Do the math

Busting the myths about managing inventory

by Fred W. Crans

Ever since Charles Housley published Hospital Materiel Management in 1978, it has been taken as word directly from the Almighty that inventories should be managed closely and turned frequently in order to achieve maximum operational efficiencies and minimize operating expenses.

All that is true — sort of.

Truth is inventory itself has absolutely zero impact on operating expense!

"What," you say, "that can’t be true." It is. From a financial perspective, inventory represents a choice for the use of cash. Items are purchased and held for future use. If unused and un-expired, those items can theoretically be converted back into cash. Therefore, inventories are considered "assets" and are reported on the organization’s balance sheet. They are only considered expenses and transferred to the operating budget when:

They are issued to and used by a requisitioning department

An inventory count has been taken and the on-hand count does not match that in the ERP system

The item’s useful time period has expired

Therefore, while it makes good "common sense" to manage inventories (as related to utilization of space, product expiration and shrinkage), the inventories themselves are neutral related to operational expenses.

Still, it is a good idea to manage them.

Recently, a long-time friend sent me an e-mail and asked me for some ideas on managing specialty inventories for departments such as surgery and cath lab. Without mentioning consignment (another article, another time), here is what I said:

Joe,

Thanks for asking for help controlling your inventories in the specialty areas. Here are some quick thoughts:

I know that your Materials Management ERP system will do an A-B-C analysis for you (probably by dollar value for the items), but there are actually three types of "A-B-Cs"

How much is spent on an item during the year (dollar value expensed to the department from inventory)

How often is the item used (number of units issued)

How easy is it to get the item through normal channels of distribution

The third question is very important when deciding how much to set the stocking level at. Here is my rule of thumb: If something can be purchased via normal distribution channels — from a distributor or directly from the manufacturer (without heavy additional charges), and can be received in a week or less — that item is an "A" and the levels can be set accordingly. If you have to wait more than a week, but less than two to get it, that item should be a "B." Anything more than a two-week delivery cycle should be a "C."

To really control inventories and inventory stocking levels you need to give all three questions careful consideration. For right now, however, let’s take a look at just the first group — ranking by dollar value.

If your inventory value is $1 million and the annual expense for those items to the user department is $4 million, then you are turning your inventory four times. Generally speaking, when you use what is known as a Pareto Analysis to look at your inventory, you will find that 70 percent of the annual cost can be traced back to 20 percent of the line items. These are the "A" items. If your inventory consists of 1,000 items, then 200 of those items will be responsible for $2.8 million of the $4 million spent annually. You want to keep very close track on those items. I would suggest counting and reconciling those items every month — which breaks down to 50 per week or 10 per day.

The next group is the "B" group. It consists of the 30 percent of the items that comprises 20 percent of the expense — 300 items with an annual expense of $800,000. I would recommend counting that group four times per year. That breaks down to 100 items per month, 25 per week or 5 per day.

The remaining 500 items constitute what is known as the "C" list. Their total expenditure is $400,000 per year. I would count them twice per year — preferably on a night shift or a weekend.

There is, however, a fourth group — "D" items. These are items that are in inventory for the convenience of the department. If you run a usage report from Lawson and see that an item hasn’t been issued for over two years, that is as "D" as it gets. Those items should be expensed to the department and set up as a departmental PAR level item with a level of 2 and a re-order point of 1. I would estimate that 1 percent of the items in inventory in a department such as surgery would qualify in that respect. In the case we are talking about here, that would mean $10,000 in items that could be moved out of inventory immediately.

So now your inventory is $990,000, and the department just got a one-time expense of $10,000.

Next, we set targets for turns. The entire process is much more complicated than I can put in this e-mail, but I am going to keep it simple. We can talk detail later. 

• You want the A items to turn the most — say 12 times. Currently, their value is $700,000. The annual expense associated with them is $2.8 million. At a target of 12 turns, the on-hand dollar value should be $2.8 million per 12, or $233,333 (rounded).
• Say you want the B items to turn six times. Their current value is $800,000. Divided by six, the on-hand dollar value should be $133,333 (rounded).
• Say you want the C items to turn twice per year. Their on-hand value should be $400,000 for two, or $200,000.
• Don’t worry about the D items. We took care of them with one move.

Here are your results.

• Current expense: $4 million
• Current inventory: $1 million
• Current turns: 4
• New expense: $4 million
• New inventory: $566,667 (rounded)
• New turns: ($4 million/566,667) 7.06

I hope this gives you something to get started with, Joe, but there are other things to keep in mind:

• You have to consider all three aspects of inventory — how much is the dollar value, how often do you use it and how easy is it to get — before setting levels.
• You have to work diligently with the user departments to get their trust and buy-in when setting, and re-setting levels.
• You have to be diligent about doing the cycle counts. Not only will they help you to adjust levels to the most appropriate for each item, they will also help to control the two worst expenses associated with inventory management — shrinkage and product out-dating.

I hope this helps, buddy. Give me a call if I can help.

Fred

Keep in mind, controlling inventories is important, because failure to control them can cost you money. But the key considerations include the cost of managing the inventories as well as limiting their dollar value.

Fred W. Crans has spent more than four decades in healthcare supply chain management in a widely varied career that includes Supply Chain Leader for several mid- to large-sized hospitals and integrated delivery networks, consultant and consulting manager for several prestigious firms, Enterprise Vice President for a major group purchasing organization (GPO) and Director of National Accounts for the ECRI Institute. Crans currently serves as Vice President of Sales, Optimé Supply Chain Inc. He can be reached via e-mail at fcrans@optimesupplychain.com.