Sunday, August 17, 2008

Inventory reduction

A more reliable approach is to use the with-without principle. That is, analyze the relevant costs under
the current system (without any change) and then analyze the same costs with the proposed change. The
difference is a more accurate gauge of cost impact than what one gets by multiplying inventory levels
by a marginal cost rate.
But even lower cost, itself, may not be the most important benefit of a reduction in inventory. Inventory
reductions can free up considerable quantities of cash, which are often critical for a rapidly expanding
business or a business on the verge of insolvency. Reductions in inventory also lower the asset base of an
operation, providing a higher return on assets (ROA).
Therefore, justifying an operating change will depend on a firm's financial objectives.
The point, quite simply, is that your own business judgment and skill must be applied to accurately capture
the right costs and benefits of inventory. Inventory models will only tell you how inventory levels
change; you bear the responsibility of translating these physical changes into changes in the relevant
financial components.

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