ARC SOLUTION GUIDE. MRO Inventory Rationalization and Optimization VISION, EXPERIENCE, ANSWERS FOR INDUSTRY DECEMBER Executive Overview...

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1 ARC SOLUTION GUIDE By Ralph Rio DECEMBER 2010 MRO Inventory Rationalization and Optimization Executive Overview... 3 Business Impact for MRO Materials... 4 MRO Material Categories and Policies... 6 Causes of Sub-Optimized Inventory Inventory Optimization Benefits of Inventory Optimization Supplier Solutions Recommendations VISION, EXPERIENCE, ANSWERS FOR INDUSTRY

2 Engineering Design Procurement Construction Project Mgt. Document Mgt. Project Performance Management (PPM) Handover Asset Performance Management (APM) EAM, FSM PM, PdM, PAM Inventory Management Reliability EH&S Sustainability Funded Projects ROI Simulation Process Models Financial Asset & Project Portfolio Management (APPM) Modification Requests New Facility Requests MRO Inventory Management Is a Key Application in APM Consequences of Dirty Data Duplicate part numbers Obsolete part numbers Incorrect re-order points Old EOQ or an estimated order quantity Re-ordering of declining-use inventory Purchase a commodity from OEM rather than part manufacturer (like bearings) Added Costs: Equipment downtime due to stock-outs Increased shipping costs for expedited delivery in reaction to stock-outs Carrying costs with excess inventory Premium pricing with small order volumes across many suppliers lost opportunity for volume purchases and commodity line grouping Protracted procurement process to find correct part number, supplier and alternatives Lost opportunity to sell obsolete items while they still have value to someone Overstock due to fear of downtime Data Cleansing and Optimization Eliminates Costs of Dirty Data 2 Copyright ARC Advisory Group ARCweb.com

3 Executive Overview Inventory optimization directly affects C-suite metrics by providing a positive impact on the P&L statement (lower inventory carrying costs and reduced spend) and balance sheet (less inventory and increased cash). Making your boss look good is always a good career move. For this report, we ve segmented MRO replacement MRO parts data clean-up and parts into two usage patterns even though, in reality, inventory optimization provides clear gray areas lie in between. Repetitive items wear and benefits to the metrics of the c-suite. It also improves operational have a history of being replaced. Organizations maintain inventory to prevent extended downtime while performance for maintenance, production, and purchasing. waiting for replacement parts to be purchased and delivered. Critical spares apply to specific equipment needed to sustain production. Here, spare parts are purchased and stocked to control risk particularly long lead time items. This segmentation helps reveal two corresponding and very different inventory management policies. Repetitive items use min/max or VMI. For critical spares, organizations use a combination of theory of constraints (TOC) and reliability centered maintenance (RCM) to identify the critical equipment and associated critical spare parts to stock. Here, min/max or VMI would lead to a catastrophic stock-out because, once used, the part will not be re-ordered. Divergent departmental metrics drive dysfunctional behavior and inventory issues. Conflicting metrics associated with handover (project engineering vs. maintenance) and inventory management (purchasing vs. maintenance) drive dirty data and sub-optimized inventory. The metrics and the related business processes are opportunities for improvement. For MRO materials, clean up the accumulation of dirty data prior to inventory optimization. Data clean-up includes part number rationalization and supplier information. Optimization involves updating the re-order point and economic order quantity (EOQ) based on recent demand and supplier performance. The benefits of MRO materials optimization include lower spend, reduced unit costs, less logistics (expedited delivery), and recovering obsolete inventory. Also, fewer stock-outs and better decision-support information improve maintenance operations. The associated inventory rationalization provides a foundation for a successful VMI program. Copyright ARC Advisory Group ARCweb.com 3

4 Supplier solutions include ERP, EAM, and others who are focused on part number rationalization and inventory optimization. Business Impact for MRO Materials MRO materials inventory often has many thousands of stocking units (SKU) in small quantities and in multiple stocking locations. Maintenance people tend to focus on work orders and the equipment while giving lower priority to managing MRO inventory. The lack of inventory optimization results in higher inventory levels, carrying costs, and operating disruptions. C-Suite Metrics Senior executives particularly those in the C-suite have metrics driven by the P&L statement and balance sheet. When proposals connect to a positive impact on the financial statements, they are more likely to obtain executive support. Senior executives have fiduciary pressures with associated governance and compliance requirements. These include: Improving profit margins on the P&L statement Improve executive support by making Conserving cash on the balance sheet the connection from your proposal to a Maintaining good financial ratios for assessing positive impact on the P&L and balance sheet. Read your organization s annual risk and price per share report to help assure your programs align with the C-suite. For publicly held companies, performance is widely published and analyzed. The financial ratios can affect the share price, the executives income, and, potentially, their job security. P&L Impact The aggregate spend for MRO material is large and material to the corporate financial statements. Particularly in asset-intensive industries, MRO represents a significant portion of revenues; 5 percent is common, with some organizations reporting up to 15 percent of costs clearly large enough to deserve executive attention. Data cleansing and optimization strategies like removing part number duplication and strategic sourcing (explained later in this report) apply. Price reductions and waste elimination improve profitability. 4 Copyright ARC Advisory Group ARCweb.com

