Inventory carrying costs .more

Some items take up more space, and are harder to handle, than other products. Many companies feel that items that take up more space should absorb more of the total cost of carrying inventory. In order to apportion the cost of space and material movement to individual products or product groups, we must determine how much of the total space used to store products is being used by an individual item.
1. Calculate the total cost of rent and utilities for the portion of your facility used to store inventoried products as well as moving material in that area.
2. Determine the total cubic volume of space currently used to store stock material. This may not be the total cubic warehouse space. For example, if you just moved into a new warehouse and are using just 25% of the available space, the inventory stored in that area would still need to absorb 100% of the cost of rent, utilities, and moving material, not just 25% of the total cost.
3. Divide the total cost by the total cubes used to store material in order to determine the storage cost per cube.
4. Determine the total cubic volume assigned to a particular product

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.

Inventory cost accounting

In almost any business analysis involving inventory, physical inventory levels must be converted to inventory costs. The exact determination of the cost rate to apply is really a cost accounting matter, but here
are the major components:
1. Capital Cost - This is usually an internal cost of funds rate multiplied by the value of the product.
Because value (materials, labor, transportation, etc.) is added to the product as it moves along the supply chain, this cost tends to increase as product moves downstream.
2. Storage Cost - Units in inventory take up physical space, and may incur costs for heating, refrigeration,
insurance, etc. An activities based cost (ABC) analysis is usually needed to determine which components of these costs are actually driven by inventory levels and which can be considered more-or-less fixed. The answer will depend on the magnitude of the inventory change you are analyzing.
3. Obsolescence Cost - A somewhat harder cost component to pin down is obsolescence cost. A technology or fashion shift may make your current products obsolete and severely deflate their value. The more inventory you have, the higher your exposure to this sort of loss.
4. Quality Cost - High levels of inventory usually increase the chance of product damage and create
slower feed-back loops between supply chain partners. The result: lower levels of quality and a rise in the myriad costs associated with low quality. Again, these costs are di±cult to quantify precisely, but the current consensus is that they can be quite significant.
Typically, all these costs are rolled together into a single inventory cost rate, expressed as a percentage
of the value of the product or material per unit time (e.g. 20% per year). Other equivalent terms for this
same cost rate are inventory holding cost rate and inventory carrying cost rate.
The value of a product is not the sole driver of inventory costs. Other product attributes, such as size, the need for refrigeration, obsolescence risk, etc., determine major components of inventory cost. Applying a single cost rate to all products at all stages of production distribution can be a gross oversimplification.
Secondly, in relying on an inventory cost rate in an analysis, one is implicitly assuming that only marginal
changes in inventory will occur. A major structural change in the supply chain may eliminate whole
categories of expenses that were considered "fixed" in the original ABC analysis of the inventory cost
rate. For example, a major reduction in inventory may eliminate the need for an entire warehouse, the
operating cost of which may have been considered fixed when the inventory cost rate was determined.

Understanding inventory cost

The real key to understanding inventory cost and service is to understand what causes imbalances in supply and demand in the first place.
Transportation related inventories are called pipeline stocks. Of course, transportation is not the only cause of delay between points in a supply chain. Lead times for production, communication and order fulfillment can also introduce significant delays. Anytime such delays are present, they may create inventories. If the delay is due to production, the inventory is typically called a work-in-process (WIP) inventory.
Inventory belongs to the shipper or the receiver. In some cases, ownership changes hands when the shipment
is initiated. From an accounting standpoint, the inventory then belongs to the receiver and becomes an entry in the accounts receivable ledger of the shipper. In other cases, ownership does not change hands until
the goods are delivered, in which case the inventory stays on the books of the shipper whilst in-transit.
The resulting cost differences can be significant when shipping delays are long.

Inventory holding cost

Many vendors offer to pay freight charges if an order exceeds a certain minimum requirement. Many buyers are "brainwashed" into thinking that they must always place an order that meets the free-freight minimum, even if it means bringing more inventory than can be used or sold in a reasonable amount of time. But is placing a free-freight order always a good idea?

