There are a number of costs that go into managing inventory. It's never as simple as just paying for the material or part on the shelf. Inventory costs are made up of a number of different factors and keeping low inventory isn't always the best solution. The freight you pay to get material or parts into your warehouse is one cost. Another is shipping or paying expedite fees from your supplier's location to yours for urgent and rush shipments when you don't have the parts available. Other costs include obsolete inventory, dead stock, and moving inventory back and forth from one location to another, in order to make space for faster moving parts and materials. Costs of electricity, heating and a whole other list of critical areas play a role in your overall inventory costs. Low inventory is also a cost. Why?
Any Cost Resulting From Holding Inventory is a Cost of Inventory
You can take any cost that is directly related to managing your inventory, as part of the cost of inventory. Knowing that there are so many aspects to analyzing inventory costs, what are the drawbacks of keeping inventory levels low? Are there any issues with keeping inventory low, or is it ideal to always keep inventory at a minimal level? Well, in a number of cases, keeping inventory levels low actually backfires as it forces companies to rush parts in to fulfill customer orders. This often implies incurring high per-unit freight cost on incoming raw materials and finished goods.
We need the parts immediately, get them here now!
- When parts aren't available, you pay higher freight bills and expedite fees.
- You also pay overtime to receive, and ship out again.
When you've kept your inventory levels low, and managed to avoid the added cost of carrying too much inventory, there are always those situations that suddenly catch you off guard. These tend to be the super urgent customer calls you get, when the opportunity to pursue new business presents itself, and you have no way of capturing the sale because the inventory is not available. Sometimes it's not simply a new opportunity, but an urgent request to replace or service an extremely important account. Whatever the case may be, the urgency is there, and without the inventory, you are suddenly in catch up mode, trying to meet the urgent request.
While you have managed to keep inventory levels low, and been satisfied with the effort, you must now do everything possible to rectify the situation and service your customers. So what does that involve? Well, you'll typically get on the phone with your supplier and request they do everything within their power to get you product. If you are lucky, you may be able to avoid paying a rush or expedite fee from your supplier. However, you'll most likely have to pay a high freight bill to rush the shipment to your facility. Once it's there, you'll likely have to pay someone overtime to wait for the shipment, and repackage it if necessary.
If you've got a customer that has been let down, and you have no other choice but to pay for shipping the product to them, you'll now get hit with another high freight bill. All this time, you were extremely pleased that you managed to keep your inventory levels low, and felt a sense of accomplishment for a job well done. Does this whole situation give you another perspective?
For some companies, it can be rather obvious what the cost was of having too low an inventory level, but for others, they will not correlate the added costs to the costs of managing their inventory. Instead, they will throw the costs in an arbitrary cost bucket and refer to it as simply the cost of doing business. It simply isn't. It is a direct cost to your inventory.
Low inventory rarely, if ever, means low costs. To learn about the two main costs of inventory, please see: Inventory Carrying Costs vs. Lost Sales: Both Destroy Your Bottom Line
Not Using Purchasing Power to Your Advantage
- You now have the burden of paying more invoices and cutting more checks.
- You are not getting the best pricing for your volume.
Inventory managers tend to concentrate on keeping inventory levels low. They do this in order to avoid the month to month carrying charges. However, in doing so, they may actually be doing more harm than good. They are not using their economies of scale to negotiate the best possible pricing. In addition, they may not be maximizing their per unit freight cost for incoming parts and materials.
There are further complications of your company's operations will process the invoices for the materials and parts that are ordered. For instance, if purchasing were to order parts too infrequently, how would each of these invoices be paid? Would they be paid individually with separate checks, or would the company be proactive and pay a larger amount for a group of invoices? Most companies are intelligent enough to work out a single payment for multiple invoices, but some don't. The hidden cost of time and money can play an important role here. It is extremely difficult to estimate the cost of writing a check for most businesses. However, it is much less expensive to pay all at once instead of multiple payments for the same item.
Learn about the bell curve of inventory management.
Most companies don't know the actual cost of having to prepare a check. However, there are several references that estimate the actual cost can be well over $25.00 per check. This takes into consideration the time needed for approvals and sign offs. You also have to deal with higher freight costs as the parts were ordered in multiple shipments. You now have to deal with a larger volume of invoices, more frequent freight bills and you've not secured stronger pricing because your orders themselves are always small volume ones. Unless there is an agreement in place on pricing with your supplier, you are simply wasting money with these practices.
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To summarize, what are the direct costs of maintaining too low an inventory?
- Lost business because inventory was not available.
- High Freight costs for incoming and outgoing shipments because inventory levels were low.
- Higher prices for parts and materials because a company is not using its economies of scale.
- Higher per unit freight cost for each part and material because shipments are split up too frequently.
- Overtime paid for shipping and receiving to stay and receive urgent parts from suppliers, and stay and ship out parts to customers.
When it comes to managing inventory, it can easily be viewed as a constant juggling act. There is no guaranteed way to avoid any of these issues. They occur and when they do, it is always best to simply take a step back and analyze the frequency with which they occur. If they continue unabated without any corrective action taken, then the costs can easily add up. It is always best to remain vigilant of how often you're faced with these situations. Low inventory doesn't always mean savings. Take the time to analyze the costs associated with being caught with too low an inventory level.
To read more recent posts about the dangers of running too low an inventory count, please refer to the following:
Best Business Practices: Avoiding The High Costs of Low Inventory
Vendor Strategies for Small Manufacturers: Eliminate Material Shortages
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