The Total Cost of Inventory: Exploring Inventory Holding Costs
For most retailers, wholesalers, and distributors, inventory is the largest single asset on their balance sheet. In many ways, your inventory defines who you are and your strategic position in the market. Define your customer’s needs and their expectations of you. Legions of cost counters are employed to accurately capture and capitalize all direct inventory costs. The cost of that inventory is the largest expense item on most income statements.
Most companies evaluate their inventory productivity through criteria such as inventory turnover, gross margin return on investment, gross margin return in square footage, and the like. These are all valuable tools for evaluating inventory productivity, but they are all limited by the fact that they use inventory at cost as the cost basis in their analysis.
The actual cost of inventory extends well beyond inventory to cost or cost of goods sold. The cost of managing and maintaining inventory is a significant expense in and of itself, but the true cost of inventory doesn’t even stop there. The total cost of inventory, in fact, is buried deep within a series of expense items below the gross margin line, almost challenging any executive, manager, or cost accountant to actually get them out, quantify, and manage them.
Studies of inventory maintenance costs have estimated that these costs are approximately 25% per year as a percentage of the average inventory for a typical business. While this information is interesting, it is not particularly useful. To manage the cost of carrying inventory, it must first be measured.
Generally recognized components of inventory holding cost include inventory finance charges or the opportunity cost of inventory investment, inventory insurance and taxes, materials handling charges, and warehouse overheads not directly associated with picking and customer order shipping, inventory control and cycle counting expenses, and inventory shrinkage, 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 Finance Charges – This may seem easy to calculate, but accurately measuring inventory finance charges is not as simple as it might appear at first glance. For some businesses, working capital financing may be essentially inventory financing and little else, but for many others it may also be accounts receivable financing. Floating between accounts payable and accounts receivable may also be partially financing inventory. For importers, this can be fairly straightforward to quantify if they are opening letters of credit before their suppliers ship from abroad. In this case, the cost of the LC installation can be easily identified as the inventory finance charges. Finally, it is essential to be able to measure how much of the inventory is financed externally and what part is financed through internal cash flow. For the part that is financed from cash flow, the opportunity costs of that investment should be measured.
Opportunity Costs – When you think about the opportunity cost associated with investing in inventory, it’s easy to focus strictly on the opportunity cost of dead or underperforming inventory. In fact, the opportunity cost is related to the value of the total inventory. If this value was 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 Tax and Insurance – These items should be fairly straightforward to quantify as a percentage of the average inventory value. And because both insurance and taxes are highly variable with inventory value, any reduction in average inventory value will drive savings directly to the bottom line, not to mention improved cash flow.
Material Handling Expenses – Measuring material handling expenses that are not directly associated with picking and shipping customer orders can be just as tricky. These expenses are primarily made up of salaries and benefits, but also include material handling equipment depreciation or lease payments, automation, robotics, and systems depreciation, 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 divide your total rent, utility, repair and maintenance, and property taxes by the percentage of the building associated with customer order processing, pickup, and shipping , and the associated building part. with receiving and storing inventory. While that part associated with receiving and warehousing may seem fixed, in fact it quickly becomes much more variable when you consider what you could rent the space for as contract storage if your inventory wasn’t there.
Inventory control and cycle counting: These expenses can also be comprised primarily of salaries and benefits, but can also include depreciation or expense on portable radio frequency (RF) units and other related equipment, as well as any miscellaneous expenses directly. related to your inventory control team.
Inventory reduction, damage, and obsolescence – Capturing and measuring these costs appears to be fairly straightforward at first glance. Loss, damage and obsolescence costs are the value of cancellations taken, or expressed in percentage terms, the value of those cancellations during a given period of time divided by the average inventory during that period. However, this assumes that all cancellations were made in a timely manner throughout the year. Were cycle counts performed on a regular basis? Was everything counted on a scheduled basis, was that schedule followed, and were higher speed items counted more frequently? Were they timely canceled? It was damaged and obsolete inventory was written off in the current period and allowed to accumulate during previous periods. Rather, cancellations were postponed during the current period, resulting in a build-up of damaged and obsolete inventory that will have to be canceled in a future period. Experience has taught us that, in some extreme cases, these cancellations are avoided for years!
To determine the cost of maintaining your inventory, these components are accumulated on an annualized basis and expressed as a percentage of your average annual inventory. Now you can see if the 25% annual maintenance cost estimate accurately reflects your business, or if your business has particular characteristics that result in a significantly different percentage.
Just as it is unwise to assume that your maintenance cost percentage will reflect a composite average across many companies, it is not appropriate to assume that all items in your inventory have the same maintenance cost percentage. Certainly, maintenance costs may differ within your company by distribution center (if you have more than one DC), product line, category, sub-category, or even item. Transportation costs may differ for high-speed, high-volume “A” items, slower-turn or add-on “B” items, or slow-turn “C” items. Large, bulky items can have a significantly different shipping cost than smaller items that take up much less space per dollar of inventory. Understanding the different transportation costs within your inventory helps you identify where the opportunities for the greatest savings might lie.
Once all inventory costs have been measured and quantified, those costs can be evaluated and managed. And what becomes immediately apparent is not just the cost of inventory that is essential to the business, but the cost of inventory that is nonessential – that is, excess, dead, or deficient – and what financial burden this inventory is for. the business. business.
Reducing unnecessary inventory, whether by adjusting front-line stocks, essential inventory, or liquidating dead or underperforming inventory has the advantage of freeing up capital for other uses and reducing costs directly variable with inventory levels, and also helps you provides an opportunity to re-evaluate fixed and mixed costs to identify other potential cost savings. When you reduce inventory, you are not only freeing up invested capital, but you are also creating opportunities to reduce expenses, improve profitability, and actually increase cash flow.