Wednesday, October 28, 2009

Finding a Home for Excess and Obsolete Inventory ?Matthew McCauley

Everybody is looking for ways to save money these days. Where can we find large savings opportunities? Look at your processes to manage and dispose of excess and obsolete (E&O) inventory.

E&O inventory represents a significant cost category for most OEMs. From the 2009 NASPC panel discussion on inventory management, we found that the average North American OEM expected to see no sales over the next two years from 3-10% of its inventory dollars.

A typical OEM will scrap about 3.5% of its inventory dollars on an annual basis, or about half of what it considers to be E&O. Automotive OEMs scrap about 5% of inventory dollars, while heavy equipment OEMs scrap only about 1.8%. Assuming North American OEMs are carrying about $6 billion in inventory at cost, this translates into a staggering $200 million in parts that the industry just throws away each year. To put this figure into context, the value of scrapped parts in North America exceeds the gross domestic product of several Caribbean countries! Assume a 15% carrying cost for non-scrapped E&O, and this cost rises an additional $25 million per year. By the way, about the same value is thrown away in Europe, too.

How can we go about harvesting this opportunity?

First, a quick disclaimer: To state the obvious, we need to forecast and order parts in such a way that does not create E&O, but this is a subject for another blog.

We found from our NASPC mini-benchmarking in March that OEMs are using a number of channels to dispose of E&O inventory: There are several key implications of this chart:
  1. There is no consistency across OEMs in the way they dispose of E&O.
  2. OEMs may be in different situations that limit the extent to which they can pursue a given disposition channel, which explains some of this inconsistency.
  3. Nonetheless, when we see inconsistency like this it suggests an under-served area of the supply chain where there is limited common knowledge about the right strategy.
  4. Some OEMs pursue certain disposition channels a lot. They must have some knowledge of what works and what doesn’t work.
We peeled the onion on these disposition channels, added some of our own, and ranked them by our general order of preference:
  • Return to Suppliers: Many OEMs have agreements where they can return parts to suppliers or parent companies. Where this is possible, it should be the first plan to dispose of E&O. The upside with this approach is OEMs face low risk of parts returning as grey market. The downside is most suppliers and parent OEMs have restrictive return T&Cs or only reimburse at a fraction of part cost when parts near their end of life.
  • Export Markets: Some OEMs can sell directly to overseas markets. Some OEMs cannot sell directly, but can sell to a large wholesaling dealer who has the capacity to sell to export markets. The risk in this channel is that some of these parts may return as grey market, so obsolete parts (as opposed to excess) would be a better target for the export market channel.
  • Third Party Wholesalers: Identify third parties who will purchase slow-moving or obsolete parts from OEMs under exclusive, long-term agreements. By selling to these companies, OEMs can benefit by taking a tax deduction by writing off inventory value that is generally accounted for in the scrap accrual account. This arrangement can save significant warehouse space for OEMs. Also, non-union labor costs at these third parties tend to be lower than OEM labor costs, which allows third parties to take on more inventory than an OEM could. The downside to these third parties is they may not accept inventory that is truly obsolete (less than 1 unit sold per year). For some OEMs, this is the majority of their E&O.
  • Charitable Contributions: Parts such as engines and transmissions can be donated, and OEMs can realize a charitable contribution tax deduction. Subaru is a standout in this area. They have a contract with Goodwill to disassemble and recycle scrapped parts. Approximately 70% of scrapped service parts material ends up being recycled or re-used. Disassemblers also receive job training, so this is a win-win for all parties involved.
  • Salvage Companies: While general scrap metal will only fetch a few cents per pound, some specialized scrap companies will pay significantly more for parts containing valuable components.
  • Advertising Direct to Customers: OEMs should not get into the business of selling direct do customers, because they do not have the capacity to advertise, process, and ship small lot orders from PDCs. OEMs can, however, advertise select E&O parts on customer enthusiast websites, which will drive customers to the dealer channel.
  • Promotions to Dealers: Pushing E&O parts to dealers, especially at this time, is a bad idea. Given dealers’ very limited cash flow and Parts Department inventory space, we want to encourage them to stock fast-moving, high margin parts. Even if E&O parts are high margin, they will not return the highest ROI for OEMs or dealers. If OEMs feel compelled to sell E&O to dealers, we have seen some OEMs prioritize small groups of high value E&O parts for quarterly dealer promotions. This process requires significant coordination between the supply chain folks and the parts sales and marketing folks. Discounts of greater than 50% are typically required to make these parts move, which should further discourage OEMs from pursuing this strategy.
  • Destroy: After exhausting all other options, it’s time to scrap remaining inventory that cannot be sold to limit carrying cost.
Bottom line: There is significant money tied up in E&O and yet the flow of inventory into the E&O bucket is seemingly never-ending. Think of the storage and handling capacity we could free up by doing a better job with this. We see a lot of ad-hoc approaches to disposing of E&O in the industry, but no defined strategy. There is much the industry still has to learn about controlling E&O and minimizing its impact on the environment and the bottom line.

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