Quite often, even among professionally run enterprises, the actual costs of inventory are inaccurate, underestimated and incomplete.
Typically, most companies view the cost of inventory as the cost of funds to finance that inventory. So, a company with $20 million in inventory and a cost of 5% to finance the inventory assumes a carrying cost of $1 million per year.
Cost of capital is only the beginning
As you know, the WACC (Weighted Average Cost of Capital) to carry the inventory can be significant. But, the actual cost is even greater. An important factor is the opportunity cost, which, when considering other opportunities, could be as much as 15% or more. What could you do if you didn’t need to tie-up all that cash or credit in inventory? What’s the cost to forego alternatives?
In addition to the substantial financial and opportunity costs, it’s also important to consider the other, additional costs associated with holding and handling inventory in order to get an accurate picture of the situation.
Paying employees to account for inventory, as well as management time spent on solving inventory issues, is costly. Headcount is expensive, especially when spent on tactical, rather than strategic, management issues. Hopefully, your staff is making up for this by optimizing systems and procedures, such as leveraging multi location activity to reduce cost of inventory. They should also be regularly negotiating to secure competitive pricing from vendors as a way to make a significant contribution to unit cost reduction.
Mishaps and other expensive mistakes
Although this may be an understatement, not everything goes as planned. Improper inventory management or late delivery of materials can contribute to loss of sales and lower profits for the company. Even incremental dead inventory can add up if your staff is buying extra inventory without disposing of it in a timely manner.
In addition to the significant financial and opportunity costs of capital tied-up in inventory, insurance on the inventory is a substantial additional expense. Also, typically, there’s loss to be considered from pilferage, shrinkage and obsolescence.
Inventory housing costs
When calculating the costs associated with inventory, it’s also important to consider the depreciation or rent on the building holding the inventory (or the portion of the building used for inventory). Other costs include utility expenses for climate control and lighting in the building holding the inventory, janitorial, security, and routine maintenance, taxes and insurance on the land and building, and the cost of capital invested in the land under the building.
Rent and/or depreciation of material-handling equipment (forklifts, etc.) can be significant, too. Also, there are direct operating costs of material-handling equipment (propane, maintenance, etc.); employee costs to receive, stack, and maintain materials; and freight and transportation costs borne by the company.
Very often, while our attention is focused on busy, day-to-day operations, many of us ignore accounting costs associated with inventory handling, evaluation method, burden cost allocation, cycle count, audit reconciliation, external auditor/s, tax evaluation, and financial reporting methods (local GAAP, IFRS, FIFO, Average, LCM, etc.). Sometimes these hidden costs tend to be very expensive in relation to out-of-pocket money spent and precious senior management & consultant resources.
So, what is the real cost of inventory?
When all of these additional costs are taken into account, the total cost of holding inventory can represent 25-30% more than the inventory’s book value. Additionally, having your cash tied-up in inventory-related expenses has an opportunity cost, which can translate to as much as 15% or more.
For the company with $20 million in inventory, that opportunity cost considered alongside other expenses translates into a combined holding cost of $8 million or more per year – 8 times higher than the simple cost-of-capital calculation mentioned at the beginning of the article. The bill can climb even higher if inventory is managed improperly.
Getting an accurate, realistic measurement of what inventory truly costs is a smart first step in addressing the issue on your way to saving money, increasing free cash-flow, improving performance (inventory turn) and increasing your competitiveness.
A company that can reduce inventory costs through operational efficiency and/or consignment will see tremendous benefit.
To take a step toward lowering the cost of your inventory and unchaining your company from other burdens associated with inventory management, check out the calculators available on the Inventory Management Solutions website at www.utiims.com/simulator.