Dollar Savings for Stock Reductions

Paul,

I'm no expert but I believe there are 2 schools of thought to this question.  The first is you have to look at what the project is providing in terms of your cash flow.  If your current state says you are tying up $100K of cash in inventory, and your improved state is that you will only be tying up $25K in the future, then you are effectively "freeing up" $75K.  This savings methods is relized once you "use up the $75K of stock and don't have to spend any cash to replace it.

You also mention the other school of thought which is to calculate the inventoy carrying cost. e.g. the value of the cash tied up to carry the stuff.  This is a bit harder to quantify, but it is also done.

I had a project and we calculated it both ways just to see.  They came to about the same savings anyway so the debate was moot.  I suggest you discuss with you core team to set a standard and stick to it for all your projects.

Hope this helps,

Patch

I would recommend using your 'cost of capital' for the savings cost.  Previous to transferring to Six Sigma I worked in Finance and I would surmise that this would make the most sense.  Your finance department should have a standard 'cost of capital' rate.  This is the amount of interest that you could be earning if that money were invested elsewhere rather than being tied up in inventory.  This is a standard rate that is used when evaluating whether or not to undertake projects.  You may also be able to determine a cost savings from the space savings which is generally allocated out as an overhead cost to various departments (although sq. footage savings are probably minimal and not worth it).

Dear Sir,

There are two reasons justifying inventory reduction :

1. The opportunity cost : if you spend only 25 $ for your inventory instead of 100 $, the difference may be used for anything else which may be more profitable (relooking your store, revamping your information system,...). 2. The carrying cost which includes the value of the freezed cash but also the cost of the warehouse (lending the building,, salary of people working there, insurance, taxe,...) and the depreciation of the inventory (dammage, obsolescence,...).

Calculating opportunity cost is very hard because this depends on the situation of your company. Concerning carrying cost, your accountancy department may calculate it.

Please don't hesitate to get in touch with me if need some more explanations and forgive my poor English.

Best regards.

Paul,

2 schools of thought...

1)  Use cost of money (ie std interest rate you would get if money was in bank) - I've always used this one - it's the safest, and easiest to justify

2)  Use % rate based on what you would normally achieve as ROI if you invested the freed up working capital back into the business - a little harder to justify, but not a totally impossible case to piece together!

Paul,

In our business we use two methods:

- "Cost of Capital" - calculated as % of the savings. We take a nominal 1% per month - the savings on reducing $100,000 of inventory would be $12,000 over a twelve month period - the run rate.

- "Inventory Handling and Storage" - avoided cost of product movement and warehouse storage space - this is more difficult to calculate and is generally taken as a one time cost saving.

Regards - Dave 

There is a one time Cash Flow pick up of $75,000 in the senerio you have given. You can also show a Carrying Cost reduction for the $75,000 in inventory, your Money Belt can help you here, He/She should know your companies internal borrowing rate to calculate this.

You might also have the additional savings of less damage, loss of stock(shrinkage) and less obsolecence. You should be saving warehousing space which could be converted to more productive uses, such as expanded manufacturing. There are many other opportunities depending on your specific business situation.

What you are really looking at is a reduction in the investment (cash) tied up by the excess inventory.  The savings is therefore the opportunity cost of investing that $75,000 into something else.  That something else could be additional equipment that could expand capacity and increase sales and gross profit, or equipment that could increase your productivity and therefore redue your operating costs.  Or maybe it allows you to reduce your company's debt and therefore its interest expense.  I hope that this is helpful.

Our company uses a "Working Capital" spreadsheet to determine the value of inventory, assets, expenditures, inflows, outflows, etc. to come  up with a working capital value for large projects.  We assign a value to inventory by keying in many factors, including the number of days that it will take to turn the inventory around.  The Lotus spreadsheet will calculate the value or working capital based on many inputs.  I do not know if this could be applied to say a daily value, but it may be possible.

Working Capital includes things like - Material Costs, portions of  direct labor, overhead (fixed and variable), volume of inventory on hand for the number of days on-hand.

The inventory generally has material, labor, overhead(s) or a "value".  If this value is not sitting on the floor somewhere taking up space, then is does need to be handled, stored, rotated, or tracked.  Generally speaking, the higher the inventory on the floor or in some warehouse, the fewer dollars are available for other things, therefore the emphasis on reducing inventory, because when inventory is up those dollars are locked up in the WIP (work in process) and can NOT be used for other things, like paying down debt or new projects.  Hench, the number of turns becomes important, less investment on the floor to do the same job.

If the inventory is turned 10 time a year vs. 3 times a year, the overall value of the inventory for the 10 turn is Annual Inv/10/360 and the 3 turn is Inv/3/360, I think.  So, $100,000/10/360 = Daily turn value of 27.8; $100,000/3/360 = 92.6.  The inventory sitting around costs you 64.0 points a day. 

Ed.

Depending on the type of product and its demand pattern, the carrying costs could be quite important.  Sometimes, because of insurance, energy, space, obsolescence, opportunity, image, and other costs, you may have anything from 30 % to 120% savings in addition to pure financial cost impact.  You may talk to your Marketing and Accounting people to find this out.  Rgds,

Andy

Paul - Did you ever receive an answer? I am facing the same challenge.

Thanks,

Randall

I don't know if this answer is good enough.  We have two financial measures for each product, one for profitability and one for cash flows.  In the case of stock reductions, the total $ value of the reduction all goes to cash flows.  Then we multiply that by our 'cost of capital' which is some crazy thing that the accountants calculate.  That value goes into the profitability category.   I think it represents the cost of tying up money in inventories and should go to the bottom line if it is reduced.

Dear Paul,

This is a typical problem which generally many of the industries face some or the other time. in your question, i feel there are two aspects to it. the first one is the effect on the cash flow and the second one which is fallout of the first  is incremental gains in your p&l. cashflow per se you will save full $75k as your cash requirement for holding that much inventory will be directly short by that amount, therefore your cashflow will be improved to that extent. Other impact will be by way of incremental profitability due to less requirement of borrowings to that extent. To quantify these gains on p&l, i feel one needs to calculate the returns on $75 k by using weighted average cost of borrowings of the company. This will highlight the gains portion affecting the p&l account.

regards

adwait

Dear Paul,

You can look into following to realize the savings:

Reduction in the stock provision (profit drained)

Convert SPACE into sales (estimated profit)

Regards

   

Question of reducing inventory from $100k to $25k, let me start some assumptions: (1) it is MRO spare parts for plant equipment. (2) the inventory is "on the books or general ledger" and is managed in a storeroom.  (3) The reduction does not close down a storeroom, employees are not laid off or attrited, and the energy requirements stay the same.

The first realization is that the location has some percentage of the following, (a) too high Max/Min levels, (b) obsolete inventory, (c) redundant parts.  Lowering max/mins and identifying a % of the redundant inventory can be done through consumption. This will provide a 1x savings at 100% of the inventory value by not having to replace it.  The obsolete inventory plus the remaining % of redundant inventory that is obsolete can either be sold back to the supplier at an approx 30% to 50% of original value, or sold for scrap value at 3 to 6 cents per pound.  Of course the $75k reduction will lower the cost of capital charge (~10%) and taxes (3% to 8% depending on what US state). This typically places the total rate in the 12% to 18% range.

This does not lead to a single number to use, but I believe it demonstrates that not all of the $75k should be credited at 100% to bottom line savings.