5 Impact on Balance Sheet The investment community uses financial ratios to help evaluate stocks to determine their value. Lowering inventory allows companies to retain additional cash and improve the financial ratios used to measure their financial risk. Less risk improves stock value. An example of a common financial metric for risk is quick ratio (or acid test ): Quick Ratio = (cash + marketable securities) / current liabilities Taking funds out of inventory and adding cash to the numerator improves the quick ratio. Similarly, using these funds to reduce liabilities in the denominator also improves the ratio. The improvement makes an investment more attractive, raising Lowering inventory and adding cash improves a common financial metrics the stock price and overall stockholder value. like the quick ratio. Since investors use this ratio to evaluate risk, an Less inventory reduces assets, which improvement will also reduce interest rates on the improves the return on assets ratio. company s debt and improve profitability. Another financial metric that improves with inventory reduction is return on assets (ROA). Business managers tend to focus on the profits in the numerator. The denominator net assets also provides improvement since a smaller denominator boosts the ROA ratio. Through optimization and less inventory, additional cash improves financial measures, stock value, and executive metrics. Improving your boss metrics is often a good career move. Avoid the Death Spiral Executives may not be aware of the downward spiral created when they reduce maintenance budgets excessively. Cuts result in less inspection, preventive maintenance, and other programs for sustaining assets. Beyond a tipping point, less failure prevention results in more expensive, reactionary repairs. The demise of an inexpensive component cascades into other, more expensive system components (just as lack of inexpensive engine oil will cause your expensive car engine to seize). Emergency equipment repairs create additional costs, including higher purchase price, expedited shipping, overtime, and extended production downtime. Without appropriate maintenance investments, repair costs escalate dramatically. To cover this increase, organizations must cut maintenance further, accelerating the downward spiral with increasing equipment failures and repair Copyright ARC Advisory Group ARCweb.com 5

6 cost. When reducing the maintenance budget, organizations can avoid this death spiral with improved MRO materials management using optimization solutions and improved business processes. MRO Material Categories and Policies MRO materials include a variety of indirect materials and other items that are not part of the company s end products. These include: Consumables: cleaning, laboratory, or office supplies Maintenance supplies: general-purpose lubricants, gloves, tools, etc. Replacement parts: pumps, valves, instrumentation, bearings, seals, electronics, specific filters, etc. Consumables and supplies are rarely subject to the equipment uptime pressures that drive excessive inventory. However, particularly in assetintensive industries, replacement parts can represent a significant portion of operating costs; some companies have reported expenses as high as 15 percent. This report focuses on inventory optimization for replacement parts since this area represents the higher dollar value and an opportunity for significant cost savings. Improve Uptime Cost Control Asset Longevity Safety Purpose of MRO Replacement Parts Inventory Business continuity requires on-time delivery of quality products, or high service availability. Since equipment wears during use, maintenance is required. MRO materials purpose is helping assure high equipment uptime. Business Drivers for Improving EAM 60% 58% 58% 82% 0% 20% 40% 60% 80% 100% Primary Metrics for Maintenance Source: ARC Survey Feb Other goals often distract from the primary goal. A focus on high inventory turns or positive purchase variance (lower price than previous purchases) are good objectives, but often become counterproductive. These materials management metrics are secondary compared to equipment uptime. As shown in the chart Primary Metrics for Maintenance, maintenance managers agree. Going 6 Copyright ARC Advisory Group ARCweb.com

7 forward, organizations will ensure high asset availability and optimize inventory with new emerging software solutions. Smart Information Asset Performance Operations Improve Asset Utilization Manage Critical Issues and Operational Constraints (i.e. Inventory ) Maintenance Improve Asset Availability Sustainability Stewardship APM Key Objectives Usage Patterns for Replacement Parts MRO replacement parts are bifurcated into two distinct usage patterns to provide clarity for this analysis. In reality, gray areas can lie in between. Repetitive MRO Parts Some parts wear which causes regular replacement. Organizations purchase replacements in quantity and maintain inventory to reduce costs. Also, equipment downtime is reduced by having the parts in stock and avoiding the time for purchasing and delivery. Critical Spare Parts Within a plant, sustaining production requires specific critical equipment. There may be just one available without alternative means of completing its associated process step. Or, it may be a pinch point that gates overall plant capacity. Extended downtime for this critical equipment negatively impacts production capacity, sales revenue, and customer satisfaction. Here, organizations purchase and stock spare parts to control the risk of a lengthy interruption particularly those parts with a long lead time. In the case of custom machines, organizations typically inventory complete units due to the unique expertise necessary to diagnose and repair. For ex- Copyright ARC Advisory Group ARCweb.com 7

