Synchronous Management Principle 7: The Marginal Value of Non-Constraint Materials | Operational Excellence Quick Hits

Max Krug: (00:05)
In today’s session, we’re going to continue on the concept of synchronous management. Today’s session is Principle number 7, which talks about the marginal value of a unit of non-constrained material. So if the organization doesn’t have a problem with getting material and material is not the constraint of the organization, what is that material worth to the organization? So we’re going to dive into this a little bit deeper today.

Max Krug: (00:32)
So let’s talk about understanding material. So material is purchased for items that the organization intends to convert into items for sale. So what we’re doing is we’re buying material. Our intent is to take that material and convert it into items that we’re going to sell for the organization. If it’s not in its final form for what the customer is demanding, then it’s either raw material, which hasn’t been transformed yet, it’s what we bought from our supplier, or it’s work-in-process materials. Also, material that’s in its final form that meets the specification for the customer but there is no demand is also inventory, which is in this case finished goods. So we have material that can be in multiple forms, raw material form, where we haven’t done any value added activity to it. Work in process where there is value-added activity, but it’s not in its final form. And then finished goods, which is in its final form, but there’s no short-term demand for it, so it’s sitting in inventory.

Max Krug: (01:33)
So now that we understand what is material, let’s talk about inventory. So what is inventory? A lot of times we have a question, if we talk to the finance people, inventory is an asset, or if we talk to operations people, it’s a liability. So what is it? It’s an asset or a liability? It can’t be both. Or can it be both, that’s what I’m going to question. So inventory that’s converted into sales within the replenishment cycle I consider to be an asset. So if we have demand for something and it’s within the replenishment cycle of what the organization can produce it in, and there’s demand within that replenishment cycle then inventory is actually an asset because it’s going to generate cash.

Max Krug: (02:13)
However, if we have excess inventory, that’s more than what’s being demanded within the replenishment cycle, then it becomes a liability. So we want to look at our inventory and we can divide it up into which inventory is asset, which inventory is liability. Excess inventory is always a liability because it ties up cash and it’s preventing us from meeting demand for other items that customers are looking to get. Inventory should be used as a shock observer to absorb the variability between supply and demand. So if we have variation in supply, variation in demand, we use inventory as a shock absorber between those two so that we can keep the production system stable and not let supply disruptions or demand changes affect our production system and make that unstable.

Max Krug: (03:05)
So what is the value of inventory? So if we look at it, contrary to popular belief, the value of inventory is equal to the purchase price of the material. That’s if the material is not the constraint of the organization, so whatever we bought the material for, that’s what the value of that inventory is. A lot of people believe in the cost world that the value of material increases as it moves through the value stream, as we go through different steps that accumulates cost, so that’s from a cost perspective. But from a throughput perspective, value of that material remains the same as it was at the purchase price, and only when it gets to final form, is it worth the full value. And that’s because the cash that was used to acquire that material is what’s tied up in inventory. We don’t allocate cost to inventory.

Max Krug: (03:54)
And in reality, if you take a product that’s partway through the value stream and you have a cost on it, that includes material, labor, and overhead, I dare to go out and try to sell that piece of material for that price. Actually, all you’re going to get for that is what that material’s worth in scrap value. Because if it’s not in its final form, it’s not worth really anything but scrap value. It’s actually worth less than what the material is in its raw state. So we want to change our perception about how we value inventory and we don’t accumulate cost or value as it moves to the value stream. It’s what we paid for that material in investment and then when it’s in its final form that we can actually sell it in the market, then that takes on the full value of the saleable price.

Max Krug: (04:47)
When we look at non-constrained material, all we want to do is we want to understand is like if we have volatility in the market, then we want to put strategic inventory in place because we don’t want the material to become the constraint of the organization. So in that case, what is strategic inventory? It’s important to understand what place material should be strategically held, in what form, and in what location to not disrupt the flow and to not become the constraint of the organization. So when we look at the value stream map, we can actually identify where it makes sense to hold strategic inventory and then we manage that strategic inventory based on pull, not push. And if we set up that strategic inventory correctly, then we can actually use it as a leverage in the market and service our customers better than our competitors.

Max Krug: (05:40)
So that’s our session for today. Next week’s session is going to be on Principle 8, and What’s the Marginal Value of a Sales Order in a Non-Constrained Market.