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Inventory Bites!

Dr Vijay Sangam, 16:58, 30 Jul 2010

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Do you know that carrying excess Inventory costs financially?  Well, you may not see the cost of carrying inventory in your Profit and Loss statement, but trust me it hurts you big time financially.  According to one survey conducted by IMR in conjunction with Harding & Associates indicate that almost 45% of the respondents have no inkling of what is Inventory carrying cost and how it is calculated.  Joseph Mazel of IOMA believes that, “The higher the number used to calculate carrying costs, the more potent it is in reducing inventory.”

But what is Inventory Carrying Cost (ICC)?

“Inventory carrying cost (ICC) is the cost of holding one unit of an item in stock for one period of time” – Waters, D.

Inventory is a tangible asset that is intended for sale. For most retailers, wholesalers and distributors, inventory is the largest single asset on their balance sheet. We do come across business leaders who are comfortable in carrying buffer inventory by sacrificing a portion of their profit margin in the form of inventory carrying cost.  Some believe that carrying buffer inventory is a kind insurance to ensure better service levels.  In my opinion carrying right inventory may improve the service levels.  But the trick lies in determining the right inventory.  There is a cost associated with carrying excess inventory and that cost is known as Inventory Carrying Cost.

Why Companies hold Inventory?

The main objective of holding inventory is to maximise the customer satisfaction by avoiding loss of sales due to lack of inventory.  However, there are six basic reasons why companies hold inventory and they are:

  • Globalization;
  • It enables the firm to achieve economies of scale.
  • It balances supply and demand.
  • It enables specialisation in manufacturing.
  • It provides protection from uncertainties in demand and order cycle.
  • It acts as a buffer between critical interfaces within the supply chain.

All the above reasons are compelling business reasons to support the top line revenue growth, to maximise customer satisfaction and at the same time to improve the gross margins.  Inventory holding helps organisations to achieve first two objectives.  In order to achieve the third objective, Inventory carrying should be optimised.  Excess inventory carrying means an additional cost of carrying which shrinks gross margins and cash flows.  It’s the emphasis to improve the bottom line performance and enhance the organisation’s cash flow position.

There are six different types of Inventory we carry.  They are:

  • Cycle Inventory – Average amount of inventory used to satisfy demand between shipments.
  • Safety inventory – Inventory held in case demand exceeds expectations.
  • Seasonal inventory – Inventory built up to counter predictable variability in demand.
  • In-transit Inventory – Inventory in transit between origin and destination.
  • Speculative Inventory – Inventory held for the reasons of speculation.
  • Dead Inventory – Non-moving inventory.

When we see the value of inventory in the balance sheet as an asset it could include all above different types of inventory.

Components of ICC:

Inventory carrying costs influences many decisions in Strategic, Analytic and Operation levels.

Strategic Decisions: Profit Margins, ROI, Make or Buy, Global or local sourcing etc.

Analytical Decisions: Total Cost of Acquisition; BTO (pull) or BTS (push); Where and what amount to store, Annual Operational Budgets etc.

Operational Decision: Lot Size; Price Break even analysis, EOQ, Evaluating promotional deals and lifetime buys etc.

As inventory carrying costs encompasses several critical decisions, it is necessary to determine what cost should be included in inventory carrying costs. Generally,  ICC is reflected in a percentage of the value of an item.  It contains several components.  The ratio of such components may vary depending on the organisation,  product involved and location.  The components of ICC would typically include the following:

The general thumb rules used for Inventory Carrying cost would be 25% per annum.  However, one has to customise the formula based on various factors.  The dominating factor of Inventory carrying cost is the cost of money, followed by local taxes, Warehouse costs, Obsolescence, and Pilferage etc.  Supply Chain Manager all over the world is concerned about carrying additional inventory. Inventory carrying is directly linked to gross profit of an organisation and profits would go up when inventory carrying is reduced and the profits diminish when inventory carrying goes up.

As mentioned in one of my articles, it is very easy to convert cash into Inventory.  However, it is very challenging to convert Inventory into Cash even though it is considered as a tangible asset.  There are several ways one can optimise inventory levels. I have already written an article on Managing Inventory, hence I am not going to spend time on how to optimise inventory.

Industry wise Inventory Carrying pattern:

Inventory carrying varies industry to industry. I was involved in a research supervision while I was teaching, based on the data collected by a student, I would like to compare the inventory carrying trends of Retail, IT/High Tech, and Automotive industries.  All of them are considered as growing industries.  The average data pertains to year 2000 to 2005.  By analysing the gross profits and inventory turns, the numbers reveal great opportunity for improving inventory carrying in Automotive, IT/High Tech and Retail.  The data pertains to the global players and they have the clout to dictate terms to their suppliers and manage better inventory turns.  The below-given data may be used for reference purposes only.

TO: Turnover; GP: Gross Profit.

Optimising the supply chain and inventory management delivers the benefit of freeing up working capital that could be used for business expansion activities.  When we reduce inventory, we are not only freeing up invested capital but also creating opportunities to reduce expenses and improve profitability and maximise cash flows.  We announce productivity numbers, we announce sales achievements, we announce profit margins periodically and we seldom come across Inventory Performance announcements.

Inventory needs our attention! Inventory reduction improves profit margins, maximises cash flows and reduces operations cost.  Let us just do it!

Cartoon Source: ReadyToManage



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