Tracking Inventory Carrying Costs and Receivable Financing on Custom Designs

As a manufacturer of custom-made, one-off designs, have you taken the time to define your inventory carrying costs and financing costs on receivables? Have you tracked these costs relative to the number of times your customer has instituted a change request, a request that has halted production and forced you to make design changes? More importantly, are you aware of how these carrying costs erode your product’s gross profit every time your customer puts a temporary halt to the project, and how your company’s financing costs increase the longer it takes your customer to close their invoice?

Granted, these are big questions, but they must be answered in order to ensure your company isn’t losing out as your customer makes one change request after another, or extends their credit terms. 

Account for Financing and Carrying Costs of Inventory

In our analysis of this issue, we’ll review the impact of both cost drivers on a fictitious design. First, it’s important to understand how a company determines its cost of capital and the role it plays in the company’s monthly inventory carrying costs. A company’s costs to borrow money relates to the yearly interest rates it must cover on its loans, business credit lines and other financing vehicles.

This yearly rate must then be converted into a daily rate in order to determine the daily impact of any delays resulting from change requests. In some cases, those delays may turn into months, but for the most part, companies will focus on the costs to hold semi-finished product in days. 

Companies must cover this cost of capital based on the fact that they have already purchased the parts and materials needed in manufacturing. The longer they hold that material waiting for the customer change request to be completed, the more expensive it becomes. However, the inventory carrying costs are far more than just the company’s cost of capital. They also include the costs of inventory damage, obsolescence, heating, electricity, warehouse management as well as several other factors too numerous to mention.

To simplify these costs, companies typically apply a monthly 3% holding cost to the inventory they retain. A company’s cost of capital is typically included in this 3%. However, the company’s cost of capital also plays a role in the company’s cost to finance its receivables. The longer it takes the customer to pay, the more the company has to cover this cost of capital. 

 

If you want to access the sample excel spreadsheet defined in the above video, then please read: Sample NRE Excel Pricing Sheet for Non-Recurring Engineering Charges

Determining the Impact of Delays and Financing Costs 

Our focus is on determining the company’s carrying costs of inventory to hold designs in a semi-finished state. The first step is to account for the company’s inventory carrying costs. The second step is to apply those costs to the product’s COGS (cost of goods sold) while the product sits idle on the production floor. A product’s COGS are those labor and material costs that go directly to manufacturing the finished good. Therefore, if customers make multiple change requests, then the company will have to account for their inventory carrying costs against the product’s COGS. This must be done through the various semi-finished states.

The third step is to summarize these carrying costs. Granted, the company’s inventory costs are costs it must cover throughout the manufacturing process. However, these customer delays only add to these costs. If not for these delays, the company wouldn’t incur additional costs and would ship and get paid sooner. The fourth step includes determining the financing costs on the receivable. Finally, an honest assessment must be made concerning the product’s gross profit after accounting for the costs to hold that inventory and the costs to support the receivable. 

1. Include carrying costs of 3%
2. Calculate carrying costs against product’s COGS
3. Summarize total carrying costs
4. Determine financing costs on receivables
5. Calculate costs relative to gross profit

 

An Example of a Custom Design in Limbo

In our example, a company is manufacturing a custom product for a client who continually makes changes. There are four change requests that impact the design of the product at various production stages. In keeping with our steps from above, the company totals their inventory carrying costs against the product’s COGS during these delays. The company applies their 3% holding cost to the COGS based on the number of days that product is held before the changes are made. For instance, the cost of the first delay is $52.50.

This calculation is done by taking the COGS of $10,500.00 and applying 3%. This gives us $315.00 for one 30 day month. We then take this $315.00 and divide it by the 30 days in a month in order to give us $10.50 as a daily inventory holding cost. Next, we multiply this $10.50 by the 5 days the product is held in order to get our holding cost of $52.50. The company then completes this process for each delay. 

In our example above, the total costs of the four delays is $756.00. However, it doesn’t end there. Once that product is shipped to the customer, the company must then cover its costs of capital. By the time the product shipped, its COGS were $20,000.00 and the customer took 60 days to pay their invoice. The company’s yearly interest rate on financing is 6%. Its daily rate is 6% divided by 365 days, which gives us a daily interest rate of 0.0164%.

This daily rate equates to a daily financing cost of $3.29. This is calculated by taking the daily rate and multiplying it by the COGS of $20,000.00. Unfortunately, not only did this particular customer make multiple change requests, but they also took 60 days to finally pay their invoice. The financing costs to the company on the receivable are $197.26 for the 60 days.

Companies must track these costs in order to fully understand the impact of their customer’s change requests and financing costs. In this particular example, the company incurred $756.00 in production delays and $197.26 in financing costs. While many point that financing receivables is just part of doing business, it is still important to be cognizant of the difference between paying within 30 days, versus 60 days. Had the customer paid by 30 days (which is standard net-30 terms) then the company would have saved itself $98.63 in financing. The fifth and final step is to account for these costs relative to the product’s gross profit. That’s something your company must do when it reviews the success or failure of its one-off, custom designs.

 

If you're looking for additional information on this subject matter, please read: Define Your Inventory Carrying Costs on Custom-Made Products