Quantifying the cost of Inventory

# Thread: Quantifying the cost of Inventory

1. ## Quantifying the cost of Inventory

I did some googling and reading on this topic, and while many websites talk about the cost of inventory, I did not find any that really apply to a smaller business and specifically how to put numbers to the cost of inventory.

Recently I have been reading alot about Lean practices. Not that I intend to implement MOST, but some are just good common sense, and some are improvements. I absolutely hated Lean, 5S, and Kaizen when working Tier 1 Automotive, not because it was wrong/incorrect, but because it was taken to the absurd extreme. Throwing away fixtures and tooling that we had not used in 6 months, only to remake and reorder in 3 months because we needed them again.

To boil it down, I am trying to quantify the cost and method to decide how much inventory to run.

Example being, I make a product, most costs are relative to the quantity run, some are essentially fixed. 4 hrs setup, soft jaws, etc are the same whether I run 1 piece or 100. For the example, say I can make 30 pcs from a 12ft bar. Tooling lasts for 60 pcs.

Pulling a number from an old job, if I run 30 pcs the cost is \$87ea, 60pcs is \$62, 120pcs is \$55.

I can compare the upfront costs, based on tooling, production time, etc. I can make a spread sheet to compare the prices if I setup the 30 pcs 4 times (\$64ea) vs the 120 pcs once (\$55ea). Running 60 pcs twice gives me \$58 ea.

If I sold 15 pieces so far this year, using that as a number, say it takes 2 years to sell the 60pcs, 4 years to sell the 120 pcs.

How do I come up with numbers to decide the cheaper price of \$55 ea is a better choice to run and have \$6600 in inventory(at cost) on the shelf for 4 years, vs running it twice at \$58ea? Or maybe running it twice at \$58 ea is the better choice?

Or maybe I should stop wasting your time and schedule an appointment with my accountant

2. I would say (WAG) if the scenario you presented is in any way realistic (2 years to sell 60pcs), it doesn't make sense to inventory much of anything except maybe the remnants of whatever stock you've cut. IE you have an order for 20 pcs, may as well run the full bar and stock the extra 10. Actual costs would depend on varying factors IMO. Are you busy and need to move to the next job pronto? Is the machine going to sit idle while you program a new job? Are you relatively sure you can sell stocked items? Could you re-program/rethink your 'hot' sellers to run more efficiently, thus eliminating a potential need for stock?

Sorry I know there are no answers here, but maybe some food for thought.

3. Diamond
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Originally Posted by Fal Grunt
Or maybe I should stop wasting your time and schedule an appointment with my accountant
Accountants may or may not know this stuff, its more finance than accounting (yes the two are quite different). The normal metric missing from your view is to look at cost of capital. The first idea to wrap your head around is all capital has a cost - even pure equity. It expects to make say 10-30% a year (not just cash, but dividend + retained earnings). What? you don't expect that....you should else the money would be better somewhere else. Then you think in terms of WACC (weighted average cost of capital). Suppose your balance sheet was half debt and half equity and debt cost 5% of you expect 15% ROE (return on equity). Your WACC then is 10%.......so if you have \$6000 sitting there for a year, the cost of that is \$600. Factor that into the cost and see what you get.

Its a misguided thing that so many business people strive for lower inventory without taking a broader view. Many are only looking at (or rewarded on) stock turns and reducing working capital. But if a \$5 cost of inventory produces a \$10 contribution, bloody well have the inventory!

4. Titanium
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Originally Posted by Fal Grunt
...Example being, I make a product, most costs are relative to the quantity run, some are essentially fixed. 4 hrs setup, soft jaws, etc are the same whether I run 1 piece or 100. For the example, say I can make 30 pcs from a 12ft bar. Tooling lasts for 60 pcs.

Pulling a number from an old job, if I run 30 pcs the cost is \$87ea, 60pcs is \$62, 120pcs is \$55.

I can compare the upfront costs, based on tooling, production time, etc. I can make a spread sheet to compare the prices if I setup the 30 pcs 4 times (\$64ea) vs the 120 pcs once (\$55ea). Running 60 pcs twice gives me \$58 ea.

If I sold 15 pieces so far this year, using that as a number, say it takes 2 years to sell the 60pcs, 4 years to sell the 120 pcs.
I figured 7% was my carrying cost- how much I lost in value if I held for one year. Interest rates were higher then, but that's not a big part of the inventory costs relative to labor or materials.

