Inventory vs COGS

We have a client who runs a small manufacturing business.  With our help, he just completed his first comprehensive physical inventory.  Perhaps not unsurprisingly his inventory is north of 60 days and it’s impacting his cash flow.  However, a prime reason for holding so much inventory is driving economies of scale to lower COGS, especially inbound freight in his case. 

This is a tough call and a common issue for many businesses.  So how do you decide when to buy more and reduce your COGS yet suffer a spike in your inventory?

Some factors to consider:

1. Cost of capital–in our client’s case he gets no terms from his A item vendors but he does have a very low interest line of credit

2. E&O risk (Excess and Obsolete)–this kicks in if you have a drop in demand or if the product changes.  In our client’s case  there is some mix risk but no obsolescence risk.

3. Warehousing / Storage–Some products are expensive to store or there is risk of spoilage or shrinkage.  Our client has excess warehouse space

4. Cost elasticity wrt volumes–This is a huge factor and is basically “how much do you save by buying more?”  If you buy 20% more what is the COGS savings?  For our client his main A item has a substantial freight component that is to first order independent of volume, so there is substantial savings.  On one of his B items there are some major volume discounts he can capture.

So what’s the best answer?  Clearly there is no one size fits all.  For our client he will continue to buy in bulk where he gets substantial discounts on volume or freight but lean up in other cases.  He will also be tracking inventory much closer going forward, and will be investigating alternate supply chain solutions with lower freight costs.

Chuck

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