The new inventory rules

Sections

Instability
When slack is removed
Hold the stock?
Spot on
Using the 'Net
Opening lines of communication
Applications rare

A couple of years ago, a major PC maker realized that when it comes to managing parts inventories, conventional wisdom isn't always right. The company had been following a typical PC maker's strategy of manufacturing motherboards in the Far East to take advantage of rock-bottom labor costs. After the boards were stuffed overseas, Houston-based Compaq Computer Corp. brought those components back to the United States for final assembly.

"We had our own motherboard operations in Singapore that were-from a cost standpoint-a good deal," says Ricki G. Ingalls, who was Compaq's manager of supply chain modeling at the time. "But because of the dynamics of the market, we couldn't even afford the couple of weeks or 10 days from the time we asked for a board until it showed up in Houston."

The fear: Some customers could become discouraged by the two-week delays and turn to other sources before enough low-cost motherboards arrived to satisfy orders.

OEMs have had to deal with such confounding inventory issues for about as long as manufacturing itself has existed. But the experience of Compaq-one of the country's largest OEMs-shows how complex the considerations have become these days.

An especially volatile market for electronics puts an equally hot premium on having the parts necessary to build the wanted products as it does on not having too many parts if demand suddenly softens. Global markets make it possible for customers and suppliers to be anywhere on the planet. Additionally, OEMs are feeling the pressure from competitors, owners and Wall Street to deliver high returns on invested capital.

That's why a 10-day turnaround from Asia used to be considered pretty good, but no more. What's an OEM to do? The answer, it appears, is to eschew "one-size-fits-all" approaches and use forecasting and collaboration techniques to find what's best for its particular business.

Instability

For Compaq, overseas manufacturing of motherboards, no matter how economical, was out. With the long lag time, board shortages could hinder the sales of in-demand PCs, while over-building would waste money in languishing inventory. A few years ago, the company shut down almost all of its Singapore circuit board operations, opting instead to outsource motherboard assembly to factories local to its European and North American customers.

The move provided a three-day turnaround, saving at least a week in delivery time. That meant a faster response time for high-demand products, as well as a chance to reduce component inventory if products didn't sell well.

"It saved some money, but the biggest thing it did was move product through the system faster," Ingalls says. By shortening the time between motherboard and final computer assembly, Compaq effectively took at least a week of inventory out of its entire supply chain. The company could assemble more high-margin systems, collect more revenue and increase customer satisfaction.

This decision to move assembly closer to customers is a type of strategy called postponement, says David Cahn, research director at the Atlanta office of Boston-based AMR Research Inc. "You're starting to see some of the contract manufacturers open global facilities so they're closer to their suppliers," Cahn says. Postponement does reduce overall parts inventory, but a more important result is lower "overall inventory valuations."

When slack is removed

When slack is taken out of the supply chain at the component vendors' end, overall part inventory drops. But when the parts are moved closer to the customer, each is installed closer to the ordering time. That means companies have more time to react to demand and appropriately allocate inventory to the most wanted products.

Having allocation flexibility is vital, because as painful and public as inventory shortages can be, Cahn and others argue that an inventory surplus might actually be a bigger problem.

"It's the shortages that get the press," Cahn says, "but I think there's more excess due to the amount of engineering change orders that go on during the product lifecycle." Because product lifecycles are so short, surplus components lose value at a rate of as high as 1% every day, Cahn estimates. Publicity notwithstanding, inventory shortfalls rarely cost that much. (See text table, "Surplus or shortage: Which is worse?")

Reaction time becomes doubly valuable because parts vendors are as much a factor in supply instability as any OEM business practice. The most chronic problems are with custom components, especially semiconductors. "If you work that chain back, it goes back to the wafer fab companies," Cahn says. "They're flat out-they're totally making to forecast-and then they get these custom orders and they try to fit them in."

Inventory difficulties, however, can affect even standard passive components. Astrodyne Corp., a Taunton, MA, power supply manufacturer, has found sourcing high-power capacitors to be fraught with problems. "Lead times can run 26 weeks on some of these capacitors," says Bob Butler, vice president for sales and marketing. Why? Capacitor vendors hold production orders until the company has a high enough number for an economically viable manufacturing run. Meanwhile, most distributors do not carry high-power capacitors because of spotty demand, so Astrodyne keeps six to nine months of supply on hand as a buffer.