8 ample, automobile dealers may inventory complete transmissions rather than repairing today s complex, digital controlled automatic transmissions. This segmentation - repetitive and critical - helps reveal two corresponding and very different inventory management policies. Repetitive Items Inventory Management Strategies Min/Max Inventory Management Items used repetitively in the past have a demand history for traditional min/max inventory management. The demand history and inventory carrying costs drive a calculation for re-order point (min) and economic order quantity (EOQ). ERP and EAM systems have features that provide these calculations. How Is MRO Inventory Managed? Source: ARC Survey, 102 responses, 8/07 Vendor Managed Inventory A core competence of a distributor includes inventory management with a high fill rate (if not, they do not last very long due to both cash flow and customer satisfaction issues). Vendor managed inventory (VMI) agreements with a local distributor can help offload the inventory and its management. The distributor s systems manage reorder point, EOQ, and the associated supply chain. Critical Spare Parts Inventory Management Strategies A combination of theory of constraints (TOC) and reliability centered maintenance (RCM) determines the critical equipment and associated critical spare parts for stocking. Many consider RCM too time consuming to use to apply every asset. Thus, focus is placed on the critical equipment identified by TOC or safety concerns. Constraints TOC is an overall management philosophy introduced by Dr. Eliyahu M. Goldratt in his 1984 book, The Goal. The TOC methodology identifies the constraint(s) and induces the rest of the organization to best utilize its available capacity including maintenance. 8 Copyright ARC Advisory Group ARCweb.com

9 Reliability Centered Maintenance RCM views an asset as providing a set of functions that benefit the organization. The focus is to preserve these functions, not necessarily the asset itself. The RCM methodologies include a process to identify the functions, failures, modes, effects, consequences, preventive tasks, and default actions. The analysis uses Failure Mode and Effects Analysis (FMEA) and systematically answers seven questions for each asset: What functions are expected and at what level of performance? In what ways does the asset fail to provide these functions? What can cause each failure to occur? What happens when each failure occurs? What is the impact of a loss of functionality? What can be done to predict or prevent each failure? What is your alternative if a suitable proactive task cannot be found? An RCM analysis provides information necessary for managing the asset to ensure reliable performance through specific, properly timed inspections, analysis, and preventive maintenance activities. Critical functions receive extensive attention. Low priority functions may have a "run to failure" strategy. RCM provides a rational approach for developing an effective asset management program. The overall result is a balanced program that applies resources where they are most effective. Do Not Use VMI for Critical Spares With critical spares, using VMI is inherently risky. Inventorying an item that has no demand goes against a distributor s systems, metrics, core competence, and culture. When one of these parts is sold, its people will celebrate getting rid of a dog, which will not be replaced. The next time the part is needed, it will not be available. Consortium Some have suggested that like plants located near each other could share expensive critical spares needed by both organizations. The companies would contribute to purchasing the inventory that is then held in a shared stocking location. Unfortunately, the companies are usually competitors at some level (for sales or skilled employees). The author has not found a successful instance of the consortium approach between independent companies. However, this approach is effective for geographically close plants or facilities of a single, larger organization. Copyright ARC Advisory Group ARCweb.com 9

10 Causes of Sub-Optimized Inventory Divergent Metrics Inconsistent departmental objectives and conflicting metrics drive dysfunctional organizational behavior. This maxim applies to asset management. Asset management functions segment into three groupings as shown with ARC s model for Asset Lifecycle Management (ALM). Here, key metrics are layered on the model. Capital Budget Uptime Schedule Quality Project Performance Management (PPM) Handover Asset Performance Management (APM) Asset Longevity Expense Budget Safety MRO Inventory Funded Projects ROI EH&S Asset & Project Portfolio Management (APPM) Modification Requests New Facility Requests Model for Asset Lifecycle Management with Key Metrics Handover-Driven Data Contamination At handover, a massive information transfer occurs from engineering to operations. But, the usefulness of this information for maintenance should be questioned since there is little incentive or methodology for engineering to ensure the relevance of the information for operations. Bill of materials (BOM) issues and part number duplication exemplify this dysfunction. Top Level Model Number vs. the Full BOM The project design team obtains the information they need to create the design. But, they have no incentive to acquire information needed for maintenance. Let s look at a valve. The design engineer obtains parameters to size the valve and the flange dimensions to match the piping. This engineer does not need to identify the parts within the valve and may not seek a BOM nor identify critical spares to inventory. For repairing the valve, maintenance must identify the components contained in the BOM. Maintenance also needs to know if equivalent components are already held in 10 Copyright ARC Advisory Group ARCweb.com

