Category: Inventory

Writing a Business Case for Inventory Reduction

Posted on by Talbot Smith

Avoiding Common Mistakes

While there is general agreement that reducing inventory levels is beneficial, there does not seem to be consensus on how to value a reduction in inventory.  Whether it’s from my university students or corporate managers and executives, I frequently see business cases associated with inventory reduction projects that grossly misrepresent the benefits associated with that reduction. At best these undervalue the benefits, but in many cases the errors would cause an incorrect decision about the initiative or investment in question.  Every situation is different, but I would like to lay out what I believe is the correct approach and framework for building an inventory reduction business case – one that puts the right variables in focus to drive good decisions.

I believe that the primary reason that many people and companies struggle with business cases around inventory is that, fundamentally, inventory is about cash flow where most supply chain business cases are about cost reduction.  This leads to the first of the common mistakes that I see:

Common Mistake #1: Focusing the business case on costs and ignoring cash impacts

The desire to focus on costs is very natural, after all it’s what we do in most other supply chain business cases.  And almost any action that impacts inventory will also impact cost elements, like warehousing and obsolescence, in addition to implementation costs.  This often creates a desire to convert the change in inventory to a set of cost impacts – with cost of money being one – and ignore the direct cash flow impacts. This is particularly true when there is a desire to hit a cost reduction target.

Many businesses use Net Present Value (NPV), Internal Rate of Return (IRR) or other Return on Investment (ROI) metrics to evaluate business cases.  While the focus is often on measuring the impact of changes in costs, these metrics are actually intended to measure changes in cash flows.  Consequently, excluding the favorable cash flow generated by a reduction in inventory would significantly understate the value of such a change.  The cost of money is reflected in the discount rate used to calculate NPV.  So, to include cost of money as a cost reduction is inappropriate as it effectively double counts those benefits.

A reduction in inventory generates a one-time favorable cash flow, as long as the inventory is sold or otherwise consumed and not scrapped.  The same reduction also creates an on-going reduction in the costs associated with holding inventory, such as the risk of loss or obsolescence and the costs of storage. Assessing those costs can be a little tricky, and I will discuss that in more detail below.  However, the bottom line is that a business case for inventory reduction is fundamentally about the cash flow impacts, and can’t be viewed solely through a cost reduction lens.

Inventory is primarily a cash flow benefit

Inventory reduction creates a one time cash benefit

Common Mistake #2: Treating inventory reduction as a recurring benefit

When considering cost reductions, if a cost is reduced and stays reduced, it delivers benefit not only in the year of reduction but in each year after that.  So if inventory is reduced and remains reduced, wouldn’t the inventory reduction continue to deliver benefits in subsequent years?  The answer is yes, and no.  When inventory is reduced, the cash flow benefit occurs only once – at the same time as the inventory reduction.  However, the cost savings associated with maintaining that inventory do recur.  For example, let’s say I have a plan to eliminate 100 pallets of inventory with a value of $ 1 million.  This inventory is stored in a public warehouse that charges $12 per pallet per month.  When the inventory is eliminated, there is a one-time favorable cash flow of $1 million.  This cash flow occurs at the time of inventory reduction.  If the inventory is reduced say, $ 700,000 in Year 1 and $ 300,000 in Year 2 then there would be corresponding cash flows of $ 700,000 in Year 1 and $300,000 in Year 2.  And nothing afterward.  Note that the second year only shows the incremental benefit that occurs in that year and not the cumulative amount.  It would be incorrect to show the total benefit of $ 1 million in any later years because this benefit only occurs once.

