In Part 2 of this series on Parts Replenishment Systems, we’re going to look at the negative consequences of Cost Accounting Metrics that are used in the Min/Max System and the behaviors that result. Again, thanks to Bruce Nelson for writing this series of posts in our business novel Epiphanized - Integrating Theory of Constraints, Lean and Six Sigma.
Consequences of Cost Accounting Metrics
Perhaps the best way to make this point is with a couple of examples. The first example deals with a company that measured and rewarded their procurement staff based on the amount of money they saved with procurement purchases. For the procurement staff their primary scheme to accomplish this objective was to buy in bulk. For the most part, this was usually quite easy to accomplish. Their suppliers preferred, and sometimes demanded, that their customers buy in bulk to receive the benefit of quantity discounts. The more you bought, the less it cost per unit. The assumption being that the purchase price per part (unit) could be driven to the lowest possible level by buying in bulk and the company would save the maximum amount of money on their purchase. It seemed like a great idea and certainly a way to meet the objective of saving money. Sometimes these supply items were procured in amounts well in excess of the maximum, but the company got them at a great price!
By employing this cost-saving strategy, the company had a warehouse full of low-cost inventory that had used a large portion of dollars. The problem was this—they didn’t have the right mix of inventory to build even a single product. They had too many of some items, even though they were all purchased at the lowest price, and not enough of other items. The bigger problem was they ran out of money to purchase any more parts—especially the parts they desperately needed! Do you suppose they wished they had at least some of the money back so they could buy the right parts, in the right quantity, at the right time so they could produce products?
Another cost saving example is the tale of a company who was a contractor to the government. In their contract with the Government, the Government had offered a very lucrative clause to save money. This company was given a budgeted amount to buy parts on a yearly basis. Based on this budgeted amount, the Government offered to split fifty-fifty any amount the company could underrun their parts budget. The company took the total budgeted dollars and divided it by twelve to establish the monthly parts budget. They also held back a percentage of the budgeted amount each month so they could claim cost savings and split the difference. Any parts purchase that would have exceeded the targeted monthly budget was postponed until the next month, even if it was urgently needed. The ability of this company to make money slowed dramatically. They were literally jumping over dollars to pick up pennies. There were many jobs waiting for parts that couldn’t finish until they had the parts to finish, but they had to wait, sometimes for several days or weeks, to get the parts, because of the cost-saving mentality.
In both of these examples it’s an issue of bad cost metrics driving the bad behavior. In both of these cases, cost savings were employed as the primary strategy. In the first example, the company ultimately went bankrupt and went out of business. They couldn’t pay back the loans on the money they had borrowed to buy all of the low cost parts because they couldn’t make any products. In the second example the company avoided bankruptcy because they provided a needed service for the Government; they were ultimately spared by seeing the error of their ways, and they decided to spend the budgeted dollars to buy the needed parts.
In my next posting, we’ll discuss an analysis of the system associated with the most popular replenishment system being used today, the Minimum/Maximum System.