Inventory-Related Costs

W

e have just reviewed some of the costs of nothaving enough inventory. Let’s now consider the more direct costs associated withholding inventory. The largest cost is usually the capital cost on the inventory invest- ment. If you have lots of borrowing room, that cost is often not much more than just the interest cost at your bank. If, though, you have little or no credit left, or are growing at a very high rate, the capital cost of carrying inventory jumps to a much higher level—to the lost-profit level called the oppor- tunity cost. That is the alternative return you could get by using funds invested in inventory elsewhere in your business, most typically through selling more high-margin product.

Consider an example: You are fully leveraged and cannot borrow more capital, so the brake on sales growth is the amount of cash available to finance A/R, which you believe is already as tightly managed as you can make it. If you could just free up $25,000 cash by better inventory management, you could sell $50,000 more per month, assuming an average 100%

markup. A $25,000 reduction in inventory seems achievable because it is only 10% of your total inventory, net of the related

payables. Inventory is turning over an average of 12 times a year (30 days inventory), so at a 35% contribution margin, you may be willing to spend quite a bit to get enough control over inventory to be able to cut it the requisite 10%.

Enter the highly recommended inventory-control special- ist with charts, formulas, computers and software. He has just come from doing that bang-up

inventory-control system at Hannaford Bros. and thinks your potential to cut inventory investment is at least double Hannaford’s in proportional terms because your current system is only minimally automated. He’s got an all- inclusive inventory-control package deal, including training your people in its use for a total cost of $25,000 in up- front licensing and consulting fees, and

$2,000 per month for a maintenance contract. Is that a deal? Probably, since

$50,000 per month extra sales multi- plied by 0.35 contribution margin results in $17,500 monthly additional contribution before tax.

Before deciding on the consultant’s proposal, maybe you need to look at the full array of inventory-related costs.

They fall into categories that can be described in a number of ways. Most commonly they are laid out as ordering cost, carry- ing cost, and the one we looked at a little earlier, the cost of running out of stock. Carrying cost is the largest of the three and has several components, the largest of which is cost of cap- ital. There are, however, a couple of other financial costs as well: taxes and insurance. There are also physicalcarrying costs that include storage and handling. Finally, there are inventory risk costs including deterioration, pilferage and obsolescence.

If you have never done so, at least roughly estimate each of these costs for your own firm, and use the resulting total as part of the trade-off analysis that you do in inventory planning. This is especially important for calculating the basic inventory-man-

If you have little or no credit left, or are growing at a very high rate, the capital cost of carrying inventory jumps to a higher level—

to the lost-profit level

called the opportunity

cost. That is the

alternative return you

could get by using funds

invested in inventory

elsewhere in your

business, most typically

through selling more

high-margin product.

agement measure known as economic order quantity (EOQ).

Let’s explore that concept a bit more deeply.

Economic Order Quantity (EOQ)

The first thing you will want to do with the estimates you work out for the carrying cost of inventory is to plug them into the formula for calculating economic order quantity. This formu- la will minimize the sum of carrying costs and ordering costs for you. Recall that carryingcosts are the financial, the physical and the risk costs as outlined above. Ordering costs generally consist simply of clerical and transportation elements. With a minor modification, this same formula can help you determine economic production run length. Let’s see some examples from Jones Dynamite Co.’s experience: The annual carrying cost per unit per year for 2,500 units of a particular product is

$1.45. Placing the purchase order, transportation charges and invoice processing through accounts payable costs $28. The EOQ formula is:

E= 2QP C

E= economic order quantity Q= number of annual quantity used C= annual carrying cost per unit

P= cost of placing the purchase order, transportation and processing the invoice through accounts payable).

In Jones’s case, the annual quantity of one of its product lines (Q) is 2,500 units; the annual carrying cost per unit (C) is

$1.45; and the cost of processing the order (P) is $28. Plugging those numbers into the formula, we get:

2(2,500)(28)

= 311 as the EOQ.

1.45

Let’s shift to the version of the formula for a manufacturer, one of Jones’s suppliers, that wants to calculate economic pro-

duction-run length. The formula remains the same, but (P) becomes setup cost rather than ordering cost. The carrying cost (C) is $0.35 unit; annual volume shipped (Q) is 75,000; and setup costs for the production run (P) is $450. Plugging the numbers in, we calculate the economic run length as:

2(75,000)(450)

= 13,887 0.35

This is the number of units that will minimize the sum of carrying costs and setup costs.

Think for a moment about why you need such a formula.

If you place only one order, or do one production setup, you automatically minimize the order or setup costs. As a result, however, the single-order approach means that you maximize your carrying cost. This is because of the much greater average number of units in inventory. At the other extreme, you can minimize carrying cost by ordering or producing only to meet actual needs as they arise. This solution, though, would push setup or order costs through the roof. The formula solves your dilemma by minimizing total cost as longer runs or bigger orders are offset in their associated costs against longer periods of carrying costs. The formula simply calculates the trade-offs between the two types of costs to help find a reasonable range for decision making.

Ultimately, of course, all of your decisions about inventory will have a customer impact. It is that perspective from which we finally have to evaluate what has been decided. We, too, are somebody’s customer and buy most of our inventory on credit.

Let’s look now at the measure of that cash driver as we consid- er accounts payable.

CCOUNTS PAYABLE IS,OF COURSE,THE FLIP SIDE OF

accounts receivable (A/R). Accounts payable is also measured in days, but days worth of cost of goods sold, rather than days of sales as with accounts receivable. There’s a simple explana- tion. Accounts payable is more closely related to inventory, which is valued at cost, while accounts receivable is inherently measured in the selling prices by which you record what the customer owes you. What we say about our customers from an accounts-receivable viewpoint is very much like our own posi- tion on accounts payable. That is, the money that is a payable on our books is a receivable to someone else, so we can think reciprocally about the two.