Understanding the true costs of inventory

Ordering costs. Carrying costs. Capital versus noncapital costs.

The true costs of inventory extends beyond the inventory itself and the cost of goods sold. Most companies are unaware or fail to measure the true cost of their inventory. This means that purchasing departments tend to rely on two popular techniques to reduce inventory costs:

• Using spot order fulfilment—that is, purchasing only what’s needed to fill that particular order. This can limit a company’s ability to use economies of scale and bulk purchasing power to negotiate better pricing and reduce costs.
• Buying the cheapest available option from suppliers, rather than factoring in quality, service and reliable delivery for the best inventory at the optimum cost.

Remember, it’s not the price you set for selling an item. Rather, it’s the profit you make on an item that matters. Insurance, duty, taxes, plus more are all costs that are part of an item’s supply chain.

To understand the true costs of inventory, what are other costs to consider?

Landed costs versus standard costs: Factor in all the associated logistics costs (meaning an item’s entire supply chain!) for your inventory from point of origin to distribution. Standard costs for manufactured items may include labor, material and overhead. Remember to include all possible landed costs, such as vendor acquisition, freight, duty subcontracted services, insurance, taxes and handling charges.

For a company with global operations, the full spectrum of landed costs adds up quickly!

Distribution or dynamic deployment costs: Making sure you have the right inventory in the right location to satisfy local demand quickly has many constraints, which makes inventory forecasting challenging. These constraints include limited transportation capacity and schedules, limited storage space, and the ability of manufacturers and suppliers to satisfy demand.

If, for example, the U.S. West Coast sales are higher than the East Coast, but inventory to meet the West Coast demand happens to be in East Coast warehouses, your ability to ship quickly and maintain inventory at lower cost will suffer. Dynamic deployment of inventory ensures inventory is moved to where it’s needed most so you don’t lose out on sales. Amazon is a great example of a company that manages its dynamic deployment costs well. They forecast demand down to the level of major cities in each state to improve upon the shipping speed and availability of inventory to meet the demand.

All kinds of carrying costs: If you have inventory sitting in your warehouse it’s like having unworn clothes in your closet with the tags still on. And that means your demand was forecasted poorly. Carrying costs can have a huge impact on profit, so forecasting better should reduce carrying costs and increase your company’s bottom line.

The cost of managing and maintaining inventory is a significant expense in its own right. But the true cost of inventory doesn’t even stop there. Inventory carrying costs typically add about 20 to 25 percent to the actual cost. And with every passing month that item doesn’t sell, the company’s margin shrinks. Once that item has become obsolete for whatever reason, it’s time to consider the last category of inventory costs.

Stock-out costs or shortage costs:  As a last resort, a company will write off excess inventory in any number of ways to finally end the carrying costs associated with the inventory. Whether the item is donated or sold to a discounter, a company should work hard to avoid having to write off its excess inventory. Writing off inventory means you are removing some or all of the cost of an inventory item from accounting records once inventory becomes obsolete or its market price has fallen to a level below the cost.

I’ll end by saying again it’s not the price you set for selling an item. Rather, it’s the profit you make on inventory that matters. Understanding the true costs of inventory can free up cash and working capital…because profit on inventory is what counts.

Next time, I’ll wrap up my series by talking about how long it takes realistically to improve a company’s supply chain. Until then…JP