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International Journal of Physical Distribution & Materials Management Inventory Carrying Costs: Current Availability
International Journal of Physical Distribution & Materials Management Inventory Carrying Costs: Current Availability

International Journal of Physical Distribution & Materials Management

Inventory Carrying Costs: Current Availability and Uses Douglas M. Lambert John T. Mentzer

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Douglas M. Lambert John T. Mentzer , (1979),"Inventory Carrying Costs: Current Availability and Uses", International Journal of Physical Distribution & Materials Management, Vol. 9 Iss 6 pp. 256 - 271 Permanent link to this document:

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Bernard J. La Londe, Douglas M. Lambert, (1975),"Inventory Carrying Costs: Significance, Components, Means, Functions", International Journal of Physical Distribution, Vol. 6 Iss 1 pp. 51-63

http://dx.doi.org/10.1108/eb014361

Bernard J. La Londe, Douglas M. Lambert, (1977),"Inventory Carrying Costs: Significance, Components, Means, Functions", Managerial Finance, Vol. 3 Iss 1 pp. 16-28 http://dx.doi.org/10.1108/

eb013393

Anna Azzi, Daria Battini, Maurizio Faccio, Alessandro Persona, Fabio Sgarbossa, (2014),"Inventory holding costs measurement: a multi-case study", The International Journal of Logistics Management, Vol. 25 Iss 1 pp. 109-132 http://dx.doi.org/10.1108/IJLM-01-2012-0004

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256 | IJPD & MM

9, 6

Inventory Carrying Costs: Current Availability and Uses

by Douglas M. Lambert and John T. Mentzer

Inventory carrying costs, the costs associated with the quantity and value of inventory stored, represent a large portion of the expense attached to distribution activities. These costs also are influenced by the configuration of the physical distribution system utilised. Therefore, accurate assessment of inventory carrying costs is essential to not only controlling the cost area, but alsofor the analysis of the cost effectiveness of different physical distribution systems. Traditionally, managers who do consider the cost of holding inventory use estimates, industry bench- marks that rangefrom 12 to 35 per cent of the value of the inventory, or textbook figures of 25 per cent. Many sources have quoted the 25 per centfigure and have not changed it in the last 30 years, thus ignoring the impact of inflation on the cost of capital. Also, it is believed that many firms do not even consider inventory carrying costs.

In an effort to provide managers with a solution to this problem, LaLonde and Lambert[l] proposed a methodology comprised of the following four basic cost categories that must be considered when calculating inventory carrying costs: (1) capital costs, (2) inventory service costs, (3) storage space costs, and (4) inventory risk costs. A subsequent publication by these authors[2] contained the results of applying the methodology in six manufacturers of consumer packaged goods. The study involved an in-depth investigation of the actual accounting records of these firms. The study results led to the conclusion that, with few exceptions, the data necessary for developing inventory carrying costs were available with minimal effort. In a third publication[3], the authors reported their findings when the methodology was used in a food manufacturer and a chemical company. Thefindingssupported the earlier conclusions. The purpose of this article is to present the results of a survey of 63 firms which describes the current availability and uses of inventory carrying costs by distribution managers.

Importance of Accurate Inventory Carrying Costs Accurate assessment of inventory carrying costs is essential to a variety of distri- bution decisions. The number of warehouses to be maintained, the configuration of these facilities, transportation, and inventory policy are all affected by inventory carrying costs. Low inventory carrying costs would lead to multiple warehouses, slower modes of transportation and larger order sizes, resulting in higher levels of

