IMPACT OF INVENTORY CONTROL ON COST AND PROFITABILITY

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Abstract

In this fast moving and rapid changing business environment, inventory that keeps in the warehouse brings significant effect on the daily business operation. Inventory control involves many levels of the organization, starting from the shop floor workers to the top management commitment. Therefore it encounters various problems in the implementation. The framework of this article consists of three parts. The first part describes the various factors that affect the cost and profitability of the organization. The second part highlights the impact caused by the factors shown in first part. The last part gives solution to the problems discussed in the first part. This article also introduces the various costs that associate with the storage of inventory, order of required quantities, perform an efficient cycle counting and report presentation for management's decision.

Inventory control definitely gives impact to the cost and profitability for an organization. Therefore, we must identify the type of inventory in our warehouse, whether they are good, bad or ugly in term of profitability and dead or slow-moving in term of duration of stocking. We need to liquidate those unwanted inventory to maximize our investment. In addition, we need to understand the cost of carrying the inventory such as storage, insurance, tax, damage and obsolescent in order to minimize the cost incurred. On top of this, we need to perform cycle counting for inventory accurately and make sure the computerized inventory system presents the report in the way we require for management decision. On the other hand, we need to determine the inventory turns required to meet the return of investment and forecast of profit. A concept of adjusted margin has to be introduced to reflect a more accurate calculation of actual inflow of money in the business. .

The Impact Of Inventory Control On Cost And Profitability

Introduction

Inventory is the stock stored that has a resale value in order to gain profit. It represents the largest cost of the company especially for the trading firms, wholesalers and retailers. It is mentioned as "piles of money" on the shelf. In normal circumstances, it consists of the 20% - 30% of the total investment. Therefore, the inventory should be properly managed in order to facilitate the company operation. This article discusses the three categories of inventory named 'good', 'bad' and 'ugly' and their impact on the cost and profit on a company. It further elaborates the various costs associated to the inventory and the relation of the cost with profit. Finally, it discusses the various methods that can minimize the cost and maximize the profit by a good inventory control system.

Research Problems

Inventory control involves many levels of the organization, starting from the shop floor workers to the top management commitment. Therefore it encounters various problems in the implementation. The followings highlight the problems in the implementation of inventory control system that would give impact to the cost and profit of the company:

true cost of carrying inventory

no consideration from other departments such as marketing and sale for management of inventory

gross profit of a product does not necessarily mean true profit for the company

Objectives of Research

The objectives of the research are: -

to determine the method to measure and determine the level of inventory by EOQ

to explain the true cost for handling and storing of inventory

to integrate various departments for a better and accurate demand forecast for a better cost saving and profitability

to investigate the inventory turns and "Adjusted Margin" method that give rise to actual profit.

Scope of Research

The scope of the research includes the wholesaler, retailer and trading companies that stock the inventory for resale.

Survey of Literature

Rick Lavely (1998) stresses that inventory means "Piles of Money" on the shelf and profit for the company. However, he notices that thirty percent (30 %) of the inventory of most retails shops is dead. Therefore he argues that the purpose of inventory control is to facilitate shop operation by reducing rack time, thus increasing gross profit. He further elaborates two types of inventory calculation that determines the inventory level required for profitability. The two calculations are based on "cost to order" and "cost to keep". Finally, he proposes seven steps to improve inventory control and five rules to live by while operating the inventory. The limitation of this literature is that he does not outline the calculation method that actually evaluates the inventory level and cost of handling it. He also fails to relate any cost, which causes by the operation of inventory.

James Healy (1998) highlights that the distributors carry ten to thirty percent of additional inventory that is unnecessary. These cause unnecessary carrying cost, lost of customers, lost sales and lost profit due to sloppy and inefficient inventory management. He points out that there is a need to set out procedures to control physical inventory, to determine the true cost of carrying inventory and an accurate running report to measure the turns of inventory. He suggests an inventory optimization method to overcome the above shortfalls. He then explains that inventory optimization is a process that let distributors reduce the amount of inventory they carry while improving service levels, ensuring that the right stock is available when and where it is needed, increasing turns and reducing lost sale opportunities. He further points out some misconceptions of inventory management such as the adequacy of the Enterprise Resource Planning System (ERP) in handling the inventory, the importance of turns in measuring the success of the inventory system and the confidence on profitability of using the inventory optimization method. He also points out keys to achieve the inventory optimization goals. The limitation of this article is that it does not give reasons for the causes of the unnecessary inventory. It gives a general statement and does not explain in details the reasons behind any cost and profit.

