Smart Inventory Solutions. Phillip Slater
4.The Operating Statement
The typical operating statement details only the expenses over a period of time. This statement might also be referred to as a Cost Center Report, Expenditure Report, or Departmental Report. The Operating Statement does not include revenue; it only includes costs and might be issued weekly, monthly, quarterly, or annually (or all four!). The statement includes items such as labor costs, overtime, and material costs, by department.
Engineering materials and spares are only included if their purchase cost is recorded against one of the cost centers included in the report. This means that they are purchased directly against an operating cost center or are ‘booked out’ or ‘issued’ from the storeroom against that cost center. This action moves the cost of the item from the capital account on the balance sheet to the P&L and Operating Statement.
How Much Cash Can You Generate?
Now let’s try and put some numbers together to get an understanding of the magnitude of the benefits that you might realize by implementing an appropriate inventory review. This is important for two reasons. First, goal setting is an important element of any improvement program. An appropriate goal provides direction and motivation—a ‘yard stick’ for measuring progress. Second, goal setting can assist in justifying an investment in the resources required to achieve the benefits. There are few things more frustrating than seeing value-adding opportunities and not being able to justify the investment required to achieve them because the benefits are difficult to quantify.
On page 47 there is a calculation sheet for you to use to calculate the benefits you could realize from a well-implemented program. However, before you complete that form, work through the example on page 46; it will help explain the elements of the calculation. Turning to Figure 3-4 you will see that the sheet is divided into two sections, Inventory Costs and Potential Savings.
Step 1: Let’s first look at the Inventory Costs. The topmost number on Figure 3-4 is the current inventory value. In this example it is $5,000,000. For your organization, this number might be more or it might be less. The important thing is that you record the value as reported by your Finance Department—don’t guess.
Step 2: The next line down reads Estimated WACC. The cost of financing working capital is much more than just the interest rate that businesses pay on borrowings. In business finance, there is a term called the Weighted Average Cost of Capital (or WACC, pronounced wack). The WACC will be different for every company because it is based on the sources of capital, such as shareholder funds, borrowings from banks, bond issues, and so on. Because this book isn’t a business finance text, I won’t be explaining this concept further except to say that for most companies the WACC generally ranges from 10–15%. To be conservative, the calculation in the example will use 10%. You should ask your Chief Financial Officer (CFO) what WACC to use for your company.
Step 3: The next line is for estimating the value of obsolescence and spoilage as well as the costs of managing and storing your inventory, as a percentage of the total inventory value. It is fair to say that this is usually the most difficult number to estimate. Some companies estimate that this cost could be as much as 25% of the total investment in inventory per year. However, for general use, a value of 10% is recommended as a suitable rule of thumb.
Step 4: Now by adding together the values from Steps 2 and 3, you get what I call the Inventory Cost Ratio. This ratio represents the annual percentage cost for just having the inventory available. This does not include the cost of actually purchasing the materials. In this example, the Inventory Cost Ratio is 20%.
Step 5: Multiply the Value of Inventory by the Inventory Cost Ratio to determine the Total Annual Cost of Inventory. In this case, $5,000,000 × 20% = $1,000,000. This is the annual dollar cost just for having the inventory available. It does not include the cost of actually purchasing the materials. Instead, this is how much it costs simply to hold this inventory each and every year.
Now calculate the benefits of an inventory reduction program.
Step 6: To calculate the benefit, the first thing to do is to estimate a target. Elsewhere in this book you will find case studies where companies have achieved results as high as nearly a 50% reduction. However, in my experience, the average is somewhere around 25%, so let’s use that value.
Step 7: To calculate how much cash you can potentially realize, multiply the Inventory Value by the Reduction Target. In this example, this is $5,000,000 × 25% = $1,250,000 and is shown as the Potential Cash Release. This calculation indicates that a program of inventory reduction with these values could realize a cash benefit of $1,250,000. That’s a lot of capital!
Step 8: In addition to the cash savings, you can also generate an ongoing saving because the cash generated in Step 7 no longer needs financing or will result in obsolescence. This means that you generate annual savings equal to the Potential Cash Release multiplied by the Inventory Cost Ratio. In this example, this is $1,250,000 × 20% = $250,000. This amount is in addition to the Potential Cash Release and will be saved each and every year.
Figure 3-4: Example of a Calculation Sheet
Figure 3-5 Blank Calculation Sheet
Ask most people which three factors have the greatest impact on their inventory holdings and they will most likely respond by identifying factors that are largely independent of people and processes, such as:
• Usage
• Risk
• Cost of a stockout
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