11 inventory, but with a different part number. This exemplifies the different informational needs leading to a disconnect between the engineering project team and the operating units at handover. Duplicate Part Numbers For an upgrade, the project team s metrics focus on budget, schedule, and meeting specifications. Companies can try to force the contractor to use a standardized MRO catalog - if it exists. Selecting parts from a catalog of existing MRO items takes additional time with no benefit for engineers. It is often easier and faster to create a new part number. Each upgrade or new equipment brings its own set of part numbers with many that duplicate existing equivalent items or good substitutions. With different needs, dysfunctional behavior occurs between the project and operating teams. Neither group rationalizes duplicate numbers, resulting in the huge problem that worsens with time. Each upgrade adds to the dirty data and compounds the MRO inventory management problem. Growing Asset Diversity The increasing diversity of equipment designs and deployed technologies continues to expand at an increasing rate. One aspect is the faster rate of innovation for particular equipment i.e., the new and improved version. In the new model, many of the old part numbers continue to exist with a few new ones for the improvements. Occasionally, all of the parts are assigned new numbers even though few are new. Another driver comes from new technology applications that allow for the design of new types of equipment. This creates an entire set new part numbers. Together, these changes drive a rapidly increasing number of items for MRO inventory. The power utilities, with smart grid, alternate energy sources, and distributed power generation, represent this trend. With distributed power generation, smaller capacity generation sources are dispersed in the grid near where energy is used. Each type of equipment has a variety of model numbers due to the size and capacity. Alternative energy generation also significantly increases the variety of assets. Solar, biomass, wind farms, low-head hydro, geothermal, etc. incorporate new technologies and use completely different equipment. These assets require a growing variety of replacement parts and MRO inventory. Copyright ARC Advisory Group ARCweb.com 11

12 Conflicted MRO Inventory Management There are two major stakeholders for MRO materials - maintenance and purchasing with conflicting metrics that drive dysfunctional behavior. Confession of a Maintenance Manager Early in my career, I managed maintenance for a mid-size manufacturer. Over time, I purchased and accumulated every spare part the original equipment manufacturers (OEM) suggested. Since the purchases were expensed and small in physical size, no executives noticed the hoard of expensive inventory. With plenty of spares, equipment uptime my main metric improved. This provided good reviews and a promotion. Good for me, but not optimal for the financial performance of the company. This is probably happening in your plant now. MTTR vs. Inventory Turns Maintenance s primary metric is high equipment uptime. This drives the desire to stock nearly every conceivable spare part to minimize mean-time-to-repair (MTTR). Since equipment uptime is needed for production to ship product on schedule and achieve sales revenue, it gets a lot of executive attention when things go badly. To avoid extended outage, maintenance often has spare parts just in case. A municipal transit maintenance group reported that, in three years, it did not use 66 percent of MRO inventory. Purchasing and materials management have a key metric for low inventory levels and high inventory turns which drives fewer spare parts. Since inventory level has a direct effect on the balance sheet, financial metrics and stockholder value, MRO inventory gets executive attention. This pressure causes purchasing to reduce material acquisition to the squeaky wheel and the loudest maintenance manager. Urgency vs. Small Dollar Value The maintenance technicians generate many small dollar requisitions for a large number of SKUs. The multitude of small dollar requisitions with inconsistent business processes and varying levels of urgency can overwhelm purchasing staff. Since these requisitions have a low dollar value, they are usually given a low priority and routed to junior people. Ever try to get urgent attention for to a $100 requisition for parts to repair a crippled machine? (The author has, and knows that it isn t easy!) This goes against the training, intuition, and metrics of the purchasing people. Highly visible and conflicting objectives drive interdepartmental conflict, and dysfunctional behavior. This report provides a strategy and recommendations for rationalizing this behavior. 12 Copyright ARC Advisory Group ARCweb.com

