It’s not uncommon to find companies that simply don’t understand all of the costs of holding inventory. There are a number of costs that companies simply don’t think apply to managing their product levels. For instance, inventory costs are often broken down into lost sales costs of inventory and high inventory holding costs. When thinking about these costs, it is always best to ask one simple question: Does this cost have anything to do with our inventory? The answer to this question isn’t always clear, but the following should clarify what constitutes your inventory holding costs.
Understanding Inventory Holding Costs
Any cost that can be traced back to holding inventory can be considered a direct cost of inventory. It is important to remember that inventory costs are made up of a number of factors. The longer inventory is held, the more these costs add up. Keep inventory for too long, and not only do the costs continue to rise, but the risk of parts being damaged or becoming obsolete, rises as well. Therefore, a large portion of these costs have to do with having too much inventory. When looking at inventory, you must be aware of your inventory turnover rate. The inventory turnover rate is simply the time it takes your inventory of a given product to be used and replenished.
For example, if you were to buy parts and materials this month, and by the end of the month, all of it was used up and you had to purchase more, then this would be considered a relatively high inventory turnover rate. However, if you purchased parts and materials and they took several months before you had to replenish the inventory, then this would be considered a low inventory turnover rate.There are a number of software packages that can provide more in depth analysis of your inventory turnover rate. Our analysis will concentrate on providing the entire breakdown of the costs of inventory. Estimates on the annual cost of inventory can be as high as 35%-40% of the inventory value. What makes up these costs?
The Breakdown of Inventory Costs
The table above is from the post: Sample Excel Sheet Calculating Inventory Holding Costs. You can input your own variables and determine your specific holding costs. The sample sheet also includes a series of pie-charts.
The above video shows how to choose a supply chain strategy matched to your market, your business and your customers' order patterns. You can learn more by going here.
A number of companies simply assume that these costs don’t apply to inventory. It takes time to properly asses your inventory costs, but once you start to concentrate on the above areas, you are better able to systematically reduce these costs. To give you some perspective, if you had an inventory value estimated to be about $100,000.00, it could cost your company anywhere from $30,000.00 to $40,000.00 a year in inventory support costs. It certainly makes sense to set a plan in motion to reduce these costs. Here are some ideas.
Ruined Inventory & Damaged Inventory: 10%
The problem with damaged inventory is that once it becomes damaged in your warehouse, you are ultimately responsible for that cost. It’s entirely on your books, and if that inventory has been at your facility for a long time, you won’t have any chance of a credit from your vendor. So, the best way around this is not to have the product in your warehouse! How is this done you ask? Well, the best way is to negotiate contractual supply agreements with your vendors/suppliers that requests them to hold your inventory for you until you need it, and are guaranteed to use it. Taking inventory only when you need it, and only when you’ll use it, guarantees that ruined and damaged inventory is no longer a concern.
Of course, your supplier will likely have to incur their own carrying charges for holding your inventory for you, and will likely put a limit to how long they hold your inventory. Be ready to negotiate but don’t make the deal one-sided. It won’t work if neither party feels comfortable with the agreement. Even with paying a monthly carrying charge with your vendor, you’ll still come out ahead in the long run. A good rule of thumb is to come up with an agreed amount of monthly carrying charge and split it.
Dead Stock or Obsolete Inventory: 5%
This requires some discipline on behalf of your sales force. The only products you should hold in inventory are products you are guaranteed to sell to multiple customers. Having more than one customer outlet is essential. In fact, decide on a number of customers you need to make sure your company is never left holding dead product. Sometimes it might only be 3 customers, for other companies in other industries, it could be 10 or more. Whatever that number is, decide upon it and don’t deviate from it.
For products where you only have 1 customer, either have a solid, written supply agreement, or make that business “made to order” business only. This means you have no inventory, and when the customer orders product, there will be a lead time. You manufacture or produce the exact amount to finish the order and nothing more. Nothing goes into your inventory and nothing remains.
Over time, High Freight Costs and Lost Customers for Inventory Stock-Outs: 11 %
I wrote about this in yesterday’s post: JIT Versus Min/Max Inventory Management Practices. If you can’t run a Just In Time inventory don’t run it. If you don’t have the volume, purchasing power, or the ability, stay away from JIT. If your business model is cyclical and fluctuates throughout the year, stick with Min/Max. Understand that rushing parts into your warehouse because you don’t have the inventory and then paying for high freight because you’re late to your customer, just drives up your inventory costs. Match your inventory approach to your business model.
The above video explains the two main costs of inventory: Lost sales and inventory stock-outs directly impact your bottom line.
Cost of Money and Electricity: 9%
The best way to defeat the cost of money, is to get paid faster from your customers. Agreed, this is much easier said than done, and in today’s economy, not at all easy. However, offering prompt payment initiatives, such as 1% reduction on invoice with net 10 day terms is one way to do it. Some companies ask for 2% net 10 – hard to do, but getting the money immediately helps to combat the daily cost of money.
Electricity, heating and air-conditioning requires some tweaking. However, it can be done and companies do find way to save money. Using compact fluorescent light-bulbs is one way, and I’ve seen other companies use environmental management systems to control temperatures to lower their overall yearly costs.
There will always be costs associated with carrying inventory. There is no guaranteed way to eliminate all these costs. Remember, these are estimates. Some companies costs are higher, some lower. However, you can mitigate the impact of the above. Now that you have a solid understanding of what makes up your inventory costs, you can set a plan in motion to reduce their impact. The most aggressive companies make it a point to reduce inventory by specific amounts. However, to succeed requires an understanding of what goes into those inventory costs.
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