On average, inventory represents approximately 15% of total firm assets for public U.S. firms. If you think the cost of your inventory is merely the amount you pay for the items, it won’t take long for you to discover the truth. Running an inventory-focused business means there are some hidden costs, not everyone is aware of: warehousing, handling of the items, loss, etc. So, do you really know the true cost of your inventory?
First, we need to address the elephant in the room – carrying cost. The use of this vague term is incredibly deceptive; it gives a false impression that the cost of holding inventory is one big sum and that little can be done about it. According to the IMS Business Academy, inventory-carrying costs are expressed as a percentage of the average dollar value of inventory over a fixed period – usually a year. As a rule of thumb, inventory-carrying cost is 25% of a company’s average inventory investment, but when you tally up all the relevant carrying costs, it can run as high as 40% or more.
This is understandable, but it perpetuates the false impression that you have little power over the total – you do. Breaking down and identifying each separate cost percentage allows you the opportunity to rein-in those costs, and it allows you the opportunity to significantly impact your bottom-line – one single bite at a time.
Below are the four, broad categories of inventory carrying cost with descriptions and real-life examples to help you take control over your inventory:
Capital Cost. Your company’s capital cost is what you spend on carrying inventory, and includes two factors: inventory financing charges and opportunity losses. Arriving at your total inventory financing charges should be easy and straightforward – this is either the interest lost on the cash used to purchase inventory or the interest paid on a line-of-credit used to purchase inventory. Opportunity costs include both the opportunity missed because your money is invested in obsolete or under-performing inventory, and the opportunity missed for ALL money invested in inventory. Implementing an inventory management solution is a low cost and extremely effective method of identifying obsolete, overstocked or underperforming inventory.
Maxim Integrated Products, a manufacturer of various electronic systems and devices, found results came quickly. “Once we deployed an inventory solution in all eight stock rooms, and all 14,000 parts were labeled with barcodes, we discovered we were housing parts that we didn’t need to keep in inventory. As a result we sent those parts back to the vendors or to one of our other U.S. manufacturing sites, reducing the overall cost of our own inventory and freeing up a lot of cash and space,” said Maxim’s Javier Saenz. That freed cash can be invested in a myriad of ways: R&D for new products, additional staff, or monetary investments like mutual funds or money market accounts.
Capital cost should be the largest portion of your total carrying cost, typically range between 6-12%.
Inventory Service Cost — Service costs include insurance to cover your inventory and all taxes. Purchasing insurance may not seem novel or exciting, it is a decision that could make or break you. You need to evaluate the various, available premiums and the value of what you are insuring. Here are a few things to consider:
• Do you want to cover your items at the depreciated value (actual cost value) or do you want to pay a higher premium that would cover full replacement cost?
• What risks are you taking by purchasing cheaper coverage?
• You should also evaluate the possibility of loss because of theft or natural causes. If there is likelihood your inventory is attractive to those with access and opportunity, or if your warehouse is geographically located in an area prone to natural disasters – then you need to pay the higher premium. Find other ways to cut costs.
• Taxes are unavoidable. You have the ability to decrease taxes by decreasing your total inventory. Logistics expert Martin Murray said many local authorities tax the level of inventory in the warehouse, so higher levels of inventory will lead to higher taxes paid. Taking the time to effectively manage stock level will improve your tax rate. An inventory management solution provides all the necessary information needed to decrease unnecessary, duplicate stock.