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The ability to put work in place at the project site requires the right people, tools and production equipment, and materials and installed equipment. Not having either enough or the right type of any one of these three factors can result in lost efficiency at the job site or the delay of critical work for the company. Having the right materials at the right time and in the right quantity is key to the success of a construction project. The electrical contracting firm’s ability to achieve planned production rates and meet its schedule is dependent on the supply of sufficient materials on time and at the required rate to keep pace with field operations. Often, the need to have the right materials at the right place and time translates into inventory for the electrical contractor. This article discusses the costs of maintaining inventory as well as the use of vendor-managed inventory (VMI) as a way of reducing both inventory costs and the risk of material stockouts.
Need for inventory
Electrical contractors maintain buffer stocks in their warehouse and at the job site to ensure that they have control over their material supply and are not caught short handed. These buffer stocks include commonly used materials such as raceway or specialized materials and equipment that are needed for a particular project. Purchasing either bulk or specialized materials and equipment in advance and then storing them to ensure that they are available when needed constitutes the company’s on-hand inventory at any particular time.
Maintaining inventory reduces the firm’s risk, because inventory allows it to control material supply, which is an important variable that can impact both field productivity and the ability to meet contractual schedule obligations. However, this reduction of risk has a cost. The cost of reducing the risk of stockouts that can impact project quality, cost and schedule comes in the form of inventory costs. Inventory costs can be thought of as the insurance premium that the company pays to ensure that it has materials and equipment when needed. Inventory costs can impact the company’s operating costs and affect its competitive position in the marketplace. Minimizing inventory costs can improve both profitability and competitiveness.
Acquisition costs are those associated with acquiring needed inventory, including the cost of requisitioning materials and equipment; identifying qualified vendors; requesting, obtaining and evaluating quotations; preparing purchase orders; shipping and receiving; and vendor payment. Inventory acquisition includes both fixed and variable costs. The fixed costs associated with inventory acquisition are those incurred, no matter how big or small the order. These costs are typically administrative, such as preparing a purchase order.
Variable costs vary with order size and include the actual material cost as well as shipping and handling. In general, the larger the order the less the acquisition cost per unit in that order. Buying in bulk not only reduces acquisition costs per unit and the risk of stockout for the firm but also increases inventory-carrying charges, which can overcome any economies of scale that result from bulk purchases.
Carrying costs include both real out-of-pocket costs and opportunity costs. Out-of-pocket costs include storage; casualty and theft insurance; losses associated with spoilage and technical obsolescence; property taxes; home office staff to handle, maintain and monitor the inventory; security; transportation to the project site; and interest on funds borrowed to finance the inventory.
Opportunity costs associated with inventory result when funds used to finance the out-of-pocket costs associated with maintaining the inventory aren’t available to the company for other uses, such as the investment in the development of new markets or capabilities that may have a higher return on investment. In general, the larger the inventory maintained by the company, the greater the inventory-carrying costs but the lower the risk of stockout.
Stockout costs occur when materials and equipment are not available when needed. Stockouts can increase material and equipment acquisition costs resulting from emergency purchases. Its actual cost is difficult to determine but can be significant.
Innovative inventory management
Inventory management should be more that just developing strategies to minimize inventory costs. Management’s goal should be to find ways to reduce the company’s inventory and associated costs of maintaining it while simultaneously increasing the probability of having the right materials in the right place at the right time. At first glance, these objectives appear to be mutually exclusive. However, inventory management is about developing policies that will achieve an optimal inventory investment. Inventory management should not only weigh the costs of acquiring and maintaining inventory against the risk of not having materials and equipment when needed. Effective inventory management should also be about identifying innovative ways to minimize the firm’s stockout risk and lower inventory costs.
Innovative inventory management can include any practice or procedure used to improve warehousing and material distribution to the field as well as reduce its operating costs and inventory-carrying charges. An innovative practice might be something as simple as putting incentives in place to encourage project managers to only purchase materials needed for their project and use of excess materials from previous projects being warehoused by the firm. Another could be the use of VMI, which takes advantage of the electrical distributor’s expertise and lowers the contractor’s inventory costs and risk of stockouts.
VMI involves the outsourcing of the company’s inventory and internal material distribution to one or more of its vendors. For the electrical contractor, VMI can take the form of either on-site inventory outsourcing or central warehouse outsourcing.
On-site inventory outsourcing involves outsourcing on-site material delivery and warehousing to a local electrical distributor. It is the most common VMI strategy used and can benefit the company. This strategy is similar to just-in-time supply, except that it involves the actual presence of an on-site electrical distributor. Outsourcing on-site inventory essentially eliminates most of the firm’s on-site procurement and material-handling activities. The on-site material inventory is maintained totally by the electrical distributor and materials are “checked out” to the craftworkers as needed. As a result, only materials used are invoiced, the company does not have to maintain any on-site inventory and there is no restocking charge for excess material return, among other advantages. Under the right circumstances, using on-site VMI can greatly simplify project procurement.
Central warehouse outsourcing is the next step up from on-site inventory outsourcing. With central warehouse outsourcing, the electrical contractor eliminates its warehousing and distribution, which should eliminate inventory-carrying charges; reduce overhead and operating expenses; reduce annual losses do to material obsolescence, loss, theft and damage; improve financial ratios and reduce debt and/or equity requirements needed to finance inventory. Central warehouse outsourcing can be accomplished by allowing the electrical distributor to take over the contractor’s existing warehouse and distribution at that facility or by moving the entire operation to the distributor’s facility.
Successful VMI implementation, either at the project site or in the firm’s warehouse, requires careful analysis and planning. First and foremost, the company must understand its current procurement policies and procedures. These need to be evaluated to determine efficiency, effectiveness and cost. It isn’t until the company thoroughly understands its current procurement practices that it can effectively evaluate improvements. Understanding current policies and procedures establishes the baseline against which innovative procurement practices can be compared to determine benefits.
If the company decides to evaluate the possibility of adopting VMI, the next step is to identify a vendor partner. Successful implementation of VMI at any level within the company requires a partnership between the electrical contractor and a distributor. This partnership must be built on trust and mutual respect for VMI. In addition, the rights, responsibilities and expectations of both parties need to be set out in a formal written agreement to avoid misunderstanding obligations to one another. Material availability, advance notification of material need, predetermined pricing, access to the materials and security, termination of the agreement and many other important points need to be addressed in the VMI agreement, however small the project. EC
This article is the result of ongoing research into innovative procurement strategies for electrical contracting firms that is being sponsored by the Electrical Contracting Foundation, Inc. The author would like to thank the Foundation for its continuing support.
GLAVINICH is director of Architectural Engineering & Construction Programs in the Department of Civil, Environmental & Architectural Engineering at The University of Kansas. He can be reached at 785.864.3435 or [email protected].
About The Author
Thomas E. Glavinich was an associate professor in the Department of Civil, Environmental and Architectural Engineering at the University of Kansas. His tenure as one of Electrical Contractor's most trusted and reliable source of industry research ended in 2014 when he passed away. Click here for more about Tom.