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Financial Impact of MRO Inventory Optimization
By Michael Hasley and Nadine Marcy

Over the past decade we have been invol...
Over the years, our clients ask the same questions regarding their MRO Inventory Optimization
investment. Here are some th...
How do I determine which are cash flow savings or pure EBITDA improvement?

Cash flow savings come from reductions that re...
MRO Inventory Optimization savings are complex and how you realize the savings can be
complicated. However, MRO optimizati...
Financial Impact of MRO Inventory Optimization
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Financial Impact of MRO Inventory Optimization


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Financial Impact of MRO Inventory Optimization

  1. 1. Financial Impact of MRO Inventory Optimization By Michael Hasley and Nadine Marcy Over the past decade we have been involved in many discussions about MRO cost savings. The main question that we continue to be asked is “How does MRO Inventory Optimization impact a company’s balance sheet and income statement?”, or quite simply, “How does MRO Inventory Optimization improve a company’s financial performance?” Poor MRO investment decisions hamper MRO material availability because it ties up money in the wrong inventory parts. Companies have finite resources, but infinite requirements. MRO inventory optimization has been universally rationalized as an investment to support operations. It is what companies have to do to ensure that their production continues. Although MRO cost savings are tangible and real, the accounting around them is quite complex. The savings are related to what is not going to be purchased, lower inventories freeing up cash and disposing of inventories that are no long needed. MRO Inventory Optimization has four direct financial impacts on a business: 1) Improves Plant Efficiency This is due to less unplanned plant downtime; a higher percentage of planned maintenance accomplished as planned; less time spent expediting; and lower premium. 2) Improves cash flow MRO Inventory Optimization results in higher levels of MRO material availability with lower MRO inventory investment. 3) Improves EBITDA MRO Optimization results in cost of capital savings and less material being purchased that will become obsolete, will not be used and will eventually be written off 4) Improves MRO Investment Decisions It’s easy to measure the financial consequences of a poor MRO Investment Decision since the result will either be a plant outage or excess/obsolete material. The resource strain is a much more difficult measure; however, the real impact may be more significant than the other more easily identified costs. How much time and how many projects has your organization initiated to tackle MRO problems?
  2. 2. Over the years, our clients ask the same questions regarding their MRO Inventory Optimization investment. Here are some things you maybe be wondering as well. Okay, I agree that I will save money. How do I measure the impact of MRO Inventory Optimiza- tion? How do I measure the value in such a way that I can validate the ROI and Payback? MRO Optimization leads to a very direct relationship between inventory availability and investment. MRO inventory levels can be compared on a pre and post MRO Optimi- zation basis. In addition to reducing inventory on over- stocked materials as part of your MRO inventory optimization, your company can invest the money it has saved and freed up into the materials that are under stocked. This will improve plant efficiency. Usually, the cost of MRO Optimization is a very small proportion of the cash flow savings that are realized. With respect to ROI and Payback, the savings described above can be related to the costs of achieving the MRO Optimization. In most cases, the payback is less than three months and the ROI is extraordinarily high. Cash flow only saves me our company’s cost of capital. Is it really worth the effort to reduce inventory by 10% when I only see a return of 10% and my cost of capital? To ensure we’re all on the same page, what we mean by cost of capital is the opportunity cost of your investment. In the question above, the cost of capital savings are the savings achieved in MRO inventory optimization from the ability to use the freed up cash in another investment. There really are two savings from increased cash flow. First, the profit & loss savings calculated by multiplying your cost of capital times the reduc- tion in inventory level is a recurring savings, each year. For example, if you free up $500,000 from inventory investment into cash and you have a cost of capital of 11%, then the cost of capital savings is $55,000 this year. But it’s also $55,000 next year, and the year after, and the year after. The cost of capital savings is a consistent savings year after year. Second, once you put in place a mechanism to determine your optimum purchase quantities and order points, you will prevent your company from ordering excess/obsolete parts that would quick- ly build up to similar overstocked inventory levels again. This stops you from spending the money now and from having to write off the excess/obsolete parts in the future.