13 Dirty Data-Driven Problems Dirty data and duplicate part numbers increase the quantity of SKUs inventoried, introducing usability problems for several constituencies: Dirty Data: Duplicate part numbers Obsolete part numbers Incorrect re-order points Old EOQ or an estimated order quantity Re-ordering of declining-use inventory Purchase a commodity from OEM rather than part manufacturer (like bearings) Overstock due to fear of downtime Maintenance planners, dispatchers, and technicians need to know: Is the part I need in inventory? If not, who is the supplier? Is a substitution available? With many similar SKUs, it is difficult to answer these basic questions. Purchasing: Duplication drives more requisitions, each with lower unit quantities. Higher prices result due to lost opportunity for volume purchases. Also, the quantity of requisitions increases workloads and can reduce purchasing productivity. Added Costs: Equipment downtime due to stock-outs Increased shipping costs for expedited delivery in reaction to stock-outs Carrying costs with excess inventory Premium pricing with small order volumes across many suppliers lost opportunity for volume purchases and commodity line grouping Protracted procurement process to find correct part number, supplier and alternatives Lost opportunity to sell obsolete items while they still have value to someone Data Cleansing and Optimization Issues for MRO Inventory Inventory management: Duplication creates multiple instances of the same inventory. After an upgrade, the spare parts associated with the removed equipment are no longer used and remain in stores. The dollar amount tied up in inventory expands continuously. In reality, the parts could be used elsewhere in the plant if the duplication was identified, or sold while they still have value. As more cash becomes inventory, financial metrics for the corporate balance sheet erode and negatively affects shareholder value. Also, higher costs adversely affect the firm s profitability and stockholder value. Financially Invisible Inventory The cost of some MRO materials is relatively small and expensed when received. Thus, the inventory does not appear on the balance sheet. Visibility is lost with the accumulated inventory invisible to financial reporting. The lack of visibility impairs business process management and control. This is compounded when many people across many functional areas make purchases using independent methods. What was thought to be a relatively small expense category becomes large across all departments and is better managed through a common inventory management system. Copyright ARC Advisory Group ARCweb.com 13

14 Inventory Optimization The opportunity to reduce costs drives data cleansing and inventory optimization. This section provides guidance for executing these activities. Initial steps in MRO inventory optimization are: Rationalizing part numbers and data cleansing to establish a relatively uncontaminated and strong foundation for further improvements Examine business processes (like handover) to avoid future contamination. One issue is the creation of new, duplicate part numbers. Another is inaccurate design drawings that do not reflect changes made during the startup phase. Part number inaccuracies occur when piping and instrumentation diagrams (P&ID) and BOMs are not reconciled with as built conditions. Optimization of the re-order points and EOQs for each item in MRO inventory based on demand history Peter Holiday, an independent EAM consultant in the UK provided this comment: In every EAM implementation I have been involved in, inventory data clean up has been overlooked or badly under-achieved. Ultimately, you will be wasting your time if you try to optimize your inventory before data clean-up. MRO Part Number Rationalization Cleaning up MRO parts starts by consolidating duplicate part numbers. As Mr. Holiday states above, this data clean-up is a precedent for optimization. But, organizations often delegate this labor-intensive activity to scarce resources. Mr. Holiday continued: The issue is that, to do it properly, data clean-up is a very labour intensive operation and requires input from busy people with critical functions, i.e., storemen, purchasing officers etc. The business is reluctant to release them to do this, so the clean-up gets passed over. Consolidate Duplicate Part Numbers A solution to Mr. Holiday s issue exists. Many organizations outsource this rationalization successfully. Well-defined and proven methodologies provide structure to each description and part number assignments. With this 14 Copyright ARC Advisory Group ARCweb.com

15 structure, duplicates are much easier to identify. This part number rationalization also provides a standardized description format that technicians, dispatchers, planners, and even those project engineers can interpret to identify the needed parts. Eddie Tsui, IT Project Business Leader, Sydney Water in Australia, provided this comment: We just cleaned up our MRO item master list and reduced 10 years of accumulated items to just one-third of the original quantity. Data rationalization is highly worthwhile before attempting inventory optimization. This two-thirds reduction in part numbers provided the basis for a similar reduction in inventory dollar value. Establishing valid substitutions provides further savings. But, one must use up the inventory of the obsolete part before applying the substitute. Mr. Tsui provides this solution: We still have more to do. What's left is accomplished gradually when re-orders are triggered. When an old item is tagged obsolete, a replacement item is entered in the Alternate field. This two-tier hierarchy continuously reduces the size of the item list while using-up excess inventory. Prevent New Duplications The rationalized MRO parts list becomes the standard MRO parts catalog, which requires master data management (MDM). Examine business processes to prevent new duplications. For example, while designing a modification, the engineers choose parts from this master parts catalog. Also, examine the ALM business processes for those authorized to add a new part number or edit an existing one, and provide visibility for these changes. MRO Inventory Optimization This report segmented MRO inventory into two areas: Critical spares for specific equipment necessary to sustain production Repetitive items that wear and have a history of being replaced The master data (MRO inventory catalog) is also segmented in this way. Critical Spares For the critical spare, minimum quantity is set to one, with a re-order quantity of one. Further optimization involves examining if an expensive spare can be shared among multiple facilities. Copyright ARC Advisory Group ARCweb.com 15

