Five Ways to Lower Inventory Costs

Any manufacturing organization knows that keeping excess inventory is costly. A proven way to keep it low? Just in time (JIT).

JIT is essentially an inventory strategy that reduces in-process inventory and the associated carrying costs. Developed in the 1970s by Japanese Taiichi Ohno of Toyota, the philosophy of JIT advocates a lean approach to production, by minimizing waste (i.e. inventory) and improving quality. Factors that typically increase costs without adding any value include inventory, overproduction, work stoppages, machine downtime, poor quality resulting in defects, set-up time, and even time spent moving product from one space to another.

A true JIT approach therefore requires focusing on continuous improvement in every step of the manufacturing process, not just in inventory reduction. However, JIT only works if you can rely on your suppliers to deliver parts of sufficient quality at a reasonable cost, on time, every time.

This makes supplier relationships extremely important. So what can you do to establish a reliable JIT supplier base?

1. Establish long-term agreements

Long-term contracts give suppliers some financial security and express your level of commitment. As a result, the supplier is more likely to make the necessary efforts to deliver high-quality products on time.

In a JIT context, this often means signing Kanban, blanket order, or blanket/Kanban hybrid agreements with your suppliers.

Kanban is a Japanese term that essentially means “signal”. So under this type of contract you would maintain only enough inventory to manufacture the products you need in the very near future, and then send a signal (various methods exist) to your suppliers to tell them it is time to deliver a new shipment [ii]. Since under Kanban agreements production and deliveries generally occur daily, your suppliers will need to reserve labour and machinery for your production, while you will need to adhere to strict delivery schedules. In other words, it is a serious commitment from both parties.

Kanban agreements are a very good way to reduce inventory, but since the frequency of shipments depends on the demand, there are a few things that you need to keep in mind. The first one is total ordering costs, which should remain low enough to make more frequent purchases more affordable in the long run. The second is the inventory turnover ratio, also known as inventory turns, which basically indicate how often a company sells through its inventory. The faster inventory is turned, the less risk of loss and depreciative value and the better return on investment. It is indeed better to only buy $5,000 worth of product and buy another $5,000 worth of product just before running out of stock, rather than buying the entire $10,000 worth of product at one time. In the meantime, the extra $5,000 can then be invested elsewhere. The number of days a company should be able to sell through its inventory varies greatly by industry and also depends on your inventory value.

Blanket orders or stocking agreements are another way to avoid holding large inventories. In this case, the buyer issues a blanket purchase order and the supplier agrees to ship materials at different times throughout a set time period (once a month, every quarter, etc.) at predetermined prices. This means that the supplier must agree to keep the stock of finished products for some time (sometimes in exchange for a stocking fee), and that the buyer must accept to buy a minimum quantity at the end of the contract.

This type of agreement is particularly interesting if you have cyclical/seasonal demand, because it gives you more flexibility over the delivery date than Kanban. The problem, however, is that once the finished products have been delivered, it may take some time for the suppliers to replenish the inventory for the next shipment.

The solution? Hybrid agreements that require your suppliers to keep in stock both finished products that are ready to ship and semi-finished products (WIP) that can quickly replenish the finished product inventory. Such agreements are ideal when you have a fairly good idea of your yearly volume, but don’t know exactly when you’ll place your orders. You may need the finished product on a very short notice, and in that case, having an inventory of semi-finished products will significantly reduce the overall lead time for your next order.

2. Improve communication with your suppliers

Regardless of the type of agreement you sign with your suppliers, keeping a constant and direct line of communication with your suppliers is the easiest way to ensure on-time deliveries.

This can be facilitated by technology, but sometimes it is as easy as establishing a single point of contact for your suppliers or creating a formal supplier program that keep suppliers informed on topics of mutual interest [iii].

3. Involve your suppliers in the early stages of new product planning

Have you ever being tempted to say to one of your customers “lack of organization on your part does not constitute an emergency on my part”? It is the same thing with suppliers. They probably have several customers besides you, which means they must constantly prioritize and decide who gets what first.

Sure, some buyers only communicate with their suppliers when a need arises, but a smarter approach is to contact them early to discuss future needs and to determine how to best work together [iv].

4. Use supplier expertise to improve design manufacturability and reduce product cost

This is an area of collaboration that is often overlooked, but when you involve a supplier early in the design phase of a new product, he or she will often make suggestions that can improve the design of the end product [i]. For example, your supplier may suggest using a different material to produce a specific part or a slightly modified design. As a result, the end product may be easier to produce, and if the production lead time is decreased, you won’t need to keep as much inventory.

5. Create a true partnership with your suppliers

To understand what a true partnership means, just think for a minute about the qualities you appreciate from your own best customers. Chances are you value customers who treat you as partners and not just commodity providers, order consistently, pay on time, sign long-term agreements to support your inventory, and adhere to their forecasts. Those are exactly the same qualities suppliers expect from you. In return, they will put you at the top of their priority list and make sure you get what you need, on time, every time… just like you do for your own best customers.

In conclusion, there is no real trick to achieve JIT delivery. It’s a process, and it takes time to form strong relationship with suppliers, but you are more likely to succeed if you make it easy for your suppliers to deliver on-time. This means working with a smaller group of suppliers that understand your business and priorities, signing mutually beneficial contracts that help them justify keeping inventory on your behalf, and treating them as true partners.