When it comes to managing inventory, companies are often conflicted between purchasing too much or too little. Another problem is how companies become fixated on their monthly inventory holding costs. In turn, they decide to manage all their parts and raw materials on a monthly basis. They do this in order to protect themselves against carrying inventory for too long, tying up too much capital in inventory and to protect against the risk of inventory becoming damaged and obsolete. There are many costs to inventory. While these are all valid concerns, some companies make it one rule for all products, and this is entirely wrong. Instead of measuring holding costs relative to the profit of the product line, they simply choose to reduce their inventory levels. So, I’ve decided to shed some light on the subject.
Companies believe that managing inventory monthly is a great way to ensure that those parts and raw materials the company buys will be much easier to pay for, IF the company is able to sell those parts immediately to their own customers. It’s all about cash flow, and cash flow is not easy to manage for many companies. Problems with cash flow can make it difficult to capitalize on savings for materials and parts through volume purchases.
- When your company buys parts and materials, you must pay your vendor's invoice in 30 days.
- If your company can sell these products to your own customers, then your company will itself be paid in 30 days. This will make it easier to pay your own invoices.
- Managing inventory monthly helps to manage your risks. If a part or material become outdated, obsolete or damaged, you won’t lose as much money when your inventory levels are low.
- It’s often easier on cash flow for companies when they manage inventory month to month. After all, your company has salaries and bills to cover.
There are plenty of reasons why companies manage inventory month to month, and they are all valid. However, there are companies that think they have to manage their inventory monthly because that’s the rule and the best way to protect against risk. For those companies that don’t have an issue with cash flow, there is a better way to save money on incoming parts and materials. If your company sells products often, and these products are considered big hitters for your sales team, doesn’t it just make sense to save on purchase price and drive up your profits on each sale? For those hot selling products, don’t make the mistake of only bringing in enough to cover one month of sales.
Use the Following Example to Drive Down Your Purchase Costs
If the savings accrued in Freight & Purchase Price from your vendor are greater than your monthly carrying charges of 3%, then you’ll come out on top.
Your company should be able to reduce your Per/Unit Freight cost of parts coming into your warehouse by 5% once you double your volume.
We’ve provided two scenarios here. One is for your customer providing a 9% price discount, and another is for a 10% price discount for doubling your purchase volume. Your price discount could easily be higher.
In both cases, both the 9% & 10% discount means you’ll now hold inventory for more than one month. We’ve assumed it will now be 3 months of holding all the inventory before depleting it and having to purchase more.
We’ve moved the analysis from a month to month view, to a quarter. You won’t be able to do this with all your products, but those that you can, you need to capitalize on this approach.
The net gain or savings, is the yellow shaded area, is simply the original cost of ownership of $58.71 minus the new cost of ownership after the end of the 3 months.
If you want to download the above excel sheet, here it is: Download HoldingCosts
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