Inventory Management: Tips for Managing Inventory Cost in Packaging and Beyond

Editor’s note: In the March/April issue of SCMR, Sean Willems offered new ways to take the mystery out of inventory optimization. In the following column, Jeremy Lagomarsino shares tips for establishing the true cost of inventory in your network.

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Profit growth is about more than just selling more products at better margins. Leading companies grow profits by blending market and consumer insights, product development, selling and business development acumen, and sound supply chain and operational practices. A key part of these operational practices is inventory management and inventory strategy.

Inventory is often a sizable portion of a company’s assets, approaching up to 30% of the total for manufacturing companies, with packaging supplies comprising a significant portion of this amount. Managing this inventory properly is important, as there’s a proven correlation between good inventory management and a company’s financial success. Developing a sound inventory strategy is complex, but it can be accomplished by exploring several tasks to help firms reduce investment without adding risk:

Establish the true cost of the inventory. The true cost of inventory is often not fully understood. Some firms think only about the “cost of capital.” So, for example, a firm with $15 million in average inventory and an 8% cost to raise money (the blended rate of return needed to pay stockholders, bondholders, and/or private parties to borrow money) sees a carrying cost of $1.2 million per year. Sounds simple, but the actual cost is much greater due to other considerations:

• Direct investment costs. These costs include insurance for the inventory, shrinkage and pilferage costs, obsolescence losses, and the fundamental cost of capital.

• Holding the inventory. Physically keeping inventory comes with several costs such as building rent or depreciation, heat and utilities, and janitorial and security costs to clean and protect the building and its contents. Companies should also consider taxes and the cost of capital for the land.

• Handling the inventory. Once the inventory is in place, there are costs that come with its movement such as handling equipment, employee costs, and freight and transportation. Consider the forklifts, pallet trucks, and vehicles that must be used to move inventory from A to B.

Additional costs for inventory include back-end expenses involved with accounting staff to measure and manage the inventory and the time spent by managers to fix inventory issues. With all these additional costs included, the total cost of holding inventory can reach 30% of the inventory’s book value. Going back to the example of $15 million in inventory, a company can see true holding costs of $4.5 million a year – much higher cost than originally thought. After establishing costs, it’s vital to determining the right amount of inventory to carry.

Right-sizing inventory. Finding the right inventory level involves balancing several factors. Too much inventory raises the holding costs, but too little means possible shortage and not meeting customer demand. Here are four elements that together should be judged to determine the right levels of inventory.

• Expected demand. Past usage is a way to determine how much inventory is needed in a year, but it isn’t foolproof. You also need to examine upcoming sales or marketing initiatives and how they will drive demand. And to forecast for key components (like packaging), you need review at the SKU level, which takes time and diligence. Knowing overall demand helps you determine a yearly buy, but not the amount to carry at any given time.

• Order frequency. If you can order frequently, then you require less carried inventory because you can do replenishments often. But placing more frequent orders may reduce your purchasing scale, with higher per-piece pricing and freight costs. The other side is not being able to order frequently, which means you need a greater inventory level on hand to satisfy demand.

• Lead times. If you’re lucky and can order an item one day and receive it the next, then you don’t much need to worry about lead times. However, this isn’t always the way ordering works, and lead times can vary due to supplier issues, the type of product, and the location of suppliers. You need precise planning to handle longer lead times, which leads some firms to hold more inventory as a hedge.

• Uncertainty. When you have uncertainty in the supply chain, you need to carry extra inventory as a safety net. If you can’t manufacture or fill product due to components being out of stock, then you risk brand failure and lost profits. You need to align safety stock levels with supply-chain uncertainty to act as an insurance policy against unforeseen issues or mistakes in your own inventory management.

Identifying inventory costs and levels is just the beginning when it comes to inventory optimization. Diligent companies can ultimately reduce expenses and free up cash with careful analysis, honed capabilities, and a supply chain with aligned partners.

A simple litmus test to spotlight opportunity – Any time more than one company in the supply chain is holding inventory of an item, you should ask: Can I rethink this to grow my profits?

Jeremy Lagomarsino is an executive vice president at Berlin Packaging.

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