| For most retailers, wholesalers and distributors, | | | | material handling equipment, depreciation on automation, |
| inventory is the largest single asset on your balance | | | | robotics and systems, as well as miscellaneous |
| sheet. In many ways, your inventory defines who you | | | | expenses for supplies such as pallets, corrugated, UPC |
| are, and your strategic position in the marketplace. It | | | | labeling materials and the like. |
| defines your customer's needs and their expectations | | | | Warehouse overhead: The quickest way to measure |
| of you. Legions of cost accountants are employed to | | | | this is to split the total expenses for rent, utilities, repairs |
| accurately capture and capitalize all of the direct costs | | | | and maintenance, and property taxes by the |
| of inventory. The cost of that inventory is the single | | | | percentage of the building associated with processing |
| largest expense item on most every Income | | | | customer orders, picking and shipping, and that portion |
| Statement. | | | | of the building associated with receiving and storing |
| Most companies evaluate the productivity of their | | | | inventory. While that portion associated with receiving |
| inventories through such yardsticks as inventory turn, | | | | and storage may seem fixed, in fact it quickly |
| gross margin return on investment, gross margin return | | | | becomes much more variable when you consider |
| on square foot and the like. These are all valuable tools | | | | what you could rent out the space for as contract |
| in assessing inventory productivity, but they are all | | | | storage if your inventory wasn't there! |
| limited by the fact that they use inventory at cost as | | | | Inventory control and cycle counting: These expenses |
| the cost basis in their analysis. | | | | may also be made up primarily of wages and benefits, |
| The true cost of inventory extends far beyond just | | | | but may also include the depreciation or expense on |
| inventory at cost or the cost of goods sold. The cost | | | | hand-held radio frequency (RF) units, and other related |
| of managing and maintaining inventory is a significant | | | | equipment, as well as any miscellaneous expenses |
| expense in its own right, but the true cost of inventory | | | | directly related to your inventory control team. |
| doesn't even stop there. The full cost of inventory, in | | | | Inventory shrink, damage and obsolescence: Capturing |
| fact, is actually buried deep within a number of | | | | and measuring these costs appear to be fairly straight |
| expense items below the gross margin line, almost | | | | forward at first glance. The costs of shrink, damage |
| defying any executive, manager or cost accountant to | | | | and obsolescence are the value of the write- offs |
| pull them out, quantify and actually manage them. | | | | taken, or stated in percentage terms, the value of |
| Studies of inventory carrying costs have estimated | | | | those write-offs over a given period of time divided by |
| that that these costs are approximately 25% per year | | | | the average inventory during that period. This assumes, |
| as a percentage of average inventory for a typical | | | | however, that all write-offs were taken on a timely |
| company. While this information is interesting, it's not | | | | basis throughout the year. Were cycle counts done on |
| particularly useful. In order to manage the cost of | | | | a regular basis? Was everything counted on a |
| carrying inventory it must first be measured. | | | | scheduled basis, was that schedule followed, and were |
| The generally recognized components of inventory | | | | higher velocity items counted more frequently? Were |
| carrying cost include inventory financing charges or the | | | | written off on a timely basis? Was damaged and |
| opportunity cost of the inventory investment, inventory | | | | obsolete inventory written off in the current period |
| insurance and taxes, material handling expenses and | | | | allowed to accumulate during prior periods. Conversely, |
| warehouse overhead not directly associated with | | | | were write-offs deferred during the current period, |
| picking and shipping customer orders, inventory control | | | | resulting in a build up of damaged and obsolete |
| and cycle counting expenses, and inventory shrink, | | | | inventory that will have to be written off in a future |
| damage and obsolescence. | | | | period. Experience has taught us that in some extreme |
| Let's take a close look at each of these components | | | | cases these write-offs are avoided for years! |
| to better understand how they can be measured and | | | | To determine your inventory carrying cost these |
| managed. | | | | components are rolled up on an annualized basis and |
| Inventory financing charges: This may seem easy to | | | | stated as a percentage of your annual average |
| calculate, but to measure inventory financing charges | | | | inventory. You can now see whether the 25% annual |
| accurately is not quite as simple as it might first look. | | | | carrying cost estimate closely reflects your business, |
| For some companies, working capital financing may be | | | | or that your business has particular characteristics that |
| essentially financing inventory, and little else, but for | | | | result in a significantly different percentage. |
| many others it may also be financing accounts | | | | Just as it's not prudent to assume that your carrying |
| receivable. The float between payables and | | | | cost percentage will mirror a composite average of |
| receivables may in fact be partially financing inventory | | | | many companies, it's not appropriate to assume that |
| as well. For importers, this may be fairly straight | | | | every item in your inventory has the same carrying |
| forward to quantify if they are opening Letters of | | | | cost percentage. Certainly, carrying costs can differ |
| Credit prior to their vendors making shipment from | | | | within your company by distribution center (if you have |
| overseas. In this case, the cost of the LC facility may | | | | more than one DC), product line, category, |
| be easily identified as the inventory financing charges. | | | | sub-category or even item. Carrying costs can differ |
| Finally, it's critical to be able to measure what portion of | | | | for high volume, high velocity "A" items, slower turning |
| the inventory is being financed externally and what | | | | or complementary "B" items, or slow turning "C" items. |
| portion is being financed through internal cash flow. For | | | | Large, bulky items may have a significantly different |
| that portion that is being financed from cash flow the | | | | carrying cost than smaller items that take up much |
| opportunity costs of that investment must be | | | | less space per inventory dollar. Understanding the |
| measured. | | | | varying carrying costs within your inventory helps you |
| Opportunity costs: When thinking of the opportunity | | | | identify where the opportunities for the greatest |
| cost associated with the investment in inventory, it's | | | | savings might be. |
| easy to focus strictly on the opportunity cost of dead | | | | Once the full costs of inventory have been measured |
| or under performing inventory. In fact, the opportunity | | | | and quantified, those costs can be evaluated and |
| cost relates to the value of the total inventory. If this | | | | managed. And what becomes immediately apparent is |
| value were not invested in inventory, what return could | | | | not just the cost of the inventory that is essential to |
| be expected if it were invested in something else, such | | | | the business, but the cost of the inventory that is not |
| as treasuries, mutual funds, or even a money market | | | | essential, that is excess, dead or under performing, and |
| account. | | | | what a financial drag this inventory is on the company. |
| Inventory insurance and taxes: These items should be | | | | Reducing unneeded inventory, whether tightening up |
| fairly straight forward to quantify as a percentage of | | | | stocks of frontline, essential inventory, or liquidating |
| average inventory value. And because both insurance | | | | dead or under-performing inventory has the benefit of |
| and taxes are highly variable with inventory value, any | | | | freeing up capital for other uses and reducing costs |
| reduction in average inventory value will deliver savings | | | | directly variable with inventory levels, and also provides |
| directly to the bottom line, not to mention improving | | | | you with the opportunity to re-assess both mixed and |
| cash flow. | | | | fixed costs to identify other potential cost savings. |
| Material handling expenses: Measuring material handling | | | | When you reduce inventory, not only are you freeing |
| expenses not directly associated with picking and | | | | up invested capital, but you are also creating |
| shipping customer orders may be just as tricky. These | | | | opportunities to reduce expenses, improve profitability, |
| expenses are made up mostly of wages and benefits, | | | | and actually increase cash flow! |
| but also include lease payments or depreciation on | | | | |