Spare Parts Inventory Management. Phillip Slater
spend that money on something else. Money is a limited resource. Therefore, if a company invests $1 million in spare parts, above and beyond the quantity of parts required to keep operating, then it forgoes the opportunity to invest that $1 million somewhere else. That might be:
• Buying more productive plant and equipment.
• Paying down debt.
• Returning to shareholders.
In financial terms this opportunity cost is determined by what is known as the weighted average cost of capital (WACC, pronounced “wack”). The WACC takes account of the sources of a company’s funds: borrowings, shareholder funds, bond issues, retained profits, to name a few. Effectively the WACC is the rate of return that a company requires in order to pay for all of its sources of funds.
In practical terms there are two major issues with applying the principle that money is limited. First, at an operational level, it only seems like funds are limited if there is a specific budget, and there is rarely a budget for spare parts inventory. Hence the funds spent on parts that become inventory are not measured against a target. Second, establishing an “inventory budget” that takes account of all the risks is very difficult (and most likely is the problem that a reader of this book is trying to solve). This is why people resort to simple metrics such as percent of replacement asset value; however, these metrics are misleading, as they fail to take account of individual circumstance. Even with these issues, it is still an important principle to bear in mind with any expenditure—money is limited.
3. Money Costs Money
Sometimes this principle is a little less obvious than the first two. Everyone understands that if you borrow money, there will be interest to pay. Similarly, if a company has debt (and most do), then the cost of the debt can be easily determined. However, there are some other dynamics at play here.
The discussion above, Principle 2, referred to the WACC. This is the way that companies determine the cost of money when they haven’t directly borrowed money for the purchase. This means that, at a minimum, money that is invested in spare parts inventory costs the company the equivalent of the WACC each and every year. Examples of the WACC at some well-known companies8 (at time of writing) include:
• Apple Inc.: 11.1%
• ExxonMobil: 7.8%
• BHP Billiton: 7.1%
• General Motors: 6.9%
• Samsung: 5.6%
• Volkswagen: 4.4%
Consider this: if Apple invests in a $100 spare part and does not use it for 5 years, then the opportunity cost of spending that $100 is 100 × 11.1% × 5 years = $55.50. This is more than half the original cost of the part! This cost doesn’t include the cost of storing and managing the inventory during that time. Which leads us to Principle 4.
4. Inventory Requires Management
Which would cost more to manage: an inventory consisting of 10,000 different types of parts (SKUs) with an average of 10 of each (a total of 100,000 items) or an inventory of 100,000 SKUs with an average of 1 each? Without even thinking about it, most people would most likely say the second scenario, 100,000 SKUs, because this scenario will require:
• More space, as each SKU will require a unique location.
• Greater utilities costs due to the larger space.
• More inward goods movements and with that more “put-away” activity.
• More outward goods movement and transactions, requiring more labor.
• More labor for stock takes and cycle counts.
• Greater allowances for obsolescence, as there are many more parts to become obsolete.
• More indirect labor for processing purchase orders and invoices
None of the above are absolute, as each situation will be different, but this list does demonstrate that the costs of managing inventory include
• Storage space (both the capital cost and opportunity cost).
• Utilities.
• Direct labor.
• Indirect labor.
Some of these costs will have a linear relationship with the quantity of inventory held. For example, fewer SKUs and a lower number of items will most likely require fewer purchase orders and less labor for stock takes.
Some of these items will more likely involve step changes in cost, as they must be “purchased” in discrete quantities. For example, if you have a 50,000 sq ft storeroom and can reduce the space needs to 30,000 sq ft, you will still have a 50,000 sq ft space. Therefore, reducing storage space requirements may only provide a significant benefit if it means paying less for space or relocating something else into the newly freed space. (Note that there may be other benefits from space reduction such as reducing “travel” times for parts put away and retrieval.)
Every situation is unique; however, the generally accepted rule of thumb is that the cost of managing and storing inventory is 10% of the inventory value per year.
5. Timing Is Important
There are two ways in which timing is important with respect to inventory. The first is that holding onto inventory, over time, costs the company through both the opportunity cost (as calculated through the WACC, as discussed in Principle 2) and the management cost (as discussed in Principle 4). By adding together these two costs, it is easy to calculate the annual cost of holding inventory. For example, and using the rule of thumb of 10% for inventory management cost, the annual cost of holding inventory at the companies mentioned previously is:
• Apple Inc.: 11.1% + 10% = 21.1%
• ExxonMobil: 7.8% + 10% = 17.8%
• BHP Billiton: 7.1% + 10% = 17.1%
• General Motors: 6.9% + 10% = 16.9%
• Samsung: 5.6% + 10% = 15.6%
• Volkswagen: 4.4% + 10% = 14.4%
Previously the financial cost to Apple for holding a spare valued at $100 for 5 years was identified as $5.50. If we now add in the cost of managing that spare at 10% per year, the management cost is $50 for 5 years. Therefore, the total cost of owning that spare part for 5 years is:
$55.50 + $50.00 = $105.50
This is more than the actual cost of buying the item.
From this you can see that if a company can organize its spare parts management to hold less inventory for a shorter period of time, it can significantly reduce its inventory costs. In this case, time really is money.
Another way in which timing is important relates to accounting accruals. One of the principles of financial accounting is that a company’s accounts must reflect the current value of its assets. In most companies the spare parts inventory is treated as an asset, which means that the accounts need to reflect the current value of this inventory.
There are two problems with this: First, over time spare parts lose value and if sold are not worth what the company originally paid. Second, some parts will become obsolete or become nonfunctional through poor storage practices (sometimes referred to as spoilage). This means that if a company pays, for example, $100 each for 100 parts purchased today, that investment of $10,000 is unlikely to be worth $10,000 in the future. To account for this, accountants use what is called an accrual. An accrual is the way that accountants try to represent the real current value of inventory over time. For example, if a spoilage rate of 5% is assumed (that means that the accountant assumes that 5% of items will become nonfunctional each year) and a value reduction (called depreciation) of 5% is assumed, then the accountants will enter into the accounts an accrual of 10% each year, based on the value of the inventory that year. This accrual reduces the reported value of the items and so is the accountants’ way of reflecting the real value