Tuesday, July 13, 2010

Growth through capacity

A decade back idle capacity was abhorred. It was the duty of the plant manager to ensure that everyone was kept busy and the machines kept churning out material. High utilisation was a rule to balance the high costs of capacity. This also led to large batch sizes and long product runs. This was the time when demand was relatively stable, competition was manageable, retailers had low bargaining power and organisations were sure that sooner or later they would sell everything that they produce.

The ripples caused by the recession and the subsequent recovery have ensured a high variance in demand. There is a steady increase in the product variety being offered. Competing players are also coming out with new products and innovative promotions. Retailers are also more adamant on the exact type of products they need. Organised retailers can in fact bully manufacturers and brand owners in product assortment and dispatch frequency. Given this scenario, now the companies are laden with many products that they are not able to sell.

In the first scenario, the only cost of inventory was the cost of interest for the amount carried. This was a minor cost. If the cost of working capital was 12% (assumed for simplicity sake) and a product stayed in the factory warehouse for a month, the carrying cost would be only 1%. The product margin more than made up for this cost. Now, with the risk of the product not getting sold at all this inventory holding cost has shot up.

Directly reducing inventory would reduce customer service. Especially with a higher variety and fluctuating demand, low inventory would lead to low fill rates. This would lead to high costs of not lost customers. Factories operating at high utilisation would have inflexible and rigid production schedules. A change of customer requirement is usually met through inventory. With low inventories, a change would have to be met with a change of production schedules. Again, with low inventories, A change of production schedule will invariably cause a stock out of some other product B.

Demand variability is very difficult to control. So, it seems inevitable that companies learn to live with high inventories and high wastage. They can of course try to squeeze costs from vendors and other service providers. This is precisely what companies are indulging in now. What the companies need to do at this stage is to re look at the way they 'cost' capacity.

Look at this article here:
http://www.livemint.com/2010/07/12233422/HUL-aims-to-react-faster-to-ma.html
The largest consumer goods company in India, HUL is planning to combat the volatility with capacity expansion. They are planning an increase in the capacity levels and a few places like the Selvas plant has doubled their existing assembly lines.

Excess capacity is definitely cost. But here again, like the inventory of the earlier era, machines are sooner or later likely to be used. Having spare capacity means that the manufacturer is more flexible. They can be more responsive to the existing market demand and give the customers exactly what they want. Making consumer goods is not like making rockets. The lead time to make a product is a few hours provided the capacity exists. Thus firms can drastically cut inventories if they have spare capacity.

Yes, the machines would be idle and the operators would also not have anything to do once in a while. But, overall the total costs would reduce and the fill rates would go up. Cheers to HUL for this change. Now with the leader showing the way, may be the others will follow.

2 comments:

KrRahul said...

This is a good analysis. Everyone loves excess capacity, though 'excess' becomes running capacity as demand increases.

Went through the news report, it gives many insights on HUL's improvements and focus areas. Though I see that many of the improvements achieved are not because of excess installed capacity but because of other reasons. And conversion of single assembly line into two - as HUL has done - is not only about increasing capacity. Its more about increasing production flexibility and this is what will give the company returns...

Neeharika said...

Wonderful read !

Another example of the same would be Zara which maintains excess capacity for driving its super responsive supply chain.

So, excess capacity is the way to forward, but not a pinch of excess inventory :)