Savvy inventory control within a supply chain reduces total inventory costs. In our series from Monday we covered consumer demand and service, including their impact upon product life cycles and the uncertainties of demand upon inventory control. This post will complete the series by addressing cost control strategies.
Inventory Cost Control
Always available products and limited availability products inventories use select models for managing costs. We highly recommend clicking and reading more about how the Economic Order Quantity (EOQ) model determines the least cost level of inventory to carry, as well as costs. The EOQ model is key for always-available products while limited-time products use News Vendor models.
Both models offer robust, simple customization by industry and have successfully taken into account all the tradeoffs between inventory costs and components. These models are very useful and have been around for years and are great tools to use for your business.
The costing approach contains comparable inventory levels, including cost of shipping and pricing based on quantity.
- carrying costs of regular inventory and safety stock;
- ordering or setup costs; and
- stockout costs.
To offset expenses incurred by shortfalls or extra ordering, Inventory control systems work to keep the cost of carrying inventory balanced.
First, carrying cost (or a cost to hold inventory) is comprised of capital costs, service costs, storage costs, and risk costs. A carrying cost involves the opportunity cost for holding inventory. A company with little inventory costs can invest or pay off debt instead. Estimate savings of an inventory reduction and plan whether to pay debts or invest in capital based on the company’s hurdle rate or “required rate of return.” With debt-reduction, use the loan’s interest rate to value the company’s inventory. Three more aspects of carrying cost are non-capital costs.
Fixed costs tend to harbor the hidden service costs of companies. By determining insurance and tax expenses from inventory stocks, a business can ascertain the true costs of inventory, particularly for states that have an inventory tax. Check inventory space costs and weigh the risks based on product type for theft, damage or market relevance. When excess inventory is warehoused, a portion is inaccessible for production or sale.
Calculate the average inventory quantity to estimate costs. Inventory carrying cost (as a percent of product cost) plus the average inventory unit price. When using inventory reductions for capital assets, inventory carrying cost may be 30% (25% opportunity costs and 5% for risk, service, and space expense). For debt reduction, a balanced rate may be 12% (7% interest rate and 5% other costs). No matter the rate used, the higher your inventory, the greater your carrying costs will be.
Safety stock, a business’ extra inventory safety buffer, protects your company from stockouts. Costs are identical to regular units at the level held multiplied by your interest rate. How much you need depends on customer service levels, average product demand, plus lead-time.
Detailed Inventory Costs Management
If a shipment delivers in ten days and approximately 20 units sell daily, we could forecast an average of 200 units over that 10 days (lead-time). Trusting in that forecast as well as our supplier and trucking service would equate to keeping 200 units on hand for ten days; however, wisdom would dictate we build in a buffer in case of error or delays. Should fewer units sell than forecast or other variations occur, having extra inventory on hand can effectively head off delays and any consumer ire. It is key to avoid running out of units (stockout) so that this problem doesn’t occur. Inventory buffer is a crucial management technique to preserve consumer satisfaction levels. That reality raises safety stock levels even while businesses attempt to lower them. With product mixes containing more new products these days, a company really has to focus most on making cuts in their lead times to reduce safety stock.
Ordering costs are another major area to focus on. These may encompass the costs of invoice processing, units being received and stored, inbound transport or order transmission. Technology advances have decreased this cost for more industries, six times less in most cases. Manufacturers now factor in production setup most often, not ordering costs.
Lastly, if a customer doesn’t buy a substitute product – stockout costs may involve lost sales. With more inventory and improved service levels, these costs will decrease. The forecast accuracy for unit demand is key in reacting quickly to changes in demand. Buyers also affect this by their reactions to a stockout (including how frequently they happen) by whether they are willing to wait or buy substitute products.
In reality, a lot of business neglect stockout forecasting. Various departments have warring interests in this regard. Marketing may desire a very high stockout cost to force a penalty cost on running out. Operations or finance may resist this as it leads to inventory buildups.
Service level goals can differ by the value placed on stockouts and indirectly carrying costs. A high stockout valuation will result in higher inventories and higher service levels. One way to evaluate an inventory management policy is to choose a service level target. From this target, the inventory policy will determine the inventory requirements and associated costs of providing that level of service. A higher service level implies that more inventory will be held as safety stock. The tradeoff decision occurs at the point where the cost of carrying extra safety stock balances the stockout cost.
Improved Inventory Management, Costs & Customer Service
The level of units are swayed by consumer demands for good service unknown unit demand, and the flexibility of the supply chain. Units with known demand and long product lives are fairly easy to achieve favorable consumer satisfaction standards for even when reducing inventory. Those items with shorter lives, erratic demands and product proliferation, however, need flexible supply chains with big inventories to achieve the same success.
Buyers are demanding more customer service from businesses all through the supply chain process. A company with excellent service can achieve that competitive edge over others without adequate supply chain capabilities or effective management. By understanding demand with knowledge of stockout costs and how to keep and manage sufficient inventory on hand – your company can meet and exceed your customer’s demands. As technology and operations in general are a core focus for manufacturers and other companies, the importance of customer service and competitiveness will become critical for firms and supply chains.