Written by: Eman Abouzeid,
When you look at the balance sheet of a typical manufacturing company, you will find that one of the largest monetary amounts in the assets section is the “value of stocks”. Published accounts analyse the total stock figure into its constituent parts; such as stocks of raw materials and consumables, work in progress, finished goods and goods held for resale.
In non-manufacturing companies, the level of stockholding may be less significant, but should not be underestimated. Likewise, retailers also hold huge level of inventory for resale. It is only in ‘pure' service organisations (such as insurance companies, consultancies etc) that the level of physical inventory is not a major balance sheet element.
Despite the fact that holding inventory plays a pivotal role in keeping the supply chain moving, by mitigating risks of unexpected situations; such as demand rising or supplier being unable to deliver the usual stock within agreed lead time. Additionally, such stockholdings can represent a safety measure in minimising production disruptions and keeping customer satisfaction high. However, holding large level of inventory has considerable costs which must be minimised.
Let’s explore in detail the various categories of costs associated with holding excess levels of inventory:
1. The cost of security:
Some warehouses store a great many valuable and ‘attractive’ items, if they are stolen in significant quantities, the company will lose a large amount of value each year, thus greatly increasing the cost of storage. Other warehouses may not carry such valuable items but may suffer from internal pilferage of such things as small tools.
These measures can be undertaken by warehouse managers to reduce, or eliminate, such theft and pilferage:
- Limit access so that only stores personnel are allowed to enter the warehouse.
- Keep buildings locked when not in use and consider employing a watchman or security staff.
- All goods received should be checked accurately for quantity, weight, specifications etc.
- Adequate systems of stock-checking and auditing should be implemented.
- Correctly authorised issues – items should only be issued against a properly signed and authorised requisition.
- Adequate records to be maintained – if you do not know what you have and keep a record of what comes in and what goes out, you will not know if anything is missing.
2. The cost of insurance:
Stock should be insured against the risks of fire, theft or damage. The value of goods held in stock will have direct bearing on insurance premiums, covering loss or damage, for the warehouse.
Insurance premiums usually increase as stock value increases and decrease as stock value decreases.
3. The cost of space used:
The greater the quantity of stock held, the more space will be required in the stores building. Once again, if we can reduce the amount of stock held to a reasonable minimum, we can reduce the size of the warehouse.
Thus, use of space is a measure of stores efficiency. If a warehouse is largely empty, the cost of rent and rates, the cost of heating, lighting and power, and other costs such as labour, and the cost of storage and handling equipment are wasted and are nothing more than a drain on company finances. It is important, therefore, to ensure that the warehouse is as full as it needs to be, to provide the organisation’s required service levels.
It is worth noting that this is not a suggestion that the warehouse should be filled simply to achieve this target.If the warehouse is too large, then it is wasting money for reasons just mentioned and thought should be given to ‘hiving off’ some of it for other purposes or, in extreme cases, renting some of it to outside organisations for temporary storage accommodation.
4. The cost of stock damage:
If items in stock are handled carelessly, they might become damaged. Clearly, this is most likely to be the case with fragile items such as those made of glass. However, even sturdier items such as those made of steel could become bent if dropped. Also, apparently sturdy material such as concrete blocks could become chipped if knocked over.
Such damage might cause the items to be useless. This means that they would need to be replaced at extra cost to the organisation. In this situation they would need to be ‘written off’, meaning that the money spent on them was wasted. Additionally, the money spent on the items could not be recovered by selling them to other users. Some of their value might be recovered by selling them for scrap but this, of course, would only recoup a fraction of their original value. Insurance could mitigate this problem.
Here are some specific measures that may be taken to reduce the occurrence of damaged stock:
- Check stock carefully as it is received into stores. Damaged or inadequate packaging needs action to ensure that the stock will be protected.
- Use stock in the order in which it is received (e.g. first in first out).
- Maintain conditions that are appropriate to the type of stock – for example, in terms of temperature, humidity, and so on.
- Train all staff in the use of handling equipment and stress the importance of moving stock items carefully.
5- The cost of stock deterioration:
Deterioration happens to some types of items or material if they are kept in stock for a long time. Examples include the following:
- Paper can become discoloured.
- Iron and steel items can become rusty.
- Damp could cause cement to become solid and therefore unusable.
As with damage, deterioration will increase the cost of storage because it means that items affected will be useless. As with damaged items, items that have deteriorated will incur costs of replacement. Once again, they may be able to be sold for scrap, which would mitigate such costs. Insurance, also, would help mitigate such losses.
The likelihood of deterioration could be minimised by reducing stockholding. More effective, however, would be to ensure that goods likely to deteriorate are stored in suitable conditions; an example would be keeping materials that are susceptible to damp in dry locations.
6. The cost of stock depreciation:
Many items that are held in stock for any length of time will depreciate in value. In other words, their value will diminish because they will be perceived as being ‘old’. This would apply particularly to retail items.
An example might be where supermarkets sell items that are approaching their “sell by date” – below their normal price. Depreciation applies to all stock items, however, and it is the main reason why it is not considered a good idea to hold larger quantities of stock than are necessary.
7. The cost of fraud:
Fraud may arise because a member of staff is seeking to achieve an illicit personal gain. It might also occur where staff are trying to mask inefficiencies such as losses of stock items.
Here are some typical warehouse frauds arising from criminal activity:
- Claiming that materials have been delivered short by the supplier – when in fact the consignment was delivered fully and correctly.
- Claiming that materials were received as damaged or faulty from the supplier - when in fact the consignment was delivered in good conditions.
- Over-picking an order so that surplus materials are on the warehouse floor – ready to be stolen.
- Putting extra materials on to a delivery vehicle for an unauthorised delivery.
- Plain petty theft.
- Failing to ‘book in’ certain attractive stock returns (items returned by users or customers because they are not needed) and stealing them.
In order to eliminate or, at least, minimise fraud, documentation should be required for any materials to be issued out of the warehouse area. Issuing materials without the correct documentation will lead to stock losses and create a possibility of fraudulent practices. Nowadays issuing stocks without any documentation is only likely to occur within very small warehousing functions or privately-owned businesses.
8. The cost of obsolescence and redundancy:
Obsolescence is usually due to items being held in stock for long periods of time, during this time advancing technology makes the item outdated. It occurs in retail organisations, for example, when customer would no longer want to purchase such items.
Costs lost through obsolescence might be mitigated by selling the item second-hand. A better approach used to reduce obsolescence is to accurately forecast usage of these items, then items could be purchased and held in stock in small quantities, and only replenished when those in stock has been sold.
Redundancy occurs when items are held in stock for a long time and there comes a point where they are no longer required. In retail organisations, particularly, those selling items that are subject to fashion, redundancy might occur because of changes in consumers’ tastes.
Once again, the best way of mitigating the effects of redundancy would be to forecast requirements as accurately as possible.
In conclusion:
One of the most significant tasks that facing procurement and supply chain professionals is to work in close co-operation with production planning, marketing, and other functions, in order to balance or (better still to reconcile) conflicting demands relating to inventory levels. Such major cooperation is essential to avoid serious costs in the form of idle time and production stoppages, or on the other hand, costs in the form of holding high level of inventory.
Thank you for taking the time to read my article !
