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Inventory

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Quickly access the new cost of lead time calculator.

  • Long, cross-border supply chains usually increase the lead time between when an order is placed and when product is received, leading to increased inventory costs.
  • Inventory costs due to long lead times often add 20-30% to product costs. These additional inventory costs often outweigh the benefits of offshoring—even without considering other hidden costs of far-flung supply chains.  
  • We offer a calculator that provides firms a simple way to determine these costs for their own products. The calculator was developed by the University of Lausanne, and more information on it is here.
  • In addition, far flung supply chains often increase vulnerability to disruptions in supply, transportation, and currency exchange rates. These vulnerabilities also require holding more inventory, and incurring greater inventory carrying costs. Inventory carrying costs include both direct expenses and the opportunity costs associated with decreased cash flow and working capital.

Firms hold inventory to meet short-term demand surges and buffer against delayed or defective deliveries. Having a far-flung supply chain increases the risks of these contingencies, thus requiring more inventory.  According to The Economist, companies importing from abroad may have to hold up to 100 days of inventory in the United States. Authors of another academic study calculated that, when companies in their dataset increased the international share of their supply chain by 10 percent, it corresponded to an average increase of 8.8 percent in their inventory investment costs.  This drives up not only the cost of acquiring the larger inventory of goods, but the carrying costs as well.

A key reason why inventory rises with off-shoring is that the lead time between ordering and receiving components increases. 

Valuing Lead Time

Companies are increasingly interested in putting a monetary value on the lead time between ordering and receiving components from suppliers. How much is it worth to them to reduce the lead time?  If there is no lead time (that is, we know what our demand or our customers’ demands will be with absolute certainty), then a firm can produce exactly the quantity demanded. Often, however, orders for parts or products need to be placed before demand is known. If a company over-predicts how much product it will need, the result is excess inventory. This situation is costly because it results in higher inventory carrying costs and the possibility that the products can be sold only at a steeply discounted price.  On the other hand, if a company under-predicts demand, stockouts occur, leading to lost sales and angry customers. As a result of this mismatch between supply and demand, the ‘savings’ offered by remote suppliers are often substantially reduced.  In an important case study, we see that this is more than theoretical. K’NEX B rands is a Pennsylvania-based toy manufacturer that “re-shored” 90% of its production to the United States. K’nex found that producing in the US was 19% cheaper than producing in China. Almost all of these savings were due to reduced inventory costs

Although managers are aware that extending the supply chain—with the substantial increase in lead time associated with such an extension—increases mismatch costs, they have not had tools to quantify how much costs could increase. In other words, they have not known how much offshoring would need to save to offset the added uncertainty and risk of manufacturing outside the United States.

Innovative work[i] from the University of Lausanne in Switzerland connects those dots and draws insights from the complex field of quantitative finance to provide a cost differential frontier tool that makes such calculations relatively straightforward. Additional instructional materials are here. The key result of the analysis is that these hidden inventory costs alone often exceed the benefits of offshoring. Stock-outs and liquidations, frequently incurred by importers due to long production lead-times, often add 20-30% to product costs.  As a result, there would need to be savings of at least 20-30% from manufacturing outside of the United States just to break even.

Why are these costs so large? When suppliers are far away, they must produce to a forecast, rather than to a known order. As the lead time gets longer, the range of demand levels that must be considered becomes wider. Since a product’s scrap value is usually far less than its full price, firms want to ensure that they do not have a “stock out”, so they order significantly more than they expect to sell. Conventional inventory management models suggest that firms with long lead times often order more than twice their median demand (what they expect to sell), leading to  huge waste.  In contrast, producing locally to order avoids these costs.

This tool calculates the “cost differential frontier” (CDF) required to offset these additional inventory costs. Below is an example of how it works.

Let’s consider a scenario where price is $100, the make-to-order cost is $44, and the salvage value is $20. Suppose that the distant supplier offers a 20 percent cost reduction. The “cost-differential frontier” generated by the tool shows how much cheaper the product needs to be to compensate for mismatch costs as lead time increases from 0 (representing make-to-order production with full demand information) to 1 (representing make-to-stock production with the lead time that results from using the supplier with the longest lead time):

 

Given user inputs for price, cost, salvage, and demand variability, the Cost Differential Frontier tool calculates the savings required to make up for longer lead times. In this case, a fully extended supply chain would necessitate a savings of 22.5%.

