Big Picture Costs of Inventory
Companies often miss the bigger picture. Recently, we have taken a small step as some companies now talk about landed costs as opposed to only the price paid for the inventory. Landed costs include the price paid to suppliers, transportation costs, customs, tariffs, banking fees (if applicable), handling, overhead, and purchasing costs. The landed cost can easily be an additional 20-30% for domestic suppliers and significantly more if the supplier has factories aboard. These costs typically represent the one-time costs from ordering to receiving, inspection, paying invoices, and moving the inventory to stock.
What Costs Should be Included
However, there are on-going cost associated with holding inventory. While landed costs are significant, companies often ignore the cost to carry inventory. Unfortunately, the vast major of corporations do not calculate their costs to carry or, if they do, they only include the cost of capital which ignores the bulk of the true costs. Carrying costs should include the expenses of employees to find, count, put away and reconcile the inventory. Along with that, smart companies include the building, heat, air conditioning, lights, insurance, cost of capital, obsolescence, shrinkage, taxes, and more. By including all of these costs annual carrying costs can range from 20 to 55%.
Cost of Purchasing Inventory too Soon
Inventory carrying costs punish companies for buying inventory too soon. A common mistake takes place at the end of every month and every quarter. Suppliers call buyers, buyers begin to negotiate for inventory not needed, the buyer gets a “win” and negotiates a price break of 10%, the suppliers in exchange asks for higher volume, and a deal is agreed-to. But what if the purchase amount is enough inventory for six, twelve, or eighteen months? The purchasing group celebrates buying goods below the standard costs. Accounting begins discussions of lowering the standard cost and the favorable variance is applauded despite the company not saving a dime. If the annual carrying costs is only 30% and the inventory sits an average of 6 months, the 10% savings is not only lost to carrying costs, there is a deficit. This story unfolds every day, in every company, with inventory turn of two or less.
Understanding the Whole Picture
What is the answer? The first step for a company is to take an honest accounting of their true cost of inventory taking into considerations all of the “hidden” costs we discussed above. Once you have that number take a look at all of the “discounts” that purchasing and finance are getting at the end of the month compare those dollar savings to the cost of caring that unneeded inventory. We have found that once a company understands the true cost of excess inventory and commits to reducing it they are able to unlock significant savings.