Shocker: Inventory Reduction Does Not Reduce Direct Costs

I run into this question fairly often. If you reduce inventory by $1,000,000, then the benefit or savings is $1,000,000, right? I have seen this calculation included as potential bottom-line benefits in project proposals, and in Kaizen report-outs. And the answer is no, absolutely not! At least not as such. The key “gotcha” words in the title are Direct and Cost.

The difficulty with this conclusion is that inventory is not a cost or expense, but an asset. Inventory doesn’t show up on a business Profit and Loss statement, although the material portion of your product cost does. Instead it shows up on the company’s Balance Sheet, what the company owns, what it owes, and what is left over. Reducing inventory has a direct impact on the Balance Sheet, by freeing up Working Capital that was previously tied up as inventory, and converting it to cash. That’s a pretty sweet deal by itself, and certainly beneficial, but it doesn’t actually impact the Profit and Loss Statement at all by itself.

But shouldn’t there be some impact to actual costs, and actual profitability, by reducing inventory? Sure, but not directly. There are many hard-dollar benefits that will flow to the P&L, but they are hard to quantify. Here are some of them:

Reduce Cost of Capital or Interest Expense

If you’re freeing up cash by reducing inventory, then that can have a positive impact on Interest Expense. You can use the cash to pay down the company debt, for example, or reduce the need for additional borrowing. Remember that many (most?) companies that go out of business simply run out of cash, even with good products and customers.

Free up Floor Space

You know for sure that inventory takes up physical space, and that space costs money. The most expensive square footage, other than your CEO’s office, is probably the factory floor, so any savings will not only delay the need for a building expansion, but also have a positive impact on operator productivity.

Reduce Material Handling

All other factors being equal, less inventory will mean less counting, less retrieving and putting away, less walking, fewer transactions. All of these have a positive impact on the overhead cost of Material Handling.

Improved Inventory Accuracy

>With less stuff to keep track of, presumably you can do a better job of keeping track of what is there. Remember that in today’s Lean world, inventory accuracy(computer records versus physical) needs to be at least 98% or better if you want your material management system to work well.

Reduce Damage and Obsolescence

It makes sense that less inventory reduces the risk of damage and obsolescence, since there is less exposure. For some industries, like electronics and aerospace, this can be huge due to the very high risk that a part can quickly become obsolete, or be designed out of new products entirely.

How to Estimate these Benefits

The challenge in estimating these benefits, which are real, is that they are hidden, indirect and may be influenced by other actions. For example, your Material Handling costs may go down due to inventory reduction efforts, but also go up because of a change to more frequent deliveries. What is inventory accuracy worth to you? Again, hard to know, but probably a lot if you run out of something because of bad records. You know that floor space is valuable, but have you assigned a cost per square foot to its use?

The Cost of Carrying Inventory

What you need to do is to come up with a factor to use, specific to your company, to estimate the indirect value of inventory reduction. This is an estimate only, and don’t expect to see a line item on your P&L that shows this; the savings are spread out over many different cost categories. This factor or percentage would be applied to the inventory reduction dollar amount, and be used for management purposes. When comparing various potential improvement projects, for example, you would use the “Cost of Carrying Inventory” value as a weighting factor to set priorities. It will be difficult or impossible after the project is over to know if these cost reductions were actually accomplished, so some confidence that they are there will be needed.

What Should the Percentage Be?

That is going to be up to you, and will determine the importance you assigned to inventory reduction as a focus for continual improvement. A high percentage means that it is highly important for your organization to focus on inventory reduction, and a low percentage means that it is less of a concern. Your percentage should not be less than your current Cost of Capital, and should probably be significantly higher than that.

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