When consumers reduced their spending in 2008, traditional stalwarts like Circuit City and Linens ‘n Things wilted under the weight of their own massive inventories. They could not turn their inventories quickly enough to pay suppliers and were forced to close their doors when
cash ran out.
At the same time, Costco continued to thrive! How? By intentionally stocking fewer items than its competitors—and employing inventory management practices that successfully reduced costs throughout its operations. While the average grocery store carries around 40,000 items, Costco limits its offerings to about 4,000 products, or 90% less! Limiting the number of products on its shelves reduces Costco’s costs of carrying inventory.
Costco also employs a just-in-time inventory management system, which includes sharing data directly with many of its largest suppliers. Companies like Kimberly-Clark calculate re-order points in real time and send new inventory, as needed, to replenish store shelves. Costco also works to redesign product packaging to squeeze more bulky goods onto trucks and shelves, reducing the number of orders Costco needs to place with suppliers.
Occasionally, the company leverages its 75 million square feet of warehouse space to reduce purchasing costs. For example, when Procter & Gamble recently announced a 6% price increase for its paper goods, Costco bought 258 truckloads of paper towels at the old rate and stored them using available capacity in its distribution centers and warehouses.
These inventory management techniques have allowed Costco to
succeed in tough times while others have failed. Costco turns its
inventory nearly 12 times a year, far more often than other
retailers. With many suppliers agreeing to be paid 30 days
after delivery, Costco often sells many of its goods before
it even has to pay for them!
Inventory management is important because materials costs often account for more than 40% of total costs of manufacturing companies and more than 70% of total costs in merchandising companies.
Costs Associated with Goods for Sale Managing inventories to increase net income requires companies to effectively manage costs that fall into the following six categories:
1. Purchasing costs are the cost of goods acquired from suppliers, including incoming freight costs. These costs usually make up the largest cost category of goods for sale. Discounts for various purchase-order sizes and supplier payment terms affect purchasing costs.
2. Ordering costs arise in preparing and issuing purchase orders, receiving and inspecting the items included in the orders, and matching invoices received, purchase orders, and delivery records to make payments. Ordering costs include the cost of obtaining purchase approvals, as well as other special processing costs.
3. Carrying costs arise while holding an inventory of goods for sale. Carrying costs include the opportunity cost of the investment tied up in inventory (see Chapter 11, pp. 403–405) and the costs associated with storage, such as space rental, insurance, obsolescence, and spoilage.
4. Stockout costs arise when a company runs out of a particular item for which there is customer demand, a stockout. The company must act quickly to replenish inventory to meet that demand or suffer the costs of not meeting it. A company may respond to a stockout by expediting an order from a supplier, which can be expensive because of additional ordering costs plus any associated transportation costs. Or the company may lose sales due to the stockout. In this case, the opportunity cost of the stockout includes lost contribution margin on the sale not made plus any contribution margin lost on future sales due to customer ill will.
5. Costs of quality result when features and characteristics of a product or service are not in conformance with customer specifications. There are four categories of quality costs (prevention costs, appraisal costs, internal failure costs, and external failure costs), as described in Chapter 19.
6. Shrinkage costs result from theft by outsiders, embezzlement by employees, misclassifications, and clerical errors. Shrinkage is measured by the difference between (a) the cost of the inventory recorded on the books in the absence of theft and other incidents just mentioned, and (b) the cost of inventory when physically counted. Shrinkage can often be an important measure of management performance.
Consider, for example, the grocery business, where operating income percentages hover around 2%. With such small margins, it is easy to see why one of a store manager’s prime responsibilities is controlling inventory shrinkage. A $1,000 increase in shrinkage will erase the operating income from sales of $50,000 (2% $50,000 $1,000).
Note that not all inventory costs are available in financial accounting systems. For example, opportunity costs are not recorded in these systems and are a significant component in several of these cost categories. Information-gathering technology increases the reliability and timeliness of inventory information and reduces costs in the six cost categories. For example, barcoding technology allows a scanner to record purchases and sales of individual units. As soon as a unit is scanned, an instantaneous record of inventory movements is created that helps in the management of purchasing, carrying, and stockout costs. In the next several sections, we consider how relevant costs are computed for different inventory-related decisions in merchandising
companies.
Source: McGregor, Jena. 2008. Costco’s artful discounts. BusinessWeek, October 20.
Interested to know more? Check out my another publication in this series; Breakeven Analysis - How the “The Biggest Rock Show Ever” Turned a Big Profit
I am Syed Ali Ameer, CA - Finalist and also an Associate Member of PIPFA. Looking forward for more opportunities to discover, learn and share knowledge. I can be reached at s.ali.ameer@live.com. Please share this publication for those who might benefit. Thank you!