Dave Piasecki (2001) presents an inventory model for calculating optimal order quantity that used the Economic Order Quantity (EOQ) method. He points out that many companies are not using the EOQ method due to poor results received resulted from inaccurate data input. He clarifies that many errors resulted in the calculation of EOQ in the computer software package are due to the failure of the users in understanding how the data inputs and system setup that control the output. He says that EOQ is an accounting formula that determines the point at which the combination of order costs and inventory cost are the least. He highlights that the EOQ method would not conflict with the Just in Time (JIT) concept. In fact, he explains that JIT is actually a quality initiative to eliminate wasted steps, wasted material, wasted labor and other costs; EOQ method is used to determine which components would fit into the JIT model and what level is economically advantageous for the operation.

Piasecki further elaborates the EOQ formula that includes the parameters such as annual usage in unit, order cost and carrying cost. Finally, he proposes several steps to follow in implementing the EOQ method. These include the testing of the formula by manually checking the result obtained, run a simulation by using a sampling of items, and maintain the EOQ formula by reviewing the interest rates, storage costs and operational cost periodically. The limitation of the literature is that it dose not elaborate further the relationship between EOQ and JIT. It dose not associate the inventory turns with the EOQ formula and fails to mention the profit gain with the quantity calculated.

Farzaneh (1997) presents a mathematical model to assist companies in their decision to switch from the economic order quantity (EOQ) to the Just in Time (JIT) purchasing policy. He starts by emphasizing the pressure for the companies to change the traditional EOQ purchasing order to JIT purchasing order. He defines JIT as "to produce and deliver finished goods just in time to be sold, sub-assemblies just in time to be assembled in goods and purchased material just in time to be transformed into fabricated parts." He highlights that the economic order quantity model focuses on minimizing the inventory costs rather than on minimizing the inventory.

From the mathematic model presented by him, he concludes that JIT can eliminate the storage, capital, insurance, ordering, and transportation costs. However, it depends on certain conditions. Under the ideal condition, whereby all the conditions meet, it is economically better off to choose JIT over EOQ because it results in a simultaneously reduction in purchase price, holding cost and ordering cost. Nevertheless, in reality the manufacturers produce a large quantity of items even though they may deliver them in very small quantities to fulfill customers need. In brief, he explains that JIT will become viable only if the annual demand of inventory items is lower than the break-even point of the model. The limitation of the literature is that he only compares the cost saving and the required quantities for choosing the system. However, he does not compare the turnover and profit resulted from the required quantities.

Andrew Blatherwick (1996) stresses the balancing stock inventories, service delivery mechanisms and retaining requisite profit margin while ensuring customer loyalty. He admits that one of the highest costs is the stock and requires immediate attention in order to retain the profit margin. He brings out the problems of lack of involvement and consideration of marketing and sales department in the inventory system management. They do not give enough information and feedback regarding the theme or strategy for the inventory department to prepare for the seasoned promotion. This results in poor customer service, as the customers cannot get the products they required. He mentions that good inventory management is the management of inventory to optimize services and profit and required a sophisticated modeling technique to determine what is the best economic order quantity and the appropriate service level. The limitation of the literature is that it does not specify how to determine the quantity of stock and the service level required in order to attain the required profit.

R.L Ballard (1996) presents how inventory can best be monitored and measured in the warehouse. He mentions that inventory control is treated as the management function, whereas the monitoring of stock is regarded as a supervisory function. However, he highlights that the monitoring and measurement process is often overlooked and thus resulted in unreliability of the data for the decision making of management. He further stresses that the need for rapid and accurate monitoring and measurement of inventory becomes vital in these competitive business world. He explains that monitoring and measuring of inventory is not just stock checking, but is about knowing at all time, everything that needs to be known about the stock to ensure the effective control of inventory. The whole process should be known rather than just the stock. In addition, he categorizes the stock information into fixed information, variable information and derived information in order to describe the properties, status, quantity and location of inventory. The limitation of the literature is that it dose not consider the monitoring and measurement of the damage, obsolete or stolen inventory. It also fails to explain the cost incurred and profit gain resulted from the effective monitoring and measuring process.

