When we meet with a company for the first time, we like to ask three simple questions to allow us to make a quick assessment of their inventory status. We ask:
- What is your revenue and gross margin?
- What is your inventory level?
- What is your average lead time?
These are three relatively easy questions but we do not always get three quick and concise answers. As we are often talking to senior executives or owners, we always get an answer to the first question, which makes total sense as these are the most basic of measures of any business. We generally get a high percentage answering the second question correctly as well. This also makes sense as most people that talk to us, a company specializing in demand planning and inventory management, do so when they suspect they have an inventory problem.
The third question is where we get our first inkling that there may be an issue at the company. In our experience, we have found that this question is not as easily answered off the top of the head as the first two. It is simply because this measure unlike the others is not looked on with as much importance and in many cases is not as easy to derive. Additionally, there is often confusion as to what we mean by lead time. It is often assumed that we are asking about lead time to their customers. Though we are as interested in that at the preliminary discussion level, we are more interested in the average lead time from their suppliers of raw, pack, and finished goods to them.
So why do we ask about lead time?
Simply stated, with the average lead time we can do a gross “guesstimation” of actual versus potential inventory turns i.e. If the average lead time is two months, there will be, on average, two months of inventory in the system (assuming the company owns the one month worth of inventory in transit) as a lower limit. This means six turns per year. We can calculate the Cost of Goods Sold by subtracting the gross margin from the revenue. With COGS and Inventory we can estimate the companies average turns. We can then compare that to the lower bound inventory we calculated based on average lead time and voila… we have a gap that provides a gross estimate of the companies improvement opportunity.
If the average lead time is not available, we already know that there is an opportunity.
On the other hand, we come across the rare instance where these numbers are known and quickly shared. They may answer: “let’s see, 60% of our goods come from Asia. Half of that is from China with a lead time of two months. The remainder is from other countries with a lead time of 3 months. The rest of our goods are imported equally from the US, Mexico, and Germany with lead times of 2 weeks for the US and 1 month for each of Mexico and Germany.” In this case, we are first impressed, but then quietly run our back of napkin inventory calculations. If our calculation shows that their performance is not optimal we quickly ask “So, tell me, how volatile is your customer demand?” That of course is a topic for another posting!
Do you know internal, external, and cummulative lead times? If not, familiarize yourself with these numbers and the consequences of the same. You may be surprised.
