Many new or inexperienced entrepreneurs may not have much experience in operational aspects of a business like inventory mangement. Here is a quit hit on the subject.
The Role of Carrying Cost in Inventory Management & Profitability
Carrying cost refers to the total cost of holding inventory over a defined period of time, usually annually. It can be argued what components of a company’s overhead should be measured as a part of the cost to carry inventory. Should a company count only fixed asset costs, variable costs, a combination of the two, or simply a single component like current cost of money.
Many carrying cost calculations include things like rent, utilities and salaries involved in managing the inventory as well as insurance, shrinkage, and obsolescence. Other calculations only consider financial costs such as the current interest rates & lost opportunity costs. The most comprehensive carrying cost calculations include all of the above.
So while the components of carrying cost calculations can be argued ad nauseam and will depend on your company’s philosophy on where to attribute operational costs, what cannot be argued is the importance of knowing the carrying cost.
You see, it’s been my experience that too many companies simply opt for a just-in-time, lean procurement strategy without taking the time to analyze the impact on profitability that strategy may have. There is no doubt that cash is king and cash flow is the lifeblood of any company. As such, turning inventory quickly and minimizing held inventory is a top priority. However, that may not be the soundest strategy for total profitability.
Instead, companies should strive for inventory optimization. A host of factors go into what it cost to manage inventory for both manufacturers and distributors/resellers. There are operational costs to analyze, order, receive, put away, pick, box, and ship product. There are the costs involved in reconciling invoices, resolving discrepancies, paying supplier invoices, & performing quality control processes. When all of these factors are considered it may just be that fewer touches is better and buying/making (and sitting on) more at one time reduces overall cost to the point where the savings outweigh the cost to carry the inventory or the cash flow benefit.
Total cost of ownership is the most often overlooked component of a purchasing strategy. Most companies look at product cost and turns. A small few incorporate freight costs, payment terms, or rebates & discounted buys as well. An even smaller few look at carrying cost. Still fewer go as far as measuring the cost of lost orders & customer dissatisfaction.
Go to any meeting where a variety of supply chain executives are gathered and ask how they calculate their company’s carrying cost. I can almost guarantee you’ll get as many different answers as there are executives in attendance. Many will say they go with “an industry standard” but will have no idea where that “standard” came from. Others will simply use the cost to borrow capital. A very few will actually say they have a specifically measured calculation.
This is a scary trend in today’s global supply chain. It’s no wonder supply chain professionals are constantly struggling with the push and pull of product in the pipeline and the demands of manufacturers/vendors & customers. There is always too much or too little. Vendors and manufacturers are constantly stuffing their channels with product to meet revenue goals. Manufacturers can’t keep up with demand or make too much. The just-in-time and lean procurement edicts imposed by executive leaders are short sighted and do not leave room for the kind of purchasing flexibility that, while may lead to tighter cash flow and/or more borrowing, could also lead to increased profitability. The simple fact is if you don’t know your carrying cost you don’t know how to optimize your inventory.
Inventory optimization is about right sizing your inventory and purchases to balance operational costs in conjunction with financial costs. Most ERP or replenishment systems trigger reorder with a minimum (MIN) inventory level or a reorder point (ROP) based on algorithms that take into account demand, lead time and order frequency. Most times the suggested order/make quantity simply brings inventory back up to a maximum amount (MAX) that is the minimum amount needed to cover the demand over the lead time + replenishment cycle. Again we are back to just-in-time or lean procurement. That suggested quantity may not be the most optimal for profit.
Enter economic order quantity (EOQ). EOQ is not a new concept. It’s been around for decades. It is a very valuable tool that, in my opinion, should be utilized more. Actually, I think every company that manages any sort of inventory should utilize EOQ.
The single most frequent reason economic order quantity is not utilized (or inaccurate) is because a prime component of the calculation is carrying cost as well as a subset of the carrying cost, the reorder cost. Remember that the carrying cost can contain many or just a few components. Regardless of how it is chosen to measure carrying cost, knowing how much it costs to simply reorder/make a product should be known. The calculation for economic order quantity looks like this:
EOQ = √(2 x RC x D) / CC
Where RC = reorder cost, D = demand & CC = carrying cost
Economic order quantity means higher profits on any particular item. You can’t have EOQ without knowing your carrying cost. Making the strategic decision to optimize inventory starts with knowing what it costs you to carry that inventory. Regardless of the complexity of even figuring out what to include in your carrying cost it is worth the effort. Once you do you’ll be light years ahead of a majority of supply chain professionals and maybe even your competition.
