Quite often, even among well-run businesses, the actual costs of inventory are inaccurate, underestimated and incomplete. While most resellers know they have dead inventory, many are unaware of just how much. Our experience, supported by other studies, shows that in even well-run companies, anywhere from 20-30 percent of inventory is dead or obsolete.
While that is huge and alone could have devastating ramifications for a business, how does one calculate the real costs to determine the hit that your business is facing? The easy answer is to take the unit cost for those dead items, add them up and you have your answer. But not so fast. There are many other hidden costs to consider before determining the true cost of your dead inventory. Ignorance about these costs of dead inventory place your business in peril. And addressing the dead inventory problem can breathe life back into a troubled situation. So what are some of the other very real costs that complete a more accurate calculation of dead inventory costs?
Cost of capital/money
To sustain an adequate inventory level, businesses sometimes must borrow money. Be sure to consider the cost of borrowing as an additional cost. Current interest rates for loans are 6.25-7.25 percent. And the longer one holds dead stock, the longer one is paying interest for the ability to have bought this stock. And remember this fact: Capital tied-down in dead inventory causes your business to lose profits.
You have invested money into merchandise inventory with one purpose; to earn profits. All profits earned as a result of this investment of capital is known as working capital or a return on investment. Cash tied-up in non-selling inventory is what we call non-working capital! Your investment should be working to bring profits which can be re-invested to buy fast-moving stock that will generate even more profits.
Finance and insurance
In addition to the significant financial and opportunity costs of capital tied-up in inventory, insurance on the inventory is a substantial additional expense. Also, typically, there’s loss to be considered from pilferage, shrinkage and obsolescence. In resell businesses, carrying excessive inventory may lead to higher finance fees and insurance premiums. Companies often buy goods on account from suppliers.
The longer you hold dead stock without liquidating it or clearing it out for new stuff, the more interest you accrue on the debt obligation. Resellers also commonly pay insurance premiums based on the value of inventory held in stores. If you store excess inventory, your premiums may increase.
Dead inventory is often a result of stocking products that were either forecasted by sales or based on historical sales data. When sold in the expected time frame and at the expected cost, they generate profit. But when these items become dead or obsolete, they must often be sold at a huge discount or even scrapped. This is a cost that is often hidden or completely ignored.
Normal warehouse costs include all costs related to rent, property taxes, building maintenance, electricity and other general utilities. These costs are expected as part of doing business, but when dead inventory is involved there are additional unanticipated warehouse and storage costs. If 20-30 percent of your warehouse space is storing dead or slow-moving inventory, you might need to rent additional space to have room for the faster-moving and cash producing items. Lack of available space for new product lines, new machinery, or expanded office space may cause a company to expand or relocate its facility unnecessarily. Buying or leasing warehouse space only to fill it with dead inventory is a waste of money.
Store design and product placement is a key for retail business. There is a science involved in giving prime space to those items that attract buyers. Retailers try to create an environment that attracts customers, entices them to spend time in the store, and encourage them to purchase impulsively while they are there. Sometimes, businesses place slow moving inventory in a prominent position in an attempt to sell it. But the wrong inventory displayed in the selling area causes your business to lose sales.
In a selling area, every square foot of space must be utilized to generate sales. While it may be a way to get rid of some slow-moving stock, the cost is the discounted price of the sale AND the loss of the space for those items sold at full price. The more dead inventory you display, the more sales you lose. Dead inventory displayed in a selling area should be pulled out and replaced with fast-moving items.
The more dead inventory you have, the higher the handling costs. Warehouse personnel are paid by the hour so every minute spent handling, counting, moving, maintaining or ultimately discarding stock adds to the cost. Shifting dead inventory out of a selling area or from prime warehouse real estate to the “back” of the warehouse will cost money in terms of labor needed to handle and also to keep product in a good and “saleable” condition.
The longer the inventory is held and the more it is moved around, the higher the likelihood of loss due to theft, damage by accident or through improper or poor handling or storage methods. Warehouses incur equipment expenses to load and unload stock as well as transport materials. Typically, fork lifts, pallet trucks, tow motors and ladders are needed as well as racks and shelves for storage and even pallets and skids for larger parts. And there are expenses associated with maintaining all of this equipment.
Other administrative expenses
Paying employees to “fix” the inventory problems, as well as management time spent on solving inventory issues, is very costly. Employees paid for tactical, rather than strategic, management issues is wasteful. Hopefully, your staff is making up for this by optimizing systems and procedures, such as leveraging multi location activity to reduce cost of inventory.
Utilizing software which can quickly identify and/or prevent dead inventory from sitting on your shelves is a worthwhile investment since it reduces these employee costs. Employees who work with your inventory should focus on negotiating competitive pricing from vendors to reduce the unit costs and insure the right products are on hand to reduce the expense of expedited shipping costs. The time consuming and tedious work of identifying and removing obsolete inventory is a drain on the business.
Opportunity Cost is a term often discussed in economics. The “opportunity cost” of a resource is the value of the next-highest-valued alternative use of that resource. As an example, if you spend time and money going to a movie, you cannot spend that time at home reading a good book, and you cannot spend the money on something important like chocolate! Related to dead inventory, when you’ve spent money on a “dead inventory” item, that is money that can’t be used to procure an item that will sell and gain profit. Consider, if you pull from your shelves 100 units of a product with a $50 cost, you theoretically lose $5,000 in revenue. But what if the anticipated profit margin was 30 percent or 40 percent or 50 percent? You’ve lost the opportunity to earn that profit.
In some cases, companies can return to a manufacturer incurring a restocking fee, or sell to an off-price reseller to collect some revenue. However, this typically won’t cover the unit cost alone for the item, not to mention the full sales price with the anticipated profit margin, Certain items like perishables, or other items are scrapped completely and thrown out without recouping any money at all. When outdated inventory is left on shelves for too long, you also miss opportunities for potential sales and profit on newer goods. So the cost is the missed profit that could have been achieved if another faster selling item had been chosen. That’s why it is important to keep inventory turning over, and why not carrying excessive dead inventory is crucial.
So, what is the real cost of dead inventory?
When all additional costs are taken into account, the total cost of holding inventory can represent a shocking 25-30 percent more than the inventory’s unit cost value. In addition, having your cash tied-up in inventory-related expenses has an opportunity cost, which can translate to as much as 15 percent or more. Getting an accurate, realistic measurement of what inventory truly costs is a smart first step to saving money, increasing cash-flow, improving performance (inventory turns and customer service) and increasing your competitiveness.
The more inventory a company carries, the higher the ongoing costs will be, which is reason enough not to carry dead, outdated, or obsolete, inventory. A company that can reduce their inventory costs through operational efficiency will see tremendous benefit.
Eric Jensen is account executive at Cutwater Solutions, an inventory management software solutions provider.