It is perhaps the biggest myth in supply chain management; that to reduce inventory costs you should keep inventory levels low.
After all, there is a difference between not tying up too much capital in inventory and incurring substantial costs when faced with shortages. Here’s how to reduce your inventory costs, while still maintaining the necessary stock levels you need to succeed.
Understand Why Companies Reduce Inventory Levels
Before venturing into the costs of shortages, it’s best to understand why companies decide to reduce inventory levels. These decisions are based primarily on carrying costs, ones that are exacerbated when sales don’t meet forecasts and a store is left with too much product on its shelves.
First, there is the cost of capital that increases over time. Second, there are costs that include pilferage. Third, there are costs defined by expired, outdated or “out-of-date” inventory. Finally, there are costs defined by freight, counting, storage, handling, and inventory damage, in addition to monthly rent and electricity. All of these play a role in a company’s unwillingness to hold inventory and they are exacerbated when sales volumes are low. However, what happens when sales volumes inexplicably trend upwards and the company comes face-to-face with a shortage? That’s correct, you lose out on potential sales and revenue.
Define Your Costs Associated With Inventory Shortages
First, why do you have inventory in the first place? Ultimately, you need inventory in order to sell products, generate gross profit, increase revenue, and keep customers happy. Inventory is needed because you want to maintain your store’s reputation as the go-to destination for specific items. You also want to keep competitors away from your most important customers! Maintaining the trust of your customers and keeping your customer retention rate high, requires you maintain healthy inventory levels.
Costs are incurred during shortages because of what your shop must do to rectify an inventory shortage. Think about what happens when a customer enters your store to make a purchase, only to find that the desired item is out of stock. Depending upon how important that customer is, and how urgent their need is, you’re likely to absorb the following two costs.
First: You’ll go back to your own vendors and ask for an expedited delivery of the item. That vendor may be able to ship immediately, or they may just decide to include a surcharge for servicing your company ahead of others. Regardless of whether you’re covering delivery charges on your own account, or your customer is including delivery to your facility in their price, your company is guaranteed to cover higher freight costs. After all, you need that shipment immediately and anything other than next-day delivery won’t suffice.
Second: Getting that all-important parcel to your customer often involves additional costs. For instance, what do you do when your customer expects you to cover delivery for not having a product ready when promised? If you failed to live up to your customer’s expectations, then you’ll have additional costs to fulfill their order.