There is one tool I always use when I need to explain the two main categories of inventory costs; high carrying costs and lost sales cost of inventory. This tool is not only useful when explaining these two cost drivers, but it's also useful when outlining the reasons why companies should use an inventory asset analyst, one that can find a happy medium between the needs of the company's sales department, and the objectives of its purchasing department. Most companies are well aware of carrying costs. These include the costs to hold inventory without sales. However, far too few understand lost sales costs of inventory. The following bell curve should help explain the impact of lost sales on your inventory.
High Carrying Costs: Most companies have an understanding of carrying costs. They understand that holding inventory without sales, costs the company money. These costs are captured by high financing, inventory damage, inventory obsolescence, pilferage (theft), the per-unit freight costs on incoming parts and the general costs of managing a warehouse; such as rent, electricity etc. When thinking of high carrying costs, think of the costs to hold product without sufficient sales. The longer you hold product, the higher your company's financing, and the more likely that product will become damaged, obsolete or stolen.
Lost Sales Cost of Inventory: On the other end of the spectrum is lost sales. Yes, losing sales is a direct cost of inventory and it’s one that most companies either ignore, or are completely unaware of. So, why does this happen? More importantly, how is lost sales a cost of inventory? After all, isn’t lost sales the result of poor sales performance? Well, yes and no. A company’s inventory is often its biggest asset on its balance sheet. It’s something the company must have in order to capture market share and increase revenue. In essence, it’s a necessary evil and while it does cost money to have, it often costs more not to have it. In order to better understand this, ask yourself the following question.
“What does your company do when confronted with a customer order and your company doesn’t have the inventory to meet that requirement?”
First Cost of Low Inventory = Lost Sales, Lost Gross Profit and Lost Customers
If you’ve resigned yourself to doing nothing when faced with the above scenario, then you’ll definitely lose the sale and will therefore lose gross profit. Worse yet, you may lose the customer’s business entirely. You’ll now have to measure that cost in terms of that customer’s business volumes for the year. This is the first cost of low inventory; losing sales is a cost of managing inventory, so it’s a direct cost of inventory. However, let’s say you’ve committed yourself to not losing this order, or this customer. What must you do to make this work? To answer this question, here is a series of additional costs pertaining to low inventory.
- Expedite Fees: You’ll immediately contact your supplier and ask that they rush parts in. Jumping to the front of the line is likely going to cost your company an expedite fee.
- High Freight Costs: Not only will you pay an expedite fee to secure product, but it’s a guarantee that you’ll have to rush those parts into your warehouse. This means higher freight costs on the incoming shipment.
- Warehouse Overtime: Depending upon your business model, you’ll likely have to pay overtime to receive, inspect, repackage and ship product out to your customer. These costs are even worse when you’re a manufacturer and you must cover overtime.
- High Freight Costs: Being late means you’ll likely have to cover the cost of freight to your customer’s location. That’s another hit to your freight bill.
“Now, do you really save money by keeping inventory levels low?”
The table above is from the post: The Bell Curve of Inventory Management: Finding the Middle Ground
Inventory Costs Aren’t Just About Your Company's Cost of Capital
I was once in a meeting with the president of a company where we were discussing contractual supply agreements. I was making the point that we should be protecting our inventory by outlining the conditions of the shipments within these customer agreements. Simply put, our customers had to understand that we could not hold inventory indefinitely. I explained that we should at least charge half our company’s support costs of inventory – which is approximately 3% of the inventory value on hand.
This 3% monthly inventory cost would be charged against the product line’s COGS (Cost of Goods Sold). This 3% is a standard inventory holding cost for companies and one that is well understood by inventory management professionals. To my amazement, the president said that this 3% was impossible, because “no company’s inventory is financed at 36% a year!” He thought the 3% was entirely financing. He simply couldn’t comprehend why, or how, his inventory could possibly cost him 3% a month. To him, it all boiled down to financing – nothing else.
When looking at your company’s inventory, start by defining the costs to hold inventory for long periods. How often does damage occur, and what are these costs? How often does inventory obsolescence occur and what are these costs? Is theft a problem? What is your per-unit freight cost on incoming parts? Identify these costs. All of these holding costs can be improved with safety stock. Yes, maintaining a safety stock will cost you more in financing, but it will help reduce your lost sales cost of inventory. Finally, track how often your company loses sales and customers as a result of low inventory counts. Track the costs of rushing parts into your warehouse in order to maintain a customer account. Don’t ignore these costs and if needed, take the time to investigate the benefit of an inventory analyst manager.