Setting the Right Inventory Carry Cost Percentage

Executive Summary

  • Inventory carry cost is a controversial topic because of the assumptions.
  • We cover how to properly set the inventory carry cost.

Introduction

Inventory carry cost is necessary for the supply chain as it allows a company to determine its costs of keeping inventory. It is also a key input into the economic order quantity, which in its base formulation (there are many EOQ formulas) trades off the cost of carrying inventory versus the cost of ordering inventory. EOQ sounds like a very straightforward formula until you ask companies to estimate their inventory carry cost and order cost.

Inventory Carrying Cost Inputs

You generally cannot simply go to the finance department in a company as they tend to know the cost of money, or the capital cost of the company, but not the other costs associated with inventory carry cost. This is a combined cost which accounts for:

  1. The cost of capital
  2. The cost of the storage facility for the product
  3. The cost of the product becoming obsolete or going bad (say as in in the case of perishables)
  4. The cost of the product being damaged while being stored

Experience in Estimating Inventory Carry Cost

I have asked about this value for many clients to perform modeling and create EOQ driven ordering quantities and frequencies. They almost always tell me that they don’t have a good number. They then ask me if I know of one.

George Plossl does a good job of explaining the arbitrary nature of such estimations in the book.”

Production and Inventory Control.” I have a quote from the book below:

“Inventory Carrying Cost: The inventory carrying cost is a useful concept (albeit an artificial one) required by the mathematical formulas used in lot-sizing calculations. As listed earlier, many separate elements are assumed to make up this cost. Obsolescence is a reality in any inventory but this cost element in the inventory carrying cost varies widely with time and is not the same for different items in an inventory (that is, it is highest for style items). This would indicate that a different carrying cost might be used for each item in the stock list. This is obviously impractical and an average figure is usually chosen, either for all products or for each major type of product. Identical reasoning applies to deterioration costs. The whole discussion is purely academic. The inventory carrying cost has practical use only as a management policy variable which, rather than being a fixed. magic number, is one that should be manipulated to attain the overall objectives of the company. “ George Plossl

Estimating Inventory Carrying Cost

Inventory carrying cost is an estimation of the percentage of the product cost that in consumed in holding the product for one year. It is often used in inventory formulas as well as cost optimization. In many popular articles that cover the subject superficially, it is often stated that a good inventory carrying cost is between 20 to 25%.

I could spend lots of time estimating this for each company, as pointed out by George Plossl, the value would always be an average. And will be too high for some products and too high for others. The major item I look for is how perishable the company’s product is. If it is more towards the perishable end of the spectrum, I increase the inventory carry cost; If it is not, I decrease the inventory carry cost.

How Best to Perform Inventory Valuation

In this article, we will cover the cost of inventory. The cost of stock is critical to both how inventory is managed as well as the final determination of the profits of a company. And the calculation method of the cost of inventory must be set up within the inventory management and financial system or systems of the entity.

There are many methods of determining the cost of inventory that relates to the inventory accounting, inventory valuation, etc.

The Types of Inventory Cost

The types of inventory cost are related to things like the purchasing cost of the inventory. However, other types of inventory cost are absorbed into things like facility costs. This is included in the carrying cost formula that is used by many companies to estimate the cost of holding inventory for a year or a month.

Other types of inventory cost include obsolescence and breakage. The types of inventory cost are quite numerous and impact a balance sheet in a multitude of ways.

Inventory Cost, Inventory Price, Inventory Valuation Methods and the Valuation of Inventory

Inventory will almost always have an inventory cost and sometimes and inventory price if the inventory is a finished good. That is an inventory price is only necessary for inventory that is sold. And the margin is determined by subtracting the inventory cost from the inventory price when the same items are purchased and sold. But this becomes more complex when a material is converted into a finished good and then sold. In that case, the combined costs of goods sold that went into the finished good must be estimated. This means subtracting the inventory cost of various materials from the final inventory price of the finished good.

This means using inventory valuation methods that allow an entity to determine the valuation of inventory. Inventory valuation methods are constrained by the tax laws of the particular country, but typically there are some standard inventory valuation methods to choose from in almost every country.

An inventory cost or inventory valuation is necessary for all of the inventory that a company maintains.

Inventory Accounting with the LIFO Method or Last In First Out Method, FIFO Method or First In First Out Method

An entity will normally choose an inventory accounting method and then configure their system to operate that way. One of the complexities is that costs change over time. Therefore, raw material “A” may cost $20 on Jan 20th, but cost $25 on Feb 25th.

  • If the raw material is issued on Feb 26th, then what is the correct cost of the raw material? When inventory is recorded in a location, it is not serialized (in most cases). Therefore the inventory at a location virtually “blends.”
  • This makes the assignment of a cost to the material difficult as 1/2 of the inventory may have been purchased at the cost of $20, and the other half at the cost of $25.