Distribution madness

Sometimes a sudden rush on a component can create a worldwide shortage, forcing companies to buy larger amounts, which in turn strains the market even more. Before the surge of demand for PDAs, cell phones and laptop computers fueled a tantalum capacitor shortage, Astrodyne was paying about 40 cents a piece in lots of 6,000 to 8,000. "I just bought the same amount," says a rueful Butler, "and I just paid $2.40 a piece for them. We're essentially paying for black market spot buys." Such price jumps not only potentially cut into product margins, but each eats into cash and credit lines, leaving less financial room for an OEM to maintain stocks of other components.

But as quickly as a shortage comes, it can vanish. Early last year, flat panel displays were on allocation because the supply was so below demand, according to Troy Blanchette, vice president for marketing at Avnet Applied Computing, a division of Avnet Inc., Phoenix. Then the PC laptop market started slowing at the end of 2000. "Now they have a surplus of inventory almost overnight," Blanchette says. "It's scary."

Distributor woes dramatically impact electronics manufacturers because manufacturers use distributors as extended warehouses to hold components at no charge on the OEM's books. As pressure from investors and management seeking better financial returns increases, the distributors will have to begin pushing back, and that will have a direct impact on OEMs.

Surpluses that pressure prices and eliminate the need for inventory stockpiling are scary for distributors that find themselves holding the bag. "Suppliers don't want to hold the inventory, so they're sending it into the distributors," Blanchette says. OEM buyers "are pushing back because of demand fluctuation. The margin the distributors are getting isn't paying for the working capital that distributors are tying up in the form of inventory."

For example, there is "a real possibility" of higher prices to cover the increased inventory costs experienced by distributors, Ingalls says. Case in point: Not only did Compaq move component inventory off the books and to suppliers or third-party logistics providers, he adds, but this practice "has been done by almost all the 800-pound gorillas in the industry."

Hold the stock?

Another potential change would be for distributors to keep less stock on hand. This would effectively force OEMs to take more inventory, because the OEM might not be able to depend on distributors for just-in-time deliveries.

A major factor driving OEMs-especially publicly held ones-to push inventory back to distributors involves the financial metric of return-on-invested capital. "It is very much in vogue on Wall Street as a way of measuring high tech," Ingalls says. "The concept is, `How fast do you turn your own money?'" The formula is profit divided by the invested capital. Since inventory is part of the invested capital, the lower the inventory, the higher the return. Increased inventory depresses this return, making investors and other sources of financing harder to court.

Yet OEMs continue to rely on practices including just-in-time manufacturing and vendor-managed inventory, making operations more difficult for distributors. Because distributors want to keep large companies happy, smaller OEMs will be the first to see a sharp shift in distributor strategies. It's already starting to happen. "I'm finding that distributors are working more like brokers," Astrodyne's Butler says. "It used to be they'd have it on the shelf. Now it's, `I'll have it in two weeks.'"

Distributors "are trying to manage that inventory down so they can reduce turns," adds Bob Kramich, vice president for marketing and e-business at NECX.com LLC, a Peabody, MA-based unit of Converge Inc. "It's a big trend right now." And so is consolidation among distributors, which is making the parts market tighter.

Not long ago, small distributors had a depth of inventory in particular product lines and the expertise to manage that inventory. As those smaller companies are absorbed into large distributors, such as Arrow Electronics Inc., of Melville, NY, and Avnet, products are merged into existing lines, Kramich says. "The consolidation," he adds, "creates opportunities for people to service demand that is going unfulfilled now."

Spot on

Many OEMs try spot markets to smooth inventory fluctuations, either buying what the company lacks or selling its surplus. Some spot market players, such as NECX.com, emphasize that these markets can really provide many more services for OEMs, especially with Internet technology allowing trading exchanges. Companies can easily use the Web to make a fast-opportunity buy to trim costs, as well as use it as a handy valve to bleed off inventory pressure. And in the face of global parts shortages, many businesses may have a difficult time without these markets.

"If you are a medium-size OEM, you will have a harder time commanding your share of product in an allocation period," Kramich says.

"Surplus components lose value at a rate of up to 1% every day" -David Cahn, AMR Research

Yet for all the benefits of the spot market, experts like Cahn discount the impact it can really have on doing business. Any efficiencies gained through spot buys touch only a tiny fraction of purchases and so have a limited ability to reform a company's operations.

