Are the Benefits From Inventory Savings Real?

Last month I wrote about the cost of delaying action when improvement opportunities are identified.

My point was that many people only consider the accrual of benefits AFTER they have taken action and not the opportunity cost of not taking or delaying action (e.g. if I can be $100 better off by doing X then it is effectively costing me $100 if I don’t do X). And by the way, if you delay action you can never catch up!

This item resulted in quite a bit of feedback so I thought that this month I would close the loop on that discussion by sharing the feedback and comments with everyone.

Essentially the comments I received come down to one concern: Are the benefits from inventory savings real? Here is a summarized version of my responses.

It is right to be cautious about the generic measures we use for estimating the value of holding inventory and we should take the generic values used for both the costs and savings as indicative.

That is, the value and opportunity will be different for different companies and circumstance, so we need to consider the specifics.

The following are some issues to consider when identifying the specifics for your situation.

1. The cost of money.
   The financial term is the Weighted Average Cost of Capital (or WACC – pronounced ‘wack’). This value takes into account the various funding sources for a company, such as loans, shareholder funds, bonds etc.

   It is often compared to (and even guided by) the opportunity costs of investing the funds elsewhere. In an economic sense these costs are real.

   As a result the value is usually much higher than the prime interest rate most people think about (usually equating the cost of money to the cost of their mortgage). Maybe your CFO could tell you what your company’s WACC is, as each situation is specific.

 

2. Fixed costs.
   It is correct to say that if you don’t eliminate fixed costs you don’t save anything in that area, you just spread the cost across a smaller number of items.

   However, we can be very effective in reducing these costs.

   For example, I have clients who have eliminated external warehousing, put off building new warehousing, been able to ‘repurpose’ space to save other costs (e.g. turn spares warehousing into general warehousing and so eliminate costs in general warehousing), been able to reduce the space they use and so reduce heating/cooling costs, repurposed forklifts and so on.

   Again each situation is specific but make no mistake, these savings are real.

 

3. Variable costs.
   One cost that many companies incur is the cost of conducting stocktakes.

   By reducing the volume of items to count you can reduce this cost. If the labor used is internal this might save overtime or you can redirect the staff to achieve other things and save costs elsewhere.

   If you bring in labor for the stock take there is a direct saving. Improved spare parts and warehouse management can also save money by reducing the time technical staff spend looking for spares. Again each situation is specific.

 

4. The ‘obsolescence time bomb’.
   I talk to companies about this ‘time bomb’ in their inventory because the stock they now carry may not show up as slow moving today (depending upon how they measure this) but still may result in significant obsolescence and write downs in the future.

   Most people see obsolescence as a ‘future and past’ issue. That is, it happens in the future based on actions in the past.

   But it really is a ‘today’ issue because today’s decisions direct our future results.

   By addressing the holding levels today many companies can minimize the impact of future obsolescence.

   This is a real saving in the cash spent today. For example, we sometimes buy large quantities of items believing that the purchase provides the lowest purchase cost. However, if we do not use the items, we do not get the advantage of the ‘economic purchase’ and so money has gone out the window.

   The ‘time bomb’ goes off when we finally realize (or admit) that something is now obsolete because we no longer need it.

 

One of my favorite quotes is from Albert Einstein who once said ‘The important thing is to not stop questioning’ and I encourage everyone to keep asking questions.
 
 
 

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