The impact of too much inventory
Too much inventory feels safer than too little, but it comes with extra costs that run on year after year.
The capital is tied up. Every euro of inventory is a euro you cannot use to invest or to borrow against. The space costs money: inventory takes up warehouse space you rent or buy, heat, light and insure. The inventory ages: food and chemical compounds spoil, technology becomes outdated, fashion and seasonal items lose their moment. What sits too long is sold at a discount, written off or thrown away.
Another effect is invisible: high inventory masks problems. Poor forecasts, unreliable suppliers and slow processes go unnoticed as long as there is plenty of everything.
How do you end up with too much inventory?
Rarely through one big blunder, usually through inertia in the settings. The best-known route is safety: after a painful stockout someone sets the reorder point a little higher, and it stays there. There are quieter routes too. Market demand changes: an item that sold weekly last year now sells monthly. Machines evolve: a new generation uses different components, and the stock for the old one stays put. And components become technologically outdated, replaced by better alternatives while they are still in the warehouse.
None of those causes is a problem in itself; they are part of a healthy business. The problem arises when nobody actively steers. Whoever does not regularly recompute their reorder points and order quantities keeps ordering for the demand of the past. That way inventory stays high on the items where demand is shrinking. How often you should recompute differs by sector and even by product.
How do you calculate it?
- Capital cost = average inventory value × WACC
- Space cost = average inventory value × space cost%
- Risk cost = average inventory value × risk% (spoilage, obsolescence, dead stock)
- Annual holding cost = average inventory value × (WACC + space cost% + risk%)
You compute the capital cost with your company's WACC, the average return your financiers expect on the capital invested. There is something on the other side: the price of what sits in stock usually rises with the market, although meanwhile you keep carrying the risk that demand falls away or the item ages. The space cost covers warehousing, energy and insurance; the risk covers spoilage, obsolescence and the write-down of dead stock, and varies strongly by assortment. A quarter of inventory value per year is the classic rule of thumb for the sum of the three: a Dutch field study of three wholesalers arrived at 26 to 36%, and in the American literature 25% is the common average too. If you know your own components, use those.
Calculate your annual holding cost
What does your inventory cost per year?
The average value over the year, at purchase price.
The average return your financiers expect. If you do not know your WACC, take the interest on your business financing. Reference value from field research: 8 to 18% (Durlinger).
Warehousing, energy and insurance. Reference value: 10 to 15% (Durlinger).
Spoilage, obsolescence and the write-down of dead stock. Reference value: 2 to 30%, strongly dependent on your assortment (Durlinger).
Your estimate of the share of your inventory that does not need to be there.
Per year
Total
- Capital€400,000
- Space€500,000
- Risk€250,000
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