Charles J. Bodenstab (1996) presents an idea of managing the customers inventory for them. He explains that there are many advantages by doing so. First, the competitors will find it difficult to make any inroads into the relationship between the company and its customers. Secondly, cost for issuing purchase order can be eliminated, reducing administrative cost and inventory investment if the system is managed well. However, he admits that there are problems associated with the above concept. First of all, the customer has to be large in order to be cost effective. Secondly, a cost effective system to manage the transferring of sales and ordering information shall be established. Lastly, there should be an efficient inventory management system that assimilates the customer's data and order the recommended product to maintain a high service level. The limitation of this article is that it does not maintain the cost to manage the customers' warehouse, as the stocks shall be physically counted to check the stock. The article also fails to include any increase in profit compared to the normal method.

Amy M. Azzam (2001) introduces the concept of flow-through warehousing technique that would replace the static warehousing technique. Flow-through warehousing technique aims to minimize the holding (carrying) cost of inventory, and increases their speed in finished goods distribution. Inventory goes from the supplier to a consolidation point straight to the customers. This eliminates put away, pick up, replenish and stock up cost. Amy points out that flow-through warehousing simply attempts to minimize how much you are holding and how long you are holding it. She defines the technique as "product moving fluidly through a network node." However, flow-through technique can only make feasible by the availability of technology and are highly information intensive, requiring computers, warehouse management system, bar coding and radio frequency identification. Amy concludes that the retail industry has advantage in applying flow-through technique. The reasons are a fixed distribution center can responsible for many different stores, the demand is known, mass production and replacement products are available, and there is less value-added services. Finally, Amy points out that the absence and inaccuracy real time information has affected the implementation of this technique. The limitation of the article is that it dose not evaluate the initial cost of setting up the system. It only mentions the reduction of inventory holding cost but fails to consider the additional cost incurred in order to coordinate with other retailers in the distribution center and usage of the facilities.

Research Methodology

Information and data of the research were gathered from various sources of secondary data. Sources of secondary data include journal articles published in the magazines such as International Journal of Physical Distribution & Logistic Management, Journal of Operation & Production Management, and Journal of Business & Industry Marketing. It also contains sources downloaded from Internet websites such as Google, Emerald, and Copernet. Some of the information was obtained by some reference books from the library.

From the secondary sources enumerated above, the research framework is developed. The framework consists of three parts. The first part describes the various factors that affect the cost and profitability of the organization. The second part highlights the "impacts caused by the factors shown in first part. The last part gives solution to the problems discussed in the first part. In addition, the framework gives some future trends in the inventory control.

Discussion, Analysis and Findings

As mentioned in the introduction, inventory consists of 20% to 30% of the total investment. Therefore we must clearly define the costs that associate with the inventory. Here the critical factors are what products to stock, when to reorder them, at what quantity and at what cost. Further to the above, we have to look into the ways of improving the profitability through building of a specific industry village such as optical village or shoe village. Since the inventory is the largest asset of the company, our main intention here is to relate the inventory with the cost incurred to store and maintain them. First, we study the cost of carrying the inventory.

The Carrying (Holding) Cost for Inventory

The carrying costs consist of four factors. First, the insurances, taxes and opportunity cost. This factor is solely dependent on value of the average quantity on hand. The more the quantity, the more insurances and taxes are required to be paid to the relevant parties. While the opportunity cost is the loss of capital gain for the money invested in inventory, as this money could have been invested in a relatively safer and more income producing investment. Secondly, the inventory shrinkage. It includes any stocked material that is purchased but not sold. This inventory is subjected to theft or obsolescence in the warehouse. Most people think that the cost of the lost material is only on the face value of the material, and they do not understand the true cost that hidden behind it. Most people think if they loss hundred dollar worth of material, they need to sell an additional hundred dollar worth of material to make up the losses. In fact, the material losses must be paid up for with profit dollar. If our net profit before tax is four percent, that means we have a four cent profit for every dollar of sale. Therefore, in order to make up the hundred dollar losses, we need a sale of two thousand five hundred dollar (2,500).

The mathematical calculation is as below: -

$100 x (100/4) % = $2,500

This is a huge amount of money if your monthly material losses are even higher. We must make sure that our employees understand the true cost of lost, broken or damaged material.

