Network Capital Analysis and Scenario Management

Carrying costs impact inventory in the following ways:

• Inventory carrying cost, or inventory holding cost, is the effective interest rate at which inventory costs are carried.
• Inventory holding cost has both financial and operational components.
• Tax effects should be considered in calculating inventory holding cost.
• Inventory holding cost has a significant impact on inventory optimization.
• Item- and location-specific inventory holding cost can be much higher than the cost of other forms of working capital.

Inventory is an investment, and alternative investments exist. Alternatives may carry more risk than a savings account or a market investment. A greater rate of return may be expected compared to a risk-free investment. Getting a loan from the bank could cost 4% interest, while an investment in new plant equipment may return a rate of 100% in nine months.

The following items are the reasons why we are not taking loans and making investments:

• Corporate propensity for risk
• Limits on a credit line
• Practical financial limitations

We need a way to average our cost of capital in the light of alternatives.

Weighted average cost of capital (WACC), is a weighted average of:

• Financial return expected by shareholders (cost of equity)
• Interest rate on debt (cost of current debt)
• Debt / equity ratio
• Risk

Example: A company’s shareholders expect an 11% return. The company’s cost of debt is 5%, with a D/E ratio of 30:70 and a 40% corporate tax rate. WACC = cost of equity (11% * 70%) + cost of debt [5% * 30% * (100% - 40% tax rate)] = 8.6%.

In addition to capital costs, inventory incurs before-tax operational costs. These may be readily available, based on the component-level data, but they are rarely as well considered as the cost of capital.

• Storage and warehousing costs (direct fees)
• Risk costs such as obsolescence, pilferage, shrinkage, and damage
• Insurance and other taxes
• Administration and other factors

Non-capital carrying costs can range from 5% to above 30% of the cost of inventory.

Good practice: Inventory Holding Cost at all locations is carried at WACC.

The advantages of good practice are:

• Considers inventory as an investment.
• Considers inventory investment cost against alternate investments.
• Easy to implement, defend, discuss, and calculate.

The disadvantages are:

• Cannot consider operational costs of carrying inventory (storage costs).
• Cannot consider risk, obsolescence, or spoilage.
• Does not allow for item, or location, specific situations.
• Is often not corrected for tax effects (corporate taxes, other taxes).

Better practice: Carries inventory at WACC + average operational costs.

This has the advantages:

• WACC (Weighted Average Cost of Capital)
• Considers operational costs, but in a basic way.

The disadvantages are:

• Operational costs require research and calculation.
• Average operational cost per unit or location may not equitably spread costs to the items or locations that incur those costs.

Detailed practice: Use WACC + Operational Costs by Item and Location:

The advantages are:

• Considers very real differences between items and locations.
• Allocates costs fairly, depending on the level of data available.

The disadvantages are: Requires research, calculation, and maintenance.

Inventory carrying cost is more than simply the financial cost of carrying working capital.

Operational costs must be used to better manage safety stock distribution in a supply chain.

Because operational costs differ by item and location, these differences can be accounted for in the optimization.

Better practice in calculating inventory holding cost considers tax effects (before tax, or after tax).

The SAP solution has the capability to consider item-location-specific inventory holding costs in the optimization.