  3. 3. How do I determine which are cash flow savings or pure EBITDA improvement? Cash flow savings come from reductions that result from lower inventory levels because of reduced minimums and order quantities. In other words, simply carrying less inventory to satisfy plant requirements will result in improved cash flow. The result is measured by looking at the inventory at the starting point and calculating the difference over time. This calculation must also model differences resulting from changes in production volume and item deletions. Direct EBITDA improvements are more difficult to measure. EBITDA improvements come from stopping or avoiding a purchase that would result in an immediate loss of the investment (ex- pensed at the time of purchase) or a future loss of the investment in the part as a result of a write- off. The best practice measurement for EBITDA improvements is to apply the improved rate of write-off against the entire inventory investment. For example, if x% of your inventory investment is written off every year and MRO Decision Support results in a decrease in the rate, then the dif- ference becomes direct EBITDA improvement. Or, another way of looking at it is that even apply- ing the same loss ratio to a smaller total level of inventory results in a higher EBITDA. The overall result of the MRO Decision Support is to reduce the amount of write-offs and, thereby, increase EBITDA. My MRO Inventory seems to be static. Why can’t I evaluate the material annually and make the best decision I can? Even though most of the MRO items are infrequently used, there is enough change in demand and change in market conditions that items need to be optimized monthly. Each month, approximately 5% of the moving items in an MRO inventory will need to be optimized for the first time. This could be because it’s a new item in the inventory or because something has happened to the way it is used that is changing the way it needs to be ordered and kept. Although 5% does not seem like much, on top of those items each month, 20% of the items that have previously been reviewed will need to be optimized again because of changes in the way the item is being consumed. Within only six months, if an organization is not consistently working on MRO inventory optimiza- tion, 55% of their moving items would have inaccurate ordering values. This will create risk to the organization and production, as well as tie up money in unnecessary investments. Any MRO item that is purchased and not installed on a piece of equipment will result in significant losses. MRO Inventory Optimization significantly reduces the number of MRO items purchased that will become excess or obsolete in the future. Not buying an unneeded MRO item results in improved EBITDA. I don’t have the resources to optimize my inventory! The problem may really be that you don’t have the resources because you haven’t optimized your MRO Inventory. Rather than dealing by exception, many companies have to scrutinize every SKU and every transaction. That task is daunting, time consuming and not a useful way to spend time. However an MRO Decision Support framework will permit you to focus on targeted, high value tasks, allowing a company to get much more MRO work done with less effort.
  4. 4. MRO Inventory Optimization savings are complex and how you realize the savings can be complicated. However, MRO optimization is not just something that needs to be done for the operations department. It also has positive results from a cash flow and EBITDA perspective that can significantly improve financial performance. Michael Hasley Nadine Marcy Chairman Production Analyst Michael Hasley has an honours degree in Nadine Marcy has been an xIO analyst with economics and political science from McGill Xtivity since early 2007. She has been in- and an MBA from Columbia University . His volved with the xIO™ MRO Inventory Deci- career has principally been in the financial sions Support implementation at multiple services industry, starting with Citibank and client sites including manufacturing, food The Mercantile Bank of Canada . He was production, consumer products, transportation Chief Operating Officer of Guaranty Trust and pharmaceuticals. before becoming CFO of Sun Life, a large, international financial services company. After Nadine graduated from the University of leading the demutualization and IPO of Sun Western Ontario with a degree in Manage- Life in 2000, Michael became Executive Vice ment and Organizational Studies. She has President and CFO of Firmbuy Inc., an e- studied the importance of continuous im- procurement services company, which led to a provement within organizations and the keys consulting relationship in the MRO field. to organizational development. Michael, in addition to being Chairman of Nadine started at Xtivity as an analyst in early Xtivity, is a financial management consultant 2007. She experienced extensive training and is on several boards, including public under Crystal Howe (Manager, Operations & and private companies as well as some not- Services) and has widespread experience for-profit organizations. He also is Chairman using SQL and Microsoft Access database. She of the Audit Committee of the Office of the currently works on the month to month pro- Superintendent of Financial Institutions (the duction of the xIO at various client sites and regulator for Canada ’s banks, trust compa- supporting the workshop analysts. nies, life and p&c companies, as well as feder- ally registered pension plans). INC. Head Office 200 Queens Avenue, Suite 310 London, ON CANADA N6A 1J3 phone: 519-642-1881 fax: 519-642-2495