I managed my inventory for 4 turns/year. If I sell 30 pcs/year, my inventory needs to be 8 pcs. So I would never run a 15 or 30 piece run unless it was so dirt cheap that the setup cost completely swamped the other costs. I would typically schedule a production run when my inventory dropped to the one month mark.

You can put some common sense in here- if there is a busy/slow season you adjust levels accordingly. Nothing is set in stone- the idea is to have enough inventory to service the demand and no more, since that's just tying up capital unnecessarily.

5. Aluminum
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Mcgyver is on the right track here. The question isn't really whether your saved labor time is making you money, but whether that tied up cash in inventory is making you less money than if you spent it elsewhere.

6. Diamond
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Originally Posted by Fal Grunt
Or maybe I should stop wasting your time and schedule an appointment with my accountant
Better yet... learn the basics of their terms and their math. It's the easiest part. MOST of their work ends up being about staying current on and compliant with laws, rules, and filing requirements - taxes, mostly, but not only.

The "math" is not as hard, even where there is more than one supported way of apply it.

Simplest form is that inventory has more than one type of cost:

- storage, security, quality-preservation costs. Think fish, wine, hard metal goods - all different.

- cost of money is much the same.

Taken in a simplistic form:

- if I have \$10,000 tied-up in inventory that won't move for 12 months, and has a "share of" my building's storage & security cost of - say \$100 for the year (which may be LOW..)

- and one of my OTHER choices was to hold \$10,000 worth of "EQM" stock - currently paying over 10% in dividends...

You might guess i am not going to be holding inventory?

Another way to goal is "turns". The more times you turn-over inventory in a given year, the less it costs and the faster you recover those costs.

As said, it isn't the math that's hard. It's making and implementing the choices.

You should buy some used collitch course textbooks, perhaps?

BTW: There's "inventory". And there's also "WIP". Work In Process.

Fifty years ago, the example actually used in a first-year textbook was Boeing. At the time, it took 18 months from the time the first materials were bought for an aircraft and it being built and ready to sell. Bean-counting industry had to adapt to that.

Don't leave out the Management ones [1]. Always harder to make a(ny) choice actually "happen" than it is to pick one.

[1] If you can only have ONE? Peter Drucker. "The Effective Executive".

7. Titanium
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Originally Posted by Pariel
Mcgyver is on the right track here. The question isn't really whether your saved labor time is making you money, but whether that tied up cash in inventory is making you less money than if you spent it elsewhere.
Very true but the hidden assumption is that you are actually able to spend the money tied up elsewhere for a useful in real \$ (or, for me £) not percentage terms. Seem to recall some supermodel type female saying she wouldn't get out of bed for less that \$10,000. Probably an exaggeration but it illustrates the point. If futzing around is only gonna make you a couple of hundred a year extra you've already spent more than than its worth thinking about doing anything other that the easy thing i.e. as Mike says "run the whole bar".

Looks to me as if you have some quality spreadsheet and headache pill time in your future getting good handle on all the costs in your business and where the potential for useful gains exist. Motorcycle racer Bob McIntyre, the first man to achieve a 100 mph lap of the Isle of Man TT course, said that he gained far more by putting more effort into the fast parts of the circuit than in the slow ones. You need to take the same sort of view. Its awfully easy to end up in something similar to the "Parkinson's Bicycle Shed" situation where the board of directors of Mighty Big Industries Inc put 2 million of investment in new machines through on the nod because they don't understand what they were voting on then spent the rest of the day debating a bicycle shed worth about 10 minutes of meeting time because it was something they thought they understood.

You can do that sort of thing to yourself by obsessing on the wrong details.

Been in that sort of meeting a few times myself. And done the obsess on the wrong details thing too.

Clive
Last edited by Clive603; 07-01-2019 at 06:54 PM.

8. Diamond
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having stuff in storage is like a garage costing \$30,000 and paying 4% property taxes and 4% utilities and maintenance fees so \$2400/year in costs (assuming no mortgage if got mortgage than maybe \$3600/yr in storage cost) to store \$2000. to \$5000 of stuff.
..... after some time you paid more to store the stuff than it cost to replace the stuff. just saying taken to extremes it cost alot. and money you pay for storing stuff is not making a 6% profit but rather storage is a 8 to 12%/ year drain or expense.
.
i have known companies to demolish perfectly good warehouses as only way to get property taxes reduced was show the building was not there anymore

9. I think the answer is that there's no good answer. You will rack your brain trying to figure this one out. Aside from calculating net present value, fixed storage costs, etc, there are so many other variables like material cost swings, risk of obsolescence, risk of inventory loss (theft, flood), etc.