16 Repetitive Parts Repetitive items lend themselves to the traditional min/max inventory management techniques based on demand and lead-time history. For each SKU, the EAM or ERP system calculates the re-order point and EOQ. Re-order point: The re-order point or minimum quantity is based on the part s demand pattern. This varies by site to serve the local demand. Leadtime accuracy and consistency is used to assess risk of a stock-out and establishing the proper safety stock. Being safe by applying the maximum lead-time increases the stocking level because the parts are actually received in a shorter time than this maximum. Sometimes, planners plug in a maximum conceivable time plus some more to be extra safe, driving higher inventory levels. Determine these lead-times rationally. EOQ: EOQ calculation involves a well-defined formula using aggregate demand and other factors. Additional algorithms can apply as with seasonal items. Economic Order Quantity Formula EOQ = (2*D*R) / (P*C/100) D = Demand in units/month The EAM or ERP software usually provides an R = Requisition and purchase order cost in $ alert for SKUs in danger of becoming a stockout (problematic with low usage items). It P = Unit price in $ C = Inventory carrying costs %/month should also have analysis tools for determining root cause and resolution of an outage. Strategic Sourcing Commodity Groups Strategic sourcing places SKUs in commodity groups with specific purchasing staff and suppliers for each group. Examples of commodity groups are bearings, hardware, or motors. Forecasting and purchasing a commodity group with one supplier provides opportunities for volume discounts, and more effective use of purchasing staff. This approach can also build into a VMI relationship. Spares pooling across multiple stocking locations or multiple sites provides additional volume for the discounts with less risk of a stock-out since parts are shared across locations. An EAM or ERP application that provides visibility across the stocking locations helps assure success with this approach. 16 Copyright ARC Advisory Group ARCweb.com

17 Benefits of Inventory Optimization Data cleansing with rationalization of part numbers provides several areas for savings as follows: Unit cost reduction through volume purchase agreements: Lower unit prices by combining purchases both for the individual part numbers and for a commodity group. Inventory Annual Carrying Costs: Cost of Money 6 to 12% Obsolescence 6 to 12% Warehouse Expenses 2 to 5% Physical Material Handling 2 to 5% Clerical Inventory Control 3 to 6% Deterioration and Pilferage 3 to 6% Taxes 2 to 6% Insurance 1 to 3% Total 25 to 55% Savings with Reduced Inventory Source: Mincom Unit cost reduction through substitutions: Instead of acquiring spares through the machine builder, which includes its mark-up, obtain the same part (such as bearings) through distribution or directly from the individual part manufacturer. Lower inventory by combining SKUs: EOQ is proportionate to the square route of demand. This formula reduces EOQ when combining the demand of multiple equivalent part numbers. 1 Combining SKUs also reduces supply chain risk, reducing the re-order point and the corresponding inventory. A third benefit involves combining low or declining volume SKUs, particularly where slow moving inventory is present for extended time periods. Logistics savings: Consolidating part numbers and commodities combines shipments, reducing shipping and freight expenses. Recover obsolete inventory: Upgrades often involve removing old equipment, which makes the associated replacement SKUs obsolete. These parts can often be used elsewhere. Rationalizing part numbers allows this inventory to be identified and recovered by moving the obsolete items to an active SKU. For spares specific to a machine, sell them back to the supplier when the equipment is removed from service. Another alternative is selling obsolete items via an on-line auction like ebay. Quicker identification of newly obsolete items should have higher recovery value. 1 Use the example of four SKUs, each of which has a demand of four. When combined, they have one SKU with a demand of 16 (=4x4). The square route of 16 is 4, which is less than four times the square route of 4, i.e., 8. Copyright ARC Advisory Group ARCweb.com 17

18 Lower inventory with optimization: Application software automates the calculation of re-order point and EOQ on a regular cycle to continuously optimize the inventory levels and account for changing demand. ARC recommends monthly updates. Fewer stock-outs: The re-order point and EOQ calculations also helps to synchronize the available inventory with current demand. Information for decision support: Warranty recovery: Monitor equipment and part warranty programs to recover costs from the manufacturer Less repairs and longer MTBF: Identify frequently replaced parts to examine maintenance practices or improve their design Lower maintenance costs: Identify equipment having a history of costly maintenance for refurbishment, upgrade, or replacement Foundation for VMI: Establishing a rationalized parts catalog provides a basis for vendor-managed inventory. Essentially, VMI outsources MRO inventory, purchasing, and a portion of stores management. Since the vendor retains title to the inventory, cash is retained and balance sheet financial ratios improved. Getting the vendor to manage the parts particularly large variety of inexpensive C classified items - is attractive. But, there are some pitfalls to consider: Most vendors want to manage the fast moving parts that provide sales revenue and support their metrics for inventory turns. Asking them to manage the critical safety stock items is problematic. As stated previously, they may not re-order after a critical spare is used. Organizations need to inventory and manage their critical spares. A distributor has its own preferred suppliers, which sometimes conflict with the user s MDM catalog. 18 Copyright ARC Advisory Group ARCweb.com

