Building a Great Inventory Strategy
Inventory is a significant asset on the balance sheet of manufacturing companies. Depending on the industry sector, it can represent up to 20% to 30% of total assets, and inventory of packaging supplies often representing a sizeable portion of that. How effectively a manufacturing company handles its inventory is closely tied to overall financial success. A 2009 study published in the International Journal of Operations & Production Management, for example, showed a significant positive correlation between financial performance and inventory performance.
Building a great inventory strategy is often complex, but answering three simple questions can help identify ways to reduce inventory investment without risking profit. Addressing these three questions – on inventories of raw materials, packaging, and finished goods – can result in improvements in inventory return-on-investment (ROI).
How Much Does Your Inventory Cost
Most of the time, the true costs of inventory are underestimated and incomplete. Many companies view the cost of inventory as the “cost of capital” of the inventory asset. So for example, a company with $15 million in average packaging inventory and an 8% cost to raise money sees a carrying cost of $1.2 million per year. But the actual cost is far greater than this when you take into consideration the costs associated with holding and handling this inventory:
Administration & Measurement Expenses
- Employee costs to account for and measure the inventory
- Top management time spent on solving inventory issues
Direct Investment Expenses
- The cost of capital invested in the inventory (as discussed above)
- Insurance on the inventory
- Yearly loss from pilferage and shrinkage
- Yearly loss from obsolescence
Costs of System Failure
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Lost business and profits or impaired goodwill from improper management or late delivery of materials
Handling of the Inventory
- Depreciation or rent of material-handling equipment (e.g., forklifts)
- Direct operating costs of material-handling equipment (e.g., propane tanks)
- Employee costs to receive, stack, and maintain materials
- Freight and transportation costs borne by the company
Housing the Inventory
- Depreciation or rent on the building holding the inventory (or the portion of the building used for inventory)
- Heat and utilities on the building holding the inventory
- Janitorial, security, and routine maintenance on the building
- Taxes and insurance on the land and building
That is a long list of additional costs. When they are all taken into account, the total cost of holding inventory is much higher than originally thought, representing up to 25-30% of the inventory’s book value. For that same company with $15 million in packaging inventory, this translates into holding costs of $4.5 million per year – about 4 times higher than the cost-of-capital calculation. And the numbers can climb even higher with improper inventory management.
This is why getting an accurate measurement of what inventory truly costs is a smart first step in enhancing inventory ROI. Then attention can turn to defining the right amount of inventory to carry. See On the Relationship between Inventory and Financial Performance in Manufacturing; you can locate this article at here.
How to Right-Size Your Inventory
Finding the right stocking levels can be a balancing act. Having too much inventory leads to unneeded costs, but having too little risks stock-outs and difficulty meeting customer demand.
There are four things to consider when calculating how much inventory to carry. The discussion below uses examples related to packaging inventory, but the same logic applies to raw materials and finished goods.
1 - Order Frequency
It may seem better to order more frequently, requiring you to carry less inventory. But more orders can often lead to higher piece-prices (as one large buy is broken up into many smaller buys) and more freight costs (as one truck-load receipt is turned into multiple LTL receipts). It may also violate vendor minimums. On the other hand, the less frequently you can order or replenish, the greater the inventory level required to meet a certain demand.
2 - Safety Stock
No business wants to find itself out of stock. Those three dreaded words lead to a cost of failure that includes customer/retailer dissatisfaction, consumer loss of loyalty, and overall brand impairment. The more uncertainty there is in the supply chain, the more likely a company needs to carry additional inventory or safety stock. This serves as an insurance policy against risks in the supply chain or miscalculations in inventory planning.
3 - Lead Times
If you can order a package on Tuesday and receive as much as you need on Wednesday, then you are lucky that lead times are simple and not a factor. But often lead times can be long and variable. Lead times may vary for many reasons: type of product (commodity vs. unique part), number of potential suppliers (few vs. many), locations of the suppliers (e.g., domestic vs. international), and buying power of the purchasing company (market mover vs. tiny player). Longer lead times require more precise planning, causing many companies to opt for higher inventory levels.
4 - Expect Demand
One of the obvious factors is how much of a package is needed in a year, but this isn’t always easy to calculate. Past history can be a guide, but to get a more accurate estimate requires a thoughtful forecast that takes into account planned marketing or sales initiatives as well as a look at the latest demand indicators. This process can be tricky because it should be done at the product-line or SKU level, but it is important to do it correctly. Getting it right defines the total buy, but not how much to carry at any one point.
Now that you’ve accurately calculated the cost of inventory and determined the right amount of inventory to have on hand, it’s time to look at ways to drive down inventory on your balance sheet by finding other places to locate the assets.
Getting Started
As the saying goes, it takes a village. Effective inventory management is a cross-functional issue. From finance to marketing, sales, procurement, manufacturing, and warehousing – team members across the entire organization play a role in creating and implementing a system to improve inventory ROI.
A successful cross-functional team needs to consider three fundamental questions with regard to packaging, raw materials, and finished goods inventories:
- How much does your inventory cost?
- How to right-size your inventory?
- Where best to place your inventory?
Each business has different dynamics and imperatives. Answering question #1 will help prioritize inventory optimization in light of other corporate needs. Then functional expertise can help unlock the savings opportunities presented in questions #2 and #3. But be sure to keep your mind open to new paradigms and opportunities for partnership across the supply chain.
Summary
Inventory planning and management are neither simple nor sexy, but they can play a critical role in a company’s success. Given the enormous amount invested in inventory (over $437 billion in the United States across all durable goods manufacturing industries as of March 2020) and the often-underestimated cost of holding this inventory, a company can rise above its competition through smarter inventory strategies.
The actions outlined in this paper – quantifying your true carrying cost, defining the right amount of inventory to carry within the system, and then locating that inventory across your suppliers, you, and your customers – provide a simple roadmap to higher ROI. There are pitfalls along the way, but with diligence and the help of experts and partners, you will be able to capture profits and efficiencies that boost your bottom line.