THE PERILS OF EXCESSIVE INVENTORY

 

 

Inventory! Accountants classify it as a current asset because it is supposed to be converted to cash within a year. It is an investment and should be treated as one.

  

Problem is, too often business owners and managers aren't aware of all costs involved with inventory. The acquisition cost is obvious enough! Ordering costs like lost quantity discounts, clerical costs, are readily seen by most managers. Also, the stock out costs of ticked-off customers that have to wait or another variety--being chewed out by a business owner are likewise within the consciousness of managers in charge of purchasing decisions. All are costs and all are very real! But perhaps overstated or excessively over-emphasized. Ordering and stock out costs have risk involved--the risk of being humiliated, losing a customer, losing out on a great quantity discount. I don't want to understate these risks!

 

However, my focus in this post, is to shed some light on the reality of carrying costs. Why? Because they carrying costs typically behave in opposition to ordering and stock out costs. And, they are in my observation and experience, typically ignored or understated.

 

Accounting textbooks include the more obvious examples of carrying costs--storage space/rent, breakage, theft, obsolescence, insurance, personal property taxes as carrying costs. Sometimes these can be significant ! 

 

Also mentioned as a carrying cost is the cost of capital of inventory.  This is where the problem begins. Cost of capital is kind of like what economists call opportunity costs--the value of the benefit that is forgone by choosing one alternative rather than another. It is less obvious, less clear to measure. Simply put, since inventory is an investment, it needs to generate a return on investment. If this cost of capital isn't measured or taken into account by managers, the temptation is to overbuy inventory. If the simple fact that inventory is an investment to maximized rather than a size to be prized is ignored, then profits will suffer.

One common measure of the effectiveness of inventory management is the inventory turnover ratio--it indicates how quickly inventory is sold. A high turnover compared to competitors, an industry average or past history is normally a good sign!

 

Because inventory is often overbought if its true investment characteristic is ignored, another problem comes up. One cost that is often not talked about or considered fully as a true carrying cost of inventory is labor. The more inventory you have, the more time is spent dusting, feeding, moving, and/or inspecting it.

In a liquor store, the labor carrying cost might be dusting bottles, moving boxes, or tidying up shelves. In a department store, the labor carrying cost could include putting away all those clothes that are tried on but aren't purchased. In a new or used car lot, the labor can entail parking cars, moving cars to different areas of the lot, gassing up cars after test drives, brooming snow off cars, or inspecting them. It is a very real cost! You might have to hire another person, have them around more hours or require high-cost staff to do low-value work.

 

So the point is, carrying costs are often not accurately measured, perhaps because they may not be as "loud" as ordering or stock out costs. But they should be, through analysis and study. They have a very real impact on your "bottom line." O'Hara Business Strategies can help you analyze your inventory to maximize your investment in it!