Your time and your efforts might be better spent investing in tooling and refining setup processes so that your 4 hour setup is reduced to 45-60 minutes. So instead of tying up \$6600 in 4-years inventory, invest \$6600 in durable tooling that will save you 3 hours on every job for the next 4 years.

The point isn't necessarily that you'll come out ahead by staying lean. Rather, it's that you get reliable data. 3 hours saved is 3 hours saved no matter how you slice it. It's a tangible number that you can work with.

10. Stainless
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Inventory is the enemy of Innovation.

Our shop guy made 10 manifold blocks when we needed 2. Then we found out the new sensor that we needed and goes in the block won't fit without \$80 worth of adapters each. I asked an assembler why they were still installing a bracket that simply did not work well. He said there were 10 more on the shelf to get rid of. I agreed with that, I put them in the dumpster that night.

I've been trying to get our shop foreman to think rapid setup, common fixturing, quick change tooling, tools dedicated to holders, CNC programs organized and commented with tool requirements etc. He can't keep a drawer full of wrenches organized!

11. Diamond
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Originally Posted by Clive603
Very true but the hidden assumption is
I don't think I'd characterize it as hidden or even an assumption. You keep common sense at hand and look at everything.....but the cost of capital and time value of money was the element missing from the OP's calculations. However, nobody has free or unlimited capital so it usually ends up (or should) being a part decision making...but you need to do it consistently when evaluating things competing for the limit dollars ({new machine, for example)...if you don't include cost of capital its like saying its free which also isn't the case. If there's nothing in your business that will get a better return than some outside investment of equal risk, maybe you should make the outside investment instead.
Last edited by Mcgyver; 07-02-2019 at 10:15 PM.

12. Cast Iron
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Don't forget the tax on personal property (Inventory). When I worked for IBM we had some very expensive electronic parts - \$200,000 to \$450,000 each and each processor had 9 of those parts. For a while we kept some of those parts at customer locations so we could repair their mainframe computer as quickly as possible. The state property tax was so expensive that IBM pulled all those parts back to a main parts distribution center and paid for an airplane and pilot to be on standby 24/7/365 to deliver parts as needed. I could get any part to a customer within 3 hours. I have no idea what the actual savings were but that system was in place for a number of years.

Bob
WB8NQW

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As with everything it depends on the situation. If I were to follow the JIT and 5S religions I would be working in the shop 24 hours away just doing setups to reduce my inventory "waste."

Are these internal parts you are making you know will never be revised or is this for a customer that may give you a surprise revision that will scrap your inventory? For my customers' cheap repeat parts I leapfrog 4 month cycles and make 1 years inventory. For their long run parts (my bread and butter) it is made on a JIT basis.

14. I say there is no way to judge what to do, its 50% accounting and 50% personal feeling.

For accounting, that's simple. How long does it take to do setup vs having inventory vs available machines vs personnel problems vs complexity.

For the personal feeling part, that's harder to understand. This means how long do you expect to keep selling the inventory. Is your customer a 20 or customer or do you feel they will bring in someone who will change shops to save 8 cents per part. How much inventory costs would you keep during the time period. This is mostly the Risk/Reward problem.

I have 1 shop that if they have the time, they will run enough to last a year of inventory. Then I have another shop that will basically only keep 3 extras no matter the size of the order in case a few get damaged in shipping or what not.

It is all up to you and what you feel is right. Sometimes your right, sometimes you got a lot of practice.

Sent from my SM-G960U using Tapatalk

15. Diamond
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What really messes up the calculation is inventory you'll never sell. Gary pointed out one reason. Customers get bought and/or unhappy, designs get changed or obsolete, customer chooses another process, a supplier bids a lower cost assembly incorporating what used to be your part, and so on.

If you're doing an ROI on carrying inventory, it should include some sensible risk factor -- and the longer the time you hold it the greater the chance you'll lose.

FWIW, I've been holding on the a very valuable personal "inventory" of a couple pricey reel-to-reel tape decks, more Nikon 35mm cameras and lenses than I can shake a uni-pod at, complete Kodak Ekatrgraphic slide projectors with rear projection and dissolve systems, Shure microphones and mixers . . .. not to mention near a hundred neckties from WAY back when. Don't get me started on tools. All seem/seemed too valuable to get rid of . . . .