Now, with an average value of $ 1 million / 100 pallets = $ 10,000 per pallet these numbers would correspond to a reduction of 70 pallets in Year 1 and 30 pallets in Year 2.  With a storage cost of $12 per pallet per month this would generate a savings of $ 10,080 in the first year (assuming the inventory was all reduced in January) and an incremental $ 4,320 per year in Year 2.  These cost savings are both cumulative and recurring.  So while the first year savings is only $ 10,080, the savings in Year 2 and beyond are $ 14,400 (10,080 + 4,320).  Storage isn’t the only cost that might be reduced, but it will suffice for this example.  Other elements of holding cost should be treated the same way

Common Mistake #3: Failing to properly consider holding costs

In the example above, I used storage cost to illustrate a recurring cost that might be reduced as a direct consequence of a reduction in inventory.  Clearly, a reduction in inventory can reduce costs elsewhere and these cost impacts [1]should be considered as part of the overall business case for inventory reduction.  Very often I see these impacts either left out or not treated properly.  A business case should address all of the costs that will change as a result of the decision being evaluated – and nothing else.  With the exception of those cases contemplating strategic or structural changes, a business case should be developed on a marginal basis with the status quo as a starting point.  The challenge then is to identify those margin changes.

We have already discussed the cost of capital.  While less inventory reduces the cost of money, it is not appropriate to include this as a cost savings.  Rather, the cost of money is addressed through the discount rate in the NPV calculation.  That leaves us with a number of other areas to consider:

  • Storage/warehousing costs
  • Obsolescence
  • Shrinkage
  • Taxes and Insurance
  • Inventory management costs

Storage is perhaps the most tricky of these.  In the example above, inventory was in a public warehouse that charged a flat monthly fee for each pallet in storage.  In cases like this, any reduction in the number pallets would deliver a reduction in cost.  However, most companies find themselves in a more complex situation with a mix of owned and contract warehousing.  Depending on the business case, it also may be necessary to consider inventory that is “stored” in-transit in trucks or ocean containers or that is on the factory floor.  This is where the concept of marginal analysis is critical.  If you have an owned warehouse that is 95% full, then reducing inventory so that it is only 80% full will not reduce the cost of operating the warehouse.  This is because the cost of the warehouse is largely fixed, and driven by the level of activity – not by the level of inventory[2].  If on the other hand, the owned warehouse is full to the point where off-site overflow storage is being utilized then there may be a clear savings if the off-site location can be downsized or eliminated.  There may also be an opportunity to eliminate the cost of transporting inventory to the secondary warehouse and bringing it back.  With respect to storage costs, it is important to ask exactly what costs will be reduced or eliminated based on the change being proposed.  If you are reducing inventory in-transit or work-in-process it may very well be that the answer is that there is no impact to storage costs.  What is required here is a thoughtful process to understand exactly what, if any, costs will be altered by the decision.

Storage costs may be the trickiest, and in my experience the most frequent source of error, but a similar process is needed for other components of holding costs as well.  Understand the impact of the inventory reduction, think through the impacts on the drivers of other costs, and include the appropriate amount.  In the case of both shrinkage and obsolescence[3] costs, it’s important to consider where the inventory is in the supply chain.  How do loss, damage, or yield rates vary along the supply chain?  Exactly what inventory is being reduced, and what rate applies to that inventory?  Similarly with obsolescence, raw materials and components in the upstream portion of the supply chain tend to have much lower obsolescence rates than downstream inventory sitting in distribution centers.  Taxes and insurance should be treated similarly.

As a general rule, the cost of managing inventory (people and systems) does not change due to the level of inventory.  Rather it is driven by the number of stock keeping units (SKU’s) that need to be managed.  However, if the source of the inventory reduction is a product portfolio rationalization, then it may be appropriate to include a component of these costs.

[1] See How is Holding Cost Calculated for more detail

[2] I will be quick to acknowledge that a very full warehouse leads to inefficiencies and there may be labor savings from creating a certain amount of free space in a full warehouse.  These should absolutely be considered if they exist.

[3] For purposes of this discussion, think of obsolescence as anything that renders the product unsaleable. This would include perishability as well as the traditional notion of the product becoming obsolete for lack of demand.

