What lies beneath? Unearthing the hidden costs of inventory

What you don’t know about your inventory can’t hurt you…..or can it?

Inventory looks harmless, even reassuring, on the surface, but buried beneath it are costs that could be killing your profitability. This is why Lean Manufacturing calls for an aggressive reduction campaign for all types of inventory, including finished goods, modules, raw materials, components, and work in progress.

Inventory, of course, isn’t all bad. In many situations, having the right inventory in the right place keeps an operation running smoothly. Lean companies, however, are able to operate with far less inventory than their counterparts, reducing their operating costs significantly. 

Some managers might not like to hear this, as it is much easier to rely on buffers and contingency stock than it is to run a leaner operation. However, if managers are honest on what inventory actually costs the company, they might be having nightmares.

Here are seven ways in which inventory kills profitability:

1. Opportunity costs: Money tied up in unnecessary assets is money that can be spent elsewhere on profitable endeavours. Lean companies reduce inventory to generate cash which is used for training, new product development, new equipment, or acquisitions.
2. Facility costs: Inventory takes up space, increasing the costs of light, heat, land use, and maintenance. Lean companies often cut their floor space requirements in half while maintaining the same output, and inventory reduction is a major contributor.
3. Obsolescence: In today’s fast-paced environment, shelf lives are short, increasing the risk of getting stuck with materials, components, or finished products that are outdated and have to be disposed of.
4. Transport: When large amounts of inventory are occupying space, it may have to be moved several times, tying up staff and equipment.
5. Clutter: Materials or works-in-progress that occupy working areas get in the way of the work, forcing operatives to make detours and sometimes even posing safety risks.
6. Searching: Large amounts of inventory make it harder to find what you need. This leads to wasted time and effort, and can cause delayed orders, un-necessary re-orders of materials, or costly mistakes.
7. Lack of transparency: The subtlest of all costs is that inventory hides variations in manufacturing processes, making it more difficult to identify and eradicate waste.

Calculate what you're spending on inventory

To get serious about inventory reduction, you need to start with the big picture, which is revealed by two widely-accepted metrics. The first is Inventory Turnover (also known as Stockturn), which is calculated using the following formula:

Inventory Turnover= Cost of Goods Sold ÷ Average Cost of Inventory

To illustrate, let’s say Company X sold £4M worth of goods in 2019, and that the average value of their inventory was £1M. The ratio tells us that the inventory turned over the equivalent of 4 times during the year. Cutting the value of that inventory in half through an inventory reduction programme – a doable task for a Lean manufacturing company - would increase the inventory turnover ratio from 4 to 8, meaning higher sales in relation to the inventory investment, and higher profits.

Another widely used ratio, Inventory Holding Period, uses similar data to show how many days, on average, inventory is held. The formula is:

Inventory Holding Period = (Cost of Inventory ÷ Cost of Goods Sold) x 365

Cutting inventory costs in half, as in the Company X example, would decrease the holding period from 91 to 46 days, reflecting less money spent on maintaining inventory, and more left over as profits.

Software can help

Of course, getting the data for these calculations can be a huge task, but the right software can alleviate much of the effort. Such tools allow inventory turnover to be automatically tracked, giving you critical day-by-day feedback on this vital aspect of your Lean campaign.

Software also helps you work with your teams to resolve the tough questions about inventory. When was this material ordered, and how long has it been here? Why is there so much work in progress between steps? Why are we stocking so many of these parts when sales for this product line have been dropping?

The right information helps teams work together to identify where inventory is needed and where it can be dispensed with. The results are a leaner operation with more money available to pursue new growth opportunities.