Your company’s inventory carrying costs vary according to the type of supply chain strategy you run. For instance, these costs are meant to be lower in JIT supply chains. However, for that to happen means your company must have linear and consistent demand for its products. High demand dictates a fast moving inventory and it's this fast moving inventory that is at the heart of Just in Time inventory.
Four Inventory Cost Drivers
Before analyzing Just in Time, and its impact on inventory carrying costs, it's best to review a company's main inventory costs. First, there is the cost of money which is included in a company's costs of financing. A company's cost of capital is an extremely important part of its overall inventory costs. These costs are only recouped once a product is sold and the company is able to collect from its customer on their purchase.
Second, there are costs of handling which pertain to damage, pilferage (theft), obsolescence, and the high costs of ruined inventory. A number of companies ignore the costs of damage and obsolescence, but there are costs that go directly to a company's bottom line.
Third, there are the costs of freight on incoming shipments of raw materials and outgoing shipments of finished goods. Lowering a company's costs of incoming freight through larger volume purchases makes sense if the company is able to increase its inventory turnover rates on finished goods. After all, there is no benefit to lowering freight costs on incoming shipments if your company doesn't have sufficient sales to keep inventory moving.
Fourth, there are miscellaneous warehouse management costs that include taxes, rent on warehouse space, insurance and the costs of counting inventory. Storage issues due to mishandling are commonplace with companies that encounter high damage rates, and ones that deal with inventory obsolescence.
- Cost of Financing
- Costs of Handling
- Freight Costs
- Miscellaneous Warehouse Management Costs
These four aforementioned cost drivers pertain to holding inventory without sales and are seen as holding costs. However, there are also costs that relate to lost sales because inventory isn’t available. Yes, there are definitive costs to encountering a stock out and they must be measured by the amount of lost gross profit when your company can’t make a sale due to low inventory counts.
Applying 3% Carrying Costs of Inventory
It is standard practice to apply 3% as a company’s monthly inventory carrying costs. This 3% is then applied to the company‘s inventory value on hand. That inventory could be made up of raw material, semi-finished and finished inventory. Now, if a company is proactive in reducing the effects of obsolescence, damage, and eliminates those costs pertaining to pilferage, then yes, they can reduce this 3% monthly carrying cost. Consequently, if they reduce their incoming and outgoing freight costs, then this too will have an effect. However, for the most part, companies apply this 3% every month as their costs to retain product.
So, how does this 3% holding cost impact companies who run JIT?
Holding Costs in JIT: Just In Time
Just in Time is structured on reducing those aforementioned costs by ensuring that the company’s inventory turnover rates are always maximized. If you reduce the time you hold inventory, then you immediately reduce the costs of financing, the costs of obsolescence, costs of damage and the costs of pilferage. In essence, you order only what you need to fulfill current demand - nothing more and nothing less.
While you may have a rolling forecast going out months in advance, the entire purpose of JIT is to reduce the amount of inventory held from day-to-day, week-to-week and month-to-month. In essence, you won’t purchase more than you have current demand for. If successful, you'll not only reduce your financing costs but you'll improve your cash flow.
Now, does this allow you to use your economies of scale to lower prices on parts, and lower your per-unit freight costs on incoming shipments? For the most part, it doesn’t. While some companies are able to use consignment inventory agreements to lock in pricing, most can’t. This is because they lack the economies of scale to make these types of agreements work across their entire supply chain. So, while JIT is structured around ensuring a fast moving inventory, it simply doesn’t allow your company to use its economies of scale to lower prices and incoming freight. Here is a table that provides a summary of how a transaction might unfold.
The Potential for Low Carrying Costs in JIT
When JIT Works
Just In Time works when the product you purchase is sold within the same month, or within 30 days of having purchased the product yourself. It’s as if you’re matching your receivables to your payables. For instance, once you purchase product from a vendor, they’ll invoice you for your purchase and ask that you pay that invoice within 30 days. If you can then invoice your own customer for that product immediately, then you’ll get paid around the same time you’ll have to pay your vendor. JIT works when your company can shorten the time it takes to make a sale, thereby reducing your inventory holding costs.
When thinking of JIT, think of a large OEM, original equipment manufacture. A perfect example would be an automobile manufacturer. They have a fixed bill of materials, a small product offering, but huge volumes spread across that product offering. They may only have five models of cars, but they sell hundreds of thousands of those cars. They buy the same parts day-after-day, week-after-week and month-after-month. Their purchasing volumes allow them to dictate service terms.
By no means is the intention to dissuade you from running this strategy. It's just meant to clarify how and why it works.
Drawbacks of JIT
In theory, JIT should reduce your costs of financing, obsolescence, damage and pilferage. However, it ignores the high costs of freight on multiple incoming shipments. Your company’s per-unit freight costs on materials and finished goods all contribute to your inventory costs. Multiple shipments only add to those costs because they don’t allow you to use your economies of scale to lower your freight costs. Granted, you should be able to use your volumes to negotiate favorable supply contracts, but multiple shipments invariably increase your incoming freight management costs; there are other costs involved in this process such as the time needed for receiving, inspecting, stocking, repackaging and finally, shipping product out to your customer. In addition, any delivery delays are catastrophic and could mean your company loses sales and customers. If that delay occurs, and you miss a sale as a result, then you have incurred a temporary stock, out which means you’ve incurred lost sales costs of inventory – lost gross profit and lost customers. Here is a summary of the high costs of delays.
JIT: Costs of Temporary Stock Outs
JIT sounds fantastic in principle; low inventory counts equates to low financing costs and low carrying costs. However, most companies can’t run this supply chain strategy the way it’s intended. In fact, when I come across a company that claims to run Just in Time, I’ve always found that they aren’t running it effectively. You must operate in a market with consistent, linear demand. You must be your vendor’s biggest priority. Those vendors must be in close proximity to your location – you can’t run JIT with product coming from China or overseas – virtually impossible. You must have large volumes of scale and you must be able to use those volumes to dictate delivery terms. You must mitigate the costs of any delivery delays and constantly ensure a high inventory turnover rate. Finally, you must have a small, robust product line, one where you maximize your purchasing volumes with repeatable sales. Very little deviation is allowed in JIT, which is why a fixed bill of materials in manufacturing is of utmost importance. This inventory strategy may sound great, but it can cost you more in the long run.
To read about holding costs in Min-Max inventories, please refer to: What are the Costs of Holding Inventory in Min-Max Supply Chains?
Or, if you manufacture custom-made parts and want to run a version of Dell's Push-Pull, then please read: What are the Costs of Holding Inventory in Dell’s Push Pull?
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