The Role of Carrying Cost in Inventory Management & Profitability
Carrying cost refers to the total cost of holding inventory over a defined period of time, usually annually. It can be argued what components of a company’s overhead should be measured as a part of the cost to carry inventory. Should a company count only fixed asset costs, variable costs, a combination of the two, or simply a single component like current cost of money.
Many carrying cost calculations include things like rent, utilities and salaries involved in managing the inventory as well as insurance, shrinkage, and obsolescence. Other calculations only consider financial costs such as the current interest rates & lost opportunity costs. The most comprehensive carrying cost calculations include all of the above.
So while the components of carrying cost calculations can be argued ad nauseam and will depend on your company’s philosophy on where to attribute operational costs, what cannot be argued is the importance of knowing the carrying cost.
You see, it’s been my experience that too many companies simply opt for a just-in-time, lean procurement strategy without taking the time to analyze the impact on profitability that strategy may have. There is no doubt that cash is king and cash flow is the lifeblood of any company. As such, turning inventory quickly and minimizing held inventory is a top priority. However, that may not be the soundest strategy for total profitability.
Instead, companies should strive for inventory optimization. A host of factors go into what it cost to manage inventory for both manufacturers and distributors/resellers. There are operational costs to analyze, order, receive, put away, pick, box, and ship product. There are the costs involved in reconciling invoices, resolving discrepancies, paying supplier invoices, & performing quality control processes. When all of these factors are considered it may just be that fewer touches is better and buying/making (and sitting on) more at one time reduces overall cost to the point where the savings outweigh the cost to carry the inventory or the cash flow benefit.
Total cost of ownership is the most often overlooked component of a purchasing strategy. Most companies look at product cost and turns. A small few incorporate freight costs, payment terms, or rebates & discounted buys as well. An even smaller few look at carrying cost. Still fewer go as far as measuring the cost of lost orders & customer dissatisfaction.
Go to any meeting where a variety of supply chain executives are gathered and ask how they calculate their company’s carrying cost. I can almost guarantee you’ll get as many different answers as there are executives in attendance. Many will say they go with “an industry standard” but will have no idea where that “standard” came from. Others will simply use the cost to borrow capital. A very few will actually say they have a specifically measured calculation.
This is a scary trend in today’s global supply chain. It’s no wonder supply chain professionals are constantly struggling with the push and pull of product in the pipeline and the demands of manufacturers/vendors & customers. There is always too much or too little. Vendors and manufacturers are constantly stuffing their channels with product to meet revenue goals. Manufacturers can’t keep up with demand or make too much. The just-in-time and lean procurement edicts imposed by executive leaders are short sighted and do not leave room for the kind of purchasing flexibility that, while may lead to tighter cash flow and/or more borrowing, could also lead to increased profitability. The simple fact is if you don’t know your carrying cost you don’t know how to optimize your inventory.
Inventory optimization is about right sizing your inventory and purchases to balance operational costs in conjunction with financial costs. Most ERP or replenishment systems trigger reorder with a minimum (MIN) inventory level or a reorder point (ROP) based on algorithms that take into account demand, lead time and order frequency. Most times the suggested order/make quantity simply brings inventory back up to a maximum amount (MAX) that is the minimum amount needed to cover the demand over the lead time + replenishment cycle. Again we are back to just-in-time or lean procurement. That suggested quantity may not be the most optimal for profit.
Enter economic order quantity (EOQ). EOQ is not a new concept. It’s been around for decades. It is a very valuable tool that, in my opinion, should be utilized more. Actually, I think every company that manages any sort of inventory should utilize EOQ.
The single most frequent reason economic order quantity is not utilized (or inaccurate) is because a prime component of the calculation is carrying cost as well as a subset of the carrying cost, the reorder cost. Remember that the carrying cost can contain many or just a few components. Regardless of how it is chosen to measure carrying cost, knowing how much it costs to simply reorder/make a product should be known. The calculation for economic order quantity looks like this:
EOQ = √(2 x RC x D) / CC
Where RC = reorder cost, D = demand & CC = carrying cost
Economic order quantity means higher profits on any particular item. You can’t have EOQ without knowing your carrying cost. Making the strategic decision to optimize inventory starts with knowing what it costs you to carry that inventory. Regardless of the complexity of even figuring out what to include in your carrying cost it is worth the effort. Once you do you’ll be light years ahead of a majority of supply chain professionals and maybe even your competition.
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