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Financial and Accounting Issues

 

Financial and Accounting Issues
Overview

Traditional Approaches

Accountants have always been aware that inventories need to be effectively managed. For this reason even early students of accountancy are taught fairly basic stock modeling techniques such as Economic Order Quantities, Re-Order levels and probabilistic safety stock calculations.

In carrying out these calculations Accountants are aware of the cost of holding stocks in terms of the cost of storage and capital, and will become immersed in optimum reorder levels to minimise costs and maximize discounts.

Invariably these models are only wholly appropriate when considering stocks held for manufacturing or where turnover is rapid and reasonably predictable.

Stocks of spare parts however are held for quite different reasons. These stocks are not intrinsically part of the manufacturing process and are usually held against the contingency of machine breakdown or other failure. In the case of some stocks they may be held simply because they are difficult to acquire and therefore lead times are exceptionally long.

Many of these stocks will have longer lead times than stock in trade and will invariably be expensive. A dollar unit sampling approach to stock control will usually show these stocks to be slow moving and expensive and would normally lead the accountant to seek to eliminate them from inventories. Only the pressure of the contingency element retains them.

In short these stocks are held not “just in time” but ”just in case”.

Impact on Profitability

In the UK it is usual for stocks to be held as balance sheet assets and not charged against profits until such time as they are used. The problem is that some of these stocks are never used and become obsolete whilst still on the shelf. The subsequent write off of obsolete stocks impact directly on the profitability of the company and therefore Accountants will seek to identify this type of stock quickly whilst it still has some resale value. In practice it is unlikely that much of this stock will be cleared out before it is actually obsolete and then the potential marketplace is difficult and time consuming to identify. The costs of taking this stock to market often exceed the value of the stock itself and therefore disposal by other means becomes the only realistic option.

In the US where stocks are usually charged straight to revenue, the effect on profitability is immediate. Whilst this takes out he surprise element there is still a risk of obsolescence where a company might reasonably have expected to realize some of the value of these stocks to bolster profits.

Stagnant Capital

Cash is a valuable commodity in any business and stocks of spare parts do not form any useful part of working capital. However the cash tied up in these semi-redundant assets can be a drain on company resources. At best this cash could be used for other purposes or at worst the company itself could be running an overdraft from which this inventory is effectively being financed.

It is usual for the capital of a company to be actively contributing towards profitability but in this cased no contribution is being made until such time as it is used. Such capital might be regarded as being stagnant. It is almost certain that if deployed elsewhere it could be put to work usefully for the company but in its present state it remains burdensome.

There is an interesting analogy here between this type of stagnant capital and Insurance premiums. Insurance is something which all companies pay hoping never to need to make a claim. It is lost money until such time as a claim is paid out. So it is with spare parts; lost money until such time as one is required.

Current solution

In order to try to reconcile the competing desires of both accountants and engineers companies may go to great lengths to try and bring these stockholdings under control. The following approaches have emerged:

  • Maintenance contracts where the contractor holds inventory on site.

  • Buy as much as possible from a local distributor and transfer the risk of obsolescence to them.
  • Apply probabilistic models to determine holdings hoping that these stand the test of actual scenarios

The most likely scenario however is that a combination of “gut feel”, hoping for the best and a network of “friends” is employed. In this scenario however stocks of spares invariably rise as they become subject to “creep”. This arises because it is difficult to keep a firm grip on inventories and engineers and storekeepers begin to “hold one of those and a couple more of those” etc.

Inventory Pooling

The concept of inventory pooling is not a new one. It is in essence no different from the “phone a friend” scenario that is usually employed. It scores heavily over this method however for three reasons:

  • It is more reliable as the network is large and scientifically based and therefore more likely to reveal the required parts.

  • It is quick and easy to search the entire network without making 20+ telephone calls.
  • Perhaps more importantly it also takes away the pain of monitoring stocks and recommending inventory levels.

How does it work?

All accountants understand the concept of safety stocks and minimum stock levels which are essentially those stocks held to cope with known and variable lead times. It follows logically that if lead times can be made more certain and shorter that the level of safety stocks and minimum stocks will reduce.

In a very simplistic model if a company holds a spare because it will last in production for 1 year on average but could fail on any given day it will probably hold one spare. Similarly if the company next door has a similar usage they will also hold one spare even if the deliver time was only one day. The chances of both these parts failing on the same day are probably infinitely small and therefore if they shared this spare they would not need to hold two, only one between them. This effect magnifies as the group of co-operating companies increases and also takes away the “Ah but what if they do both fail” possibility.

Competitiveness through co-operation

Except in the most highly competitive industries one company would have no pecuniary interest in the failure of a competitor’s machine. Only where continued failure made that competitor unattractive to the market generally would there be anything to gain from such a scenario. There would be even less to gain from the failure of a company in a completely unrelated industry and yet research has shown that commonality of spares holdings between such companies to be normal.

  • Industry has constantly sought to find better ways of remaining competitive, few of which involve profiting from the misfortune of others. Most strategies involve production efficiency and cost reduction.

  • Inventory pooling is just another way of attacking the cost structure, whilst at the same time providing the same level of security of knowing that spares are always available.
  • The inventory pool can also make spares available to companies, which previously they had not held in their inventories thus improving responses to machine failure.

Stock Reductions

brite-sparks analysts have calculated that it is possible to achieve stock reductions in spare parts inventory of up to 70%. These savings are real and available through the brite-sparks inventory pool. Even those companies, which need the reassurance of taking a measured approach to the inventory pool, can achieve immediate reductions in inventory of a relatively modest 30%. His can still have a marked effect on profitability.

Guard Against Obsolescence

The risk of carrying obsolete stock items is greatly reduced by using inventory pooling, as the amount of stock actually held will reduce significantly. In addition to this brite-sparks members enjoy a free saleroom service where spares, which are considered disposable by one member, can be easily bought by another. This has many advantages not least of which is access to a specialized marketplace which both exposes this inventory to potential buyers and saves time and effort in negotiating disposals.

Other Services

Whilst inventory pooling is the keystone of brite-sparks membership it is not the only product available. As a member of brite-sparks companies will also have access to a network of control engineers worldwide who are available 24 hours per day 7 days per week. Most machine failures not specifically related to spare parts are due to software problems which can usually be fixed remotely by internet connections or by on site staff taking advice from on line experts. This service is free to access for all members although they pay an hourly rate for the work carried out by consultants. There are safeguards in the system to ensure that companies are happy with the consultant’s competence and regular customer feedback allows brite-sparks staff to provide a star rating system for consultants. This system has two major advantages:

  • Consultants are available to companies who do not employ their own engineers.

  • Consultants are available out of hours to those companies, which do employ their own staff, or where on site staff need advice on solutions. Sometimes it can be useful to talk a problem through with another expert in the field.

The cost reductions achievable in this area are difficult to estimate however it is clear that they could be considerable particularly in those companies which work to tight deadlines.

Neil Timms

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