The Monthly Metric: Inventory Carrying Cost
As this space has discussed often, few dynamics of supply management have been affected more by the coronavirus pandemic than inventories. And one of the metrics most impacted is inventory carrying cost, which many companies put on the back burner as they scrambled to replenish and maintain stocks.
“Inventory carrying cost is a calculation that was probably thrown out the door at a lot of places,” says Tracey Smith, MBA, MAS, CPSM, president of Numerical Insights LLC, a boutique analytics firm in Charlotte, North Carolina. However, as many procurement organizations consider boosting stocks as a buffer against supply chain disruptions and long lead times, the metric is likely to carry more weight in inventory management strategies.
As COVID-19 slowed most aspects of manufacturing and business in 2020, inventory carrying costs decreased 15 percent, according to research by Kearney, the Chicago-based global management consulting company. However, the trend appears to be reversing, as higher inventory levels are considered not only a risk mitigation strategy but also a lower-cost option for companies that cannot pass 100 percent of materials price increases to customers.
“For the environment we’re in, I would say companies are willing to carry more inventory and, therefore, will have more inventory cost, (even though) for some, it’s still a struggle to get materials,” Smith says. “The costs that go into holding inventory can be a tricky calculation for companies. It depends a lot on the inventory management model.”
Meaning of the Metric
Inventory carrying cost (ICC) is a self-defining metric, as it’s the percentage of total inventory expenses devoted to transporting and storing materials in stock until orders are fulfilled. While many companies threw ICC caution to the wind as COVID-19 spread, it’s a critical gauge to help avoid costs of excess inventory, which ties up cash flow — and supply management organizations are primarily measured by cost savings and inventory management.
ICC is generally considered to have four components: (1) capital costs of the materials, including interest, transportation and maintenance fees, (2) service costs like insurance, taxes and management software, (3) risk costs stemming from such incidents as damage, theft, depreciation and obsolescence, and (4) storage and handling costs, whether a company has its own warehouse, labor and equipment or uses a third-party facility.
Some organizations, Smith says, might factor opportunity costs — how they could have otherwise spent the money invested in inventory: “If that amount of cash was free, the company could invest in a CD (certificate of deposit) or municipal bond,” she says. “(The return) might be a whopping 1 percent, but it’s an opportunity cost some might want to add in.”
There are no consensus ICC benchmarks, though most companies strive for between 20 and 30 percent of total inventory costs. “The more components (for ICC) that a company includes in the calculation, the higher percentage it’s going to get,” Smith says. “But it’s critical to be accurate and thorough. For me, this metric is not so much about a benchmark. It’s more important for a company to improve year over year.”
For some companies in recent months, accurate and thorough accounting has meant including work-in-process (WIP) inventory. Institute for Supply Management®’s (ISM®) Glossary of Key Supply Management Terms defines WIP as “semi-finished goods, located at some point in the production process” that require additional assembly.
Even though missing part(s) are usually beyond a company’s control, WIP inventory should be included in ICC, Smith says. Some organizations try to clear WIP inventory before calculating ICC, a task that she says should be performed monthly at companies that can automate a report. “At other companies, it can a painful exercise of trying to get numbers from different places in different systems,” Smith says. “For those, I would say to do it quarterly.”
Current and Post-Pandemic Lessons
While the just-in-time versus just-in-case debate continues, companies are trying to boost inventories, at least in the short term. According to ISM® Report On Business® data, manufacturing companies are having more success at replenishing stocks than those in the services sector. ISM’s Manufacturing Inventories Index has been in expansion territory (above 50 percent) since August, while the Services gauge has contracted for seven straight months.
Higher inventory storage and handling costs will, naturally, increase ICC, so companies will look to reduce costs among the other three components, Smith says: “They’re willing to take on more inventory, but it’s ideal for the (ICC) percentage to stay roughly the same.”
Lowering transportation costs and ICC is one of many reasons some companies are looking to move manufacturing and sourcing operations closer to the U.S. For example, one of Smith’s clients is trying to consolidate parts so it can rely on fewer suppliers.
“Companies are trying to figure out whether they should adhere to (pre-pandemic) inventory management models or move their supply chains closer,” she says. “How will they mitigate this risk? Some may feel the likelihood of another pandemic is pretty low. Others might think that because it’s been such a huge impact, they’re willing to pay a little more for raw materials and reduce lead times.”
A company getting the most bang for its ICC bucks, Smith says, requires updated and accurate inventory metrics like safety-stock level and reorder point, especially since COVID-19 has extended lead times. While excess inventory can be costly, missed business because of a stockout can be even more so. Also, better command of other metrics could result in faster inventory turns, which can lower ICC.
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