A lot of projects propose to deliver ROI through inventory reduction. Servicing the demand at desired service levels with lower inventory should save the company some money. How exactly?
Well, let us think in steps. If a company had an inventory level of 1000 to date, and they now learn that they could do just as well with 900, then they have 100 extra units of inventory.
Well, first off, the company can take a month or two to sell off this extra 100 units of inventory. In this case, all the money invested in that inventory is recouped at the cost of a couple of months of extra carrying costs.
If the product does not sell at full price, the company could force the issue with a discounted price. Perhaps, in this case, the company dips below the actual cost and recoups only part of the previously made investment. In this case, an inventory write-down in the books would mean a lowering of net income resulting in lower margins and taxes.
A third case would be that the inventory is deemed unsellable, and the company must dispose of it. This would lead to a total loss of the prior investment as well as some additional disposal costs. Inventory would be written off as opposed to written down in the step above. The books would show a lower net income resulting in lower margins and taxes.
Depending on which of the three options above apply to the company, there will be different cash flow implications.
From this point on, the company would operate with the newly achieved lower level of inventory. That means, that for that portion of the inventory:
- No borrowing money to build. This would save the cost of borrowing money (interest payments).
- No need for extra warehouse space. This would decrease warehousing costs (rental, electricity, staff, etc.).
- No fear of pilferage, theft, and obsolescence.
My colleague Bram Desmet calls this ‘rent + room + risk’. All these are real savings that the company would be able to realize.
The word rent here applies to renting (or borrowing) money from the market. What interest rate does one pay to borrow this money? Let us try and look into this.
Have you ever applied for a car loan? Or a home loan? Do you know of others who have? Do you know anyone who got rejected? Or got a lower rate? Or a higher rate? Well, then you know that in all cases, banks charge a higher interest rate when lending money compared to what they pay on deposits. This is one of the basic ways banks make money.
However, it does not stop there. Banks will charge a higher or lower interest rate based on the creditworthiness or the credit score of the borrower. That is why there can be differences in the rate for different people. Other factors can include timing, banking institution, length of the borrowing period, etc.
This same idea applies to companies when they are borrowing money. Depending on their credit rating, overall levels of debt, quality, and margin of the business, banks will charge them a different rate. If a bank sees a loan as riskier, it will charge a higher rate and vice versa. The average cost of getting this external capital is often called the Weighted Average Cost of Capital (WACC). In all cases, this is higher than the rate of interest the banks are willing to pay to the depositors.
When a company builds inventory, it uses this borrowed capital to make the product. As a result, the inventory cost is calculated based on WACC.
Companies often use WACC as the annual cost of carrying inventory. Further, many companies would estimate WACC as a % of the product cost. I have seen this to be in the range of 6-30%. Let us assume 10% for this discussion.
In our example above, say the product cost of the 100 units of inventory was $1,000. Then, the annual carrying cost would be $1,000*10% = $100.
Let us put all this together:
- Total savings in Y1 = 1-time cash flow increase of $1,000 – any discounts (say $200) = $800
- Savings in Y2 and every year after that = Reduced inventory carrying cost ($100).
- One could take this further and calculate Net Present Value and other financial numbers.
What do you think? Did I miss anything? Let me know via comments.
