Calculating inventory carrying charge, two case studies at Lantmännen
Carl Wikner, David Hammarström
Abstract
As a part of a larger project consisting of reducing tied up capital, Lantmännen wishes to have a clearly defined inventory carrying charge in order to manage their inventory in a cost efficient way and to gain control over the total costs associated with carrying inventory. The aim of this master thesis has been to define the inventory carrying charge and its components and further aim has been to explain how the inventory carrying charge can be used as a management tool in order to gain control over the total inventory costs. Moreover, have the current carrying charges been calculated through a case studies for two of Lantmännen’s business units, Cerealia and Swecon.The carrying charge consists of the cost of capital plus all variable inventory costs divided by the average inventory value. By variable costs we mean inventory costs that vary continuously with the amount of inventory. The case studies show that the inventory carrying charge differs greatly between the different business units studied and between their groups of products.Our results show that the inventory carrying charge is between 8 % and 29 % for the different product groups where the main variable costs, apart from cost of capital, are shrinkage costs for Cerealia and inventory write-downs for Swecon.
Introduction
Lantmännen has recently uncovered a greater need of decreasing their working capital in order to free tied up capital and improve profitability. As a part of this larger project, Lantmännen need to clearly define inventory carrying charge in order to manage their inventory in a cost efficient way and to gain control over the total costs associated with carrying inventory. The inventory carrying charge measures the inventory carrying costs, meaning the variable costs, for a given inventory, as a percentage of the inventory value. It is an important parameter when analysing the total costs of an inventory system and is used both on an operational level as well as on a strategic level. On the operational level the main objective is to compute economically optimal order quantities in order to manage inventory cost efficiently. Strategically the main objective is to gain control over the total costs of carrying inventory and for strategic purchasing decisions.
The aim of this paper is to put together a definition of the inventory carrying charge and its components that works well for all of Lantmännen’s business units. The aim is also to explain how the inventory carrying charge can be used as a management tool in order to gain control over the total inventory costs. To exemplify this we have calculated the inventory carrying charge and its components for two of Lantmännen’s business units, Cerealia within their food division and Swecon within their machine division. We have only chosen to investigate these two business areas and within them only to look at the most relevant sites that represent the whole business. We have thereby investigated the sites Malmö, Järna and Laholm at Cerealia and at Swecon we have investigated new machines, used machines and equipment.
Carrying cost definition
Many authors have studied inventory costs and developed different models for calculating the inventory carrying charge. The main ones examined in this paper areAronsson et al. (2003), Mattson (2002) and Lambert & Stock (2001). They all present different models of how to calculate the carrying charge but they all agree thatit generally should be calculated through the following formula:
By examining different theories covering inventory carrying charge we have come up with a definition applicable for all of Lantmännen’s business units. This definition consists of the cost of capital plus all variable inventory costs divided by the average inventory value. By variable costs we mean inventory costs that vary continuously with the amount of inventory (see fig. 1) which is different from fixed inventory cost (see fig. 2).[1]
Figure 1, variable inventory costs
Figure 2, fixed inventory costs
One of the more detailed models for finding and calculating these variable costs is stated by Lambert & Stock (2001), which is also the basis of our definition:
There are different theories of how to calculate the capital cost which is often believed to be the main cost of r.One of the most common used methods is to usethe weighted average cost of capital, WACC, which states that the capital cost should be the average claim for yield in the company. It is calculated through multiplying the percentage of equity in form of debt with its average interest rate, and then adding the percentage of equity in form of shareholders equity which is multiplied with their expected return[2]. Another theory is to use the opportunity cost of capital which states that the cost of capital should be the highest possible return which could be achieved from another investment (with the same financial risk).[3][4]
A third alternative that often is used is to use the risk free interest rate as the cost of capital. The argument to use the risk free interest rate is that generally investments in inventory are considered a low risk investment and therefore the cost of capital should be lower than a general investment.[5]
The risk costs could be e.g. costs for obsolesce, theft, shrinkage, waste etc. And is often one of the main variable costs. Service costs are costs for taxes, insurances etc., if they are variable. Warehouse costs are cost for personnel, warehouse, handling equipment etc., if they are variable and increase with a marginal increase of volume. Costs for personnel and warehouses are often fixed costs but could be variable e.g. if you rent warehouse space per pallet at an external warehouse. [6]
Combined, all of these costs constitute the inventory carrying charge, where the focus is to find all the variable costs associated with the inventory system.
