Post on 13-Apr-2017
Managing Inventory-Driven CostsFor profit and efficiency
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Learning Objectives Classify the hidden costs of inventory. Know how to:
Trace costs to the source Find the lowest-cost option Link inventory costs to financial performance
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IntroductionPC Industry in late ’90s Commoditized Fierce price cuts High rate of
devaluation High rate of
obsolescence HP: Market Leader
with lean profits
Personal Computer
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Introduction (contd.)HP Metrics outdated Impossible to see
impact of local decisions
Impossible to see impact of strategic decisions
Fuzzy Vision
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The Hidden Cost of InventoryInventory-Driven Costs: Commonly considered by companies:
Holding cost of inventory Plus, 4 more they should look at and measure:
Component devaluation costs Price protection costs Product return costs Obsolescence costs
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The Hidden Cost of Inventory- Component Devaluation Costs HP had no control over component prices, but…… It could control how much inventory it was holding That meant:
Reducing number of nodes in the supply chain Consolidating manufacturing facilities Just-in-time material inputs Coordinating with vendors to get minimum inventory
when prices expected to decline.
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The Hidden Cost of Inventory- Price Protection Costs
To limit this cost:
Keep manufacturing turnaround times short
Have frequent replenishment cycles
Give dealers incentives to carry low inventory
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The Hidden Cost of Inventory- Product Return Costs
Product return costs are simply 100% price protection costs.
To manage this cost:
Optimize supply chain Reduce inefficient
inventory Improve service levelsProduct Returns
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The Hidden Cost of Inventory- Obsolescence CostsObsolescence costs are: End-of-life write-offs Discounts on about-to-be
discontinued products Market costs to accelerate
sales------------------------------To manage obsolescence
costs: manage product introductions skillfully
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The Hidden Cost of Inventory- Calculating Costs of Devaluation
Mostly, devaluation rate is outside managerial control.
To reduce its impact, try to do a better job of matching demand and supply, thereby shrinking inventories.
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The Hidden Cost of Inventory- Price Protection & Return Cost Calculations
Price protection cost is the price drop times the number of units of the product in the distributors’ inventory
Return cost is the number of items returned of a particular product times the wholesale price paid by the retailer in the first place.
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The Hidden Cost of Inventory- Calculating Obsolescence Costs The amount of obsolescence cost is
determined by several factors:
100% write-off of finished goods in inventory Write-off of components in pipeline Marketing & discounting costs of selling off
about-to-be discounted products in fire sales.
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Tracing Costs to the SourceInventory-Driven Cost IDC as a Percentage of Revenues
Product A Product B Product C
Component Devaluation 2.10 4.20 2.20
Price Protection 7.15 2.30 0.80
Product Return 1.15 0.60 0.60
Obsolescence 2.55 0.65 0.40
Holding Cost of Inventory 1.30 1.10 0.80
Total 14.25% 8.85% 4.80%
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Tracing Costs to the SourceInventory-Driven Cost IDC as a Percentage of Revenues
Product A Product B Product C
Component Devaluation 2.10 4.20 2.20
Price Protection 7.15 2.30 0.80
Product Return 1.15 0.60 0.60
Obsolescence 2.55 0.65 0.40
Holding Cost of Inventory 1.30 1.10 0.80
Total 14.25% 8.85% 4.80%
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Quiz 1: Select the best optionWhat does IDC stand for?
a) Industry-Driven Costsb) Inventory-Driven Costsc) Initiative-Driven Costsd) Innovation-Driven Costs
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Quiz 2: select the best optionUnderstanding and managing inventory-driven
costs can have a significant impact on _____________.
a) researchb) salesc) moraled) profits
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Quiz 3 select the best optionWhat major challenge did HP face in 1999 after
overtaking IBM in the PC market share?
a) Gaining market shareb) Designing productsc) Making profitsd) Recruiting staff
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Quiz 4 fill in the blankAround 1997, a common rule of thumb was that
the value of a fully assembled PC decreased at the rate of _____ % a week.
a) 1b) 2c) 4d) 5
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Quiz 5: select the best optionAt HP, in/around 1997, what is it that failed to
keep pace with its evolving supply chains?
a) Customer satisfaction b) Management –accounting metricsc) Staff skillsd) Technology investments
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Quiz 6: select all that applyWhich ones are costs of inventory?
a) Component devaluation costsb) Price protection costsc) Product return costsd) Recruitment costs
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The Turnaround HP’s Mobile Computing
Division was losing money To become profitable,
managers felt: centralize manufacturing and ship products directly to customers
Problem: How to build a compelling case for above?
