The Costs of Inventory

It’s difficult being in a position to point out that something people work so hard to make is, in Lean terms, waste. When we describe inventory as waste (one of the 8 wastes of Lean – Transportation, Inventory, Motion, Waiting, Overproduction, Overprocessing, Defects, unused Skills), people think of it as criticism. It’s understandable. They devote a lot of resources to producing it, they use it to ensure their customers are well served, and frankly a big bunch of something is impressive-looking. It’s common to think “My warehouse is paid for, so I don’t have any inventory carrying costs.” Yet Lean describes it as waste. So, here are some costs (certainly not all) of inventory.

Inventory costs you…

  • Capacity and opportunity – you used capacity to make this inventory when you could have been making something else to sell
  • Cash – you spent money on the materials and the labor to make it – that money is gone until and unless you sell it
  • Space – you can’t put two things in the same place – that rack and that building you paid for aren’t generating any money storing stuff
  • Time – it took time to make and you can’t get that back. It took time to store it and that’s gone too
  • Material Handling – if you store it, you’ll need to handle it at least twice
  • Searching – the more you have, the longer it takes to find anything. The more there is, the more likely it is that someone will put something “just anywhere”
  • Risk of obsolescence– if your forecast or demand changes or your orders cancel, your inventory is worth nothing
  • Risk of damage – every time you drive a forktruck through a warehouse, you risk damaging your inventory. The more inventory you have, the greater the risk
  • Environmental risk – roofs develop leaks, moist air can cause rust or swelling or condensation, dry air can lead to brittleness or cracking, cold can cause product to shrink, heat can loosen adhesives, dust can settle making it unsightly (or unshippable)
  • Risk of unknown defects – If you unknowingly made bad product, now its yours

Many of the above costs can be calculated concretely. Others are potential costs or risks. Still, inventory is a comfort, so we often defend it.

  • We wrap our pallets to keep them clean and stable.
  • We clean the dust off before we ship anything.
  • We have desiccants and preservatives to keep product fresh.
  • We limit how fast our material handlers can drive to avoid damaging product.
  • We have environmental controls to keep product in a stable environment.
  • We just had the roof replaced.
  • We have high-density racks and an automated picking system.
  • We record every location in our MRP system
  • And those things are costs created by inventory too: labor, material, equipment, technology, and overhead costs.

We usually don’t account for these activities very well and many of them are just rolled into overhead or being part of the job. Perhaps the biggest cost of inventory is less tangible but still very real: Motivation. Inventory hides your customers from your people. If you ask people to make something that’s going out the door, today, they will bust their butts to make it. If on the other hand, you ask them to make something to fill up a rack so it can sit for 4 months, you can’t make the case that their work is important, vital, or urgent in any way. And when they see you throw away 10% of what they made because you can no longer sell it, when they see their work getting dirty and damaged every day, when it gets remaindered or sold at a discount, when they stare it in the face sometimes for years, when they see the quality deteriorate by sitting on a shelf, when the dates on your inventory tags are ever further in the past, you can’t hide that from them either. The cost is morale, motivation, trust in the management that makes the production schedule, in the schedule itself, trust in leadership, your own credibility, ownership, efficiency and conscience in their work. Those are terrible costs.

But still, we make inventory for a reason so we respond to this too.

  • We have supervisors to keep people focused on efficiency
  • We have managers and MRP systems to figure out how much inventory we need
  • We have quality inspections before we ship anything out
  • We have a customer service department to quickly handle any quality issues (because you can quickly replace it with some other old inventory)
  • Our sales team works with operations to constantly update and adjust our forecast
  • We review our inventory levels twice a year when we do our physical inventory

Those are costs of inventory, too: Management and administrative costs.

Inventory reductions connect you AND your people to your customers. If you add up all the above costs associated with inventory and say “this is how much I can spend on reducing inventory and serving my customers better”, it will almost certainly be more than enough to pay for whatever improvements are needed to reduce your inventory to match capacity and real demand. If it isn’t, you may have a very different problem.

None of this should be taken as criticism, just an observation about the real costs associated with inventory buildup. Even the Leanest of companies usually don’t entirely eliminate inventory, but we make every effort to size our inventory to a level no greater than needed to always serve our customers. The bottom line: a warehouse is a terrible customer. He doesn’t pay his bills.

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