I don’t think the method for calculating inventory benefits has changed significantly since the 1990’s, but there is still a need to review this issue periodically for the new generation of business professionals. It is still not uncommon to see inventory reductions proclaimed as “savings” without really understanding where these savings are coming from. The implication is that inventory savings flow directly to the bottom line, and this is not the case. This topic is a quick review of how to go about understanding and reporting inventory reduction benefits.
First, understand that inventory is not the same as cost or expense. Sure, physical products require material, but this is not what we’re discussing here. The material cost portion of your product cost doesn’t change unless you redesign the product or to pay more or less for the materials. Reducing the inventory levels in your warehouse does nothing to change the material cost of your product. Inventory instead of being a cost is an “asset”, although it is the kind of asset that doesn’t do us much good until we sell the product. This asset shows up on your Balance Sheet and not on your Profit and Loss Statement.
When you reduce inventories by consuming inventory that you have and not needing to replace it, what you have done is increased cash to keep things in balance on the Balance Sheet. You now have more cash and less physical inventory. That is a very good thing because cash is your most flexible asset. You can do all kinds of things with cash, whereas with physical parts you’re much more limited.
One of the primary reasons that companies struggle or go out of business is not from lack of customers or lack of good products, but simply because they run out of cash. The cash needed to finance inventories (and everything else) is called Working Capital, and a lack of Working Capital is a major contributor to company failures. Converting inventory to cash is a very good thing, but don’t confuse that with profit and loss results. At least not yet.
But is there, you might ask, a relationship between inventories and actual out of pocket costs? The answer is yes. Having physical inventories does drive actual costs. For example the material needs to be stored somewhere in a building that you need to pay for. You’ll need to hire people to move it, to receive it, to cycle count it, to dispose of it, to transact it. If your material hangs around too long it runs the risk of becoming obsolete, damaged, or simply lost. If you needed to borrow money to finance the inventories you have an additional interest expense to add to your list of direct costs.
Estimating all of the direct out of pocket costs related to having inventories is what we call the Cost of Carrying Inventory. This is often expressed as an annual percentage of the inventory value. For example if your company has established 10% as an annual Cost of Carrying Inventory percentage, and you have one million dollars in inventory, then an estimate of your annual out of pocket expense in maintaining that inventories is $100,000.
You won’t find this number on your Profit and Loss Statement because it represents expenses included in a variety of different accounts. Instead it is used as a management tool to estimate the relative benefits of inventory reduction and for budgeting purposes. It represents a policy decision. By setting the Cost of Carrying Inventory percentage high the company places a higher value on the benefits of inventory reduction. On the other hand if your Cost of Carrying Inventory percentage is low it reflects a lesser priority given to inventory reduction.
In summary, if you wish to calculate the benefits of the inventory reduction there are two values you need to consider. One is the actual inventory reduction itself and the benefit is an increase in cash and a reduction in working capital requirements. The other benefit is an estimate of the direct costs by applying an approved Cost of Carrying Inventory percentage to the inventory savings. The combination of these two benefits will give you a complete picture of the potential savings related to an inventory reduction effort.