The Real Cost of Inventory
What does dead inventory truly cost?
We talked already about traditional warehouses that serve manufacturers and wholesalers. For a long time they had been seen as buffer within the supply chain and then have evolved to vital links of distribution centres, situated closer to end customers. But whether it’s traditional warehousing or modern warehouse centres, cost of dead inventory affects most participants. It’s not rare that even among well-run businesses the actual costs of inventory are inaccurate or underestimated, even though some operators know they have dead inventory, the costs associated with it are completely underestimated and some operators have no clue of how much. Studies support that even well-run businesses have 20 – 30 % of inventory that is dead or obsolete.
1. Cost of Capital
In order to stock up operators sometimes need to borrow money and aren’t aware that it is accompanied by additional costs – cost of borrowing. Let’s just make an educated guess, operators have to pay 6 – 8 % of current interest rates for loans annually. The longer they hold dead stock, the longer they have to pay interests for stock of fast selling items but also for stock of slow-moving items – dead inventory. As consequence it affects profits tremendously. In fact, operators invest and get loans to stock up merchandise with one purpose: to make profits. All profits earned are the result of the investment in stock which is also considered as working capital or return of investment (ROI). Now imagine how 20 – 30 % of dead inventory affects the ROI. Cash tied-up in non-selling inventory is non-working capital. That is slowing down the overall business growth. Operators invest to make profits in order to re-invest in fast-moving stock that will generate even more profits.
2. Finance & Insurance
On top of the significant costs of capital tied-up in inventory, operators need to consider insurance on the inventory as a substantial additional expense. In addition to that, they might have loss from pilferage, shrinkage and obsolescence. The more inventory, the higher finance fees and insurance premiums. Imagine the affect it has on excessive or dead inventory.
3. Discounts
Dead inventory results from stocking products that were forecasted by sales or based on historical sales data. Only when the inventory is sold in the expected time frame at the expected cost, businesses make profit otherwise dead inventory must often be sold at a huge discount, sometimes even scrapped which causes additional costs but are often ignored.
4. Inventory Housing
Every warehouse operator has to pay for rent, property taxes, building maintenance, electricity and others. Of course, these costs are directly associated when business do warehousing themselves instead of using a third party. But if 20 – 30 % of inventory is slow-moving or dead inventory, additional unanticipated warehouse and storage costs cause a significant decrease in margins. Some operators separate fast-moving from dead inventory, or new product lines from slow-moving inventory. Hence, they need more space and expand or relocate the facility unnecessarily. To lease warehouse space only to stock up dead inventory is a bad investment.
5. Selling Area
Especially for retail businesses, store design and product placement play a major role and are a key for success as they are direct touch points for customers. Retailers arrange prime space to fast-selling items that attract buyers. Sometimes, retailers place slow-moving items in a prominent position in an attempt to sell it. As consequence, wrong displayed inventory causes loss of sales where retailers should actually want to take advantage of customers who purchase impulsively. To prevent misplaced items, retailers use a simple calculation of sales per square meter to make the best decision of product placement. But not every retailer uses this simple trick to get rid of slow-moving items that are misplaced. The more dead inventory they display, the more sales they lose.
6. Handling Costs
The more dead inventory operators have, the higher handling costs. Items require warehouse personnel who are paid by hour. As consequence, every single item of dead inventory costs money as staff needs to handle, count, move, or maintain stock. Even if they shift dead inventory out of selling area or from prime warehouse real estate to the back of the warehouse, it requires labour to handle it and keep products in a good condition. The longer and the more often obsolete products are held the higher the likelihood of loss due to theft, damage by accident or through improper handling or storage methods. In addition to that, warehouse operators incur equipment expenses to load and unload stock as well as transport material. Every single time a fork lift, a pallet truck or tow motors is been used cause expenses associated with maintaining this equipment.
7. Other Administrative Expenses
As already mentioned, to move inventory you need staff. Every employee receives a wage based on hours. Paying employees to fix inventory problems such as obsolete, slow-moving or dead inventory as well as management time spent on solving inventory issues affects tremendously the payroll and hence profits. To pay employees for tactical rather than strategic management issues results in losses. Technology, digitalization, IT infrastructure are developing at a fast rate, as consequence it requires the management to adapt, to develop, and to update their softskills to use the opportunities that derive from the so called industry 4.0. Hence, leveraging software which quickly identifies and prevents dead inventory is a worthwhile investment since it reduces employee costs.
8. Opportunity Cost
The opportunity cost of a resource is the value of the next-highest-valued alternative use of that resource. That means, if operators have spent money on dead inventory that is money that can’t be used to procure a fast-moving item. The more space, time and resources warehouse operators invest in slow-moving or even dead inventory, the less they can give to profit generating items. Simply said, when outdated inventory is left on shelves, operators miss the opportunity for potential sales. As consequence, the cost is the missed profit that could have been achieved.
Real Cost of Dead Inventory
When all additional costs are taken into account, holding inventory represents 25 – 30 % more than the inventory’s unit cost value. Also, tied-up cash in inventory related expenses is accompanied by an opportunity cost that is about 15 %. Hence, the first step to save money is to get an accurate and realistic measurement of inventory costs. Another important step is the increase of the cashflow and improvement of the performance. In addition to that, if warehouse operators or retailers do not update their softskills, others will do. As consequence, they have to incur a loss of marketshare by decreased competitiveness.