19 Supplier Solutions Work Order Management Asset Information Management MRO Materials Management Labor Management Service Contract Management Mobility Reporting & Analytics EAM Functional Groupings Put simply, enterprise asset management (EAM) systems track the needed maintenance activities and the associated priorities, information, materials, tools, and skills. Maintenance management systems have been available for decades. ARC published its first EAM market research study in Computerized maintenance management system (CMMS) is an older term used when these systems were standalone solutions for one site. The term EAM came into use as these systems evolved into a networked environment that could serve multiple sites. Suppliers in this mature market have a good understanding of the functional requirements. Particularly in the asset-intensive industries, MRO inventory is big and complex. MRO materials are managed using a min/max approach. As material is used, the inventory minimum quantity is reached and this triggers procurement of more material. The methodology responds to actual demand. ERP suppliers and independent EAM vendors provide EAM applications, including MRO inventory management. Other suppliers offer specific applications focused on optimizing MRO inventory. Some part manufacturers support inventory management programs. For example, SKF provides services for bearings and seals that include VMI. EAM and ERP Integration Many ERP suppliers have their own fully integrated EAM applications. EAM applications from independent suppliers often offer packaged integration with the purchasing, inventory management, and accounting modules of the more popular ERP systems. The key areas of functional overlap are purchasing ARC plans further research comparing and inventory management. Should this be managed in the EAM or ERP application? Since ERP is ERP and EAM for inventory management and purchasing. The author welcomes your comments. usually the prime source of information for finance Please contact Ralph Rio at to accurately determine the P&L and balance sheet rrio@arcweb.com. statements (keeping the CEO out of jail), finance tends to favor the ERP system. But, operating groups in maintenance and production (that keep the plant running effi- Copyright ARC Advisory Group ARCweb.com 19

20 ciently and support stockholder value) prefer the EAM system. (So which to risk stock price or jail time?) ERP's Purchasing Module ERP's Inventory Management ERP's Cost Accounting ERP's Capitalization & Depreciation ERP Materials Management Companies use ERP systems to help plan and execute production schedules. The methodology is planning (the P in ERP). It excels at What ERP integration with your EAM system? exploding 45% 54% 62% 60% 8% 11% 11% 6% 6% 11% 14% 63% 17% 77% 78% 85% a product s BOM down to the components, and adding leadtime to determine a production and purchasing schedule. Materials management focuses on this planning and tracking progress. ERP's Production Scheduling ERP's Human Resources ERP's Analytics and Budgeting ERP's Payroll ERP Other 38% 37% 32% 35% 6% 9% 15% 20% 8% 23% 8% 46% 63% 60% 63% Have Now 2010 Budget 3 yrs Total ERP systems are also very capable of min/max inventory management. After an ABC analysis, the low-value C items are often put on min/max and ERP systems can manage these parts. This capability is applied to MRO materials. 0% 20% 40% 60% 80% 100% EAM Integration with ERP Existing and Planned Source: ARC Survey Feb ERP suppliers typically use the ERP system s inventory management modules to manage inventory for the EAM modules. ERP suppliers with EAM capabilities include: IFS Applications Lawson M3 Enterprise Management System Oracle with Oracle E-Business Suite, JD Edwards, PeopleSoft, Siebel Field Service, and Oracle Utilities Work and Asset Management SAP Enterprise Asset Management EAM Materials Management Independent EAM systems include MRO inventory management focused on the min/max approach. Independent EAM suppliers include: ABB/Ventyx (acquisition history includes Indus) IBM with Maximo 20 Copyright ARC Advisory Group ARCweb.com

21 Infor (acquisition history includes Datastream) Mincom with Ellipse 8 Which to Choose for Materials Management At this point in ARC s research, both ERP and independent EAM systems provide excellent functionality for inventory management using min/max. With ERP systems, the inventory is integrated with the higher-level modules for accounting and business reporting. With the independent EAM systems, packaged integration is available for the popular ERP suppliers. For users, the significant decision drivers become consistency with their strategies for systems architecture, business process improvement, and reducing dysfunctional organizational behavior. ARC plans future research into this ERP vs. EAM question. If you have input particularly for MRO materials management - please contact Ralph Rio at rrio@arcweb.com. MRO Inventory Optimization MRO inventory optimization updates each SKU s re-order point and order quantity based on recent demand history and supplier lead times. Conceptually, this appears simple, but the computational algorithms can become complex. A power utility that is an IBM client had 369,000 SKUs with inventory levels increasing at the rate of US$4 million per year. IBM s DIOS solution helped reduce inventory by US$30 million. Several suppliers provide solutions specifically for MRO inventory optimization across multiple dimensions to balance costs and the risk of a stock-out. These include: IMM System Source: SupplyPro Inc. IBM DIOS Mincom Critical Inventory Optimization (MCIO) Oniqua Analytics Solution (OAS) Managing MRO at the Point of Use Managing the moment when materials meet people improves productivity and reduces expenses. Intelligent materials management (IMM) is a combination of hardware for dispensing materials and software for managing inventory replenishment (reference ARC Insight, Managing when MRO Meets People September 4, 2008). This class of application offers opportunities to reduce spend, allocate costs, improve operator productivity, lower inventory levels, and reduce stock-outs. Back-office activities are Copyright ARC Advisory Group ARCweb.com 21

