Fundamentals of Logistics Management

Chapter – 5 Inventory Management

1. Explain how excessive inventories can erode corporate profitability.

Excessive inventory levels can lower corporate profitability in two ways:

1. Net profit is reduced by the out-of-pocket costs associated with holding

inventory, such as insurance, taxes, storage, obsolescence, and damage.
2. The cash invested in inventory is not available for other projects that could
generate revenue or reduce expenses.

2. Many businesspeople rely on industry averages or textbook percentages

for the inventory carrying costs that they use when setting inventory levels.
Why is this approach wrong?

There are problems with the use of industry averages and textbook percentages
for a number of reasons. First, the cost of money is the largest single component
of the carrying cost percentage. However, depending on a company’s current
cash position and the investment opportunities available to the firm, the cost of
money could range from as low as the interest rate paid by a bank to as high as
50 percent before taxes. This is because the inventory investment should be
expected to earn a rate of return comparable to the other investment
opportunities available to the firm. Even within an industry, the opportunity cost of
capital may vary substantially among firms. For example, in one company the
cash made available from a reduction in inventories may be placed in a bank
account at three percent interest or treasury bills at four percent. In another
company, a bank loan at 10 percent interest might be repaid. But, in a third
company the cash might be used to purchase new equipment for the plant that
would generate an after tax rate of return of 15 percent, which is approximately
30 percent before taxes if the marginal tax rate is 50 percent.

The second major area of concern is the valuation of the inventory. If fixed
factory overhead is included in the inventory value it will be overvalued. Also, if
labor contracts prevent management from paying production employees for less
than a full week’s work, then factory labor is a fixed cost. It may be necessary to
add transportation and warehousing costs to the value of field inventory. If out-of-
pocket expenses have been incurred placing inventory in the field locations, then
these costs have been inventoried just as the variable cost of materials. In
addition, the variable manufacturing costs will differ among manufacturing
locations because of the age of the facilities and the degree of mechanization.

Therefore, it is extremely unlikely that an industry average or a textbook

percentage would accurately reflect the true costs of a firm. This point of view is

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supported by the fact that the majority of textbook percentages have remained at
25 percent for more than 50 years while during the same time period interest
rates alone have ranged from three percent to in excess of 20 percent.

3. Explain how you would determine the cost of capital that should be used
in inventory decisions.

The appropriate cost of capital to be used in inventory decisions is the

opportunity cost of capital, the rate of return that could be realized from some
other use of money. In companies experiencing capital rationing, the hurdle rate
(minimum rate of return on new investments) should be used as the cost of
capital. The important question to be asked is where would the capital be
invested if inventory investment was reduced? For companies that attempt to
classify investments by various degrees of risk and use different hurdle rates for
projects with different levels of risk, the risk involved with holding inventories
should be determined and used to identify the appropriate hurdle rate.

However, if the cash would be used to pay off a bank loan, the current cost of
borrowing would be the relevant rate. The current interest rate on bank deposits
would apply if the cash would be placed in a bank account. The current interest
rate would apply in most cases where inventory is being built up on a short-term
seasonal basis.

4. How would you determine the cash value of a manufacturer’s finished

goods inventory investment? How would this differ in the case of a
wholesaler or retailer?

The following procedure would be useful to determine the value of a

manufacturer’s finished goods inventory investment:

(1) Ask accounting how the company currently values its inventories. If standard
costs are being used, chances are that the company will be using full absorption
costing which means that fixed overhead costs are being included in inventory
values. When this is the case, it will be necessary to obtain a copy of the
standards in order to deduct the fixed costs associated with each product. The
result will be a variable standard manufacturing cost per unit of product. When
the company uses an actual costing system, only actual variable costs are
relevant.

(2) The next step is to determine where the inventory is being held. Inventory in
units (i.e., cases) of each product for each storage location is necessary.

(3) Next, the average inventory value at variable manufactured costs should be
calculated for each location. This is accomplished by multiplying the number of
cases of each product at each warehouse location by the variable manufactured
cost per case.

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(4) For field warehouse locations it is necessary to determine the average
transportation cost associated with the volume of inventory being held. For
example, if the annual throughput is 300,000 cases, the average inventory is
30,000 cases, and the annual inbound transportation cost for that location is
$180,000, then the transportation cost to be added to the inventory value is:

(5) It is also necessary to increase the inventory value by any variable out-of-
pocket costs associated with moving the inventory into storage. In the case of
public warehouses this is relatively straightforward. It is simply the handling
charge per case multiplied by the number of cases in inventory. If the first
month’s storage is payable when the product arrives, this cost also should be
included. In the case of the company’s own facilities, only variable out-of-pocket
handling costs that could be avoided by decreasing the volume of inventory held,
should be included.

(6) The total value of inventory, based on variable costs delivered to the storage
location is found by summing the values for each of the storage locations. The
other option would be to calculate a separate carrying cost for each location in
which case the inventory values for each location would not be combined. As
was pointed out on page 382 of the text, General Mills has calculated a separate
inventory carrying cost for each storage location. For a wholesaler or retailer the
process is simplified because the inventory value is simply the landed cost of the
product (product cost plus in-bound freight if it is not paid by the vendor).

