The Coronavirus pandemic has turned the Supply Chain and the rhythm of inventory rotation completely upside down, but accumulating can be very expensive. We have witnessed it recently with oil, which has reached its lowest price in history when it became more cost-effective to sell it off than to store the surplus. To manage it more efficiently, you should know your actual inventory cost.
This is a textbook case: on April 20th, a barrel of oil cost -$38 in the United States. With a drop in the global consumption of roughly 20 to 30 million barrels per day, we hit a point where the suppliers had to pay their clients to take their goods off their hands. Managing the stock overage was just more expensive.
When the oil companies reached the maximum fill rate, they had to find quick fixes such as trains or tankers at outrageous prices to store the merchandise. Their inventory costs exploded because if the fixed expenses are initially proportionate with the volume of the stock, they take a big leap when your storage gets to capacity. The curve of the costs is not linear.
Demand became much lower than supply, and the stocks are overflowing. For the first time, the price of the barrel fell under zero – and well under zero, for a few markets.
This extreme example is indicative of an underlying problem: we considerably underestimate the cost of our inventory.
How much does your inventory really cost you? Let me tell you about the 9 parameters which can influence the cost of inventory :
- Cost of carrying inventory
- Insurance costs
- Storage costs
- Costs to check inventory
- Costs relating to quality gaps with inventory
- Promotion costs
- Destruction/donation costs
- Complexity cost
- Non-investment costs
1. Cost of carrying inventory
How much does your credit cost you, exactly? In the past few years, money has become quite cheap: with extremely low interest rates, it is fairly easy to borrow funds.
We can see it with the case of the United States in the graph below. After a fall of the rates due to the 2008 crisis, they stand today at around 2.5% – to which the bank usually adds its processing fees when you contract a loan.
But be careful with mistakes when you calculate your cash flow: you should not measure your interest rates based only on your inventory’s value, you also have to include the payment periods.
Between your payment to the suppliers and the one you get from your client, you have a cash flow gap that you have to include in your calculations.
Example: I have to pay my supplier after 30 days, I get the payment from my client after 60 days. I have a cash flow gap of 30 days.
You need to add this gap to your stock rotation to calculate it in its entirety. So if your stock rotation is 70 days, for example, your total inventory to fund will be significantly higher, 100 days.
Some businesses still manage to obtain a positive cash flow, I’ll tell you about it in a future article.
2. Insurance costs
Many companies will choose to insure their inventory, and the rates vary. It can go from some tenth of a percent to several percentage points depending on the risks of the product.
If you choose to insure your inventory, you have to add these costs.
3. Storage costs
You should obviously take into account the price of your storage space. Just like the oil example mentioned earlier, the curve of your costs won’t be linear.
Your fixed costs (rent, utilities, electricity, handling staff…) first increase proportionally; but once you reach 85 or 90% of your occupancy rate, you are at full capacity. Then you have no choice: you have to start stocking the surplus of merchandise in a new space. And this can generate overhang fees – generally higher – as well as transport costs. Suddenly, your costs explode and the curve climbs instantly.
4. Costs to check inventory
It is the price you pay to have the quality of your inventory checked. Because if you have inventory problems, you’ll have supply problems and eventually get out of stock.
It represents generally a price per unit, or a percentage of your total inventory volume every year.
5. Costs relating to quality gaps with inventory
The inventory can show unpleasant surprises: missing products, quality issues, computer or synchronization problems…
The gaps can be only a few tenths of a percent or outright several percentage points of your stock. The missing elements will have to be replaced, which adds more fees.
6. Promotion costs
It is a difficult number to incorporate into the calculation, but it is underestimated. It is notably visible in the textile industry, which is punctuated by summer and winter sales.
Your winter collection product, which initially costs €50, sees its value affected when summer sales come. You will have to consider a discount. And the drop in prices won’t be linear, it radically speeds up with the arrival of good weather.
The average rates vary from industry to industry, but you have to count the impact of promotions on the profitability of your product when you are evaluating your stock.
7. Destruction/donation costs
Consumables, fresh goods, or fashion products lose value quite fast if not sold.
You have several options: once the promotion time has passed, you can gift the product (coupled with another one, for example, we see it a lot in mass retail). From a purely financial point of view, it is more interesting to give the product away than to destroy it or recycle it, which will bring new costs.
Think about the percentage of products you give away or destroy when calculating the total price.
8. Complexity cost
The number of warehouses you use plays a great role in the smoothness of your supply chain. The more inventory you have, the more complicated it is to handle, as you can see in this graph.
Complexity costs are hard to quantify, but having less inventory will allow you to considerably simplify your process and eliminate management errors – and it will help you think about all this more calmly.
To illustrate it, I take the example of the fridge: if it is too full, you will struggle to see what is hidden at the back. You risk having to throw away a lot of food. If you keep it at the bare minimum, all of your elements are accessible and you are not as likely to waste.
9. Opportunity cost
It is probably the most subtle of your costs. The funds blocked in your inventory will not be invested in the development of your business, whether it is to buy a new product or launch on a new market. It takes away the opportunity of other potentially more profitable investments.
You would have to discuss it with your financial director, but it is also an expense to factor in if you want to have a truly global vision of the cost of your inventory.
So, how much does your inventory cost exactly?
Companies usually evaluate their costs at around 5 or 6%, but taking into consideration all of the parameters we just listed, in reality, it is more often than not over 10%. Of course, it depends on your industry, and notably the costs of promotions and destruction.
Example: You add €1M worth of inventory to your company; the cost of this inventory will be 20%, so €200.000 of fees generated.
There is Supply Chain a real issue in understanding the impact of the stock.
It is obviously necessary at the start to improve your service rate. But your service rate curve will stagnate quickly, and that is when your returns drop, as you can see in the graph below.
Your goal in Supply Chain will be to find your balance point in your profitability. It is extremely hard to find: you have to know precisely your level of inventory and your acceptable service rate.
To learn more about this matter, please read my article about the Wilson formula.
I insist on the importance of calculating your inventory cost because it is for me a fundamental and wildly underestimated parameter. Businesses usually only focus on their service rate or availability ratio, which impacts their rentability.
As a Supply Chain Manager or Director, to better manage your inventory, your challenge is to find the famous balance point between inventory cost and service rate. My advice is to adapt your goals to the different types of products and use the ABC Analisis (which I explain HERE) to concentrate your efforts on your most important references.
Don’t hesitate to share these numbers within your company, for example with the communication/marketing departments, who often don’t realize the impact of inventory surplus on a business, its future investments, and growth potential.
To go further
If you want to go deeper into the topic, please take a look at my articles about :
- ABC Analysis : Example in Excel with 500 products
- EOQ & Wilson Formula calculation
- Safety Stock Formula & Calculation : 6 best methods
Become an inventory management Expert
If you want to get my complete method to optimize your inventory in 45 steps applied to a concrete situation, join my program. I will teach you how to reduce your inventory and increase your service rate, using the case of a company that was able to reduce its inventory by 21% in 6 months. The program gives you access to downloadable Excel templates and checklists, and a private coaching and mentoring to achieve your goals.
Founder of AbcSupplyChain | Supply Chain Expert | 15 years experience in 6 different countries –> Follow me on LinkedIn