David Brown: What’s Your Inventory Really Costing You?

IT’S A FACT — the longer an item sits on your shelf, the more it costs you. Even if you didn’t use debt to purchase it.

Let’s do an exercise with a pair of gold earrings that have cost $100 to purchase from the vendor. What is the true cost of this ring if it is sitting on your shelf 12 months later?

Let’s look first at the one-off costs at time of purchase. There is freight to get it in-store, computer processing, time spent selecting the piece and time spent getting it displayed in the store. Let’s allow $5 for freight and another $10 for staff and your time in selecting the piece, processing it in-store and getting it on display.

On top of this we have holding costs for the 12 months. Let’s use 5 percent interest for the year (although in more prosperous trading times this would be closer to 10 percent). In addition we have the time spent cleaning and showing the piece during the 12 month period even though it hasn’t sold, plus insurance, a percentage of rent, advertising, boxing, the tax you had to pay on it given that you diverted “profit” to purchase it … and so on.

(Note: Most financial experts agree that the holding cost associated with non-performing inventory is 20 percent per annum.)

So even giving you the benefit of the doubt we are already up to $130 cost for this item in just 12 months and we have not allocated any packaging yet because it hasn’t sold. If the item needs to be reduced and cleared after this period these costs will further reduce the profit on the item — if there is any.

But the real cost of this item is the opportunity that has been missed. Opportunity cost is a term often discussed in economics. It represents the cost of choosing one particular action as opposed to another. In the case of our jewelry example the cost is the missed profit that could have been achieved if another faster selling item had been chosen.

That’s why it is important to keep inventory fresh and turning over, and why not carrying excessive dead inventory is crucial. Without stock-turn these humble gold earrings suddenly start to look very expensive indeed!

We can’t all be crystal ball gazers and know with certainty what will sell, but the important thing is to acknowledge when an item has become old and to “cut your losses” as soon as possible.

Realistically, for every $100,000 you are overstocked you will be looking at $5,000 to $20,000 in holding costs — so carrying $400,000 in excess inventory will take $20,000 to $80,000 off your bottom line while contributing nothing to sales. In fact, it may even reduce your sales if your percentage of aged inventory is so high your customers can’t see the good product for the bad.

This story is from the January 2010 edition of INSTORE.