The Full Cost of Inventory: Exploring Inventory Carrying Costs
When you reduce inventory, not only are you freeing up capital, but you are also creating opportunities to reduce expenses, improve profitability, and increase cash flow.
For most retailers, wholesalers and distributors, inventory is the largest single asset on your balance sheet. In many ways, your inventory defines who you are, and your strategic position in the marketplace. It defines your customer's needs and their expectations of you. Legions of cost accountants are employed to accurately capture and capitalize all of the direct costs of inventory. The cost of that inventory is the single largest expense item on most every Income Statement.
Most companies evaluate the productivity of their inventories through such yardsticks as inventory turn, gross margin return on investment, gross margin return on square foot and the like. These are all valuable tools in assessing inventory productivity, but they are all limited by the fact that they use inventory at cost as the cost basis in their analysis.
The true cost of inventory extends far beyond just inventory at cost or the cost of goods sold. 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. The full cost of inventory, in fact, is actually buried deep within a number of expense items below the gross margin line, almost defying any executive, manager or cost accountant to pull them out, quantify and actually manage them.
Studies of inventory carrying costs have estimated that that these costs are approximately 25% per year as a percentage of average inventory for a typical company. While this information is interesting, it's not particularly useful. In order to manage the cost of carrying inventory it must first be measured.
The generally recognized components of inventory carrying cost include inventory financing charges or the opportunity cost of the inventory investment, inventory insurance and taxes, material handling expenses and warehouse overhead not directly associated with picking and shipping customer orders, inventory control and cycle counting expenses, and inventory shrink, damage and obsolescence.
Let's take a close look at each of these components to better understand how they can be measured and managed.
Inventory financing charges: This may seem easy to calculate, but to measure inventory financing charges accurately is not quite as simple as it might first look. For some companies, working capital financing may be essentially financing inventory, and little else, but for many others it may also be financing accounts receivable. The float between payables and receivables may in fact be partially financing inventory as well. For importers, this may be fairly straight forward to quantify if they are opening Letters of Credit prior to their vendors making shipment from overseas. In this case, the cost of the LC facility may be easily identified as the inventory financing charges. Finally, it's critical to be able to measure what portion of the inventory is being financed externally and what portion is being financed through internal cash flow. For that portion that is being financed from cash flow the opportunity costs of that investment must be measured.
Opportunity costs: When thinking of the opportunity cost associated with the investment in inventory, it's easy to focus strictly on the opportunity cost of dead or under performing inventory. In fact, the opportunity cost relates to the value of the total inventory. If this value were not invested in inventory, what return could be expected if it were invested in something else, such as treasuries, mutual funds, or even a money market account.
Inventory insurance and taxes: These items should be fairly straight forward to quantify as a percentage of average inventory value. And because both insurance and taxes are highly variable with inventory value, any reduction in average inventory value will deliver savings directly to the bottom line, not to mention improving cash flow.
Material handling expenses: Measuring material handling expenses not directly associated with picking and shipping customer orders may be just as tricky. These expenses are made up mostly of wages and benefits, but also include lease payments or depreciation on material handling equipment, depreciation on automation, robotics and systems, as well as miscellaneous expenses for supplies such as pallets, corrugated, UPC labeling materials and the like.
Warehouse overhead: The quickest way to measure this is to split the total expenses for rent, utilities, repairs and maintenance, and property taxes by the percentage of the building associated with processing customer orders, picking and shipping, and that portion of the building associated with receiving and storing inventory. While that portion associated with receiving and storage may seem fixed, in fact it quickly becomes much more variable when you consider what you could rent out the space for as contract storage if your inventory wasn't there!
Inventory control and cycle counting: These expenses may also be made up primarily of wages and benefits, but may also include the depreciation or expense on hand-held radio frequency (RF) units, and other related equipment, as well as any miscellaneous expenses directly related to your inventory control team.
Inventory shrink, damage and obsolescence: Capturing and measuring these costs appear to be fairly straight forward at first glance. The costs of shrink, damage and obsolescence are the value of the write- offs taken, or stated in percentage terms, the value of those write-offs over a given period of time divided by the average inventory during that period. This assumes, however, that all write-offs were taken on a timely basis throughout the year. Were cycle counts done on a regular basis? Was everything counted on a scheduled basis, was that schedule followed, and were higher velocity items counted more frequently? Were written off on a timely basis? Was damaged and obsolete inventory written off in the current period allowed to accumulate during prior periods. Conversely, were write-offs deferred during the current period, resulting in a build up of damaged and obsolete inventory that will have to be written off in a future period. Experience has taught us that in some extreme cases these write-offs are avoided for years!
To determine your inventory carrying cost these components are rolled up on an annualized basis and stated as a percentage of your annual average inventory. You can now see whether the 25% annual carrying cost estimate closely reflects your business, or that your business has particular characteristics that result in a significantly different percentage.
Just as it's not prudent to assume that your carrying cost percentage will mirror a composite average of many companies, it's not appropriate to assume that every item in your inventory has the same carrying cost percentage. Certainly, carrying costs can differ within your company by distribution center (if you have more than one DC), product line, category, sub-category or even item. Carrying costs can differ for high volume, high velocity "A" items, slower turning or complementary "B" items, or slow turning "C" items. Large, bulky items may have a significantly different carrying cost than smaller items that take up much less space per inventory dollar. Understanding the varying carrying costs within your inventory helps you identify where the opportunities for the greatest savings might be.
Once the full costs of inventory have been measured and quantified, those costs can be evaluated and managed. And what becomes immediately apparent is not just the cost of the inventory that is essential to the business, but the cost of the inventory that is not essential, that is excess, dead or under performing, and what a financial drag this inventory is on the company.
Reducing unneeded inventory, whether tightening up stocks of frontline, essential inventory, or liquidating dead or under-performing inventory has the benefit of freeing up capital for other uses and reducing costs directly variable with inventory levels, and also provides you with the opportunity to re-assess both mixed and fixed costs to identify other potential cost savings. When you reduce inventory, not only are you freeing up invested capital, but you are also creating opportunities to reduce expenses, improve profitability, and actually increase cash flow!
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