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Expected
Actual
Carrying
costs
Inventory value
late their costs. Factors range from the space, labor and
equipment employed to the money borrowed to fund these
activities. Comparing this total cost to the value of inventory
gives a percentage (carrying costs divided by inventory). There
is a concern, however. Logically, some of these costs dont, and
shouldnt, change with inventory value. The challenge is determining which costs change and which dont. Only when costs
change with inventory value can a percentage be applied broadly.
In almost all cases, you cannot create a carrying cost percentage based on Buy
inventory value that works
broadly for four
Build
product
reasons: A inventory
large portion of costs result from
the infrastructure
that supports carrying the inventory; the operating model can
A infludetermine infrastructure cost; the type of inventory can
ence cost; and the costs that truly change with value are relatively
small.
Infrastructure costs. When a company decides it wants
Time
to store inventory, it must make a commitment to do so. This
involves getting space, equipment and people to move and
manage inventory and other people. The result is expenses associated with the labor, equipment and space. Whether completely
empty or filled to the brink, the costs to lease the space, lease lift
trucks or pay people will be the same. Hence, they are independent of inventory value, as shown in Figure 1. These are all costs
involved with carrying inventory, but they do not change when
value changes.
Operating model. Consider two warehouses of the same
size. One has $1 million in inventory that turns once or twice per
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Industrial Engineer
year. Its a lights out operation that people only visit for the occasional order. The other has an average inventory of $1 million
as well, but it turns the inventory 52 times per year. Trucks
arrive, are unloaded, materials come in, are stored, pulled and
prepped for shipment and loaded daily. Based on this description alone, the second warehouse clearly is more expensive to
operate because it needs more infrastructure. The first facility
might Sell
need only one person and a lift truck due to infrequent
product
activity. The second has many lift trucks buzzing up and down
B planning and operating the facilities
the aisles and more people
and moving inventory. Although both have the same inventory
value,Store
the operating model itself determines
the costs required
Sell
to operate
the site. These costs,product
too, are independent of invenproduct
tory level.
B
The operating model often reflects culture. Damages and
theft can result in operating models with poor cultures. These
other carrying costs are tied loosely to the operating model, and
they must be considered and also serve as improvement opportunities.
Inventory type. The makeup of the inventory could cause a
company to incur costs that are independent of inventory value.
Special conditions such as environmental requirements for
temperature and humidity make certain inventory types more
expensive to maintain. Similarly, low cost items that require
special protection or packaging can be more expensive to own
and maintain than more expensive items that do not have such
requirements.
Inventory value
extended borrowing
Figure 2. Up to point A, all products are the same. Then one product is sold, and the other is stored. For the stored product, this creates a
time delay between A and B where borrowed capital is not generating any return. Infrastructure costs remain the same, however, as they
already have been accounted for.
Sell
product
Buy
inventory
Build
product
Store
product
Sell
product
B
Time
Finally, inventory level could influence the cost to carry inventory independently of value. Maintaining a vehicle lot with one
$200,000 car may be easier to manage than a dealership that
has to clean and maintain 40 cars worth $5,000 each.
Some costs do vary with inventory value. These include any
insurance or taxes that are paid based on the value of inventory.
The payment is determined when a periodic value assessment is
performed. Another cost that comes up in this conversation is
the cost of the money borrowed to build inventory. This is often
accepted as a percentage of the inventorys value. But is it? The
answer is: partially.
Consider a company that buys materials, produces an item
and sells it immediately. The items value as inventory starts
as raw material. Value is added throughout the production
process as a function of the labor, additional materials and, in
some cases, equipment used. The process creates a salable item.
When it is sold, its value is the primary contributor to the cost
of goods sold line item on the income statement.
Now consider the same scenario, but instead the item is
placed in inventory instead of being sold, as we see in Figure
2. The value of the same item goes onto the balance sheet as an
asset rather than the income statement. When sold, it is transferred off the balanced sheet and onto the income statement as
the cost of the good sold.
What costs have increased as a result of putting the item into
inventory versus selling it? The biggest change is that the money
for the investment in materials might be borrowed for a longer
time. This cost penalty is tied only to the material costs. The
other costs that increase value exist whether the item is sold or
inventoried, so they are not tied to the choice to inventory the
item.
Many mistakenly tie the cost of money to the overall value of
The implications
Inventory carrying costs are real, and they can be substantial.
To determine carrying cost improvement opportunities from
reducing inventory, one must look at changes that are enabled
by the reduction. Those include:
1. Reducing the amount of infrastructure
2. Creating a lower cost operating model
3. Creating cost reductions from inventory types
4. Reducing the length of time money is borrowed
The focus on infrastructure should be on whether inventory reductions will reduce the amount of capacity (space,
labor, equipment) the company needs to buy. The term buy is
important because if inventory improvements do not reduce the
amount of capacity needed to be purchased, there will be no true
reduction in carrying costs. Business cases that attempt to create
a dollar value for carrying costs based on space saved, equipment
utilization or labor productivity will create false expectations of
savings. Remember, regardless of how much space is consumed
by inventory, the lease cost stays the same. Reductions will only
occur if you have to purchase less infrastructure.
This doesnt mean that inventory reduction wont enable cost
savings elsewhere. For instance, in some cases a third-party
logistics provider could, at a lower cost, handle everything from
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Industrial Engineer
assumes that if the item is eliminated, the carrying cost goes away.
That is not true. The refrigeration costs are there, and the change
likely wont be substantial. The costs that are spread equally to
all items will now be spread to fewer items, increasing the carrying cost percentage. Making a major dent in actual carrying costs
might require eliminating all items that require refrigeration.
When considering adding or dropping inventory, determine
what you can eliminate by reducing inventory and what you will
have to buy to support that inventory. That will give your operations a clear understanding of how the type of inventory carried
affects costs and keep you from thinking that costs will go away
when they will not.
Any time revenue is generated faster from investments, it
is a good thing. A positive about lower inventory levels is that
they will tie up less investment money than higher inventories. Spending the money to buy items that have to wait in a
queue before being sold is an unnecessary financial waste. Any
decisions that can speed the cycle from when you borrow for
inventory until you are paid for the products created can have an
impact on carrying costs.
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