The real cost of inventory

When asking a financial director what he thinks the cost of inventory is, he will undoubtedly give an answer like the Return on Capital Employed (ROCE) or the Weighted Average Cost of Capital (WACC). When asking a logistician the same question, his answer will be the sum of interest, storage space and risk. Unfortunately both are in the wrong, and not just by a little.

Both the financial director and the logistician underestimate the real cost of inventory. Of course inventory ties up working capital. Dependent on the cash flow and/or the required level of returns, these costs can be significant. Surely you will also have to store the goods. Sometimes the available storage space will suffice and sometimes it will not. Finally it is self-explanatory that keeping inventories causes risks; selling superfluous stocks may appear to be difficult or even impossible.

An issue that neither the financial director nor the average logistician seem to worry about is the lead time that inventory represents. A chain that is holding a lot of inventory happens to be a long chain. Reason is that inventory level divided by sales volume equals lead time. And this is a problem, since a long chain happens to have a number of fundamental disadvantages.

Firstly, a long chain is not responsive, meaning that it is slow to react to quality issues and product developments, to name but a few examples. Neither can it react quickly to fluctuations in demand levels. At least as disadvantageous is the fact that the length of the chain functions as a catalyst to the bullwhip effect. Reason is that the bullwhip effect is a direct consequence of variability and lead time. You may compare this to a real whip: the longer it is, the bigger the movements at the tip. Slow and highly variable, so a double and negative impact! It is almost unavoidable to get into a vicious circle. Forecasting variable demand is difficult enough in itself and when combining this with a highly inert chain that also amplifies the variability, there seems to be only one way out: put in even more inventory!

In summary, it is a gross underestimation to say that the cost of inventory is equal to ROCE, WACC or the sum of interest, storage cost and risk. We still calculate en masse with inventory costs in the range of 10 to 25%. It seems reasonable however to work with double these numbers or even higher. An even better option is to stop taking the inventory cost as a starting point, but to use the advantages of short lead times and therefore low inventories.

Imagine a situation where, thanks to short lead times, you are able to respond to changes much faster, make more accurate forecasts, deliver better quality, realise a much shorter time to market, etcetera, etcetera. I.e., imagine that thanks to short lead times, you are able to leave your competitors struggling in your wake. Not having short lead times therefore represents the real cost of inventory. Who is still talking about ROCE, WACC and the likes?

Alex Tjalsma, partner/consultant Involvation