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After a while of posting this question, I am intrigued at it not being answered sooner. When I read the question, I read, "What are we doing with inventory anyway?" Now I am quite a purist and each company has its own approach and excuse for inventory. The top line is that we should responsibly, honestly and ethically build products or book hours which add value through products and services being sold not held, stored, hidden or defended. To not do so is a lie. There is a strategy behind some inventory like maintenance build up for planned outages. Inventory used for any other reasons than this reflect fear, anxiety or perceived wisdom of the past known as a false security blanket. I cannot place a value on the impact false security has in many companies but, there is a heavy cost. I can say, my experience has been that inventory of any type only has value as perceived by leaders who demand or allow it. Unfortunately, holding inventory simply dilutes the impact and flavor for change needed so much across so many industries and service providers. Therefore, this thought process applied to inventory holding costs would make it a Cost of Non-quality and all the processes used to store, hide, defend or miss the sales which should have happened but did not. Man, its tough when so many see the function of business from the eyes of revenue generators only. Yet, nurturing, challenging, encouraging and serving value-adders less. I am not sure we can ever calculate the impact on our people. But the idea of managing to inventory has costs industries everything that speaks of, "The Lead".
Thanks for your ideas Michael.
I completely agree that there are all sorts of reasons why we have inventory. Some are good reasons (I need to have a supply of this flu vaccine because it takes so long to make and I don't know how severe the flu season will be). Some are bad reasons (my quality stinks so I need inventory to make up for uncertainty of supply). Those who subscribe to lean (or common sense as the case may be) will recognize that holding inventory costs money. If the reason we are holding inventory is to cover up other problems, the cost of this inventory can be much deeper than just a percentage of the value of the inventory. It is the associated costs of the bad process being concealed by this inventory that we want to uncover and eliminate. This drives back to my original question. How we value inventory can influence how important controlling inventory is to the company. How do you value inventory in your company (or your client's companies if you are a consultant) so that the true cost of holding this inventory is revealed?
The true cost of carrying inventory are all the costs incurred as a consequence of holding inventory that would not otherwise be incurred in the course of your business. That includes:
- Cost of capital (e.g., buildings, warehousing equipment, computers, infrastructure and, of course, the value of the inventory itself)
- Maintenance of these capital items'
- Utilities expenses for warehouses
- Labor (including direct and indirect expenses related to labor)
- Cost of support activities (e.g., the portion of your IT services that go toward supporting warehousing activities)
- Shrinkage (e.g., spoilage, obsolescence, theft, losses in transit)
- Supply chain management cost related to inventory (if they would remain even if you could shift entirely to drop-shipments or 3PL, then don't count them here)
- Other apportioned operating expenses directly related to holding inventory
However, in considering these costs, they should be separated into two distinct groups: those that vary directly with the amount of inventory you are holding and those that increment up or down in steps (like the need for a new warehouse, more racks, a larger refrigerator, or more employees). Making these distinctions clear will help you avoid being mislead by "expense savings" calculations that are not real or will not be obtained if inventory falls by $100,000, but may be realized if inventory falls by $750,000.
I think the quickest way to calculate inventory holding cost is,
- Inventory value and capital tied up
- Insurance coverage
- you can use cost per volume/weight from 3PL warehouse
Remember that lots of fixed costs are sunk cost, you have to pay it anyway, even though you don't keep anything
in your own warehouse.