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Traditional Costs Scenario 1 Scenario 2 Scenario 3 Scenario 4 Scenario 5
Manufacturing 100% No change -15.6% -11.1% -21.0%
Distribution 100% No change No change No change No change
Freight 100% No change +7.4% -28.4% +56.8%
Total costs w/o IDC 100% No change -9.2% -10.2% -6.7%
IDC Costs
Inventory finance 100% -18.5% -29.6% -44.4% -51.9%
Inv. Devaluation 100% -51.6% -55.7% -58.0% -63.5%
Inventory Obsolescence 100% -24.0% -34.9% -52.7% -58.1%
IDC Total 100% -19.2% -29.3% -43.6% -51.2%
Total costs w/ IDC 100% -15.5% -24.0% -28.1% -28.3%
Finding the Lowest Cost Option - Costs Relative to Scenario 1
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Traditional Costs Scenario 1 Scenario 2 Scenario 3 Scenario 4 Scenario 5
Manufacturing 100% No change -15.6% -11.1% -21.0%
Distribution 100% No change No change No change No change
Freight 100% No change +7.4% -28.4% +56.8%
Total costs w/o IDC 100% No change -9.2% -10.2% -6.7%
IDC Costs
Inventory finance 100% -18.5% -29.6% -44.4% -51.9%
Inv. Devaluation 100% -51.6% -55.7% -58.0% -63.5%
Inventory Obsolescence 100% -24.0% -34.9% -52.7% -58.1%
IDC Total 100% -19.2% -29.3% -43.6% -51.2%
Total costs w/ IDC 100% -15.5% -24.0% -28.1% -28.3%
Finding the Lowest Cost Option - Costs Relative to Scenario 1
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Traditional Costs Scenario 1 Scenario 2 Scenario 3 Scenario 4 Scenario 5
Manufacturing 100% No change -15.6% -11.1% -21.0%
Distribution 100% No change No change No change No change
Freight 100% No change +7.4% -28.4% +56.8%
Total costs w/o IDC 100% No change -9.2% -10.2% -6.7%
IDC Costs
Inventory finance 100% -18.5% -29.6% -44.4% -51.9%
Inv. Devaluation 100% -51.6% -55.7% -58.0% -63.5%
Inventory Obsolescence 100% -24.0% -34.9% -52.7% -58.1%
IDC Total 100% -19.2% -29.3% -43.6% -51.2%
Total costs w/ IDC 100% -15.5% -24.0% -28.1% -28.3%
Finding the Lowest Cost Option - Costs Relative to Scenario 1
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HP Tastes Success MCD gives the lead Other divisions follow
MCD’s approach to costing in their supply chain decisions
HP implements new metrics in all PC operations
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The Payoff Now each product
group is free to choose the supply chain configuration best suited to it
Now managers are saved from moves that suit local unit but add to overall costs.
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The Payoff (contd)
The IDC metrics are valuable in a whole range of R&D and marketing decisions.
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The Payoff
DaysReceivablesOutstanding
DaysPayables
Outstanding
DaysInventory
Outstanding
Working CapitalRequirement Fixed Assets
Revenues ExpensesReturnon NetAssets
=
PriceProtection
ProductReturn Obsolescence
ComponentDevaluation
Inventory-Driven Costs
-
+
TraditionalInventory
Cost
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Linking Inventory Costs to Financial Performance
DaysReceivablesOutstanding
DaysPayables
Outstanding
DaysInventory
Outstanding
Working CapitalRequirement Fixed Assets
Revenues ExpensesReturnon NetAssets
=
PriceProtection
ProductReturn Obsolescence
ComponentDevaluation
Inventory-Driven Costs
-
+
TraditionalInventory
Cost
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HP – Personal Systems Group saw quick returns
Between 2000 and 2002: Worldwide inventory went down 50% Inventory costs went down 70%
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IDC applicable in many industriesConsumer Electronics
Personal Computers Perishables
Fash
ion
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Summary There are five main components of inventory costs:
Holding costs Component devaluation costs Price protection costs Product return costs Obsolescence costs
Without appropriate metrics some may be hidden Understanding and managing inventory-driven costs can have
a significant impact on a company’s profits. RONA is a more accurate measure of shareholder value than
market share.
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Quiz 1a: Fill in the blankAt HP, it soon became clear, that the mismatches
between demand and supply leading to excess _____________ were the main drivers of PC costs.
a) cashb) peoplec) inventoryd) information
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Quiz 2a: select the best optionWhich one is the most readily identifiable
component of inventory-driven costs?
a) Product return costsb) Price protection costsc) Withholding costsd) Holding costs
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Quiz 3a: select all that applyWhat steps should firms take to counter
component devaluation costs?
a) Recruit design talentb) Reduce nodes in supply chainc) Consolidate manufacturing facilitiesd) Procure material just-in-time
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Quiz 4a: select the best optionWhat should companies manage skillfully to
control obsolescence costs?
a) Product introductionsb) Product designsc) Product varietyd) Product quality
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Quiz 5a: True/ False?Companies that maintain high stocks of raw
material, may well find that the write-down in the value of the inventory, stemming from reductions in raw material prices, can, in any one year outweigh the benefits of lower input prices.
a) Trueb) false
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Quiz 6a: Fill in the blankAs important as identifying the various hidden components of
inventory costs, even more powerful is the understanding how, the impact of each IDC component differs for different products - that has profound implications for the way a company manages its __________.
a) Product designb) Product portfolioc) Product costd) Product image
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Quiz 7aHP found that return on net assets (RONA) is a
more accurate measure of shareholder value than _____________.
a) Market outlookb) Market valuec) Market shared) Market image
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Quiz 8a: Fill in the (?) blank
Returnon NetAssets
=Revenues - Expenses
( ? ) + Fixed Asset
a) Working capitalb) Working profitc) Working margind) Working machinery
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Quiz 9aLowering inventory-driven costs can not only
decrease total costs and raise revenues, but also raise working capital requirements by reducing the number of days of inventory outstandings.
a) True ?b) False ?
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Quiz 10a : select all that applyWhich organizational functions of manufacturing
industries benefit by using IDC metrics?
a) R&Db) Marketingc) Operationsd) IT
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References Managing Supply Chain Inventory; Hau Lee
& Corey Billington; Sloan Management Review (Spring 1992)
Competing on Analytics: The New Science of Winning; Thomas Davenport & Jeanne Harris; (HBS Press 2007)
Supply Chain Management; Sunil Chopra & Peter Meindl; (Prentice Hall; 3rd ed)