Inventory reduction can also reduce on-going costs relating to holding and managing inventory

A Simple Example

A Simple Example

Perhaps the best way to illustrate the right way to do an inventory business case is with a simple example.  It has been proposed to implement additional functionality in the planning system to better manage inventory.  This requires new software which will have an annual license fee of $300,000 and an initial implementation cost of $ 1 million.  It is expected that the new software will deliver a $ 10 million reduction in inventory over two years, with $ 7 million in the first year after implementation and an additional $ 3 million in the second year.  The initial $ 7m reduction will allow the company to exit an overflow warehouse with cost savings of $ 100,000 annually.  Inventory in this location typically incurs shrinkage of 0.1% annually and obsolescence / perishability of 5% annually.  Taxes and insurance are 1% annually. 

With this information, a correct business case would look like this:

Note that each element has been labeled as to whether it is on-time or recurring.  As noted above, the full savings in storage costs occurs with the first $ 7m inventory reduction.  The other holding cost elements ramp up in line with the cumulative savings in inventory ($7m reduction in Year 1, $ 10m reduction in Year 2).

All in, this is a very attractive business case with a 500% internal rate of return (IRR), and a net present value of over $ 7m.

The spreadsheet shown above can be found here: Inventory Business Case Example

How is Holding Cost Calculated?

Posted on by Talbot Smith
Holding Cost =
+ Cost of Money
+ Property Taxes
+ Insurance
+ Obsolescence
+ Shrinkage
+ Physical Storage

It’s universally agreed that there is cost to holding inventory, but very few companies have a good understanding of what that cost really is.  Optimizing inventory implies a trade off between the cost of carrying inventory with some benefit, such as being able to meet customer expectations, or a reduction in operating costs.  However, it’s often easier to articulate the benefits vs. the cost of the inventory, leading companies to carry more than they should.  Similarly, I have seen many business cases for inventory reduction that were fundamentally flawed in the way they addressed inventory related costs.

The goal of this article then is to demystify the concept of holding costs and get you asking the right questions to be able to use this concept in business decisions

Holding costs are usually expressed as a percentage of the inventory value.  This can be helpful as most inventory decisions are on a margin basis, i.e., adding or reducing a certain amount of inventory.  I’m not sure where this practice originated, but it may come from the simple fact that many components of the holding cost are also typically expressed as percentages.

Holding cost should include all of the costs related to financing, storing, and disposing of inventory.  Typically it consists of the following components:

  • The cost of the money that is tied up in inventory
  • Where applicable, the cost of property taxes paid on inventory
  • The cost of insuring inventory or accepting the risk of loss
  • The cost of obsolescence, including both the cost of the inventory itself and the cost of disposal
  • The cost of physically storing the inventory

Each of these is discussed in turn below.  I leave the physical storage costs for last because these are the most problematic.

Cost of Money

The cost of money addresses the cash that is tied up in inventories. Inventory is a key component of working capital and consumes cash that could be used elsewhere: to pay down debt, to invest in a new business , to finance new capital equipment, to dividend to shareholders, etc.  As such, the cost of money should be viewed as an opportunity cost.  What else could I do with this cash if it wasn’t tied up in inventory?

Some companies use the company’s marginal, short term borrowing rate as the cost of money.  Today (in late 2020), that number is likely to be only a few percentage points.  I personally believe that this approach significantly understates the cost as it implies that the company has nothing better to do with extra cash than pay down short term debt.

Cost of Money

A better approach is to use what is know as the Weighted Average Cost of Capital, or WACC.  The WACC represents the average return expected across all of a company’s sources of cash, weighted by the amount of cash from each source.  It incorporates not only the cost of short and long term borrowing, but also the return expected by shareholders.  In my experience, even with low borrowing costs it is common for WACC to be in the 9-12% range depending largely on a company’s size and ownership structure. 

Many companies publish their WACC for use in internal business cases, either as the discount rate for Net Present Value (NPV) calculations or as the expected minimum return or ‘hurdle rate’ for investments.  If your company does not publish a rate you can usually get it from Finance and particularly the Treasury department.

