Understanding Inventory Driven Costs

The most readily identifiable component of inventory-driven costs is the traditional inventory cost item, usually defined as the “holding cost of inventory,” which covers both the capital cost of money tied up in inventory and the physical costs of having inventory (warehouse space costs, storage taxes, insurance, rework, breakage, spoilage). Surprisingly, the holding cost accounts for less than 10% of total inventory-driven costs.

So what are the other costs?

Inventory affects costs in more ways than you may realize. Understanding and managing inventory-driven costs can have a significant impact on margins.

1. Component Devaluation Costs: This is a BIG factor of Inventory costs in environments where key components drop in price quickly and steeply. The price of a CPU, for instance, might fall as much as 40% during its nine-month life cycle, and the penalties for holding excess parts when a price drop occurred could be enormous.

Companies have no control over component prices, but it can control how much inventory it is holding.

2. Price Protection Costs: This is a BIG factor of Inventory costs in environments where sales happens through multiple channels not owned by the company. If company drops the market price of a product after units have already been shipped to a sales channel, the company has to reimburse its channel partners for the difference for any units that had not yet sold, so the channel partner didn’t have to sell at a loss. Given how quickly value decays, this mismatched inventory exposes companies to big price protection risks.

3. Product Return Costs: This is a BIG factor of Inventory costs in specially channels like Online where the returns can be as high as 35%. End users/ Distributors can simply return unsold goods to the manufacturer for a full refund. Apart from incurring the operational costs (shipping, handling, product retesting, and the like), returns lengthened the time a product spent in the supply chain before reaching an end user, increasing company’s exposure to additional devaluation risks and inventory finance costs.

4. Obsolescence Costs: End-of-life write-offs were initially the most obvious portion of this cost. The other related but sometimes less obvious components of obsolescence costs were discounts on about- to-be-discontinued products and the associated marketing effort required to accelerate their sale.

Devaluation, price protection, and return costs are essentially continuous costs; they occur all the time and can be calculated at any point. Obsolescence costs, however, are discrete, arising only when a company decides to retire a particular product and therefore cannot be estimated until that moment.