What does it cost to finance inventory? More importantly, how does someone figure out the daily cost of money and its impact on inventory costs?
Don't Hold Inventory for Too Long!
Most companies understand that inventory costs money. There’s an upfront cost to purchase that inventory and store it. However, few understand what role the daily cost of money plays over time in terms of inventory costs and why it should be the motivating factor in selling obsolete and outdated parts immediately, rather than hold and wait. What is the cost of money and how is it calculated?
The Cost of Money is one Reason Why Inventory is Measured Monthly
Most companies use loans and business credit lines to finance the purchase of their inventory. As such, they have a yearly interest rate charged on the money they borrow. It’s the same way someone uses a credit card to purchase something. Every month they’re assessed an interest rate on their outstanding balance owing. While the interest rate on business loans and credit lines is much better, the same principle applies.
This yearly interest rate can be broken down into a monthly and daily interest rate. Every day inventory is held and not sold, is a cost of money. Why? Well, the company used the loan to purchase that inventory and will continue to pay interest on that amount until they sell it. So, if a company had obsolete and outdated inventory worth $500,000.00, it would continue to pay a daily interest rate on this amount until they sold that inventory.
Since companies must pay these interest rates monthly, or within 30 days, they tend to extend 30 day terms on customer invoices. It’s also the reason why most companies measure their inventory costs monthly.
How Does One Calculate the Daily Cost of Money?
Continuing with this example, let’s assume that a company had a business line of credit, or loan, that had a yearly interest rate of 8%. The amount of the interest rate is not entirely important. What is important is what this yearly interest rate means to the company in terms of a daily interest rate. In this case, the calculation is rather straightforward and is summarized below.
- Take the Yearly Interest Rate and Divide it by 365 (days in a year)
- 8% Divided by 365 days = 0.0219% - this is the daily interest rate
What Does This Mean in Terms of Inventory Costs?
A number of individuals look at the above and immediately assume its costs are limited and not at all severe. However, every day that $500,000.00 worth of dead stock isn’t sold, it costs the company $109.59 a day in interest rate charges. To be sure the math is correct, a good rule of thumb is to do the entire calculation over again.
- Yearly Interest Rate on Business Credit Line: 8%
- Total Yearly Interest Charges on $500,000.00 of Obsolete Inventory: $40,000.00 ($500,000.00 X 8%)
- Daily Cost of Obsolete Inventory Converted to Yearly Cost: $109.59/day X 365 days = $40,000.00
The cost of inventory rises every day it isn't sold. The longer it's held, the more expensive it becomes. It's the cost of money that impacts inventory every day. However, there are some simple strategies to reduce a company's cost of money.
How Does a Company Reduce Their Cost of Money?
Given the severity of this recession, that $109.59 a day in wasted money speaks volumes! In today’s business environment, it’s essential to reduce costs at every turn and to eliminate waste in all its forms. When companies have obsolete or outdated inventory, and choose to hold onto that inventory in the hopes of selling it for full value, they are not taking into consideration the impact of the cost of money. This is the single most important reason why liquidating obsolete & outdated inventory is so important. So, are there any strategies to reduce the impact of the cost of money on inventory? There are, and they are provided below.
1. Immediately Liquidate Slow Moving, Obsolete & Damaged Inventory
Liquidating obsolete, slow moving or even damaged inventory is essential. The faster it’s sold, the less expensive it becomes. Even damaged inventory has a value. A number of companies take their damaged inventory and sell portions of it as scrap material. At the very least, companies track their daily inventory costs and push to liquidate that inventory before it becomes too costly.
2. Prepayment With Bad Credit Accounts
One of the most effective ways to reduce inventory costs is to get paid faster. Every day an invoice goes unpaid is a direct cost of money. Therefore, whenever possible, companies should pursue prepaid customer accounts. A number of companies actively pursue these customers and force them to wire transfer the money or provide a certified check before shipping product.
3. Incentivize Prompt Payment From Existing Accounts
Companies also pursue existing accounts and offer incentives for prompt payment. The most common terms are 1% net 10 days. Therefore, if a customer pays within 10 days of receiving product, they get a 1% discount on their invoice. Prompt payment initiatives not only reduce inventory costs, but also improve cash flow.
When it comes to mitigating inventory costs, it really amounts to being cognizant of the costs to hold and manage that inventory. While there is an upfront cost to purchase inventory, there is another cost to finance it. Companies that hold onto obsolete inventory are simply wasting money. Given the severity of this recession, it simply raises inventory costs.