In this article, we're going to examine a process that will let you determine whether or not placing a free-freight order is a good buy. As you will see, sometimes you can maximize your profitability by paying the freight.

How much is free freight worth? That's easy. It's the dollar amount on the freight bill. This amount is an additional discount offered by the vendor. Using the process described below, you can determine whether this discount exceeds the cost of carrying the additional inventory necessary to meet the freight prepaid requirement.
Calculate the inventory holding cost that would be experienced at each discount level. The holding cost is the amount of money necessary to maintain the balance of a vendor shipment in your warehouse during the time it takes to sell the entire shipment. It is calculated using the inventory carrying cost percentage, a measurement that reflects who much it costs to maintain a dollar's worth of stock inventory in your warehouse for an entire year. How to determine the inventory carrying cost percentage is discussed in some of our other articles. The company in this example has an annual inventory carrying cost of 30%. That is, it costs 30 cents to maintain a dollar's worth of inventory in the warehouse for an entire year.
Your total cost of inventory (including all of the costs you will incur) is the net investment plus the holding cost dollar.
Finally, calculate the cost per dollar of inventory. The cost per dollar of inventory relates the total cost of inventory at each purchase level to the amount of inventory you will receive.
Even considering the cost of carrying the additional inventory, the freight savings realized with a $2,500 order make the larger purchase worthwhile.
So, if you plan to take advantage of free-freight offers, perform the analysis described above. And only purchase these quantities when it's time to place a normal target with the vendor. You'll always know when your vendor is offering you a good deal!

10 ways to lower inventory costs

By Ralph Cox
Inventory policies drive two types of costs: operating expenses and working capital requirements. The latest "Logistics Cost and Service Report" by Establish/Herbert W. Davis and Co. indicates that while total logistics costs as a percent of sales are falling, and most individual companies have succeeded in reducing inventory levels; total logistics costs per hundredweight are increasing, as are inventory costs as a percent of total logistics cost.

Many organizations, however, fail to address opportunities to reduce inventory costs. If your company needs help taking money out of inventory, there are a number of strategies you can implement today that will provide payoff:

1. Base cycle stock on economics. For purchased products, getting a handle on your acquisition transaction costs will either reduce average inventory or allow for reducing purchasing and receiving labor. For manufactured products, if production equipment changeover costs are in a similar state, getting them in place will either reduce average inventory through shorter runs or allow for reducing changeover and receiving labor through longer runs.
2. Control order transaction costs. In the office, use the computer to generate purchase orders (POs), electronic data interchange (EDI) for PO transmission, advance shipping notices (ASNs) to reduce expediting, and historical vendor performance to prioritize expediting to lower purchasing costs. In the manufacturing plant, preplanning; prestaging of needed parts or materials; use of special tools or equipment; changeover initiation prior to completion of the previous run; teamwork and work division; maintaining equipment temperatures; and minimizing quality assurance/quality control work all reduce cycle stock inventory. In the distribution center, statistics-based inspection and checking; barcode scanning for data entry; certifying key vendors to eliminate receiving functions; and stocking forward storage locations first and reserve locations second can all reduce purchase transaction costs and cycle stock accordingly.
3. Lower inventory holding costs. Improve space utilization in the DC through narrow aisle handling equipment, mezzanines, layout modifications, or more appropriate storage modes.
4. Base safety stock on customer service. Using the appropriate number of product classes, setting the dividing lines between each class in the best manner, updating safety stock levels dynamically, and basing the service levels for each class on the financial goals of the business all serve to reduce safety stock inventory or out-of-stock situations and increase revenue.
5. Use routine demand forecasting. Using manually edited arithmetic forecasting models to reduce forecast error will reduce overstocking, backorders, and DC returns from stores, holding inventory levels closer to only what is required to support the desired customer service level.
6. Forecast events. If one-time demand clutters the sales history, or if one-time demand events are part of the future, then they need to be taken into account in any forecasting, both in terms of editing them from history and in terms of incorporating future events into the routine demand forecast.
7. Think postponement. For parent products from which multiple SKUs can be manufactured, only partially completing manufacturing, placing semi-finished product in inventory, and then completing manufacturing of the final SKUs to order reduces total inventory. In a similar manner, component products from which final SKUs may be assembled can be purchased to inventory and then the final SKUs assembled to order, providing that the time for assembly doesn't exceed the customer lead time.
8. Rationalize SKUs. Removal of inappropriate product from the product line can be a controversy-ridden process, but it may reduce inventory significantly if handled in a constructive manner:

• Develop consensus on the objective of maximizing profit.
• Develop activity-based costs for each SKU and separate them into three groups:

o those with selling prices that create positive gross margin
o those with selling prices that cover their variable cost but do not completely cover their fixed cost o those with selling prices that do not cover their variable cost.