It should be noted that even obsolete inventory has a significant cash value. For
example, if management writes off $10 million in obsolete inventories there will
be a $10 million expense for tax purposes. With a marginal tax rate of 50 percent
this write-off would generate cause of $5 million. If the inventory was sold for less
than the $10 million book value, the difference between the selling price and the
$10 million would represent a loss for tax purposes and one-half of this amount
(assuming a 50 percent tax rate) would be added to the selling price to determine
the cash value.

5. What is the difference between the transportation cost component of

logistics cost trade-off analysis and the transportation cost included in the
inventory valuation (cash value)?

The transportation cost component of logistics cost trade-off analysis is the

transportation cost that is incurred on each unit of product sold to customers. The
transportation cost included in the inventory valuation (cash value of the
inventory) is the transportation cost that is incurred one time when the inventory
is shipped to the storage location, or conversely, is the expense that is avoided
one time, if field inventory is sold and not replaced.

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6. What problems do you foresee in gathering the cost information required
to calculate inventory carrying costs for a company?

The problems most often encountered when gathering the cost information
required to calculate inventory carrying costs include:

1. reaching agreement on the opportunity cost of money that should be used.

2. identifying the variable cost of the inventory (cash value) delivered to the
storage location; and,
3. identifying the non-cost-of-money components of inventory carrying cost
such as insurance, taxes, variable storage costs, obsolescence, damage,
shrinkage and relocation costs that may not be recorded as functional
costs in the firm’s accounting records.

7. Describe the circumstances under which inventory carrying costs can

vary within a given manufacturing company. Explain why total inventory
carrying costs decrease, but at an ever-slower rate, as inventory turnovers
increase. Consider raw materials, goods in process, and finished goods
inventories in your answer.

Inventory carrying costs will be different for raw materials, goods in process, and
finished goods. While the opportunity cost of money will be the same for each
type of inventory, storage costs and inventory risk costs may be quite different.
Also, determining the cash value of the inventory is much more straightforward
for raw materials (purchase price plus transportation costs, if they are not paid by
vendor) than it is for in-process inventory or finished goods inventory which
contain fixed overhead cost allocations that must be removed.

Total inventory carrying costs decrease at a decreasing rate as inventory

turnover increases because each improvement in inventory turnover represents a
smaller incremental reduction in inventory. For example, going from one to two
inventory turns reduces inventory by one-half. To have another inventory
reduction of the same magnitude the rest of the inventory would have to be
eliminated. To cut inventory in half again it is necessary to improve turns from 2
to 4. If the firm has 4 turns, it is necessary to go to 8 turns to cut inventory
investment in half. If current turns are 8, it would be necessary to increase turns
to 16 to reduce inventories by 50 percent and so on.

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8. Calculate the inventory carrying cost percentage for the ABC Company
given the following information:

ATTENTION DONNÉES LÉGÈREMENT DIFFÉRENTES DU LIVRE

• Finished goods inventory is $28 million valued at full manufactured cost.

• Based on the inventory plan, the weighted-average variable manufactured
cost per case is 65 percent of the full manufactured cost.
• The variable transportation cost incurred to move the inventory from plants
to warehouse locations close to customers was $1,5 million.
• The variable cost of moving the inventory into these warehouse locations
was calculated to be $300,000.
• The company was currently experiencing capital rationing and new
investments were required to earn 15 percent after taxes.
• Personal property taxes paid on inventory were approximately $200,000.
• Insurance coverage to protect against loss of inventory was $100,000.
• Storage charges at public warehouses totaled $500,000.
• Variable storage in plant warehouses was considered to be negligible.
• Obsolescence was $100,000.
• Shrinkage was $100,000.
• Damage related to inventory storage was $50,000.
• Transportation costs associated with the relocation of field inventory to
avoid obsolescence was $50,000.
• The marginal tax rate is 40 percent.

The inventory valued at variable cost delivered to the storage location is

$20,000,000 and was calculated as follows:

inventory at full manufactured cost = $28,000,000

variable manufactured cost is = x 65%

therefore, variable manufactured cost = $18,200,000

plus variable transportation = 1,500,000

plus variable handling = 300,000

variable cost delivered = $20,000,000

The cost of money is 15 percent after taxes. To convert to before taxes it is

necessary to divide the after tax rate of return by one minus the marginal tax
rate:

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 STEP COST CATEGORY AMOUNT
NUMBER

1 Cost of money $25% pretax (15% after tax

return divided by one minus
the 40% marginal corporate
tax rate)

2 Finished goods inventory $20,000,000 valued at

valued at variable costs
delivered to the distribution
center
variable cost delivered to the
DC. Variable manufactured
cost equaled 65% of full
manufactured cost. Variable
cost FOB the DC (after
adding transportation and
handling costs) are 71.4% of
full manufactured cost.

3 Taxes (personal property) $200,000 which equals

1.00%

4 Insurance $100,000 which equals

0.50%

5 Storage (public warehouses) $500,000 which equals

2.50%

6 Storage (variable plant) NIL

7 Obsolescence $100,000 which equals

0.50%

8 Shrinkage $100,000 which equals

0.50%

9 Damage $50,000 which equals 0.25%

10 Relocation Costs $50,000 which equals 0.25%

11 Total Carrying Costs 30.5%

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