The Costly Consequences of Poor Inventory Management (2024)

Inventory management is a critical aspect of any business that involves the storage and tracking of goods. Inventory refers to the goods and raw materials that a business keeps on hand to sell or use in production. These items can include finished products, components, supplies, and materials.

The use of inventory is multifaceted. Companies use inventory to meet customer demand, maintain production schedules, and take advantage of economies of scale in purchasing. Inventory can also provide a buffer against supply chain disruptions and unexpected changes in demand. However, having too much or too little inventory can lead to major problems for a business.

When a company does not have enough inventory, it may face stockouts, delays in production, and lost sales. Stockouts occur when a customer places an order for a product that is out of stock, which can damage a company's reputation and lead to lost sales. Delays in production can result in missed deadlines, which can impact customer satisfaction and lead to increased costs. Finally, lost sales can lead to a loss of revenue, market share, and profits.

On the other hand, having too much inventory can also be problematic. The cost of holding inventory is the sum of all expenses incurred to keep inventory on hand. These costs can include storage costs, insurance, taxes, and the opportunity cost of capital tied up in inventory. Opportunity cost refers to the potential earnings that could be generated from using the capital elsewhere, such as in marketing or R&D investments.

CALCULATING THE COST OF HOLDING INVENTORY

When calculating the cost of holding inventory, several elements must be considered.

• Capital Costs: The cost of capital tied up in inventory, including the interest paid on loans used to finance inventory and the opportunity cost of tying up capital that could have been invested elsewhere.
• Opportunity costs: This is the cost of tying up capital in inventory instead of using it for other purposes that could produce more benefits for the organization.
• Purchasing costs: The cost of acquiring the inventory. This includes purchasing personnel, stationery, communications, etc. A good purchasing department must know exactly how much its operations cost to the organization and that cost must be distributed according to specified criteria between the different activities it performs, including purchasing of inventory.
• Storage Costs: The cost of storing inventory, including rent, utilities, insurance, and maintenance. If the warehouse is owned then instead of rent calculate using the rent cost per square meter in your area, an average will do just fine.
• Handling Costs: Handling costs refer to the cost of moving inventory within a facility. This includes reception and inspection, classification, segregation, sometimes repacking is necessary, moving the products to their designated storage area, moving it again when performing inventory counts, and then moving it again for distribution. This of course involves the cost of personnel and material-moving equipment (pallets, lift trucks, etc.).
• Obsolescence Costs: The cost of inventory becoming obsolete or losing value due to changes in demand, technology, or fashion.
• Risk Costs: The cost of inventory being damaged, lost, or stolen, as well as the cost of liability associated with storing and transporting inventory.
• Taxes: The cost of taxes associated with owning and holding inventory, including property taxes and inventory taxes.

By considering each of these elements, businesses can gain a better understanding of the true cost of holding inventory and identify areas where they can reduce costs. For example, by optimizing inventory levels, businesses can reduce the capital costs associated with holding excess inventory. By implementing effective risk management strategies, businesses can reduce the risk costs associated with storing and transporting inventory.

BEST PRACTICES

Best practices for reducing the cost of holding inventory include:

• Inventory Optimization: Utilize data and analytics to determine the optimal inventory levels for each product. This practice involves analyzing customer demand, lead times, and other factors to ensure that inventory levels are neither too high nor too low.
• Demand Forecasting: Predict customer demand to ensure that inventory levels match the level of demand. This practice involves using historical data, market trends, and other factors to forecast future demand for products and adjust inventory levels accordingly.
• Lean Manufacturing: Focus on minimizing waste in production, which can reduce the need for excess inventory. This practice involves identifying and eliminating inefficiencies in the manufacturing process, such as overproduction, excess inventory, and unnecessary motion.
• Vendor-Managed Inventory (VMI): Allow suppliers to manage inventory levels for their products. This practice involves partnering with suppliers and granting them access to sales data and inventory levels, enabling them to manage inventory levels based on customer demand.
• Just-In-Time (JIT) Inventory Management: Deliver products to customers at the precise time they are needed, rather than maintaining a large inventory. This practice involves coordinating production and delivery schedules to ensure that products are delivered just in time to meet customer demand.
• ABC Analysis: Prioritize inventory based on its importance and value. This practice involves dividing inventory into categories based on their importance and value, with category A items being the most important and valuable, and category C items being the least important and valuable. By prioritizing inventory, businesses can focus their resources on managing the most important items more effectively.

By implementing best practices to reduce the cost of holding inventory, businesses can streamline their inventory management processes, free up cash, meet customer demand more effectively, and make more informed decisions about inventory management, purchasing, and production, ultimately leading to improved profitability and competitiveness.

AN EXAMPLE

Let's say a company has an annual average inventory value of $1,000,000. To calculate the cost of holding inventory, we would need to sum up all the costs associated with holding that inventory, such as storage costs, labor costs, insurance costs, and the opportunity cost of tying up cash in inventory.

Assuming the total cost of holding inventory is $150,000, we can calculate the percentage of the annual average inventory value that cost represents by dividing the total cost by the inventory value and multiplying by 100.

Percentage of inventory cost = (Total cost of holding inventory / Annual average inventory value) x 100 = ($150,000 / $1,000,000) x 100 = 15%

Therefore, the cost of holding inventory represents 15% of the company's annual average inventory value. This information can be useful for identifying areas where the company can improve inventory management practices to reduce costs and improve profitability.

This, of course, is just an example, typical holding costs vary by industry and business size and often comprise20% to 30% of total inventory value, and it increases the longer you store an item before selling it. It can also be higher, a lot higher.

THERE IS NO SUCH A THING AS FREE INVENTORY

Even if products are obtained for free, there are still expenses associated with maintaining the products in the warehouse.

Let's say that a company obtains some products for free, perhaps as a donation or as a part of a promotional offer. While the company did not have to pay anything for the products themselves, they still need to store, manage, and maintain the products until they can be sold or distributed.

This means receiving, inspecting, using warehouse space for storage, insurance, handling the product, tracking it, etc. and there may also be, depending on the nature of the product, additional costs associated with maintaining them in good condition.

In short, while it may be tempting to think of free inventory as a cost-saving opportunity, it's important to remember that there are still significant expenses associated with maintaining the products in the warehouse. These holding costs can quickly add up, so it's important for businesses to carefully consider the true cost of holding inventory and implement effective inventory management strategies to minimize these costs.

Unbalanced inventory levels can have a significant impact on an organization and its customers. For example, a stockout can damage a company's reputation and lead to lost sales. Excess inventory can tie up capital and lead to increased storage costs. In both cases, the customer experience can be negatively impacted, leading to decreased satisfaction and potential loss of business.

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