Have You Figured ALL The Costs of Inventory?

Analyst Insight: Inventory working capital reduction is a wonderful concept; however, it is important to understand all of the potential financial impacts before beginning. – Ralph Cox, principal, Tompkins International

As senior management focuses more on reducing inventory working capital, it is helpful to understand how profit and free cash flow will be impacted by these decisions. Regardless of how the reduction is managed, any inventory can be viewed as having two components – safety stock and cycle stock – each driven by very different factors.

When cycle stock inventory working capital is decreased by minimizing forecast error, the balance sheet and profit and loss (P&L) are improved through reduced period inventory holding costs.

However, when cycle stock inventory working capital is reduced through reduced purchase or transfer order quantities (i.e., increased mean time between orders), the balance sheet is improved but the P&L can be negatively impacted by:

• Increased purchasing and expediting labor cost;

• Higher receiving labor cost due to the number of receipts;

• Growing warehousing labor costs due to dock congestion; and

• Missed shipments due to receiving delays.

When safety stock is decreased through reduced forecast error, shorter lead times or improved supply reliability (receipt order fill rate) while maintaining the level of customer service provided (order fill rate or SKU in-stock percentage), then the balance sheet and the P&L are improved through the reduction of period holding costs. Revenue remains unchanged.

For most businesses, when safety stock is reduced through a reduction of customer service, period revenue and margin can be reduced. This is a far riskier approach to reducing inventory working capital. The balance sheet may be slightly improved, but the P&L is almost always negatively impacted. Technically, the period inventory holding costs are decreased, but the drop in gross margin usually more than offsets any gain forming a net reduction.

To get the best cycle stock financial performance, reduce forecast error at the SKU-location level and determine order quantities so as to minimize total variable cost.

To get the best safety stock financial performance and the economically-optimum level of customer service, reduce forecast error at the SKU-location level and balance safety stock investment with gross margin. Assess the extent of the need for safety stock by addressing this question, “To what extent does the company lose sales – or alternatively, retain the sale but incur additional costs – when the location serving the customer is out of stock?”

The Outlook

In order to achieve the best possible inventory performance, improve competitive advantage and maximize profit perform the actions below:

• Educate personnel and collaborate;
• Apply appropriate enabling technology, such as inexpensive third-party modules;
• Refine business processes; and
• Measure inventory performance on a continuing basis.