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Inventory Carrying Costs | 257

inventory and inventory in-transit. On the other hand, high inventory carrying cost would result in concentrating inventory at a limited number of stock locations and utilising faster modes of transport for more discrete shipment sizes and lower in- ventory levels. Inventory carrying cost is also essential for analysis of individual products on a fine line basis[4]. Fine line analysis sets inventory levels for each product based on its relative profitability and importance with respect to corporate goals. Thus, higher levels of inventory are carried on the more profitable, important products to de- crease the likelihood of a stockout. Since the cost of carrying inventory varies with its value, fine line analysis of the profitability of individual products is impossible without accurate inventory carrying cost information. Without an accurate assessment of inventory carrying cost, it is unlikely that a company would choose the distribution policies that would lead to maximum profits. Further, inventory carrying costs are essential if cost tradeoff analysis is to be con- ducted with the other logistical system cost components; cost of lost sales, trans- portation costs, warehousing costs, and lot quantity costs[l]. Accurate carrying costs also are required as input to distribution models which can be only as good as the input cost data. Therefore, inventory carrying costs are of serious importance to distribution executives and, based on previous studies, the data for such determinations are available. In order to determine whether such data is utilised by distribution ex- ecutives, a mail survey was conducted. The objectives of this research were to study the availability of the individual cost components of inventory carrying costs, to determine the percentages used for. these components and to investigate the current uses of inventory carrying costs in distribution decision-making. The specific objectives were: (1) to relate current industry practice to the progress that has been made in the literature toward the development of an inventory carrying cost methodology; (2) to assess the avail- ability of the component costs of inventory carrying costs; (3) to determine who was involved in determining inventory carrying costs within the firm; and (4) to deter- mine how the inventory carrying cost, once calculated was being used and in what types of decisions.

Methodology In order to accomplish the research objectives, a sample of 300 was selected from a mailing list of distribution executives who had purchased an NCPDM publication on inventory carrying cost[5]. It was felt that individuals requesting this publication would represent a cross section ranging from executives that were seeking initial information about inventory carrying costs to those who wanted to update their current carrying cost procedures. Further, all members of the list had exhibited an interest in inventory carrying costs by purchasing the publication. The instrument was a detailed six page questionnaire which required specific data on distribution

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costs. One follow up mailing resulted in a total of 63 useable questionnaires for a response rate of 21 per cent. Given the length of the questionnaire and the types of data that were requested, the response rate was considered to be good. Analysis of responses revealed that respondents represented a reasonable cross section of ex­ perience with inventory carrying costs. While non-response bias is always a potential problem with mail surveys, cross tabulations by mailing (first or second wave) re­ vealed no statistically significant differences (α ≤ 0•05) with questions on cost availability and the current and perceived uses of inventory carrying costs. This supports the conclusion that non-response bias is not a major limitation of this research.

Findings Profile of Respondent Firms The demographics of the respondent firms are shown in Table I. A review of these data reveals that 37•9 per cent of the companies had annual sales of less than S100 million, 29•3 per cent had sales in the $100 million to $499 million range and 32•7

Table I.

Profile of Respondent Firms

(A) Annual Sales Volume Sales

Number of

Per cent

(X $1 Million)

Respondents

Response

 

2-99

22

380

100-499

17

29•3

500-999

6

10•3

1000-6500

13

22•4

(5)

Location of Respondent Firm

58

1000

 

Number of

Per cent

Region

Respondents

Response

Northeast

10

16•4

Mid-Atlantic

6

9•8

Midwest

21

34•4

Southeast

4

6•6

North Central

8

13•1

South Central

2

3•3

West and Southwest

6

9•8

Canada, International

4

6•6

(C)

Industry Type

61

100•0

 

Number of

Per cent

Industry

Respondents

Response

Manufacturing, but not specified

15

23•8

Chemicals

11

17•4

Food Production and Processing

7

11•1

Machinery

6

9•6

Electrical Machinery and Equipment

5

7•9.

