Contrary to a common misconception, the cost of carrying inventory significantly exceeds bank interest costs on the investment in inventory. Other holding or ‘hidden’ costs of inventory often not considered include: storage, equipment, labour, obsolescence, slippage, damage and insurance. The actual full cost of holding inventory, including these costs, can be many times the interest cost. Furthermore, there is the opportunity cost of otherwise investing the cash tied up in excess inventory into other profit generating areas of business.

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For organisations carrying excess inventory the overall impact to costs and profitability can be significant, and can be catastrophic for some organisations contributing to failure as companies run out of funding.

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So what is the actual holding cost? It depends on the organisations situation and products. For an organisation with high debt, excess inventory and products subject to perishability or obsolescence, the actual holding costs can be very high which can potentially and inadvertently steer the organisation into financial difficulty or insolvency. If realised, the cash tied up in excess inventory can be used to pay bills when due. When all costs are considered the full inventory annual holding costs can be between 20% and 50% of the total inventory value with 20% a conservative estimate.

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Even for an organisation with liquidity and cash in bank to purchase inventory and products not prone to perishability and with long lifecycles, the profitability impact can be significant where excess inventory exists. Costs saved by reducing excess inventory flow directly to the bottom line of the profit and loss statement which, as demonstrated in the simplified example below, can be the equivalent of an annual double digit percentage increase in sales revenue dollars.

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Simplified Example – Organisation XYZ         

XYZ, a wholesale who imports the majority of the products they sell, has;

• Annual sales of $40,000,000.

• Gross profit margin (GPM %) of 50% or $20,000,000.

• Profit as measured by Earnings Before Interest and Tax (EBIT) of 10% or $4,000,000.

• Inventory levels are typically $8,000,000.

• With cost of sales (COS) being $20,000,000 (Sales X GPM%), inventory stock turns are 2.5 per year (COS / Inventory).

 

The company is generating profit, but carrying high levels of inventory to achieve it.

Based on the conservative annual holding cost of inventory of 20% of inventory value, the annual inventory holding cost for XYZ is $1,600,000.

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It has been identified that inventory levels are high, but where is this inventory? By carefully reviewing and classifying inventory by sales and inventory levels using techniques such as Pareto analysis classifying products into categories such as A, B, C & D where A = 80% of sales dollars, B = 15%, C = 5% and D = 0%, XYZ management has identified that it is holding $3,000,000 of excess, obsolete and slow moving stock.

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As indicated in the below table, inventory is reduced over a 12 month period from $8,000,000 to $5,000,000 with stock turns increasing from 2.5 to 4 turns per year (note - stock turn targets will vary depending on industry and organisation).

 

Provided all associated cost reductions are realised, this reduction in inventory value provides an annual inventory holding cost savings (or increase in profit) of $600,000 (being conservative).

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Strategies to consider for inventory reduction and optimisation can include;

• Sales strategies and processes to reduce excess and obsolete inventory

• Implementation of Sales & Operations Planning (S&OP) to improve forecasting

• Review / develop tools for monitoring inventory levels and reporting purposes

• Develop KPI's and targets

• Ordering to demand

• Revising order frequency/cycles with suppliers

• Reviewing product range for potential rationalisation

 

Conclusion

As this example demonstrates, the annualised holding cost of inventory can be significant. While organisations may classify some of the costs differently, where this inventory level can be reduced without jeopardising service levels, the associated cost savings will fall straight to the bottom line and increase profitability as measured by EBIT by the same amount. Assuming that any incremental sales would generate a 15% EBIT margin (rather than the current business average of 10%),  to generate the same $600,000 increase in profitability through sales growth alone, the organisation would need to increase revenue by $4,000,000 or 10% from current revenue of $40,000,000. This may be difficult in a mature or declining market where the organisation is market leader with significant market share.  

       

Monitoring and optimising inventory levels should be a focus for organisations carrying inventory, with key indicators regularly monitored. Ignoring inventory levels or underestimating its true cost could be significantly reducing profitability and return to shareholders, or placing the organisation in financial difficulty with potentially catastrophic results.

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What strategies have you implemented to increase profits by reduce inventory levels?

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Scott Pickering - is an operational consultant with Scopic Group Pty Ltd, with substantial experience assisting organisations to review capabilities and systems, re-engineer processes and implement cost reduction strategies.