16. Stainless
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I haven't seen stock mentioned yet. It is part of the inventory and, depending upon your type of work,is either 100% important or completely unneccessary. My line of work was cams and tools for screw machines and nobody but nobody wanted a set of cams and/ or tools until they received an order. The shit would now but the fan and you had better have the cam or tool blanks in stock because everything was wanted yesterday. Yes I have had orders with a delivery date of yesterday. One highly valued customer had three stamps which he never failed to use, URGENT,DOUBLE URGENT and TRIPLE URGENT.
That particular customer was one of the few who went to the top of the pile because I never had to chase for payment. Guess how high up the pile late payers were.

17. Titanium
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Originally Posted by PeteM

FWIW, I've been holding on the a very valuable personal "inventory" of a couple pricey reel-to-reel tape decks, more Nikon 35mm cameras and lenses than I can shake a uni-pod at, complete Kodak Ekatrgraphic slide projectors with rear projection and dissolve systems, Shure microphones and mixers . . .. not to mention near a hundred neckties from WAY back when. Don't get me started on tools. All seem/seemed too valuable to get rid of . . . .
PeteM, Some Nikon Digital SLRs will use some or all Nikon SLR lenses. Some Nikon Film cameras and lenses are collectable. These folks have been reliable to buy and sell from: Used Cameras, Lenses & Gear For Sale | Buy & Sell at KEH Camera

I have scrapped Omega and Besler enlargers, Ektamatic processors, Color print processors, stainless steel film hangers and racks, etc. It gets less painful the more I do it.

Paul

18. Lots of great posts, thank you all for the input. I kept out of responding as people posted as I did not want to influence the discussion too much.

Originally Posted by Orange Vise
I think the answer is that there's no good answer. You will rack your brain trying to figure this one out. Aside from calculating net present value, fixed storage costs, etc, there are so many other variables like material cost swings, risk of obsolescence, risk of inventory loss (theft, flood), etc.

Your time and your efforts might be better spent investing in tooling and refining setup processes so that your 4 hour setup is reduced to 45-60 minutes. So instead of tying up \$6600 in 4-years inventory, invest \$6600 in durable tooling that will save you 3 hours on every job for the next 4 years.

The point isn't necessarily that you'll come out ahead by staying lean. Rather, it's that you get reliable data. 3 hours saved is 3 hours saved no matter how you slice it. It's a tangible number that you can work with.
Did Frank Mari tell you to post that? The \$6600 would be mostly spent between you two. Excellent advise and one I have considered. The job I used as an example maybe wasn't the best example, the part was a pain, several form tools, thin material, custom fixtures, nothing to probe on the part. It probably took longer than 4 hours to get it all up an running the first time.

I like the point that, rather than beating my head against the wall for small gains, look at the data that is easily quantifiable and improved. Chances are my "gut" for the number of parts to run is good enough, and instead of trying to find the perfect number, look at other cost savings/value added improvements.

19. Titanium
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Most of the time, 99% perhaps, a small shop will have vastly better results from inventory than other options.

Limited in capital, in time, in capacity, and in addressable market, one cannot simply do "something else" very productively and endlessly.

The *cost* of inventory in widgets is mostly cost of raw materials, at 4-7% interest rates, but with much lower per-part costs.
The financial burdened cost is realised when you sell the widgets, not when you carry them as inventory in wip + stuff.
So the 58\$ cost is maybe 20\$ materials and 38\$ stuff.
And at 5% per year,1\$ per part per year vs saving of 15-25\$ per part in production costs.

Originally Posted by Fal Grunt
Lots of great posts, thank you all for the input. I kept out of responding as people posted as I did not want to influence the discussion too much.

Did Frank Mari tell you to post that? The \$6600 would be mostly spent between you two. Excellent advise and one I have considered. The job I used as an example maybe wasn't the best example, the part was a pain, several form tools, thin material, custom fixtures, nothing to probe on the part. It probably took longer than 4 hours to get it all up an running the first time.

I like the point that, rather than beating my head against the wall for small gains, look at the data that is easily quantifiable and improved. Chances are my "gut" for the number of parts to run is good enough, and instead of trying to find the perfect number, look at other cost savings/value added improvements.

20. Diamond
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At some point no-matter what is is this run will end and you will now be holding dead stock.
Maybe two thousand dollars, maybe a quarter million, Is that in the plans for an absorbed loss?
Do you think this is a never ending order stream? That is so rare.
It is a good bet in good times, it has killed many with a small retraction or ending of a product.
Imagine that the 3800 V6 goes away and you are sitting on close to a million dollars in inventory of special tooling to support it's running.
Bob