The third factor is the "cost of counting" of inventory in the warehouse. It can vary from one item to another item depending on the size and packing. We need to group the similar stocked items and store them in similar storage units. We also need to determine the labor cost of performing the actual counting as well as the time spent in counting and entering the count information into the computer system. The last factor is the rental, utilities and cost for moving the material. Some products take up more space, and are harder to handle than other products. Items take up more space should absorb more cost. We need to determine the total space used to store material and the space currently used to store the inventory. By dividing the total cost that needed to occupy the space by the total cubic used, we determine the storage cost per cube. We can then apportion the cost of individual item based on the cubic space assigned to them. Lot of efforts is needed in order to maintain the inventory items in the warehouse. If this concept is understood, it will lead to a better and outstanding result.

Turnover

Another important factor that gives impact to the cost and profit is the turnover of the inventory. Turnover is calculated by dividing the cost of goods sold from stock sales during the past twelve months with the average inventory investment during the past twelve months. Its rate measures how quickly you are moving the inventory through your warehouse. Normally, most distributors who have 20 - 30% gross profit should achieve an overall rate of five to six turns per year. Inventory turnover measures the number of times you sell your average investment in inventory each year. It is the number of opportunities you have to earn profit on the money you have invested in inventory. Therefore it should be measured accurately.

By increasing the number of times distributors turn their inventory, they gain more profit. However, they must consider the valuable discount, profitability in forward-buying opportunity and economic buying cycles. The discount given for various ordering size does not always results in the best value. On the other hand, distributors or retailers must maintain a budget and projection for their inventory. This budget is referred to as "target inventory investment", calculated as following: -

Target Inventory Investment = Projected Annual Cost of Goods from Stock Sales

Target Inventory Turnover

By setting a target, we can reduce the target inventory investment by gradually increasing the target inventory turns.

In addition, you should look at the dead and slow-moving items that are stocked in your warehouse. You need to store them only if the items are critical such as repair spare parts or new stocks that are certain of future sales. An item that doesn't sell would not contribute any profits necessary for you to maintain the business. Therefore, you must prepare an average value of the entire dead and slow-moving inventory you plan to keep in future. You should not have any dead inventory beyond 5%of the total inventory investment and additional 10% for slow-moving inventory of total inventory investment

Traditional Profit Margin Calculation Vs. Adjusted Margin Calculation

Every business desires to maximize its profit. Profitability is the foremost goal of every company. We are going to look into how the Inventory control relates to this goal, to meet the high customer service level while contributing positively to the company's bottom line. There are three types of inventory classified according to the profit making:

a) The Good : The inventory that provides a positive return on our investment.

We make money from the sale of this inventory.

b) The Bad : The Inventory that doesn't provide return on investment, but merely

contributes to other profitable sales. Example such as spare parts for automotive.

c) The Ugly : The inventory that doesn't provide a return on investment, and doesn't

contribute to profitable sales. We must liquidate this type of inventory immediately.

When we ask any salesperson about the profit of their company, they will mention about the gross margin of the company. Gross margin is defined as below:

Gross Margin (GP) = Annual Sales Dollars - Annual Cost of Goods Sold

Annual Sales Dollars (Revenue)

The higher the gross margin, the better the profit. Under most circumstances, the G.P. is approximately 20% for the distributor or wholesaler. But does the company actually make money with that 20% of margin? It is uncertain as the actual net profit depends on the average value of inventory we need to maintain to generate the sales. The average inventory investment will depend on cost of the products, variation in customer demand and quantities that must be purchased in order to sell the products at a competitive price. As mentioned earlier, the carrying cost of a product is about 25% - 30% per year of the average inventory value. A product with a gross margin of 25% should contribute more than a product with a gross margin of 20%.

The calculation is as below.

For Product A,

Annual Sales = $ 25,000.00

Cost of Goods Sold = $ 18,750.00

Gross Profit= 25,000 - 18,750 = 25%

25,000

For Product B,

Annual Sales = $ 25,000.00

Cost of Goods Sold = $ 20,000.00

Gross Profit= 25,000 - 20,000 = 20%

25,000

Product 'A' contributes more to the company's profitability. However the gross margin doesn't reflect the average inventory of Product 'A' & Product 'B'. Product 'A' might need higher average inventory than Product 'B' in order to achieve the same sales. We need to adopt a new measurement of profitability. The 'Adjusted Margin' is a better method to measure the true profitability of the product.

