When it comes to product management, determining inventory holding costs by product line is an essential part of controlling costs and maximizing gross profit. Like every company, your enterprise probably has some products that sell very well and others that likely don’t. However, have you ever taken the time to consider what your company’s inventory holding costs are to support those less than stellar product lines? Have you ever wondered what percentage of your company’s sales revenue is occupied by your company’s biggest hitters versus those ancillary products, and what the inventory costs include to support all products?
To analyze a company’s product mix involves categorizing the company’s products by their revenue. These products are then broken down into various categories, or classes. The purpose is to determine what percentage of revenue each product class is ultimately responsible for. What are the top performing product lines for the company relative to the stagnant products where growth is minimal? What can be done to improve the performance of those stagnant product lines?
This is somewhat similar to the 80/20 Pareto Principle where 80% of a company’s revenue often comes from the top 20% of its customer base. To successfully level out this ratio is akin to minimizing the company’s risk. Can this same approach be applied to the company’s product mix? It most certainly can!
Let’s assume the company has a total of 20 products and wants to determine the revenue derived from each line and their appropriate inventory holding costs. Its first priority is to break down the revenue of all 20 lines into their appropriate classes. Next, they need to determine the inventory costs to support these products. These costs would essentially be the company’s monthly holding costs relative to the product’s “COGS” (Cost of Goods Sold). Here is a summary of the steps
- Determine revenue by product line
- Determine COGS by product line
- Determine inventory holding costs by product line
In our example, the company has five product lines that account for 70% of its revenue, while the remaining 15 products account for 30% of the revenue. They have properly divided up their products into their appropriate classes (A,B,C). Next, they’ve determined their inventory costs by factoring in the average days inventory is held for each product. In the example below, I’ve determined the company’s monthly inventory costs to be the standard 3%. The average days held is then divided by 30 days in a month and then multiplied by the appropriate product line’s “COGS”.
Please note, COGS refers to the costs to purchase, ship and receive parts and raw materials, in addition to the company's labor costs, but it doesn't cover the product's inventory holding costs. Now, this is merely a rudimentary calculation, but the idea is to show what the inventory support costs could be for the company’s best performing product lines versus those that don’t perform as well. The video below explains holding costs and the table below that is the one we'll use in our example.
To better understand the impact of holding costs and lost sales on your inventory, please go here.
Table Outlining Inventory Holding Costs by Product Line
Analyzing the Company’s Inventory Costs
When looking at the table above, it becomes readily apparent that those lines that represent 70% of the company’s revenue have a higher inventory turnover rate (sell faster) than those under-performing lines that take longer to sell. All the product lines categorized as “A” have inventory turnover rates of less than 30 days. In fact, all have an average number of inventory days held under 15 days. As such, their inventory holding costs are minimal compared to the volume of gross profit they bring in and their “COGS”. Looking at the “B” & “C” product categories, it’s pretty obvious that their inventory turn over rates are much higher and that their average number of inventory days held is over 30 days. What does this mean for these “B” & “C” products?
1. Higher Incidence of Inventory Damage
The longer inventory is held, the more likely it is to become damaged. To complete this analysis, the company would need to track the incidence of inventory damage across all product lines. The incidence of inventory damage is likely to be higher among the “B” & “C” product lines because those lines are held for longer periods of time before they’re finally sold – hence they have a low inventory turnover rate. The products most susceptible to damage are the “C” product lines as each product in this category average 73.4 days of inventory held before it’s sold.
2. Higher Incidence of Obsolete & Outdated Inventory
Another impact of holding inventory for longer periods is that those “B” & “C” product categories are more likely to become obsolete and outdated product lines. Again, the longer inventory is held the more expensive it becomes. Inventory holding costs (3%) add up and the likelihood that the company will need to scrap parts increases substantially.
3. Higher Miscellaneous Inventory Support Costs
The company will likely incur additional costs to support those slower moving product categories. What are these additional costs? Well, for one, the company will likely have to move these parts more frequently within their warehouse to make room for those “A” category of products that sell faster. In fact, the more successful the company is at selling its “A” product lines, the more likely they’ll be forced to move their “B” & “C” product lines more frequently and that means a higher incidence of damage, not to mention the ancillary costs of warehouse employees handling these parts more frequently.
Product management not only involves maximizing the product’s market share, but also includes minimizing the inventory costs to manage those lines. You may even have qualified your popular products as essential to your company’s product mix, while the less than popular ones as merely ancillary or “me-too” products that your company offers, but could easily do without. It’s essential to be aware of these inventory support costs so as to put plans in motion to reduce their impact.
A solution to those “B” & “C” product lines might include not holding inventory and trying to sell them to customers with a lead time. However, there are other solutions and when companies take the time to analyze their inventory holding costs by product line, they are in a much better position to reduce those costs. I've included three videos below that explain the three main strategies to managing a company's inventory and supply chain. There is a link to an article that explains the pros and cons of running each strategy.
The three videos above explain Min-Max, Just in Time (JIT) and Dell's Push-Pull supply chain strategies. They are taken from the post: Choose the Right Supply Chain Strategy: Make it an Easy Choice
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