WACC (Weighted Average Cost of Capital)
Property Taxes
Property Taxes

The second element of holding cost is property tax. Some tax jurisdiction will assess property tax on the value of inventory.  Of course if you operate in multiple locations you may pay property tax in some and not others, and when you do pay the rates will almost certainly be different.  For simplicity, I recommend computing an average rate and using that.  Your company Tax team within the Finance organization can help you understand total annual inventory related taxes and you can divide this by the average inventory balance to get a percentage.

Insurance

Insurance is the next component.   Most companies will carry insurance against the risk of catastrophic loss.  The trick here is to identify all of the relevant insurance costs (don’t forget insurance for goods in transit) and separate out the portion that relates to the inventory from that which relates to liability or replacement cost of buildings.  Treasury is usually responsible for managing the insurance policies or you may want to contact your corporate Risk group.

Taxes and insurance can be a bit of work and it’s common to add 1% to cover both of these.  Not that that number has an particular scientific basis or validity.  If you want to be precise, the actual numbers should be easily available.

Insurance
Obsolescence
Obsolescence

Inevitably, at some point you will make or buy too much of something and it will sit in inventory (and sit, and sit).  When it’s clear that there is no more demand for a product or material, accounting principles require that a reserve account be setup to reduce the value of the inventory to zero.  What’s important in determining obsolescence cost is not the value in the reserve account, but the annual amount that is added to the account.  For example, a company may have $ 100 million in inventory and an inventory reserve of $15 million.  Each year the company charges (as an expense) $5 million to the reserve account and removes a similar amount as inventory is scrapped.  The number we want is the average amount added to the reserve annually.  Take this as a percentage of total inventory (in this example, $5m / $100m = 5%) as the holding cost due to obsolescence

Shrinkage

Another basic fact of inventory is that things disappear.  They get lost, or damaged, or worse pilfered.  Regardless of the reason, the result is the same: the lost inventory must be written off as an expense and removed from inventory.  To compute the shrinkage component of holding cost, take the annual cost of shrinkage and divide by the average inventory balance to get a percentage.

Shrinkage
Physical Storage
Physical Storage

At last we come to the physical storage costs, and this is where things get interesting.  Physical storage, and how you should think about it, is highly situational. Particularly if you are working on a business case for inventory reduction.  Let’s look at some possible situations as examples:

  1. Your inventory is held in a shared warehouse where you pay a fixed fee per pallet per month for storage
  2. Your inventory is held in a warehouse that you own or lease with 80% of the available pallet positions occupied
  3. Your inventory is held primarily in a a warehouse that you own or lease, but the warehouse is completely full and 1,000 pallets are stored at a second warehouse where you lease space

These situations are not mutually exclusive.  Indeed I once worked at a company where all three situations existed at the same time but for different warehouses.

Situation #1 is the simplest in the context of holding cost as there is a very clear cost that is tied directly to the amount of inventory on hand.  In this case, simply take the annual cost per pallet and divide by the average value of a pallet to get a percentage.

Situation #2 is a bit more tricky.  For longer term, strategic decisions about inventory it would be appropriate to take the annual facility costs (not including labor) and divide by the average inventory value to get the holding cost percentage.  But here’s the catch: if you reduce inventory you won’t save any of this cost.  The warehouse is still there, it’s just less full.  The reduction in inventory hasn’t saved you a penny on the physical storage costs.  This is no good if you are trying to make a business case on inventory reduction!  From a business case perspective, you may still be able to make a case on cost avoidance.  For example, the inventory reduction prevents you from having to go out and lease more space next year as volumes increase (if that is actually true).  If there is another use for the space or the potential to lease less space going forward, then you can also apply an opportunity cost.  But if it’s just a simple case of inventory reduction your business case may be out of luck here.

