Managing inventory driven costs

Managing Inventory-Driven CostsFor profit and efficiency

Learning Objectives Classify the hidden costs of inventory. Know how to:

Trace costs to the source Find the lowest-cost option Link inventory costs to financial performance

IntroductionPC Industry in late ’90s Commoditized Fierce price cuts High rate of

devaluation High rate of

obsolescence HP: Market Leader

with lean profits

Personal Computer

Introduction (contd.)HP Metrics outdated Impossible to see

impact of local decisions

Impossible to see impact of strategic decisions

Fuzzy Vision

The Hidden Cost of InventoryInventory-Driven Costs: Commonly considered by companies:

Holding cost of inventory Plus, 4 more they should look at and measure:

Component devaluation costs Price protection costs Product return costs Obsolescence costs

The Hidden Cost of Inventory- Component Devaluation Costs HP had no control over component prices, but…… It could control how much inventory it was holding That meant:

Reducing number of nodes in the supply chain Consolidating manufacturing facilities Just-in-time material inputs Coordinating with vendors to get minimum inventory

when prices expected to decline.

The Hidden Cost of Inventory- Price Protection Costs

To limit this cost:

Keep manufacturing turnaround times short

Have frequent replenishment cycles

Give dealers incentives to carry low inventory

The Hidden Cost of Inventory- Product Return Costs

Product return costs are simply 100% price protection costs.

To manage this cost:

Optimize supply chain Reduce inefficient

inventory Improve service levelsProduct Returns

The Hidden Cost of Inventory- Obsolescence CostsObsolescence costs are: End-of-life write-offs Discounts on about-to-be

discontinued products Market costs to accelerate

sales------------------------------To manage obsolescence

costs: manage product introductions skillfully

The Hidden Cost of Inventory- Calculating Costs of Devaluation

Mostly, devaluation rate is outside managerial control.

To reduce its impact, try to do a better job of matching demand and supply, thereby shrinking inventories.

The Hidden Cost of Inventory- Price Protection & Return Cost Calculations

Price protection cost is the price drop times the number of units of the product in the distributors’ inventory

Return cost is the number of items returned of a particular product times the wholesale price paid by the retailer in the first place.

The Hidden Cost of Inventory- Calculating Obsolescence Costs The amount of obsolescence cost is

determined by several factors:

100% write-off of finished goods in inventory Write-off of components in pipeline Marketing & discounting costs of selling off

about-to-be discounted products in fire sales.

Tracing Costs to the SourceInventory-Driven Cost IDC as a Percentage of Revenues

Product A Product B Product C

Component Devaluation 2.10 4.20 2.20

Price Protection 7.15 2.30 0.80

Product Return 1.15 0.60 0.60

Obsolescence 2.55 0.65 0.40

Holding Cost of Inventory 1.30 1.10 0.80

Total 14.25% 8.85% 4.80%

Tracing Costs to the SourceInventory-Driven Cost IDC as a Percentage of Revenues

Product A Product B Product C

Component Devaluation 2.10 4.20 2.20

Price Protection 7.15 2.30 0.80

Product Return 1.15 0.60 0.60

Obsolescence 2.55 0.65 0.40

Holding Cost of Inventory 1.30 1.10 0.80

Total 14.25% 8.85% 4.80%

Quiz 1: Select the best optionWhat does IDC stand for?

a) Industry-Driven Costsb) Inventory-Driven Costsc) Initiative-Driven Costsd) Innovation-Driven Costs

Quiz 2: select the best optionUnderstanding and managing inventory-driven

costs can have a significant impact on _____________.

a) researchb) salesc) moraled) profits

Quiz 3 select the best optionWhat major challenge did HP face in 1999 after

overtaking IBM in the PC market share?

a) Gaining market shareb) Designing productsc) Making profitsd) Recruiting staff

Quiz 4 fill in the blankAround 1997, a common rule of thumb was that

the value of a fully assembled PC decreased at the rate of _____ % a week.

a) 1b) 2c) 4d) 5

Quiz 5: select the best optionAt HP, in/around 1997, what is it that failed to

keep pace with its evolving supply chains?

a) Customer satisfaction b) Management –accounting metricsc) Staff skillsd) Technology investments

Quiz 6: select all that applyWhich ones are costs of inventory?

a) Component devaluation costsb) Price protection costsc) Product return costsd) Recruitment costs

The Turnaround HP’s Mobile Computing

Division was losing money To become profitable,

managers felt: centralize manufacturing and ship products directly to customers

Problem: How to build a compelling case for above?

