A number of companies forget about the importance of explaining their inventory holding costs to their salespeople and their marketing department. Instead, most companies rely upon reminding salespeople that inventory costs money, or merely making a statement to that effect. However, very few take the time to explain why. The right approach is to depict these costs in such a way as to show the impact of retaining inventory for extended periods without sales and the cost of not having inventory to meet customer demand.
When looking at a company’s inventory holding costs, we are referring to the costs to hold inventory without sales. Of course, there are inventory financing costs, but there are also other issues pertaining to inventory obsolescence, inventory damage and inventory that becomes so ruined it can only be sold for scrap. There are also costs pertaining to incoming and outgoing per-unit freight costs, the costs of overtime, and the impact of lost sales as a cost of inventory.
Most salespeople hear all the time that inventory is expensive, but few are able to go into any great explanation as to why. If you want your salespeople and marketing department to better understand why inventory is so expensive for your business, then it’s essential that your company not simply remind them, but show them. This involves giving them some real world examples of how inventory is expensive and why it reduces a product’s gross profit. In fact, don't make it a point to show them just once. Make reviewing your inventory costs something your company does every quarter.
1. Financing Costs of Inventory
Most employees don’t understand how companies finance inventory. What’s needed is a real world example of how the daily cost of money impacts inventory and erodes the company’s gross profit. Most companies use business credit lines and loans to finance their inventory purchases. These financing vehicles have a yearly interest rate that can be applied to a daily interest rate. For instance, a yearly interest rate of 10% would have a daily interest rate of 0.0274% (365 days/10%).
Now, most would assume this to be a minor cost, but when inventory is retained for 30, 60, 90, 120 or even 180 days, this daily interest rate becomes incredibly expensive. How expensive? To answer this question, take the time to provide your salespeople with a real world example. Take one of your product’s COGS (Cost of Goods Sold) and show the company’s financing costs of inventory over these various periods. Here’s an example of what it might include.
2. Inventory Obsolescence, Damage & Ruined Inventory:
It’s important to note that the above only explains the company’s inventory financing costs. The company’s holding costs include far more than the cost to purchase inventory and retain it. As mentioned, inventory obsolescence, damaged inventory and ruined inventory, all play an extremely important role in a company’s cost of inventory. Most companies make it a point to track their company’s monthly holding costs. As such, they typically track the issues of obsolescence, damage and ruined inventory over a period of one month, one quarter and a given year.
I’ve separated damaged inventory from ruined inventory for those manufacturing companies that sometimes must rework damaged inventory in order to retain its value. Make sure to include examples of where these three aforementioned cost drivers increased your company’s inventory holding costs. Sales & marketing should be made aware of the costs of retaining inventory for too long and how it always leads to inventory damage or obsolescence.
The above video is from the post: Inventory Carrying Costs vs. Lost Sales: Both Destroy Your Bottom Line
3. Graphical Depiction of Inventory Holding Costs
Finally, make sure to show your marketing and sales team what it means when the company encounters high inventory holding costs. The table and video below shows what inventory holding costs look like, as well as what the company’s lost sales cost of inventory are, and the circumstances under which both happen.
When the company has high inventory levels, with low customer demand or sales, then the company is encountering high holding costs of inventory. When the company has low inventory, and loses sales as a result of not having product, then it encounters lost sales cost of inventory.
The Blue Line represents the customers’ demand patterns
The Green Line represents the company’s inventory levels
The graph and video above are from the post Supply Chain Management: When Inventory Doesn’t Match Customer Demand.
Sales and marketing must have a clear understanding of what it means to hold and retain inventory. A company’s inventory holding costs are typically 3% per month. This is made up of the daily cost of money/cost of capital, the cost of inventory obsolescence, damaged inventory, ruined inventory, per-unit freight costs on raw materials and parts, as well as the time needed to reconcile inventory counts.
The best approach is to thoroughly understand your company’s specific holding costs, define them to the company’s salespeople and marketing department, and impart upon them the importance of reducing these costs. This can be done by constantly raising the bar on sales forecast accuracy, immediately liquidating slow moving or dead inventory, and last but not least, imposing a sales penalty for slower moving inventory (when applicable).
To read more about how to get your company’s sales professionals to sell slow moving inventory and reduce your inventory holding costs, please read: Sales Management Strategies: Getting Sales to Sell Slow Moving Inventory
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