Inventory Carrying Costs Can Destroy Good Warehouse Operations

Inventory carrying costs have the potential to significantly impact any operation. It truly is alarming how little attention is paid to excess and obsolete inventory, both from operational & financial managerial perspectives, and how little is understood about their true impact on an operation and a company’s bottom line.

My clients usually have available space as one of their primary concerns when looking to automate or improve their operations. However, when a velocity study is run on the inventory model, a significant portion of the total product cube may be made up of excess inventory (sometimes with 1,000’s of days of products on hand) or truly obsolete products. However, all efforts to improve operations, create space, and increase inventory turns are directed towards other inventory segments, potentially overlooking some of the most overlooked (or low-lying fruit) opportunities.

Even at the C-suite levels, there can be a more dismissive mindset about this issue. ISD may be there helping to find solutions because of operational space constraints; maybe an expansion, physical move to a larger facility, or new building is being considered – but the effect of the obsolete and overstocked inventory is just a passing thought and not considered any significant part of the problem.

However, the excess and obsolete inventory can both dramatically affect the useful inventory by consuming critically needed space (creating issues for picking and replenishment), creating slotting and inventory movement headaches, and lowering the overall “inventory turns”, which is a key financial metric. In many cases, inventory is used for collateral to secure loans with a financial institution, but obsolete inventory may cause issues with compliance statutes in terms of the inventory valuation claimed.

Let The Facts Speak for Themselves About the Importance of Inventory Carrying Costs

Am I overstating the fact that many companies don’t see this as a critical issue? Interesting facts:

*In several major studies, over 60% of companies surveyed did not calculate actual inventory carrying costs; they either use rough estimates or don’t compute them at all. Furthermore, most had no systematic way of defining obsolete inventory.

So how do inventory carrying costs get calculated, and what is the financial impact? It is actually a simple percentage of the value (at cost) of the inventory. A rough standard estimate used is 25% of the cost of an item, year over year. However, that can range from as low as 18% to as high as 70% of the item cost per year, depending on industry, product, regulations, seasonality, shelf life, etc.

What Is the Inventory Carrying Cost Metric Comprised Of?

Estimates carrying cost load by percentage (normal averages):

• Cost of Money: 6-12%
• Taxes: 2-6%
• Insurance: 1-3%
• Warehouse Expenses: 2-5%
• Physical Handling: 2-5%
• Clerical/Inventory Control: 3-6%
• Obsolescence: 6-12%
• Deterioration/Theft:  3-6%

TOTAL Avg. Range: 22-55%

To illustrate the inventory carrying cost and how it’s applied, let’s look at an example of an excess inventory item and how carrying costs are applied financially:

Product XYZ costs a company $20 each. There are 50 units on hand, a $1000 inventory, and there is 1 unit sold per year. At the 1 unit sold level per year, there are roughly 49 years of inventory on hand for this item, based on actual sales.

At the 25% carrying cost of the items purchase value, it costs a company about $245 per year to stock and hold the other 49 units. The following year, those carrying costs add another $245 in costs, for $490 (and so on, year after year). In 5 years, that $1000 investment would cost roughly $1225 just to stock & hold, and any sales and margins made wouldn’t even dent the carrying cost.

For example, if 2 units of those units are sold in 2 years at a 20% margin, the item would have generated $10 in gross profit total (far less in net profit), making the net impact a loss of $480 in two years. Add this up over 1000’s of items, it could add up to hundreds of thousands of dollars, even millions of dollars in carrying costs, and the financial and operational impacts would be enormous. Thinking that sitting on excess and obsolete inventory, waiting for sales so as not to “lose” the value of the items purchased, is fool’s gold, as in this scenario, the best case is to limit the impending losses. Fire sale it, offer it as a freebie with other items, donate it, scrap it for whatever value you can get, or throw it out. But waiting for something to happen is NOT a viable plan, it is a financial drain.

Here’s another way to look at the problem, or if you just don’t believe in the inventory carrying cost percentage metric. If a company is expanding a building, adding an expansion, using outside storage, adding more racks, adding mezzanines, etc., due to a lack of available storage space, it may be in large part due to the excess and obsolete inventory.

The Physical Storage Requirements of Excess Obsolete Products Are Real

Even if you don’t use the value of the inventory carrying costs, it’s easy to understand that if a company is building more storage capacity and there are significant amounts of this type of inventory, it is in at least partially due to storage of the excess and obsolete inventory. In other words, there are even more wasted dollars being wrapped around these products.

How do you tackle this potentially massive issue when there are practical limits to taking “writedowns” on inventory that affect net profit (especially in publicly traded companies)? First is to understand the problem and the true financial impact – really define the depth and cost of your excess / obsolete inventory. Then develop a process to start to deal with those products. Start with the largest cube items first. Take the maximum amount of writedown the C-suite will authorize EVERY YEAR. Work with sales and purchasing to understand what the root causes of the excess and obsolete inventories are.

If you want to understand more about your inventory and operations or get help with detailed modeling and system design (including a true understanding your inventory model), please contact me @ bjones@isddd.com for a free consultation or see our eBook “Automating Your Warehouse” https://www.isddd.com/insights/#guides