Free up working capital

Crucially, inventory policies drive two types of costs: period operating expenses and working capital requirements. At Growth Street we help businesses that are experiencing strain in these departments. However, you can access and free up working capital by other methods than external finance. This is something your finance providers would most likely never tell you.

We know that optimising your supplier/customer relationships and processes can be a very powerful tool to minimise financing costs. This brings us on to a topic where knowledge can lead to proper saving and, subsequently, increased access to working capital. Minimising lead times while reducing costs is a daily juggling act that all procurement and inventory management facing businesses face. While there is no silver bullet to this complex issue, there are ways to better control your inventory without sacrificing service.

Inventory Strategy
Inventory Strategy

Companies seem to have a love-hate relationship with this necessary evil. On one hand it is a constant reminder of the cost of money, while on the other it is a necessity whose importance goes far beyond its cost. Companies need enough stock to get product to market faster, increase market share, capture opportunistic sales, and ultimately exceed their customers’ expectations. 

What makes the situation even worse is the fact that most companies are unaware of and/ or fail to measure the true cost of their inventory. This means that purchasing departments tend to rely on two popular techniques to mitigate their inventory cost:

  • Using a method of spot order fulfilment, which entails purchasing only what’s needed to fill that particular order. This often limits a company’s ability to use economies of scale and bulk purchasing power to negotiate better pricing.
  • Compromising their selection criteria for good suppliers by purchasing the cheapest available option. This can negatively impact quality, service and delivery.

In order to address the issue of inventory costs and how to reduce it, you first need to properly identify and understand the real costs of inventory. This includes a number of factors that often go unmeasured. The vital thing to keep in mind is that inventory is not just an up-front cost. It becomes increasingly expensive over time – especially if the inventory turnover rate is low (frequency with which a company liquidates or sells all inventory before replacing it). The longer a company holds its inventory or is unable to sell it, the more costly it becomes.

The REAL cost

To illustrate the severity of some of these factors, we have put an estimated pound value on each cost. Consider the example below, which is based on £100,000 worth of inventory and £500,000 in annual sales.

Category: Annual Cost (£); Cost (%)

Shipping costs:  £1,500 - 1.5%

If inventory is not available you must pay for expedited orders and rush shipments to your customers.

Lost business due to late deliveries & lack of inventory:  £2,000 - 2.0%

Customers might leave to buy elsewhere due to lack of inventory and poor service.

Overtime in shipping & receiving:  £1,000 - 1.0%

Employees need to arrive early or stay late to meet customer demands due to a lack of inventory or late deliveries.

Cost of money:  £8,000 - 8.0%

To sustain an adequate inventory level assume you borrow £100,000 at 8.0%

Inventory damage:  £2,500 - 2.5%

Estimate £2,500 of inventory lost to poor handling and storage methods.

Cost of managing idle parts:  £3,000 - 3.0%

Products with strong sales histories that suddenly stop selling and remain in inventory.

Dead stock:  £2,000 - 2.0%

Products forecasted by sales that are no longer required due to obsolescence. These are often sold at a discount or scrapped – a cost that is often hidden or ignored.

Warehouse cost:  £6,000 - 6.0%

Cost related to rent, maintenance, electricity, general utilities etc…

Extra warehouse space:  £3,000 - 3.0%

Assuming 20%-30% of your warehouse space is occupied by dead or slow-moving inventory, you must rent additional space to meet the demand of faster-moving products.

Cost of managing excess inventory:  £1,000 - 1.0%

Costs include overtime spent handling, counting, and managing excess inventory.

therefore

REAL INVENTORY COST is £30,000 - 30%

(* rates subject to fluctuate) 

Not all companies face the same issues, but all are surprised to find that their inventory is costing them more than they would like in ways they never anticipated. Inventory cost is not simply the unit cost of the item, but includes all of the items listed above as well.

Now that we have properly identified a company’s true cost of inventory, we can analyze how to reduce that cost. Companies typically use rough estimates to figure out their cost of inventory. As we have shown above, the standard rule of thumb is roughly 30% of inventory value on hand. More importantly, managing idle parts represents 3% of that cost. This is not to be confused with dead stock. Idle stock can be defined as products that have a strong sales history, albeit cyclical, but suddenly stop selling and remain in inventory for extended periods. The question everyone wants answered is:

“How can I reduce my inventory costs, minimise inventory levels, and at the same time be able to respond to the immediate demands of my customers?”

How to minimise inventory costs

The best way to do this is to create cooperation across all key contributors to your supply chain. More than just standard terms and conditions, you need an agreement that will minimize the lead time for stock replenishment. Limiting your stock replenishment time will result in less “emergency shipping costs” from your supplier(s), and will also limit the number of rush shipments you must make to your customers due to late deliveries.

As mentioned, your inventory cost is made up of more than just the cost of the product. Shipping cost to and from is a huge component of your overall inventory costs. Finding ways to limit the impact of this cost will help your bottom line. A Blanket Order / Kan Ban Hybrid is an ideal way to accomplish this by ensuring the agreements with your suppliers limit your lead times.

Blanket Order / Kanban Hybrid Strategy

Under this type of agreement your supplier will maintain an agreed upon finished product inventory for you. These are products that are completely packaged and ready to ship. Your supplier will also maintain semi-finished product ready to replenish the finished product inventory, thereby minimizing your future stock replenishment time. A good rule of thumb is a 2:3 ratio. This will account for any unforeseen spikes in demand.

The time needed to convert the semi-finished product inventory into finished product inventory should be no more than a week. When negotiating inventory volumes you should try and come as close to your supplier’s EOQ (Economic Order Quantity) as possible. This is the volume whereby any additional amount ordered, does not lower their costs or your price. It may not be possible to always reach this amount, but discussing it up front with your supplier will help open the door to lower pricing. Purchasing one widget at a time for ten straight days will never be as cost effective as ordering ten widgets in a single shipment.

How does this strategy help?

  • It will better control shipping costs and ultimately lower a key cost of your inventory.
  • Using both finished product and semi-finished inventory levels will strengthen your negotiating power. Volumes are a powerful tool.
  • It could actually save you the 2-3% cost of managing idle parts as your supplier will share the burden of your inventory costs.
  • It will reduce the risk of damage to your inventory, which we have shown can represent 2.5% of your inventory cost. As long as the inventory remains at your supplier, they are responsible for any damage incurred to it.
Result

Using some of the approaches mentioned in this article across your entire inventory will result in significant overall savings. Reducing your cost of inventory coupled with minimizing your product to market lead times for your clients, is a realistic goal. Identifying the areas where you can use these practices, will result in being more efficient and effective in your inventory management practices.

You may not be able to use this approach with your entire inventory, but identifying those areas in which you could, may result in significant savings.

Even if you’re not working for one of the big guys, there is a common yardstick measurement for cost savings that translates into real profit. One pound saved in cost (total cost of ownership) translates into an average of £8 in direct profit. That’s an 800% return!

Written on in Business Insights