Inventory is something that all companies need. The difficult question to answer is 'How much do they need?'

In manufacturing companies, although there are a few exceptions, material is usually between 60 - 85% of cost of sales, depending upon the industry. In electronics, it would be about be about 85%, with overheads about 12%, and direct labour 3%. These percentages indicate where management attention should be directed!

As inventory is by far the single greatest cost, we need to examine the four causes that contribute to that cost.

THE ORDER PROCESSING/SET-UP COST

Many people are not aware of the real cost of placing and processing a purchase order. The total cost should include the cost of purchasing, goods receiving, incoming inspection and accounts payable. Each of these departments only exist because we need material. If you divide the total budget for these four departments by the number of orders placed during a year, it will give an average cost per order. Some divide by the number of receipts to give the average cost of a receipt, as 3 out of the four costs are related to a receipt. The average cost of a receipt for companies using the traditional receiving process is usually between $40.00 and $80.00, depending upon the process used.

For manufactured items the equivalent cost is known as set-up. This includes all the costs that are not related to the order quantity, viz preparing the order paperwork, processing and tracking the order operations, the cost of setting up the machine, and first off inspection.

This total ordering/processing cost has to be carried by the quantity of items resulting from the process.

INVENTORY CARRYING COST

Costs result from the fact that the item is in stock. These are real costs which must be accounted for. The total cost is made up of several elements.

• Cost of capital

• Insurance

• Pilferage and spoilage

• Obsolescence and deterioration

• Storage and handling

The total cost to the company is 35% per annum of the value of inventory held, or 3% a month.

STOCK-OUT/BACK ORDER COST

Because a company cannot afford to keep sufficient stock to meet every demand, stock-outs must occur. Stock-outs result in either a lost sale, or the customer is prepared to wait, so his order goes on back order.

A lost sale results in the business going to the competition. Back ordering a demand causes additional costs, viz extra paperwork, the time spent handling this extra paperwork, a system to handle the back orders, extra delivery notes, and invoices, extra packing and delivery costs. In many cases, the average cost of processing an individual order line item that has been back ordered can be as much as $20 to $30. Often more costly than the sale value of the item back ordered.

EXCESS AND OBSOLETE STOCK

Excess inventory is the quantity of material in stock or on order that is greater than the anticipated demand for an agreed time period.

Obsolete inventory is that for which there is no anticipated demand. This inventory typically occurs due to model run outs, engineering change notes, or suppliers minimum/multiple order quantities. Companies tend to be reluctant to write off this value as it is a loss in the books of accounting, and so affects the profit.

SUMMARY

In simple terms, it tells us that inventory is our biggest cost and the more we have, the higher our cost. To keep our costs down we should have only what is needed, when it is needed. This is why many companies appoint a Materials Management Specialist to control the company's inventory.
 
 

September 1999