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Understanding The Real Cost Of Inventory To Free Up Working Capital

  • Written by  Debbie Shropshire Whetstone, TouchPath

0aaDebbie Whetstone TouchPathFor many businesses keeping an up-to-date inventory can seem time consuming, but most understand the importance. Ensuring you have enough stock (and the correct stock) to meet demand means that products get to customers quicker, market share increases, further sales opportunities are seized and ultimately you have happy customers.

However, what many businesses fail to understand is that the cost of the inventory is so much more than the cost of the goods themselves. It’s not the price that you sell an item for, but profits, and so into this cost analysis you must factor a whole host of additional elements. For example, if inventory turnover is low (a company holds onto its inventory for an extended period of time), it becomes more expensive.

So in addition to the upfront costs one must consider a number of other factors, including:

  • Domestic Shipping Costs: If the requested inventory is not available, then once it arrives you must expedite the order to your customers.

  • Overtime Costs: Your staff may need to stay late in order to keep up with demands due to lack of inventory.

  • Lost Business: If an order is late, or an item is out of stock, a customer may go elsewhere.

  • Loans & Invoice Financing: In order to maintain a sufficient inventory level, you may need to borrow money.

  • Additional Warehouse Space: If some inventory stays idle whilst others fly off the shelves, you may need to purchase extra space to meet the demand for the faster moving items.

  • Dead Stock: Inventory that is not sold is either marketed at a discounted price or scrapped.

  • Warehouse Costs: Warehouses cost money, including rent, maintenance, utility bills, insurance etc.

  • Excess Inventory Costs: This includes overtime spent handling, managing and sorting the extra inventory.

As you can see, there are several extra costs that come hand in hand with the basic upfront inventory landing costs. Many businesses often fail to take this into consideration, leading to financial losses. So when undertaking your inventory management, for a conservative estimate, you can generally add 30% to the initial cost. This will ensure that you are on top of your costings, leaving you less likely to be hit by any surprises.

So having looked a little deeper into your extra inventory costs, the key question is, how can you go about reducing them to free up your working capital?

Essentially you need terms of agreement from every part of your supply chain. For example, this agreement must look at minimizing the lead time for stock replacement. In turn, this will reduce your emergency shipping costs from your suppliers, as well as the rushed shipments made to customers due to late deliveries.

There are two methods, Blanket Order and Kan-Ban Agreements, that can help minimize inventory exposure, reduce finished goods pricing, improve lead time and reduce a company's inventory costs.

Blanket Order: This specifies a set quantity to be purchased over a given business period (quarter, semi-annual or yearly). You are able to use your volumes to negotiate lower pricing, while allowing the supplier to plan production, sales and its own inventory requirements.

The supplier boxes an agreed upon quantity of finished goods, and then waits for a release from the customer. Once those goods are shipped, the supplier will immediately start to replenish inventory for the next shipment.

This agreement is perfect for cyclical and seasonal demand patterns. For example, you may know an item’s quarterly volumes, but you may not know specifically which month the finished goods will be needed. In this case, finished goods are held until you need to take a shipment.

Kan-Ban Agreements: This differs slightly from the blanket order, as it also involves maintaining semi-finished and work-in-progress inventory in order to meet the strict delivery requirements of this supply contract.

Your supplier will maintain the semi-finished products ready to replenish the finished product inventory. This minimizes your future stock replenishment time and will account for any unforeseen spikes in demand. The time needed to turn the unfinished product into finished should be no longer than one week. This agreement requires the supplier to ship deliveries daily, weekly or monthly.

By using one of these methods, or a hybrid of both that works for you and your suppliers, you can start to reduce your inventory costs by:

  • Having better control of your shipping costs;
  • Reducing your costs for dead or idle stock;
  • Avoiding extra charges from storing too much stock; and
  • Reducing the risk of damage to your inventory, which can incur an extra 2.5% of your inventory cost (as long as the inventory stays at your suppliers, they are responsible for any damage occurred).

This will result in significant savings, and release more cash into your business. This allows you to protect your business from any unforeseen circumstances that may occur, as well as potentially allowing you to invest in other areas, such as marketing, and continue to ensure your company grows from strength to strength.

If you need further proof of the benefit of proper inventory and supply chain management, then you just need to take a look at the Best In Class companies. On average, they tend to spend only 5.8% of their expenses on their supply chain, compared to 12.2% from the average best performing company. That’s a huge 6.4% difference, and that’s money that could be placed into other integral areas of your company.

Therefore, it is even more salient, given the tangible savings your company can make, that you install a system that can track your inventory. A staggering 46% of Small and Medium Enterprises either do not track their inventory, or use a manual method, which is astounding given the benefits automated inventory management offers. By automating your inventory processes, data accuracy is greatly increased, ultimately eliminating duplication errors and human errors.

There are software solutions to ensure that not only is your inventory tracked, but that every element of your warehouse is managed effectively, from validating components or ingredients to optimizing capacity and increasing efficiency. Increasingly, these software solutions can be accessed via mobile devices — in fact, 67% of warehouses use, or plan to use, mobile devices to manage their inventory — increasing their speed and operational efficiency. These software packages will help you keep your inventory costs under control, thereby freeing up more of your working capital.


Debbie Shropshire Whetstone is VP of Marketing with TransitionWorks LLC (d.b.a. TouchPath).  As a member of the executive team, she oversees all marketing initiatives and maintains the business analytics. Whetstone possesses more than 30 years of previous management experience, first with the Food Lion grocery chain for 13 years and later as sole proprietor of two direct sales businesses for more than 12 years.  Following her retail experience, she was the Office Manager for IDVelocity (6 years), Business Operations Manager of the AIDC Solutions Group within NCR Corporation (2 years), and Operations Manager, then VP of Marketing for TouchPath (9 years).

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