The formula is as below:

Adjusted Margin =

Annual sales - Annual cost - (Average inventory X % carrying

of goods of goods sold value cost)

Annual Sales (Revenue)

Let us use the above examples again.

Product 'A'

Average Inventory Value = $ 8,000.00

Carrying Cost = 25%

Adjusted Margin = 25,000.00 - 18,750.00 - (8,000.00 x 0.25 ) = 17%

25,000.00

Product 'B'

Average Inventory Value = $ 2,000.00

Carrying Cost = 25%

Adjusted Margin = 25,000.00 - 20,000.00 - (2,000.00 x 0.25 ) = 18%

25,000.00

Even though Product 'B' has a lower G.P., however it has a much lower average inventory value, its adjusted margin shows that it contributes more to the company profitability. From the above calculation, it could be seen that if the operating expenses are more than 17%, we might be probably running the business at a loss.

A very easy way to know whether the company is making money or not is by comparing the adjusted margin with the percentage of "Non-Inventory Related Expenses" (NIREP). It is defined as follows: -

NIIREP = (Annual Non-Inventory Related Expenses / Total Annual Sales) * 100%

If adjusted margin is more than NIREP, the company is making money; else you need to liquidate the inventory as fast as possible.

Electronic Data Interchange & Internet

Electronic Data Interchange (EDI) is the process of electronically sending business documents from one company's computer system to another company's computer system. The transfer of purchase order (PO), sales orders and invoices are facilitated and controlled by and EDI Value Added Network (VAN) provider that provides the platform on how to contact each other. Usage of EDI can significantly save the labor costs, time and errors besides gives the users a high reliable and secure system. On the other hand, Internet gives a convenient way to publish and sell your products especially those slow moving products. You can send and receive mails electronically from your customers or vendors in minutes. You can publish the inventory status of your products in the Internet to potential customer globally.

Dell does not build PC based on forecast demand, but rather build to customers' orders and ship PCs directly to the end users. It has been able to hold lower inventory levels, reduce the overhead and achieving pricing advantage. How Dell is doing it? Dell requires their suppliers to set up shop near their plants, so that they could get inventory quickly and easily. With the help of Internet and EDI, Dell can complete 90% of its purchases entirely on-line. With the ninety percent of his suppliers have been hard-wired into the company, their suppliers are able to see exactly what parts Dell needs daily and how many it expects to need in the coming week. Therefore their suppliers have been able to more accurately forecast and produce for Dell real-time. One of his plastic parts suppliers has managed to cut the inventory on hand by 70%. Dell uses the concept of Just In Time (JIT). It orders only the supplies it required to keep production running for the next two hours. The suppliers' warehouse, which located near Dell's factory is electronically tells what to deliver. This virtually eliminates inventory. Dell can deliver the PC within15 hours of the order.

Future Trends

In this dynamic and uncertain era, there is increasing demand for cost efficiency and agility. This has forced the competitors, suppliers and distributors to work together and set up their factories in closed proximity to form a specialized industrial village or town. They all share a common interest in lowering costs and improving value of products. For example, by gathering the distributors, various manufacturers in a specified village, the parts could be stored, assembled to order, and delivered anywhere in the country within a short period. Retailers and distributors would no longer have to carry large inventory on their stock or unsold products.

Conclusion

Inventory control definitely gives impact to the cost and profitability for an organization. Therefore, we must identify the type of inventory in our warehouse, whether they are good, bad or ugly in term of profitability and dead or slow-moving inventory in term of duration of stocking. We need to liquidate those unwanted inventory to maximize our investment. In addition, we need to understand the cost of carrying the inventory such as storage, insurance, tax, damage and obsolescent in order to minimize the cost incurred. On top of this, we need to perform cycle counting for inventory accurately and make sure the computerized inventory system presents the report in the way we want for management decision. On the other hand, we need to determine the inventory turns required to meet the return of investment and forecast of profit. A concept of adjusted margin has to be introduced to reflect a more accurate calculation of actual inflow of money in the business. Some cases in the personal computer industry are presented to give examples of the impact of inventory. Last but not the least, the future trends of applying Internet, EDI, virtue based inventory and specialized industrial village are briefly described to give an understanding of latest development.

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