• Quantify the sales volume correlations among SKUs, based on the analysis of both individual orders and aggregate order patterns by customer.
• * Identify the combination of SKUs that maximizes profit on a fully absorbed basis.

9. Reduce lead times for product acquisition. For both manufactured and purchased product, any reduction in lead time, whether supplier lead time, transportation time, or receiving cycle time, provides a one-time, permanent reduction in cycle stock inventory proportional to the throughput level of the SKU and the degree of lead-time reduction. In a similar manner, reducing lead-time variability and increasing inbound unit, SKU, or order fill rates increases supply reliability and reduces safety stock inventory for a given customer service level.

10. Implement common supplier joint procurement for purchased products. Joint procurement of multiple SKUs from a common supplier serves to effectively reduce unit purchase transaction costs and thereby reduces cycle stock inventory as well as annual purchase transaction expenses. In a similar manner, joint procurement of multiple SKUs from different suppliers located in close physical proximity and consolidation of inbound less-than-truckload (LTL) volume to form full truckloads serves to reduce the incremental transportation cost portion of purchase transaction costs and reduce cycle stock inventory.

Carrying Inventory

by Jon Schreibfeder
The carrying cost of inventory is the cost of maintaining your average inventory investment of inventory in your warehouse, storeroom, stockroom, or other location where you stock raw materials or finished goods. What costs do you incur in carrying inventory?

* Cost of putting away stock receipts and moving material within the warehouse. How much of your employees' time is spent in these activities?
* Rent and utilities for the portion of your warehouse used to store stock inventory.
* Insurance and taxes on inventory. If it's in your warehouse, you have to insure it, and it may be subject to tax.
* Physical inventory and cycle counting. The more material in your warehouse, the longer it takes to count.
* Inventory shrinkage and obsolescence. The more material in your warehouse, the higher the possibility of shrinkage and obsolescence. After all, it's hard to steal something that isn't there!
* Opportunity cost of the money invested in inventory. How much could you make if you were to take the money you're investing in inventory and invest it in a more traditional investment (such as treasury bills)? Or if you are financing your inventory, how much interest are you currently paying the bank?

The carrying cost percentage is calculated by dividing the sum of these expenses (along with the opportunity cost) by the average inventory value. It is the amount of money it takes to maintain one dollar's worth of inventory for an entire year.

For years many industry consultants have maintained that determining your company's actual carrying cost is too difficult to calculate in a reasonable amount of time, and that you should use a rule of thumb such as "current prime rate plus 20%." One inventory "guru" recently suggested that you should adjust your carrying cost percentage so that the economic order quantity formula suggests "reasonable" reorder quantities.

This is backwards thinking. The economic order quantity formula is designed to calculate the lowest total cost reorder quantity (i.e. your "best buy quantity") based, in part, on the cost of carrying inventory. If it costs you less to maintain inventory in your warehouse, you will tend to stock more. If your carrying costs are high, you will probably want to keep just enough inventory in your warehouse to protect customer service. Guessing at your carrying cost will not ensure that you are buying the quantity that will minimize your firm's total cost of inventory.

Just as important, using an approximate carrying cost does not help you identify areas for potential improvement in your warehouse operations. In these days of increased competition, lower margins, and greater customer demand of product availability, it is important to lower operating costs and increase productivity wherever possible. By closely examining the specific components of the inventory carrying cost and comparing the numbers to other firms in your industry and region, you can identify areas that are candidates for improvement.

