6 benefits of light inventories

Locking company’s resources to places that don’t benefit the company is never a good idea. Efficient inventories enable better availability with less money, and the released money can be used for something more valuable, like financing growth strategies.

When estimating the total variable costs of inventories, the focus is typically on cost of capital. This puts the estimated variable cost of inventories in the ballpark of 5% per year compared to inventory value. Most products’ margin buffers can absorb this kind of hit, which can lead to the conclusion that their inventories are financially healthy investments, or having high inventories is like 'having money in the bank'. 

However, inventories cause other, more difficult-to-pinpoint variable costs, such as warehouse rents, insurances, breakages, control costs, lost cost erosions… These small streams add up, and spike up the total variable costs for carrying inventories to a ballpark of 20% of inventory value. This hurdle is so much higher that many products begin to struggle crossing it with their margin buffers. Having inventories is not the same as having money in the bank.

If operations are allowed to absorb cash into inventories without tight control, they become a heavy burden when companies want to grow: Not only does growth require financing the new products, sales, marketing and such that are set to deliver the growth, but they also need to finance the beefy inventories that are needed to support the larger business size. And since growth requires operating in more uncertain businesses, these new inventories tend to be proportionally less efficient than for legacy business. Operations that absorb less money into inventories can grow faster and more profitably.

Companies that irreversibly lock their bets far into the future by preparing availability and building inventories according to uncertain forecasts will have a hard time adjusting the course when reality and plans go their separate ways. The more uncertain the business is, the more companies should focus on ensuring that they can respond quickly. One such element increasing the agility are well-designed risk sharing practices with suppliers and customers.

Inventories are the result of decisions made throughout the company. If the company struggles with high inventories and is unable to implement corrective actions, it can be an indication of other deep-rooted issues in coordinating across the company. Improving inventory efficiency can reveal places where company is not aligned, which is the first step towards fixing it.

Efficient operations and inventories tie up and release cash in a predictable way that’s closely linked to company activities, performance and size. If inventory changes cause surprises and inconsistent financial performance despite steady sales and growth, it can raise questions for investors on how robust or risky the company is. When operating in uncertain business one should minimize the variables that Murphy could flip the wrong way all at the same time.