Are you aware that your inventory holding costs include those instances where you must rush parts in because of a lack of available inventory? More importantly, do you track the incidences of lost time on your shop floor due to material shortages? It’s amazing to think that manufacturers encounter lost time because of a lack of inventory, but they do. In today’s business environment, manufacturers everywhere are trying to reduce their inventory holding costs and for some companies, that means limiting the amount of inventory they hold.
While running a tight inventory may seem like a good way to reduce costs, in reality, it does nothing more than increase holding costs and in the worst instances, increases lost time in manufacturing.
One of the biggest reasons companies run tight inventories is because they equate high holding costs with high inventory levels. To these companies, mitigating the amount of inventory they retain allows them to reduce the amount of money tied up in inventory, and therefore, reduce their expenditures. Unfortunately, it’s not quite that simple. What these companies fail to track is the impact of lost time caused by material shortages and how these shortages actually increase the company’s costs of inventory. How does this happen?
Inventory holding costs include the costs of freight for both incoming shipments of parts & raw materials and the outgoing freight on finished goods. Therefore, if a material shortage is encountered, not only does it cause lost time in manufacturing, thereby decreasing production throughput, but it also means the company must pay expedite fees and high freight costs to rush parts and materials in to meet manufacturing schedules.
This issue often occurs when manufacturers run an inventory & supply chain strategy that is contrary to their business model. However, there is a way manufacturers can secure the inventory they need without having to hold it themselves.
Blanket orders and contractual agreements
A Case Study in How Contractual Agreements Reduce Holding Costs
Supply contracts help to reduce a company’s inventory costs while protecting it against material shortages. The focus is on reducing the impact of stock-outs and their resulting effects in manufacturing. By ensuring the inventory is available when needed, a company is able to reduce those instances where they must rush parts in to meet demand.
Scenario #1) The table above is an example of what I worked on with a manufacturer who had issues with high holding costs of inventory. Our focus was to address the impact of material shortages and the resulting high freight costs incurred for urgent shipments. In this situation, the company rationalized that it had low inventory holding costs because it didn’t have high inventory levels. In essence, they ran a “tight” inventory and believed it helped lower their expenditures.
The company’s material requirements was spread across three vendors, each securing a different volume and offering a different price. The first vendor was the company’s primary source, while vendor “2” & “3” were support vendors. None of the vendors retained inventory and therefore didn’t charge the company any holding costs. The company rationalized that they had low inventory costs because they didn’t retain inventory for extended periods and didn’t ask their vendors to hold inventory for them. However, every time the company encountered a material shortage, and weren’t able to secure parts from their primary vendor, (for whatever reason), they immediately incurred higher prices and expedited freight costs to rush parts in from vendors 2 & 3. These were the results of their expenditures over a given quarter. For their entire volume of 20,000 units amongst the three vendors, their average cost was $2.13 per-unit.
Scenario #2) The second table above is what we did to resolve the issues of material shortages and higher freight costs. We used contractual supply agreements that guaranteed volume for all three vendors. Vendor 1 retained their pricing at $2.00 per-unit and didn’t charge any holding costs because they had consistent volumes to ship. Vendors “2” & “3” agreed to lower prices because they could plan their own manufacturing and weren’t burdened by a demanding customer asking them to drop everything and ship parts.
As a condition of the agreement, both vendors included a 4.5% holding cost for the quarter. However, even with these holding costs, the company was able to keep its per-unit freight costs at $0.03 because it doesn’t pay high expedite fees and rush shipments when confronted with inventory stock-outs. Vendors 2 & 3 had no issues with providing better prices because they weren’t asked to expedite parts at the last minute. After these changes were made, the company’s average cost dropped to $2.09 per-unit. This represented a total savings of $744.00 for the quarter. We then duplicated this across multiple product lines and different material requirements.
Using contractual agreements allows companies to reduce inventory holding costs while guaranteeing supply. As long as the vendor retains the inventory at their location, they are ultimately responsible for any damage. This allows a company to eliminate a huge cost driver of their inventory – the incidences of inventory damage and obsolescence. However, for this approach to work, a company must be willing to pay its vendors to hold inventory. In this case, a company is transferring its own holding costs to its vendors. As such, they must be willing to cover a portion of those costs.
Most companies apply a standard 3% monthly inventory holding cost based on the inventory value on hand. Over a quarter, that amount becomes 9%. In our example, the vendor agreed to cut this in half. You may not be able to get the same concession, but if you can, you will see a reduction in your overall costs.
To read more about inventory holding costs, please read: Sample Inventory Costing Excel Sheet: Graph & Pie-Chart of Expenditures
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