The Cost of Bad Inventory Control
By Jon Schreibfeder
If one of your warehouse employees walks past an item lying in the middle of a warehouse aisle, do they pick it up and put it in its proper location? Do they pretend not to see it? Do they feel they are too busy to deal with it? Do they kick it out of the way?
The answer to this question provides a good indication of what your employees think about your inventory. For any company to be successful, its employees must see the direct relationship between inventory and their paycheck. The same “pile” of money that is used to pay employees is used to buy inventory. Furthermore, inventory must be transformed back into cash (through sales) for the company to have the money to pay its employees in the future. You cannot be successful (or perhaps even survive) unless all your employees understand this relationship.
Everyone must understand that if your company loses $1,000 in material, it experiences more than a $1,000 loss. Like any other expense, material losses due to bad inventory control—whether from theft, breakage, misplaced warehouse stock, etc.—must be paid for with gross profit dollars. If a company’s average gross margin is 25 percent (a respectable number for many firms), the organization earns a 25-cent gross profit for every dollar of sales. The replacement material, along with all of your other expenses, has to be paid for with these 25 cents on the dollar.
Therefore, to make up for a $1,000 loss, your company doesn’t need $1,000 in new sales, it needs $4,000 in new sales! Twenty-five percent of $4,000 is $1,000. If we change this equation around slightly, you get a calculation that illustrates the true cost of lost material:
Value of Lost Material ÷ Average Gross Margin % = Needed Additional Sales
The value of lost material includes any inventory that cannot be sold to a customer or used to produce other goods or services that will be sold to a customer.
Examples of lost material:
• Missing inventory
• Stolen inventory
• Borrowed inventory by sales and technicians that is not recorded and doesn’t find its way back
• Broken or damaged stock
• Obsolete products (less any liquidation value)
• Remnants of an item that are too small to be sold or used (also known as “orphan inventory” or “drops”)
• Quantities of non-stock products ordered for a specific customer that exceed what the customer buys (an inventory management issue)
Illustrating the Point: Every week, post the value of lost material along with the additional sales needed to make up for the loss. Making everyone aware of a problem is the first step in its solution.