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What's Involved in The Total Costs of Inventory?
When companies think of increasing profit, they often concentrate solely on the benefits accrued from their sales & marketing efforts. However, there is another equally important method of increasing profit. Its approach is on the back-end and involves lower costs through proper supply chain management practices. So, what is the business value of supply chain management and how can it play an important role in increasing a company’s profit levels?
Understanding Inventory Costs
When companies look to reduce their cost of ownership on parts and materials, they often concentrate solely on securing the lowest possible price. While nobody would ever disagree that low prices help, there are other equally effective methods of lowering inventory costs that also help to lower a company’s month to month holding costs, transit and freight costs, total cost of ownership and reduce the incidence of damage to inventory. It’s all about streamlining supply chains, being cognizant of all the costs associated with inventory and setting plans in motion to reduce their impact.
It’s Never Just About Price
To give some perspective about how problematic it can become to concentrate solely on price in supply chain management, consider the following scenario. A company realizes that by purchasing large volumes it can dramatically reduce its purchase price on parts and materials by 10%. The company therefore moves forward with the purchase. They end up holding that inventory for up to 3 months. During this period portions of the inventory become damaged, some of it becomes obsolete, it’s continually moved from one part of the warehouse to another to make room for newer inventory. Almost all of it remains there for the entire duration. The company finally sells the inventory. Now, did the company really save 10%? Well, there are a couple of issues they ignored. These are summarized below.
- Monthly inventory holding costs: Most companies include a 3% charge on their monthly inventory. This includes the daily cost of money and its effect on inventory that is not sold. For the 3 months, it cost the company 9% to finance this inventory.
- Damage to inventory: There is one inherent rule of inventory management. The longer inventory is held, the more expensive it becomes. The aforementioned monthly holding costs play one role, but another portion of the cost comes from inventory damage. In this case, it’s a complete loss. The longer that inventory is held, the more likely damage will occur.
- Obsolete & redundant parts and materials: Obsolete and outdated inventory is another issue companies must be cognizant of. Again, the longer inventory is held, unsold or not used, the more likely it will become obsolete and outdated.
- Cost to move parts inside of warehouse: Moving parts from one part of the warehouse to another is yet another cost. It takes time and manpower and this is a direct cost of inventory. Newer inventory coming in means companies must allocate space and sometimes expand that space!
- Quarterly Inventory Counts: While not all companies have to physically count inventory, some do. A number of smaller companies run tight inventories and therefore do manual counts by quarter. More unsold inventory means more time spent counting, which is another cost.
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Simple Strategies to Streamline Supply Chain Management
To drive this point home, most inventory analysts agree that all these factors above, and some others not mentioned, are the reason why it costs companies anywhere from 25% to 30% annually in inventory support costs. So, if a company had an inventory worth $1 million, it could cost anywhere from $250,000.00 to $300,000.00 to support that inventory! Therefore, for every 3% to 5% reduction in inventory costs, a company saves approximately $30,000.00 to $50,000.00 annually based on a $1 million inventory value.
The Business Value of Supply Chain Management
Continuing on the example above, how much sales would it take the company to generate $30,000.00 to $50,000.00 of profit? Well, in some cases, it can take $8.00 of sales to generate $1.00 of profit. Using this as a reference, it would take $240,000.00 to $400,000.00 of sales to generate the same return. This is the ultimate business value of supply chain management. Reduce these costs and companies will save money and increase profit. However, how is this done?
- Vendor consolidation: Consolidating vendors is an excellent way to reduce both hard and soft costs. First, by purchasing larger volumes from fewer vendors, companies use their economies of scale to reduce pricing, as well as lower their per unit freight cost on incoming parts. These savings are hard cost savings. Soft cost savings include fewer bill payments and less time spent managing multiple vendors.
- Contractual supply agreements: Want to reduce your monthly holding costs and damage to inventory? Well, the right supply agreement with a company’s vendors can not only reduce monthly inventory holding costs, but dramatically reduce the costs associated with damaged inventory. As long as it remains at the vendor’s facility, the company can’t be liable for any damages.
- Stronger inventory/sales forecasting: Sales and inventory management often lose track of each other’s responsibilities and therefore become too centrally focused on their own priorities. This is especially true in large corporations. While it’s much easier said than done, improving visibility between sales forecasting & inventory demand plays a pivotal role in cost reductions. Sometimes the solution really is better communication.
Understanding all the costs of inventory is just one aspect of better supply chain management practices. Concentrating solely on purchase price, while ignoring other factors, will only lead to higher costs in the long run. The business value of supply chain management is that every $1.00 in savings goes directly to the company’s bottom line. Now, that’s a solid return!