I’ve written many times about the damaging effects of inventory stock outs. Regardless, I continue to come across instances where my customers believe that low inventory equals low costs. Granted, when inventory levels are low, your company isn’t burdened by the costs of financing, costs of obsolescence, costs of damage and most importantly, isn’t worried about having valuable capital tied up in inventory. However, while each of these are valid points, it’s important to understand what your company does when confronted with an inventory stock out and a customer, who needs product immediately. Well, if you're company is like most of the ones I've worked with, then you're guaranteed to encounter a number of hidden costs of low inventory.
The Importance of Safety Stock
A large number of my customers cringe at the thought of maintaining a safety stock. They like to think they run their inventory so accurately, and so well, that they simply don’t need to adopt this practice. To them, safety stock is akin to Min/Max and Min/Max is outdated and antiquated when compared to the benefits of running a JIT system. Unfortunately, most companies can’t possibly run a successful JIT system. They lack the economies of scale, the purchasing power, the clout and the internal mechanisms to properly run a system that is typically the domain of the large enterprise. After all, it’s not just in time if it’s always late! This is ultimately why you must match your inventory strategy to your business model.
Safety stock works because it allows your company to reduce the damaging effects of an inventory stock out. Now, as previously mentioned, most customers have a hard time understanding what the costs are of inventory stock outs. They can’t understand how it costs them money not to have inventory. Therefore, here’s a couple of immediate outcomes of not having inventory when you need it most.
Lost Sales Cost of Inventory
Inventory stock outs mean your company is likely to lose a sale. Lost sales means lost gross profit and in a number of instances, lost customers. Granted, you may rationalize your decision not to hold inventory by assuming that you’ll react to this situation if and when a customer calls. In your mind, your saving money on financing, obsolescence, damage and the like. When your customer calls, then you’ll respond accordingly. However, what do you do when your customer calls? In essence, what must your company do to keep that customer’s business?
- Expedite Fees: If you’ve decided not to lose that business, then you’ll immediately call your supplier to rush parts over. Now, it’s more than likely that your customer will charge an expedite fee – for jumping to the front of the line. This is the first cost of an inventory stock out.
- High Freight: You’ll now have to rush those parts into your warehouse. That will mean a high freight bill for expedited delivery. This will increase your per-unit costs of incoming parts.
- Manufacturing Overtime: If you’re a manufacturer, then the inventory stock out will be measured by high manufacturing cycle times, down time, and finally, overtime. You’re guaranteed to pay time & ½ for that inventory stock out. Now, is this all the overtime you have to cover? What about shipping and receiving? What about incoming and outgoing inspection? Are there any costs in either of these instances? There are.
- High Freight to Customer: If you want to salvage that relationship, then it’s fairly certain that you’ll have to cover the cost of freight out to your customer’s location. You’re late on this delivery, so now you must cover that cost on your own. This is the second high freight cost your company must absorb itself.
Now, after reading the above, did keeping inventory levels low really save you money? The image below is taken from the post Determining Safety Stock & its Impact on Inventory Holding Costs The article provides insight into the critical steps a company must take when looking to determine its safety stock, its reorder points and its replenishment time.
Don’t think for an instant that running Min/Max is outdated, or that maintaining a safety stock is an antiquated approach to inventory management. It isn’t! It is ideally suited to those enterprises who deal with infrequent customer demand, whose business cycles are cyclical and whose product offering is spread across a large product line, with low volume sales across each of those lines. Just in Time works for enterprises who are their supplier’s main priority, who have the volumes, economies of scale and purchasing power, to dictate terms and conditions. JIT is ideally suited to companies with a small and robust product line, but whose volumes across those lines are substantial. To read more about understanding the difference between Min/Max and JIT, please read JIT Versus Min/Max Inventory Management Practices
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