In the past, most operations managers used the income statement in managing their businesses, and they weren’t too concerned about inventory. Shipping late or losing an order would hurt their careers far more than having a lot of money tied up in inventory.

When the prime rate went over 20 percent, inventory became a significant cost on the income statement, and suddenly even the most tradition-bound operations manager took notice. The pendulum swung and, in many cases, the objective quickly became slashing inventories of finished goods, work-in-process and supplied components, regardless of the impact on operations.

The prime rate today is 4.75 percent and not likely to go much above that for at least the next year or so. However, most operations managers and all consultants still focus on eliminating inventories! Let’s look at two common approaches and their consequences.

  • One familiar approach is Just in Time. The JiT philosophy is that a supplier should be able to respond to customer demand from current output. This makes sense philosophically, and if demand stays constant it can be achieved. But demand rarely stays constant for long, if at all. One way to deal with this is to invest in enough capacity to produce at peak demand and have idle capital equipment during down markets. Alternatively, you could build inventory to accommodate peak demand and have excess inventory when demand is soft.

    Either alternative presupposes you’ve achieved maximum agility, flexibility and cost-effectiveness. However, someone in the supply chain must either carry inventory or overinvest, no matter how lean you’ve become!

  • Another approach is the rigid sequential process that builds only one product. In this process, work is handed directly from one process step to the next, each process step has exactly the same work content as the one before and after, and nothing ever breaks down. Too bad this never occurs in real life! Real process streams have to deal with product families, each of which requires different process steps with different work content, changeover time and replenishment.
The rigid sequential process can’t achieve the planned output because each process step is inefficient and the effects are cumulative. In a sequential process when one step shuts down they all shut down. And because each step shuts down at random, the time out of production is the sum of all downtime. If a process includes 20 steps, and each is inefficient by 1 percent, the best you can expect to achieve is 80 percent of planned output.

The answer is to add buffer, but the question is how much and where? Trial and error is one approach, but the best answer is to create a mathematical model of the process stream and test it under varying operating conditions.

The effect of any perturbation on the dynamic behavior of a process stream is often quite subtle, and intuitive solutions are usually wrong. Simulation shows you where the constraints are and how much buffer is needed.

There’s absolutely no doubt that if a firm is to be competitive—especially in today’s market—it has to operate at optimum efficiency, and controlling inventory is essential to optimizing efficiency. There’s an optimimum tradeoff between investing in hardware and inventory; between managing with the income statement and the balance sheet. The successful operations manager will find that optimum tradeoff.