Results from case studies
To exemplify this we have calculated the inventory carrying charge and its components for two of Lantmännen’s business units, Cerealia within their food division and Swecon within their machine division. Cerealia is a producer of food mainly based of grain, while Swecon is a distributor of installation machines made by Volvo CE. These two business units are quite different and the reason for choosing them is to show Lantmännen what range the inventory carrying charge has.
For Cerealia we can see that the businesses in Järna and Laholm have significantly higher shrinkage costs than the business in Malmö (see fig. 3). This is because the groups of products stored in Malmö are more standard and generally consists of grain (73%) which is easier to store.Below are the detailed results for each site.
Figure 4, Carrying charge for Cerealia - Laholm
Figure 5, Carrying charge Cerealia - Malmö
Figure 6, Carrying charge Cerealia - Järna
The reason for the higher carrying charge in Laholm is that variable warehousing costs exist. These costs occursince Laholm uses an external warehouse, owned by Frigoscandia, for some of their products. Frigoscandia charges Cerealia for all handling of their products but also for the warehouse space Cerealia uses and for the amountof time the products are stored.
From the detailed results we can determine that the shrinkage differs significantly between product groups, resulting in a large variation of the carrying charge. The reason for high shrinkage could be one-time events, but also if the product group is sensitive e.g. products with short shelf-life, which is common in the food industry. The importantthing is to define the shrinkage that represents the typical behavior of the product group, meaning that one-time events should be excluded.
The same investigation was done for Swecon with the following result.
Figure 7, Carrying charge Swecon
Apart from the cost of capital, the write-down cost is the main variable inventory cost for Swecon. By write-down cost we mean reduction of inventory value due to decline of market value. We can see that new machines have no write-downs since Swecon only places an order after first receiving an order from their customers. There is still however a payment gap meaning that the cost of capital exists. The test machines, which are new machines used for customer demonstrations, have the largest write-downs.
Summary
We have concluded that Lantmännen should use the model presented by Lambert & Stock (2001) to calculate their inventory carrying charge. When calculating the cost of capital they should use a WACC which for Lantmännen today is 8%. The reason is mainly that the responsible for each business unit is measured on tied up capital where the WACC on 8% is used, indifferent on business unit.
Through the case studies we have discovered that the inventory carrying charge differs greatly between the different business units studied and between their groups of products. A discussion has been raised in the theses if the inventory carrying charge should be the same for all groups of products within a business unit or if it should be differentiated among them and if so, how complex this differentiation should be. Our results show that the inventory carrying charge is between 8 % and 29 % for the different product groups where the main variable costs, apart from cost of capital, are shrinkage costs for Cerealia and inventory write-downs for Swecon.
We recommend Lantmännen to differentiate among product groupsin order to find a carrying charge that represents the true costs of carrying inventory.When managing inventory levels for certain product groups, it is important to use the specific carrying charge for that given group. For an entire business unit an average inventory carrying charge can be used. This charge is computed by calculating a mean value of the specific product group inventory carrying charges.
Figure 3, Carrying charge for Cerealia
Regarding the inventory carrying charge as a management tool, we have come up with the conclusion that it should be used both on a strategic and operational level with emphasis on managing inventory levels, where the inventory carrying charge should be a parameter when computing economic order quantities.
References:
Aronsson H, Ekdahl B & Oskarsson B (2003). Modern logistik, Liber Ekonomi, Malmö.
Berling P (2005). On Determination of Inventory Cost Parameters, Lund Institute of Technology, Department of industrial management and logistics, Lund.
Lambert D, Stock J (2001). Strategic Logistics Management,McGraw-Hill Publishing Co.; 4th edition.
Mattson S-A, Jonsson P (2005). Logistik: Läran om effektiva materialflöden, Studentlitteratur, Lund.
[1] Aronsson et al. (2003)
[2]Timme et al. (2003)
[3]Nilsson et al. (1993)
[4] Lambert & Stock (2001)
[5] Berling (2005)
[6] Lambert & Stock (2001)