When companies try to mitigate their costs of inventory, they often have tunnel vision and employ a rather simplistic approach. Most immediately assume that to reduce inventory costs means having low inventory levels on parts and raw materials. Running a tight inventory may seem like a great idea, and it does look good on paper, but there is far more to the costs of inventory than simply not carrying too much. After all, if there’s no inventory and a customer order is lost, what’s the cost then? A number of companies don’t see lost orders as a direct cost of inventory, but it is. Not only is it a direct cost of inventory, but there are other costs of running a low inventory that companies either ignore or are completely unaware of. Interested in knowing what they are?
Inventory Costs Include a Number of Variables
Inventory costs are never as simple as just counting up the prices paid for parts and materials. Included in these costs are the freight costs to get those parts in and out of the warehouse. How long the inventory is held is another cost. Obsolete and damaged inventory are other costs. As costly as these are, the costs of not having inventory are equally as high. In fact, when properly tracked, an argument can easily be made that not having inventory is far more costly.
We’ll review the costs of running low inventory levels by analyzing the aforementioned example of an important customer who calls to place an order and the inventory is unavailable. The actions taken by the company to service their customer only exacerbate the severity of the situation and drive their costs up. So, what happens when that important customer calls and the inventory isn’t available?
The Costs of Low Inventory Counts
When looking at inventory, it’s important to include all the costs. We’ve covered a couple above, but there are others. One of them is the cost of losing customers because the inventory wasn’t available. This isn’t the cost of the lost order, but the cost of a customer who decides never to return.
The cost of the lost order is one thing, but losing a customer account forever is another direct cost of inventory. According to some estimates, lost customers as a result of low inventory can represent 3% to 5% of the inventory cost annually. In this example the company doesn’t want to lose the order, or the customer for that matter, and decides to take the following action.
1. Faced With a Stock Out, they Rush Parts in
Not wanting to lose the order, the company immediately contacts its supplier and orders parts with a high level of urgency. If the parts are available, then the costs may simply include shipping the parts overnight. However, if the parts aren’t available, then it’s more than likely the vendor will charge a rush fee to get the parts made sooner. Here’s the first cost. Are there other costs?
2. High Costs to Expedite Incoming Shipments
Another cost is the freight required to get those parts into the warehouse. Because of the urgency of the request, it’s more than likely those parts will be shipped priority next day. The heavier the parts, and the larger the shipment, the higher those freight costs will be. However, there is another expense in all this. Who is going to receive the parts and ship them out again? Well, it’s more than likely the company will have to pay an employee overtime to receive the parts, unpack them, label them again and ship them out to the customer.
3. Additional Freight to Ship Finished Goods to Customers
The company isn’t out of the woods yet. They’ve managed to get the parts into their warehouse, repackage them and ship them out again. However, who’s going to pay for freight to get those parts to the customer? It’s more than likely the customer won’t. The company already incurred a rush fee to have the parts made and a high freight bill to get the parts, but now they’ll incur additional costs.
In order to save the customer relationship they’ll now pay to expedite the shipment out to the customer. In this case, the company wasted money by keeping a low inventory count and may have lost the customer regardless of their last minute efforts.
To Learn more about the costs of low inventory counts, please read: Lost Sales Cost of Inventory: Lose Gross Profit, Lose a Customer and Then Lose Market Share
Why do Companies Ignore These Costs?
One of the biggest reasons why companies are unaware of these costs is because they lack the ability to properly track them back to their source. In some cases it’s because they don’t expand their view of inventory management beyond that particular day. Sometimes it’s because they lack cohesion between their sales forecasting and their procurement department.
Companies must be cognizant of all their costs of inventory and properly track these costs back to their original source. Ignoring the impact of these costs simply means the company will make the same mistakes time and again.
While it may seem like a good idea, keeping inventory levels low can be problematic. Make sure to improve the communication between your company’s sales & procurement departments. Be aware of all the costs of inventory and watch out for low inventory counts.
Choosing the right supply chain strategy comes down to matching an approach that addresses the needs of your market, your customers and your own business model.
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