We get this question from supply chain managers when presented with a detailed analysis of the total landed costs of a product with the inventory carrying costs calculated.
Whilst inventory carrying costs may not make up the largest part of the total landed costs they are significant, both absolutely and as an indicator of overall end-to-end supply chain management. Perspectives on inventory carrying costs vary from company to company, both in terms of how they are viewed and how they are calculated.
Here are some of the views that we have been exposed to:
“Our cost of inventory is zero. We don’t have debt and we’ll sell everything that we produce and don’t borrow money to finance the operations.”
Or “Our cost of inventory is 35%. We have a make-to-stock model in a fiercely competitive market and cannot miss a sale. But we also need to factor in obsolescence and all the risks associated with product life cycle.”
Or “It is about 8% because that is our WACC.”
0% is definitely not the answer if you sell widgets, whilst 35% implies that the supply chain strategy and operations need a real overhaul. 8% is the most common answer, however this should not be a standard answer applied to all. A real calculation needs to be done to get to the true number and to understand where the costs are accumulated from.
Inventory cost is made of two parts - capital cost and non-capital cost.
Inventory capital cost is the largest component of inventory cost. All the elements related to the investment, the interest on working capital and opportunity cost of money invested in the inventory are included in the inventory capital costs. Inventory capital cost is the expected financial return if the capital is invested in an alternative investment of equivalent risk. ‘Weighted Average Cost of Capital’ (WACC) is commonly used for calculating inventory capital cost. It is not sufficient to say we do not borrow to finance inventory. If cash is being used here, it could be deployed elsewhere, at least to earn interest, and perhaps to open up greater opportunity in the market.
Non-capital inventory costs are all the costs associated with inventory service, storage and risk. Physical handling, like inventory control and cycle counting, needs to be considered. Inventory storage costs include the cost of warehousing or building, i.e. space cost, and its maintenance appropriated to the portion of the building used for receiving and storing inventory. Risk costs cover the risk associated primarily with inventory value of the goods diminishing over time they are stored (obsolescence). This also includes shrinkage due to errors, theft, fraud etc.
Uncertainty is the Mother of Inventory
With a global outsourced manufacturing model, supply chains are stretched far and wide resulting in multiple suppliers, distribution centers, longer transit times and inventory buffers to mitigate risks. To reduce inventory costs, first optimize the supply chain and logistics network through manufacturing and postponement strategies, node consolidation and analyzing freight modes trade-offs (e.g. air vs. ocean) that simultaneously meet your total landed cost and service level goals.
Further, inventory optimization solution would help to minimize your inventory exposure while meeting or exceeding your service level requirements.