recaptured to make the RIGHT material. This can lead to shorter and shorter cycles – and more lost time and increased transition material – in a vain effort to re-balance inventories with demand.
The Bottom Line’s Bottom Line
Accurate forecasts, on the other hand, can not only prevent the wrong stuff from being produced but also give confidence to both management and production personnel that the forecasts can be trusted and followed. As long as higher forecast accuracy is maintained – and other good inventory management practices are followed – the benefits of lower inventory AND lower costs can be made to co-exist. Good forecasts and good inventory practices together come as close to a “magic bullet” as the supply chain can get.