Situation #3 is better, because the cost reduction opportunity is clear.  If you can reduce inventory by 1,000 pallets, you can eliminate the cost associated with the second warehouse.  And if this is strictly an overflow warehouse, you can eliminate the labor at that site and the cost of trucking material back and forth at the same time.  As with Situation #2, if you are looking to calculate a holding cost for strategic decisions (or, say to use in inventory optimization decisions) you can roll up all the facility costs and divide by the average inventory value to get a percentage cost for physical storage.  If you’re trying to make a business case for inventory reduction, you can build that case on the elimination (or downsizing) of the secondary warehouse as these are very real costs that can be eliminated if inventories can be reduced to the point that they fit in the primary warehouse.

As a final thought in this section, there is no physical storage cost for inventory in-transit.  Business cases that deal with reducing inventory by reducing transit time would not have a physical storage component to holding cost for in-transit inventory — though it would still be appropriate to apply physical storage costs to any resulting reduction in warehouse inventory due to the reduced lead times.

Financial vs. Operational Inventory

Posted on by Talbot Smith
Operational Inventory ≠ Financial Inventory

When measuring inventory levels it’s important to make a distinction between two different views: Financial, or what appears on financial statements, and Operational, what your planning team uses to make decisions.  Managers should understand the differences and be able to translate their operational decisions and actions to the balance sheet.

Operational inventory is simply what is visible in your company’s planning system (sometimes this is called Gross Inventory).  Generally speaking, this will be the quantity physically on hand.  There are of course exceptions to this as detailed below.  Operational inventory is valued at cost and so the total value of operational inventory is simply (quantity on hand) x cost.  Operational Inventory is important because it is what is used as the input to planning production and purchases.

Operational Inventory Value = Sum(Quantity on Hand x Cost)

What cost to use?  Every company has an established way of costing material in inventory, although one company may use different methods for different types of materials.  There are basically two approaches in common use: standard costing and average costing.  Standard costs are typically determined once a year determined during the annual budget process.  The standard cost represents what the company expects to pay for each unit of inventory.  ‘Expects’ being the operative word.  This can be very simple (e.g., the supplier contract price for the next year) or the result of complex calculations (e.g., for a manufactured item).  The important thing is that it’s a fixed number that typically only changes once per year.

Average costing seeks to compute the average cost for the items in inventory and is frequently used for spare parts and materials that are not end products or components of end products (otherwise known as indirect materials).  The average most often assumes FIFO, or First In, First Out, inventory movement, though other assumptions are possible (LIFO or Last In First Out, etc.).  Under this approach, if you have 97 units in inventory and a FIFO assumption of how inventory moves, the cost would be the average cost of the last 97 units to arrive.

Once you understand how your company handles costs, you should also get clarity of exactly what is included in Quantity ‘On Hand’.  If you work in a small company with only one location, it’s pretty safe to assume that ‘On Hand’ only includes the inventory that is physically present.  Larger companies, particularly those with more sophisticated ERP systems such as SAP, may also track inventory that is:

  • In transit between company locations
  • In the hands of suppliers (e.g., when a production step is outsourced)
  • Inbound from suppliers (less common as it requires data integration with the supplier)

To make thing even more complicated, what is considered On Hand may vary by location, particularly if different systems are used.  Be sure to understand what the rules are for each location in your company.

Financial Inventory =
+ Operational Inventory
+ Internal In-Transit
+ In the Hands of Suppliers
+ In-Transit from Suppliers
+ In-Transit to Customers
± Cost Variances
– Reserves
– Intercompany Profit

Believe it or not, valuing Operational Inventory is the easy part.  Financial Inventory starts with Operational Inventory and applies a number of adjusting entries to get to the amount that the company shows on its balance sheet.  Let’s look at each of these adjustments:

Internal In-Transit

If quantities in-transit between company locations (e.g., from a manufacturing site to a distribution center) are not visible in the company systems, then an accounting adjustment is needed to capture the value of this inventory.  There are multiple ways to do this, such as looking at quantities shipped and not yet received at month end.

