Inventory Carrying Cost Does Not Drive Inventory Right-Sizing
By Chris McLaughlin
Inventory carrying cost: a concept that is well understood (academically), but very rarely utilized correctly (operationally). In my experience many companies do not utilize or even attempt to capture all of the aspects of inventory carrying cost (ICC). We are not going to focus on the inputs of ICC or how to capture them; there are many good sources that can be found online to answer those questions. Instead, we are going to show ICC’s impacts on inventory and why it is important to find the true ICC if you want to reduce inventory.
Calculating Inventory Carrying Cost
Inventory carrying cost is simply the cost associated with holding and managing inventory, as well as the potential lost return on ‘tied-up’ cash and the risks associated with having inventory. The capital costs (WACC) are what are typically thrown down as ICC if there isn’t a well-defined ICC policy in place. This will typically be a value somewhere between 6-9%. In general, the true ICC will be somewhere between 18-25%. It’s the disparity between cost of capital and ICC which is important to capture and use. The difference between calculating the true ICC or not, may be the difference between getting ‘buy in’ in order to effect changes that will allow for inventory reductions.
Right Sizing and Optimizing Inventory
Right-sizing and optimizing inventories are two terms that are often used interchangeably. For our sake, we’ll assume the meanings to be the same. Optimizing inventories means setting the correct inventory levels and policies that puts the correct inventory amounts in the right place to ensure system sustainment, but with the minimal amount necessary to accomplish this. This is done mostly through quantitative means.The system itself will essentially dictate exactly how much inventory needs to be held. The answers are unambiguous, there needs to be exactly X amount, no more no less. Most of the time when we are tasked with optimizing inventories, there is an assumed expectation that inventories will reduce. This is mostly true as inventory positions are typically well above what is necessary for functional operations, but it does not have to be the case.Right-sizing is setting the inventory to exactly what it needs to be, which may be more inventory than is currently being held.
The Inventory System
Either way, inventory reductions are not fundamentally tied to the idea of optimizing inventory, but are tied to changing the system to allow for a reduction of inventory. Having a good understanding of the true ICC does not drive inventory reductions directly; if the system has X amount of inventory and has been set to the correct levels, it will cost Y. Reducing inventory to save in inventory costs could potentially destabilize the systems that are dependent on the inventory. In order to reduce inventory we must change the system (hopefully for the best).
In general changing the system will require some sort of capital investment or at the least buy-in to effect the change. Using the true ICC to estimate the cost savings for the system change can give a better understanding of the savings. Don’t sell the impacts of inventory reduction short; apply the right inventory carrying cost and arm yourself better to effect a system change that will reduce the inventories.Share