Inventories, also known as stocks, are kept just in case there is a mishap in the supply chain to synchronise demand and supply.
In reality, demand is unpredictable — so is supply — necessitating the desire to hold inventories to smoothen the humps in supply and demand.
It is unfortunate such a noble cause comes at a cost to institutions. The costs are in three classes – capital/acquisition costs, storage/handling costs and costs associated with failure to hold enough inventory.
Regardless of organisations’ operations and sectors, the effects of costs are the same in any business. The only difference is that the impact of such costs might be felt at different stages within the organisation.
Capital costs relate to many factors that include economic principles of opportunity cost. With reference to opportunity cost, an organisation incurs a cost when it forgoes other investments or activities in favour of buying inventories.
Holding $500 million worth of inventories inevitably implies the same organisation can no longer venture into other activities to the tune of that sum held in inventories.
On the other hand, the cost of inventory can be related to capital costs as stipulated by money markets.
Using the $500 million inventories value with a lending rate of 15% per annum, the organisation will incur a $75 million bill on cost of capital at the end of the financial period.
This bill is more pronounced if the money used to finance inventories is borrowed. Applying the opportunity cost of capital on the capital cost, the same organisation will be losing $50 million annually if the money markets are paying 10% annually on investments if that $500 million had been invested.
When decisions have been made to invest in inventories, the inventory manager now needs to consider the costs related to the safety and security of the inventories.
Inventory holding costs include warehouse space rentals, rates, electricity, lighting, temperature controls, insurance, security, shelving, etc, that need to be added to the cost of capital at the end of the financial period.
This cost is normally associated with the volume and value of the inventory, the more you hold, the greater the cost.
While holding costs add to capital and operational costs of an institution, failure to hold stock equally has same implications.
If an organisation fails to hold stock, sales are lost the same with revenues resulting in loss of goodwill. In manufacturing setup, production time is lost and idle time creates a wage bill that cannot be recovered.
There is therefore need to balance inventory availability and inventory costs given the above discussion. The financial implication of holding too much are equally damaging as holding too little.
Supply chain managers have the headache of balancing the two. In many organisations, this is difficult because of the way procurement and stores units are structured.
In many organisations, the units are independent of each other resulting in the stores manager having an appetite to keep stock at maximum level and piling pressure on procurement to process requisitions without taking too much regard to the implications on costs.
Divorcing store and procurement activities do not promote use of innovative supply chain techniques that involve engaging critical suppliers to reduce stock-holding whilst maintaining or even improving the service level in an organisation.
Many argue that marrying the two reduces control given the fact the same person responsible for buying is also responsible for distribution.
They forget procurement and stores transactions are controlled by various other departments that include finance and user departments that acknowledge receipt of supplies from stores.
Businesses need to seriously consider purchasing and stores relationships in order to remain competitive.
Nyasha Chizu is a Fellow of CIPS and the current CIPS Zimbabwe branch chairman who writes in his personal capacity. Feedback: firstname.lastname@example.org