Using the `Net

An OEM would be better off redirecting its interests in the Internet, says Krish Dharma, director in the high-tech practice of PricewaterhouseCoopers, New York City. "On the one side, the market does shift very rapidly, no doubt about it," Dharma says. "But on the flip side, the underlying information exchange infrastructure and the processes associated with it are what's really lacking." In other words, although periodic global shortages of a component are inconvenient, the real issue is the poor communications among OEMs, customers and suppliers.

An OEM must develop better techniques to exchange information with its customers if it is to have a prayer of creating an accurate sales forecast and avoid the slap of market whim. Similarly, a manufacturer that fails to inform suppliers of its needs is likely to fail in obtaining components when markets are tight. There is no one for management to blame but itself.

"You're starting to see some of the contract manufacturers open global facilities so they're closer to their suppliers" -David Cahn, AMR Research

Opening lines of communication

Some companies have taken the time to create systems in-house. Hewlett-Packard Co., Palo Alto, CA, for example, developed a Web-based supplier management inventory tool a couple of years ago for its laser printer division. The company now plans to deploy the software company-wide.

"We're providing [suppliers] with the forecast," says Dave Austin, an IT engineer in the supply chain information solutions group. "They're entering this information into a tool that will send alerts if [inventory] levels are not met." The software has optimization tools to determine component shipment dates that will match product build plans. The reason HP chose to build instead of buy was pragmatic. "There really wasn't anything you could buy out-of-the-box," Austin says.

"Companies generally do not trust each other with such sensitive information as internal equipment utilization or inventory"-Krish Dharma, PricewaterhouseCoopers

More difficult than finding the software, though, is what Dharma calls the "trust issue:" Companies generally do not trust each other with such sensitive information as internal equipment utilization or inventory. Even when corporations have become comfortable with the idea of sharing specific data, the method of doing so can remain problematic.

"To have a view into the data, the simple problems have to be solved," Austin says. "How do you bridge the firewall without granting all kinds of permissions to HP networks?"

Another question is the reliability of data, especially when it comes to product forecasts. Memec LLC, a Thame, England-based distributor with North American headquarters in San Diego, has about 30,000 customers, according to Debbie Sears, director of North American supply chain solutions. "Most people are pretty good [at forecasting] within the current month," Sears says, adding that more than half can get within 10% of needs during a single quarter. "The problem is that-depending on market conditions-lead times can be between a couple of weeks and 26 weeks," she says. As accuracy falls, stocking levels have to rise to prevent possible product shortages.

The GSM RBS division (radio base stations for GSM cellular communications) of LM Ericsson Telephone Co. in Gävle, Sweden, has been working with a mix of forecasting approaches to contend with inherently unstable customer demand. "We have quite good knowledge about the evolution of the market and trends, but there is always uncertainty about how the evolution will be," says Pontus Andersson, factory manager of CCL Gävle, the cellular base stations unit of Ericsson.

Component shortages can virtually hold prices hostage, contends Bob Butler, vice president for sales and marketing at power supply manufacturer Astrodyne.

The group has used monthly forecasts for about 10 years, but added weekly demand forecasts in 1996 when it started performing final assembly of radio base stations. Accurate forecasts are critical because the factory receives completed radio equipment from suppliers-often from other Ericsson divisions-and installs that equipment in cabinets. Maintaining enough stock would require too much room, since demand can vary by 25% from one week to the next. Similar to HP, Ericsson uses an internally developed program that is Web-based.

Applications rare

Analysts and other industry observers say using off-the-shelf software and Web-exchange products for these inventory management challenges may not be as prevalent as some may think. That's the case despite the rise of RosettaNet and other industry efforts to better manage the supply chain.

"The systems to manage inventory today are very, very expensive, especially when you're talking about the large [vendors like] Manugistics Group Inc. [Rockville, MD] or i2 Technologies Inc. [Dallas]," Kramich says. "The average OEM may have a harder time affording those systems."

Other new technologies also may not be adopted as soon as some would expect. "The use of the Internet to exchange information is not as prevalent as one would have hoped," Dharma says. "There's a lot of noise, but people have not been sold on it having an impact immediately." It seems that even in the high-tech world, the more things change, the more they stay the same.

Erik Sherman is a writer who covers business and technology for such publications as Newsweek, Computerworld and CommVerge. His latest book is Home Networking Visual Jumpstart (Sybex). He can be reached at esherman@triangle-publishing.com and at http://www.eriksherman.com.