In the Hands of Suppliers

Some companies will send inventory to suppliers to perform a process step or other activity.  Some examples are sending material to a supplier for sterilization (medical devices) or sending inventory to a co-packer to build store displays (consumer goods).  Regardless of the reason, if this inventory is not visible in the company systems then it needs to be added back via an accounting entry.  Typically this will cover the time from shipment to the supplier to receipt of the resulting item

In-Transit from Suppliers

It’s common for a company to take ownership of inventory before it is physically received.  If inventory is purchased from suppliers at any INCOTERM that does not include delivery (i.e., other than DAP or DDP), and transportation is anything less than instantaneous, it will be necessary to add an amount for in-transit inventory.  For example, let’s say your company purchases material from a supplier in China and the goods are shipped by sea to your location in California.  If the terms of the purchase are Ex-Works, then you take ownership as soon as the goods leave the suppliers location.  However, they may not be received and visible in your inventory for a month or more.  One way to value this is to look at inbound shipments for which you have received an invoice from the supplier or other indication of shipment such as an ASN (Advanced Ship Notice) and subtract what has been physically received.  There are other approaches and you should ask your Finance team how it’s done at your company.

In-Transit to Customers

Similarly, if you ship to customers using an INCOTERM that causes title to transfer somewhere after the goods leave your location (e.g., a delivered term) then it’s necessary to account for the inventory that is no longer on your system (having been shipped), but which you still technically own.

Cost Variances

Good news! If your company uses average costing, you can skip this section.  For companies that use standard costing however, it’s necessary to adjust the value of inventory by any variances from the standard.  This is perhaps best explained through an example.  Last year you set the standard cost for an item at $1.00.  However, your purchasing team was later able to negotiate a discounted price of $0.98.  You have 100 units in inventory currently.  If you value that inventory at the standard cost it is worth $100.  But you only paid $98 to obtain it.  To correct for this, an accounting entry is added to reduce the value of the inventory by the amount of this favorable variance.  So the value of the inventory is then 100 units x $1.00 standard cost – (100 units x $0.02 favorable variance) = $98. Most companies will capitalize both purchasing cost variances and production cost variances into a special inventory account to address this.  These variances may or may not be tied to the specific items that generated them.  Even if they are, the variance account may not be reduced at the same time that the inventory is consumed or shipped as many companies will transfer these variances into cost of goods sold (COGS) on a fixed schedule (e.g., variances go to the balance sheet for three months and are then amortized or transferred to costs).  Note that variances can be negative (favorable) as in the example above or positive (unfavorable) resulting in an increase in inventory.

Reserves

Accounting rules require a company to value inventory at the “lesser of cost or market”.  Consequently, if the Operational Inventory value exceeds what the inventory could reasonably be sold for, a reserve must be taken.  From an accounting perspective, the difference between book (Operational) value and fair market prices is written off as a cost and the value kept in a reserve account that acts as an offset, or negative, to inventory value.  Reserves may be taken for a variety of reasons:

  • Product cost exceeds selling price (i.e., a money losing product)
  • Obsolescence.  There is no longer a market or need for the item
  • Quality.  Items that failed quality inspection and are expected to be scrapped or that are otherwise unfit for use

The methodology for computing reserves can vary from simple to complex.  Best practice is to involve Planning in the identification and calculation of reserves, particularly for obsolescence.

Reserves may or may not be tied to the specific item(s) that caused them to be created.  Reserves are reduced by the value of inventory scrapped.

Intercompany Profit

If you work for a company that has more than one legal entity, then it’s necessary to adjust inventory to remove any internal profits.  Again, this is probably best explained via an example.  Your manufacturing site in the US produces a product at a cost of $100 per unit.  The US company then sells the product to your German subsidiary for $110.  The German company incurs $5 in freight cost and so the inventory in Germany reflects a cost of $115 per unit.  However, the actual cost to the company of the German inventory is only $105 (the original $100 manufacturing cost plus $5 in freight).  If we are going to aggregate total company inventory, we need to adjust the value of the German inventory to remove the $10 ($110 selling price – $100 cost) internal profit created by the sale between the two legal entities.  Companies that have this situation will typically capture the intercompany profit in an account that is an offset (negative) to inventory until the goods are sold to a customer outside the company.