A company’s purchasing department must always decide between its monthly inventory carrying costs, and the savings that comes from placing higher volume purchases. It’s a decision they must make daily, and it’s one that is rarely easy. After all, any immediate savings in price, and lower incoming freight, is easily eroded by high monthly holding costs. This is especially the case if the company is forced to hold that inventory for longer than anticipated. All it takes is to be burnt once for a company to become apprehensive about taking advantage of any future deals. That’s why today we’ll provide some guidelines on how to decide between high hold costs, and high volume purchases. Surprisingly, there are some simple approaches to simplifying whether you should maintain your current inventory counts, or purchase more.
The Monthly Inventory Carrying Costs of 3%
Most companies are shocked to see just how much their inventory costs them on a monthly basis. Some assume that the costs of inventory only concern the company’s costs of financing. Other companies understand that obsolescence, damage, pilferage, and freight, all play a role in their monthly costs to hold inventory. However, very few companies ever take the time to define their own costs of inventory. Very few take a systematic approach to outlining their company’s monthly costs of inventory. After all, some companies aren’t nearly as concerned about obsolescence as they may be about theft and damage.
Understanding why your monthly inventory carrying costs are 3% is of vital importance to coming up with strategies to reduce these costs. After all, your company’s monthly holding costs could be higher, or lower, than this 3% so it's essential to understand what they are. In our example, we’ll apply this 3% monthly holding cost to the product’s COGS or "cost of goods sold".
Scenario #1: Holding Inventory for Two Months
In our example, the company is comfortable holding two months worth of inventory. This allows them to close cyclical sales; they know a sale will fall every two months, but are unsure of which month those sales will occur. They don’t want to hold onto inventory for too long because they don’t want to have issues with damage, obsolescence etc. The month-to-month holding costs are defined in both months.
Scenario #2: Holding Inventory for Four Months
To date, the company has been unwilling to purchase more than two months worth of inventory because of the fear of high holding costs. However, their supplier has offered them a discount, provided they purchase double their normal volume. This means the company will now hold the inventory for four months. However, the company also knows that it will save on price, and on the costs of freight, by taking a larger upfront volume. The total savings is 4% off their initial purchase. Therefore, their incoming cost is $9.60 per unit. This amount is represented on the first month and the 3% holding cost is applied every month thereafter.
The only month where the company incurs a “loss” is during the fourth month, where the delta of $10.61 (second month first table) and $10.82 (fourth month second table) leave a loss of 21 cents per unit. However, the savings over the first three months are substantial.
Are These Hidden Costs?
Now, most of my customers immediately ask if their carrying costs of inventory are in fact hidden costs. Unfortunately, they aren’t. I accidentally mentioned they were in the video, but they aren't hidden costs by any means. Some are more difficult to nail down, but all of these cost drivers are present in a company's inventory, or put differently, all have the potential for impacting your company's costs of holding inventory. For instance, when damage occurs to inventory, it often becomes a complete write-off, especially if it’s damaged beyond repair and can only be sold as scrap. When obsolescence happens, it often means companies must liquidate their inventory at huge discounts. Theft completely wipes out the product itself, and it costs companies a substantial amount of money. Incoming and outgoing freight also plays a role. A company that is unable to manage its freight costs is surely going to have problems. Additional costs such as electricity, overtime and inspection, all play a role. Finally, it costs money to finance inventory.
The only way to know what your company’s holding costs are is to take the time to itemize them as I have in the table below.
The table above comes from the post: Sample Excel Sheet Calculating Inventory Holding Costs. The sample sheet allows you to define your own monthly carrying costs by using your own unique variables.
When it comes to measuring your inventory carrying charges against higher volume purchases, start by accounting for your current month-to-month costs. Define the savings of any deal in terms of its reduction in price and freight. After that, focus on applying your 3% monthly carrying costs of inventory to each additional month that you’ll hold that inventory. Next, do a month-by-month comparison in order to determine the net savings of the deal being offered.
This entire process works when your company has done everything it can to mitigate the costs of inventory damage, inventory obsolescence and theft. Finally, take the time to define your company's unique monthly inventory carrying costs - similar to the above table.
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