The cost differential frontier in the figure shows that, if a firm sees its weekly demand double for only two weeks a year, a 22.5 percent cost savings is required to make up for mismatch costs. So, if the overseas supplier with the longest lead time offers only a 20 percent discount compared to a domestic supplier, it does not make sense to offshore the supply chain. Suppose that supplier requires 12 weeks of lead time (a typical number for suppliers in Asia). If a closer supplier (say in Latin America) offered ½ of that lead time, the required cost differential would be about 16 percent (the number corresponding to 0.5 on the horizontal axis). 

What factors make re-shoring attractive? The tool shows that the following factors are particularly important:

  • Large or frequent unexpected spikes in demand
  • Low salvage value compared to full selling price
  • Local supplier is able to quickly make to order.  The steep slope of the curve near a relative lead time of zero shows that getting very close to zero lead time is especially valuable.

Note that these factors are not confined to particular industries, and that on-shoring even labor-intensive production may be profitable if demand volatility is high enough, as in much of the apparel industry.

Carrying Costs

The CDF tool discussed above shows that long lead times add costs by increasing required production, including of products that will most likely be sold at a steep discount.  Holding this additional inventory also adds expense, due to “inventory carrying costs”.

Inventory carrying costs include myriad factors:

  • Warehouse space
  • Administrative management costs
  • Scrap, sorting, and rework
  • Obsolescence and deterioration
  • Insurance
  • Taxes
  • Cost of capital

The last of these factors, in particular, can be easily overlooked.  The cost of inventory is not solely determined by the direct expenses associated with storing, managing, and maintaining the goods, but also by the opportunity costs that arise when money is tied up.  Goods represent a store of value; keeping resources tied up in products or components that are not being utilized or sold immediately restricts a company's overall cash flow and may reduce the amount of liquid capital available.  Inventory management requires a careful balancing of all these costs against the benefits of having more goods or inputs available on demand.

As a rough rule of thumb, many sources, including the Reshoring Initiative, use 25 percent of a product's unit price as an estimate of annual carrying costs per unit. However, the actual number for any specific company, product, or component may be considerably higher.

In addition to the costs of carrying inventory onshore in the United States, companies must also consider the carrying costs of inventory in transit.  It is easy to overlook the carrying costs associated with these products because they are not sitting in a warehouse, but they form part of a company's overall inventory and represent money that is tied up in goods.  They also require the payment of insurance, consideration of the ultimate need for scrap and rework, and other factors.  Companies must be mindful not to disregard the cost of carrying inventory that has not yet arrived at its final destination, especially given the amount of time this inventory will spend in transit and the associated financing costs. 

Supply Chain Flexibility

In competitive markets, being the first to offer a new product secures important market share before similar products are offered by competitors.  Sourcing goods close to their final markets allows for new products to have smaller production and transit cycles.  For some products, it also allows firms to design, modify, and adjust products almost at will, while also enabling them to scale production according to demand and to avoid waste.  Longer supply chains can decrease this flexibility.  Companies can expect to wait a month or more between the time components are shipped from foreign factories and the time they arrive in the United States.  For high value consumer items, this is often an uncompetitive strategy.  According to one study, each day a desired consumer product is stuck in transit is equivalent to an ad-valorem tariff of 0.6 to 2.3 percent.  This means that domestic competitors with even moderately more expensive production costs can win market share by bringing products to market faster.

Conclusion

Inventory and lead time costs are important, and are reflected in firm’s location decisions. According to a 2013 study by Accenture, about four in ten manufacturers surveyed reported that they had relocated production facilities to new locations since 2011. Of those firms, nearly one-third listed reduced transportation costs as one of their top three reasons. One quarter cited increased responsiveness or reduced lead time. Nearly half of all firms surveyed had started new operations since 2011, and one in four cited reduced transportation costs and lead time as top-three factors.

Lean inventory management and supply chain flexibility have become key components of the modern business environment. Companies choosing to produce or source abroad must carefully consider the costs of increased inventory and the risks associated with a longer supply chain

[i] This article was published in the Journal of Operations Management, Vol. 32, Suzanne de Treville, et. al., "Valuing lead time," pp. 337-346, Copyright Elsevier (2014). The Journal of Operations Management may be accessed online at http://www.journals.elsevier.com/journal-of-operations-management