Two of the most common inventory accounting valuation methods are LIFO Method or Last In First Out Method, FIFO Method or First In First Out Method.

  • The LIFO Method or Last In First Out Method: This method values the inventory at the cost which goes to the last item cost received. So in the example above the $25 per unit cost would be used.
  • The FIFO Method or First In First Out Method: This method values the inventory at the cost which goes to the first item cost received. So in the example above the $20 per unit cost would be used.

Inventory Accounting with the Weighed Average Method, Average Cost Method

Another inventory accounting method is to now use a specific price, but rather the weighted average method or average cost method.

  • Weighted Average Method or Average Cost Method: This method values the inventory at the cost which is an average of the cost received. So in the example above the ($25 + $20),/2 or $22.5 would be the cost used.

Overall the weighted average method or average cost method has the advantage of being far less complex than the LIFO method or the FIFO method.

The Concept of Average Inventory Value

Average inventory value means taking an average of the inventory holding position and then applying a particular value (as determined as explained above). Average inventory value is used to improve the value determined in the system. The article up to this point has focused on the average inventory value for a specific product or product location combination. However, average inventory value also applies to the overall product database. The average inventory value for the overall product database is then typically tracked by companies and compared to a maximum stock level that the company wants to hold.

Cost of Goods Sold

Apparently, these various inventory accounting methods are used to determine the cost of goods sold. The costs of goods sold in total combined with the administrative and overhead will serve as the cost basis for the company.

Inventory Value

While the inventory value is the average cost of the materials time the number of materials, the term inventory value can mean several things. Any one item can have an inventory value. Or the overall system or network-wide inventory can have an inventory value, or the inventory value can be just of the materials kept at a particular distribution center.

Most companies try to cap the overall inventory value at a specific number. Such as no more than $100 million in inventory.

Conclusion

One of the current (2016) issues with using a value between 20 and 25% is that they have tended to be created when interest rates and inflation (which is built into interest rates) was higher. Therefore, those companies that use the higher figure would tend to overestimate inventory carry cost. One of the perplexing things about using quantified values for both order cost and inventory carry cost is that the order quantities become much higher than is “politically acceptable” within companies.

This is one reason that companies often ignore quantification of order quantities and determine the order quantity using judgment methods.

Inventory valuation works behind the scenes in inventory but drives many decisions. At this point, most ERP systems have strong capabilities for the valuation of inventory. Once the ERP system is configured properly, the valuation of inventory is automatic. Most ERP systems can show inventory valuation at any point in time.

Another important factor related to inventory valuation is sales and operations planning. This is where the company projects supply and demand, and the impact on the overall inventory valuation of the planned inventory to be carried.

See our EOQ calculator at this link.

Also, learn about the limitations of EOQ at this link.

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References

Production and Inventory Control: Techniques and Principles 2nd Edition,” George Plossl, Prentice Hall, 1985

Lean and Reorder Point Planning Book


Lean and Reorder Point 2

Lean and Reorder Point Planning: Implementing the Approach the Right Way in Software

A Lost Art of Reorder Point Setting?

Setting reorder points is a bit of a lost art as company after company over-rely upon advanced supply planning methods to create the supply plan. Proponents of Lean are often in companies trying to get a movement to Lean. However, how does one implement Lean in software?

Implementing Lean in Software

All supply planning applications have “Lean” controls built within them. And there are in fact some situations where reorder points will provide a superior output. With supply planning, even within a single company, it is not one size fits all. The trick is understanding when to deploy each of the approaches available in software that companies already own.

Are Reorder Points Too Simple?

Reorder points are often considered to be simplistic, but under the exact circumstances, they work quite well.

There are simply a great number of misunderstandings regarding reorder points – misunderstandings that this book helps clear up.

Rather than “picking a side,” this book shows the advantages and disadvantages of each.

  • Understand the Lean Versus the MRP debate.
  • How Lean relates to reordering points.
  • Understand when to use reorder points.
  • When to use reorder points versus MRP.
  • The relationship between forecastability and reorder points.
  • How to mix Lean/re-order points and MRP to more efficiently perform supply planning.

Chapters

  • Chapter 1: Introduction
  • Chapter 2: The Lean versus MRP Debate.
  • Chapter 3: Where Supply Planning Fits Within The Supply Plan
  • Chapter 4: Reorder Point Planning
  • Chapter 5: Lean Planning.
  • Chapter 6: Where Lean and Reorder Points are Applicable
  • Chapter 7: Determining When to use Lean Versus MRP
  • Chapter 8: Mixing Lean and Reorder Points with MRP-Type Planning

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