The Eternal Battle: Inventory vs COGs, Part 2

We have a client who runs a small manufacturing business.  A year ago we convinced him to do his first physical inventory.  Not unsurprisingly it was north of 60 days and was impacting his cash flow.  At the time we discussed with him a number of aspects, including:

1. Cost of capital–in our client’s case he got no terms from his A item vendors, but he had a 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 was 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 had excess warehouse space, so this was not an issue at this stage

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 (Cost of Goods Sold) savings?  For our client, his main A item had a substantial freight component that is to first order independent of volume, so there is substantial savings. 

Like most companies he has to constantly make these hard tradeoffs, and its not as easy as just saying “buy the cheapest” or “keep as little inventory as possible.” Compromise is, as they say, a mother.

As to our client, over the course of a year his business has actually grown quite nicely, and inventory is also coming down.  Which is good because otherwise he would need to beef up his working capital. He now buys in bulk where he gets discounts and to minimize freight, which tends to boost inventory, but has a better handle on his run rates and has smarter “buy triggers.”  He’s generating a little cash and paying down the LOC, and continuing to avoid any E&O.  Today his pains are more from rising costs of his A items, due to global factors, and seasonality.  He’s also evaluating alternate vendors on the biggest A items, including in his criteria transportation costs (!).

Obviously what works for one business may not work at all for another.  The key is to think about it, measure where you are and where you are going, model your alternatives, and make smart choices.

We’ll check in on him in another year.

Chuck

Leave a Comment