With all of this in mind, EIM would like to help you calculate your cost of carrying inventory. If you will print and fill out the attached questionnaire and send it to us by email, mail, or fax, we will calculate your carrying cost and send you a comparison of your answers to each question to others in your region and industry. There is no charge for this service as long as you agree to let us add your information to our database. Please note that all responses are confidential. Data we present to other companies will not identify your company name or location.

Even if you don't fill out the questionnaire, please review it, as it includes most (if not all) of the factors you must consider as you calculate your own inventory carrying cost.

Inventory costs

Inventory costs consist of:
• Cost of money - The cost of capital to the company or, in some cases the "opportunity cost" or return that might be earned on the money by applying it productively elsewhere.
• Obsolescence - The risk of inventory never being used, or needing rework to make it usable, needs to be factored into the cost of owning INVENTORY. In theory (and practice), the larger the inventory is, and the longer it is held, the more likely engineering changes, customer preferences and technological changes will render that inventory unusable. In the clothing industry, it is not uncommon to see inventories depreciate as much as 90% when styles change. Certain portions of the electronics industry have problems with inventory becoming obsolete very quickly, due to technological changes.
• Shrinkage - A portion of inventory becomes unavailable to the owner due to loss, damage, theft or spoilage. The longer inventory is there and the more there is, the more likely this is to happen. Steps to prevent it only raise carrying costs in other areas, such as security, climate control, better control systems, recruiting policies, etc.
• Quality Factors - Allowances for yield, attrition, scrap and rework. This is really more of a function of the process than the amount of inventory invested and is more related to throughput, but is sometimes included as part of the aggregate inventory carrying cost.
• Technological or Price Obsolescence - Prices don't always go up. In fact, in industries such as electronics, prices often plummet due to constantly improving designs, product and process technology improvements. Therefore, it is desirable to minimize inventories in high-risk areas.
• Taxes - There are two dimensions to this: 1) in some areas, a tax is levied on inventories, so the more inventory, the more tax is paid. 2) inventory is regarded as an asset by most accounting and tax rules. Therefore, increasing inventories shows "profits" and profits are usually taxed, usually by multiple government entities.
• Insurance - The cost of carrying insurance on inventory needs to be considered, as well as insuring the space, equipment, people and other resources needed to control it.
• Space - Costly storage space sometimes occupies 25-30% of the total facility, when one considers raw material warehouses, stockrooms, work-in-process storage, receiving, shipping, outside warehouses, MRB and residual storage areas. Inventory reduction campaigns can help companies avoid the need to move to large facilities, or permit them to shut down or cut back existing facilities.
• Manpower - All of this inventory needs people to order, receive inspect, record, move, count, store, retrieve, post it to the ledger, etc. People are the largest or second largest expense (behind material) for most manufacturers.
• Record Keeping Systems - Software, procedures, equipment and paper must be used to track and control inventory.
• Material Handling/Storage Equipment - Conveyors, fork lifts, bar code readers, scales, automated storage and retrieval systems, trucks, carts, bins, racks, shelves must all be purchased, leased, maintained and cared for.
• Physical Inventories, Reconciliations - Must be conducted to ensure that inventories are properly accounted for and maintained.
• Transportation - Must be provided to move inventory in and out of the facility, to vendors, within the facility, to different workstations and storage areas.
• Energy - Heat, light, humidity control, air conditioning, refrigeration and fuel must be consumed to make all this happen.
• Inappropriate Lot Sizing - In inventory formulae, the carrying cost of inventory is often expressed as a flat percentage of the inventory value, for convenience of computations, but that is an oversimplification of reality. For instance, consider material handling/storage costs. Just because a dollar of inventory is added, doesn't mean that carrying costs go up, say, $.02. In reality the costs would not usually go up in a direct proportion at all, but only when we had to pay for an additional expense, or make the next capital investment in equipment or space to accommodate the inventory. So actually, most of these costs are step functions, rather than continuous curves.
We urge caution in the use of so-called EOQ (Economic Order Quantity) formulae in planning. While these can be useful guidelines in some cases, they can easily go awry and are hypersensitive to changes in carrying costs and order costs, which are usually no more than guesstimates, at best. We smile in amusement at PhD's made or lost on the study of such arcane calculations, often failing to consider basic realities such as; how much space and money do we have, anyway? You can refer to Paul's book, Production & Inventory Management in the Technological Age, pages 137 to 139 for a detailed explanation of why this lot sizing method is weak and should be used with caution.