Traditional Costs Scenario 1 Scenario 2 Scenario 3 Scenario 4 Scenario 5

Manufacturing 100% No change -15.6% -11.1% -21.0%

Distribution 100% No change No change No change No change

Freight 100% No change +7.4% -28.4% +56.8%

Total costs w/o IDC 100% No change -9.2% -10.2% -6.7%

IDC Costs

Inventory finance 100% -18.5% -29.6% -44.4% -51.9%

Inv. Devaluation 100% -51.6% -55.7% -58.0% -63.5%

Inventory Obsolescence 100% -24.0% -34.9% -52.7% -58.1%

IDC Total 100% -19.2% -29.3% -43.6% -51.2%

Total costs w/ IDC 100% -15.5% -24.0% -28.1% -28.3%

Finding the Lowest Cost Option - Costs Relative to Scenario 1

IDC Costs

Inv. Devaluation 100% -51.6% -55.7% -58.0% -63.5%

IDC Total 100% -19.2% -29.3% -43.6% -51.2%

Total costs w/ IDC 100% -15.5% -24.0% -28.1% -28.3%

IDC Costs

Inv. Devaluation 100% -51.6% -55.7% -58.0% -63.5%

IDC Total 100% -19.2% -29.3% -43.6% -51.2%

Total costs w/ IDC 100% -15.5% -24.0% -28.1% -28.3%

HP Tastes Success MCD gives the lead Other divisions follow

MCD’s approach to costing in their supply chain decisions

HP implements new metrics in all PC operations

The Payoff Now each product

group is free to choose the supply chain configuration best suited to it

Now managers are saved from moves that suit local unit but add to overall costs.

The Payoff (contd)

The IDC metrics are valuable in a whole range of R&D and marketing decisions.

The Payoff

DaysReceivablesOutstanding

DaysPayables

Outstanding

DaysInventory

Outstanding

Working CapitalRequirement Fixed Assets

Revenues ExpensesReturnon NetAssets

PriceProtection

ProductReturn Obsolescence

ComponentDevaluation

Inventory-Driven Costs

TraditionalInventory

Linking Inventory Costs to Financial Performance

DaysReceivablesOutstanding

DaysPayables

Outstanding

DaysInventory

Outstanding

Working CapitalRequirement Fixed Assets

Revenues ExpensesReturnon NetAssets

PriceProtection

ProductReturn Obsolescence

ComponentDevaluation

Inventory-Driven Costs

TraditionalInventory

HP – Personal Systems Group saw quick returns

Between 2000 and 2002: Worldwide inventory went down 50% Inventory costs went down 70%

IDC applicable in many industriesConsumer Electronics

Personal Computers Perishables

Summary There are five main components of inventory costs:

Holding costs Component devaluation costs Price protection costs Product return costs Obsolescence costs

Without appropriate metrics some may be hidden Understanding and managing inventory-driven costs can have

a significant impact on a company’s profits. RONA is a more accurate measure of shareholder value than

market share.

Quiz 1a: Fill in the blankAt HP, it soon became clear, that the mismatches

between demand and supply leading to excess _____________ were the main drivers of PC costs.

a) cashb) peoplec) inventoryd) information

Quiz 2a: select the best optionWhich one is the most readily identifiable

component of inventory-driven costs?

a) Product return costsb) Price protection costsc) Withholding costsd) Holding costs

Quiz 3a: select all that applyWhat steps should firms take to counter

component devaluation costs?

a) Recruit design talentb) Reduce nodes in supply chainc) Consolidate manufacturing facilitiesd) Procure material just-in-time

Quiz 4a: select the best optionWhat should companies manage skillfully to

control obsolescence costs?

a) Product introductionsb) Product designsc) Product varietyd) Product quality

Quiz 5a: True/ False?Companies that maintain high stocks of raw

material, may well find that the write-down in the value of the inventory, stemming from reductions in raw material prices, can, in any one year outweigh the benefits of lower input prices.

a) Trueb) false

Quiz 6a: Fill in the blankAs important as identifying the various hidden components of

inventory costs, even more powerful is the understanding how, the impact of each IDC component differs for different products - that has profound implications for the way a company manages its __________.

a) Product designb) Product portfolioc) Product costd) Product image

Quiz 7aHP found that return on net assets (RONA) is a

more accurate measure of shareholder value than _____________.

a) Market outlookb) Market valuec) Market shared) Market image

Quiz 8a: Fill in the (?) blank

Returnon NetAssets

=Revenues - Expenses

( ? ) + Fixed Asset

a) Working capitalb) Working profitc) Working margind) Working machinery

Quiz 9aLowering inventory-driven costs can not only

decrease total costs and raise revenues, but also raise working capital requirements by reducing the number of days of inventory outstandings.

a) True ?b) False ?

Quiz 10a : select all that applyWhich organizational functions of manufacturing

industries benefit by using IDC metrics?

a) R&Db) Marketingc) Operationsd) IT

References Managing Supply Chain Inventory; Hau Lee

& Corey Billington; Sloan Management Review (Spring 1992)

Competing on Analytics: The New Science of Winning; Thomas Davenport & Jeanne Harris; (HBS Press 2007)

Supply Chain Management; Sunil Chopra & Peter Meindl; (Prentice Hall; 3rd ed)

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