22 Confession of a Third Shift Forman Early in my career, I was a foreman on the third shift in an electric motor manufacturing plant. Employee lockers were placed against the wire mesh screen around the parameter of the stores crib, and the other side of the wire mesh had more lockers. Between the two sets of lockers, a hole had been cut in the enclosure. This secret of the third shift fraternity can be revealed now because the building has since been razed. The crib was not manned during third shift. When an equipment failure occurred, I (the shift foreman) would move the lockers, go into the storeroom, and get the needed part to get the equipment running again and make the production schedule. My main metric meeting the schedule - drove this dysfunctional behavior. I wish we had an automated IMM system automated so that purchasing professionals focus on negotiating good agreements with key suppliers. An IMM system provides MRO materials distribution including automated stores. SupplyPro is a leading supplier of these systems. Recommendations Often, maintenance people focus on the equipment with much less attention given to materials management. Their metrics for high equipment uptime tend to drive up MRO parts inventory, which consistently grows. Optimization of this inventory has significant opportunity for reduction and cost savings that can have a positive impact on the balance sheet and P&L statements. The steps for MRO inventory optimization are: Part number rationalization: Examine part numbers and apply a standardized part number assignment schema. Identify and remove duplicate part numbers. Consider outsourcing this activity to avoid delays with scarce internal resources and speed time-to-benefit. Identify and dispose of obsolete or overstock items: For duplicate items tagged for removal, use a two-tier hierarchy until the inventory is gone. Put a hold on buying addition parts and enter the replacement item in the Alternate field. This continuously uses excess inventory while reducing the size of the item list. For items with no application, consider selling the inventory back to the supplier or through ebay. Reduce creation of new duplicate part numbers: For the remaining rationalized part numbers, create an MRO parts catalog. Examine the business processes for creating a part number and assure that the preferred choice is a part in the catalog before creating a new part number. 22 Copyright ARC Advisory Group ARCweb.com

23 Support equipment uptime; the key metric for maintenance: Identify critical spares: For emergency repair of critical equipment, apply TOC and RCM to determine needed spares. Manage inventory of repetitive spares: Optimize EOQs and reorder points based on demand history and supplier performance to reduce inventory levels and stock-outs. Software automates this and monthly optimization is a good objective. Consider VMI for the repetitive spare parts. Some distributors will operate on-site storerooms. Manage MRO at the point of use: This is particularly important in distant areas where an on-site storeroom is impractical, consider automated stockrooms. Copyright ARC Advisory Group ARCweb.com 23

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25 Analyst: Ralph Rio Editors: Wil Chin, Paul Miller Distribution: EAS and MAS Clients Acronym Reference: For a complete list of industry acronyms, refer to our web page at ALM Asset Lifecycle Management BOM Bill of Materials CEO Chief Executive Officer CMMS Computerized Maintenance Management System EAM Enterprise Asset Management EH&S Environmental, Health & Safety EOQ Economic Order Quantity ERP Enterprise Resource Planning IMM Intelligent Materials Management IT Information Technology MDM Master Data Management MRO Maintenance, Repair, Operations MTBF Mean Time between Failures MTTR Mean Time to Repair P&ID Piping and Instrumentation Diagram P&L Profit and Loss RCM Reliability Centered Maintenance ROA Return on Assets ROI Return on Investment SKU Stocking Unit TOC Theory of Constraints VMI Vendor Managed Inventory Founded in 1986, ARC Advisory Group has grown to become the Thought Leader in Manufacturing and Supply Chain solutions. For even your most complex business issues, our analysts have the expert industry knowledge and firsthand experience to help you find the best answer. We focus on simple, yet critical goals: improving your return on assets, operational performance, total cost of ownership, project time-to-benefit, and shareholder value. ARC Strategies is published monthly by ARC. All information in this report is proprietary to and copyrighted by ARC. No part of it may be reproduced without prior permission from ARC. You can take advantage of ARC's extensive ongoing research plus experience of our staff members through our Advisory Services. ARC s Advisory Services are specifically designed for executives responsible for developing strategies and directions for their organizations. For membership information, please call, fax, or write to: ARC Advisory Group, Three Allied Drive, Dedham, MA USA Tel: , Fax: , info@arcweb.com Visit our web pages at Copyright ARC Advisory Group ARCweb.com 25

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