• Supply variation—refers to the reliability of the supplier to deliver the desired units in the needed quantity, at the right time, at an acceptable quality level. If this can't be done reliably, then companies tend to carry a buffer (safety) stock to make up for the deficiencies in the supply system.

• Demand variation - refers to the ability to reliably forecast what the customer will require (whether that is an internal or an external customer). Lower reliability tends to encourage buffer (safety) stocks.

• Defects —Extra inventory is often carried to allow for probable rejections. This is just a specialized form of safety stock for supply and demand buffering.

• Logistics constraints/transportation costs - This also sometimes falls under the heading of supply and demand variation and it certainly can affect it. For example, one of our clients transports parts by ocean freight to a plant in Portugal, or at least they do that if they don't have to ship by air to get them there faster. Because ships traveling between economical ports only leave every few weeks, a 20 or 40 foot long container is the most practical shipping size. A certain amount of time is required for packing, transportation to the terminal, Loading, transport, unloading, customs and transport to the consignee. These are very real logistics constraints that must be built into the "pipeline" portion of the inventory model.

Inventory managment and inventory costs

(c)Frank Dooley
Different models are used to manage inventory for products that are continually available (like milk) or products available for limited time (like seed).The Economic Order Quantity (EOQ) model determines the least cost level of inventory to carry, as well as costs. News Vendor models are used for products only available for a single period.

EOQ and News Vendor models have proved useful for managing inventory for many years, analyzing tradeoffs among major cost components. These models are robust and easy to customize to particular industries. Their approach to costing is similar reflecting levels of inventory, as well as shipping costs or quantity discounts.

Inventory costs fall into three classes:
1) carrying costs of regular inventory and safety stock;
2) ordering or setup costs;
3) stockout costs. Inventory control systems balance the cost of carrying inventory against the costs associated with ordering or shortfalls
Firms carry extra inventory to guard against uncertain events. Known as safety stock, the purpose of this inventory is to provide protection against stockouts. Safety stock is costed just like regular inventory, it is an interest rate times the level of safety stock.
If less is sold than expected during the 10 days or if the shipment arrives early, we will still have inventory on the 10th day and no customer service problems are encountered.
Managing the uncertainty surrounding safety stock is the key to reducing inventory levels.
stockout costs involve lost sales when no inventory is on hand. Such costs fall as inventory (and customer service) levels increase. The relationship between stockout costs and inventory depends upon the accuracy of the demand forecast and the ability of the firm to recognize and react to a change in demand.
One way to evaluate an inventory management policy is to choose a service level target. From this target, the inventory policy will determine the inventory requirements and associated costs of providing that level of service. A higher service level implies that more inventory will be held as safety stock.
Check new inventory management software.

INVENTORY COSTS

1. Purchase cost
2. Order/setup cost
3. Holding Cost
4. Stockout cost
In the inventory analysis relevant costs are considered
Purchase Cost
· Unit purchase price - from an external source
· Unit production cost – produced internally
· Unit production cost includes direct labour, direct material and factory overhead
Order/Setup Cost
· Expense of issuing a purchase order to an outside supplier or from internal
production setup costs
· Vary directly with number of orders or setups
· Order cost includes transportation cost, and cost for requisition, analysing
vendors, writing purchase orders, transportation cost to transport the order,
receiving materials, inspecting materials, following up orders and doing the
process necessary to complete the transaction
Holding Cost or Carrying Cost
· Cost associated with investing in inventory and maintaining the physical
investment in storage
· Contains capital costs, taxes, insurance, handling, storage, shrinkage,
obsolescence, and deterioration
Stockout Costs
· Economic consequence of an external or an internal shortage
· External shortage – when customer’s order is not filled
· Internal Shortage – When an order of a group or department is not filled
· External shortages can incur backorder cost, present profit loss and future profit
loss
· Internal shortage can result in lost production and delay in completion date