Carrying cost on excess inventory increases need for efficient disposition

I read a very good article on inventory management today called Aggregate Inventory Management. It was written by George Miller of PROACTION. I particularly liked his comprehensive description of “Carrying Cost” of inventory. Although we generally focus on, and pitch, the fact that we can help increase recovery rates, we really need to incorporate some of this into the ROI calculation of our solution. The most eye opening stat is that a typical carrying cost number is 25% of the inventory value. This can be very meaningful for large companies with substantial excess inventory sitting in the warehouse, like in the case of appliance auctions. Here is George’s overview of carrying cost.

Carrying cost

This refers to the cost of owning inventory. Let’s look at what goes into inventory “cost of ownership”, frequently called the “carrying cost” and expressed in terms of percent cost of inventory valuation per year of ownership. For example, a 25% carrying cost (typical) would indicate that it costs about $.25 to own each $1.00 of inventory each year. These 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. The cost of money has ranged anywhere from 6% to 18% in the USA in the last 25 years. Obviously, this has a very significant impact on investment strategy.

• 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 with certain options like electronic liquidation.

• 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.