Wholesaling—Retailing

5

7•9

Transportation and Material Handling Equipment

3

4•8

Paper, Packaging, and Related

2

3•2

Hospital Supplies

2

3•2

Other

7

11•1

63

100•0

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Inventory Carrying Costs | 259

per cent had sales in excess of $500 million per year. A total of 41 0 per cent of the respondents said that their firm's sales were subject to large seasonal variations, 16•4 per cent reported some seasonality and 42•6 per cent reported that their firms did not experience large seasonal variations in sales. Inventory levels ranged from $1 million to $1•2 billion. Almost 45 per cent of the respondents reported finished goods inventory levels from $1 million to $10 million, 34 per cent reported inventories ranging from $11 million to $99 million and 21 per cent had finished goods inventories in excess of $100 million. The firms represented a national sample although the largest group of respondents were from the Midwest (34•4 per cent) followed by the Northeast (16•4 per cent) and the North Central US (13•1 per cent). The distribution of respondent industry types illustrates that a wide variety of consumer and industrial goods manufacturers were represented as well as firms in retailing and wholesaling. However, the variety of industry types combined with the sample size meant that meaningful analysis by industry type could not be performed. Analysis of the job titles of respondents revealed that 66 per cent were managers; 1•6 per cent were general managers; 16•3 per cent were directors of distribution, purchasing, materials management or traffic; 11•3 per cent were vice presidents; and 4•8 per cent were analysts or some other title.

Determination of Cost of Money and Inventory Investment Two of the most important pieces of information necessary to calculate inventory carrying costs are the cost of money and the valuation of inventory at variabe costs delivered to the storage location. Consequently, these two components were of major interest in this study.

Table II.

Method of Determining Corporate Cost of Money

Number of

Per cent

Respondents

Response

Management Fiat

10

25•6

Prime Rate

6

15•4

Cost of Capital

5

12•8

ROI

5

12•8

Cost of Capital and ROI

5

12•8

Cost of Capital and Prime Rate

2

5•1

ROI and Prime Rate

2

5•1

Risk and Capital

1

2•6

Risk and ROI

1

2•6

Prime Rate and Government Securities

1

2•6

Bonds and Short Term Loans

1

2•6

39

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Table III.

The Corporate Cost of Money

Does your firm use different costs of money for different types of decisions?

 

Number of

Per cent

Response

Respondents

Response

Yes

7

42•8

No

18

28•6

No Response

13

28•6

63

100•0

Reasons for Using Different Costs

Number of

Per cent

of Money

Respondents

Response

Varies by type of investment decisions

8

33•3

Short-term cost of money versus long-term cost

4

16•6

Varies with capital availability

3

12•5

The level of risk associated with investment

3

12•5

Cost of money for inventory decisions is lower than the minimum R.O.I. for capital investments

3

12•5

Varies by division

2

8•3

Higher cost of money for new products

1

4•2

24

Only 39 of the 63 respondents (62 per cent) answered the question of how the cor­ porate cost of money was determined. Of those who responded, 33•3 per cent men- tioned cost of capital, 33•3 per cent mentioned return of investment risk. Management fiat was the largest single response and accounted for 25•6 per cent of the methods used (Table II). A total of 42•8 per cent of the respondents indicated that different costs of money are used for different decisions and statistical cross tabulations by corporate size, seasonal variations and inventory levels revealed no significant differences (α ≤ 0•05). The specific reasons for this policy are shown in Table III. Determination of the corporate cost of money was primarily a top management financial decision. Only 10•4 per cent of the managers involved in setting the cost of money were at the "manager", "general manager", oi "director" level. The vice president of finance was named most often (38•5 per cent) followed by the treasurer (30•8 per cent), the controller (28•2 per cent) and the president (25•4 per cent). Vice presidents of transportation, distribution, sales and finance were mentioned a total of 10•4 per cent. Various other top level managers accounted for 15•6 per cent of the replies. (Responses totalled more than 100 per cent because of multiple responses.) Just 25 respondents (40 per cent), were able to answer the question: "What costs are included in variable manufacturing costs for inventory decisions ?" The determina­ tion of variable manufacturing costs most frequently included labour (84 per cent), materials (80 per cent) and overhead (64 per cent). Variable storage was included by 20 per cent of those who responded to this question. Complete responses are sum­ marised in Table IV. Three methods were given for valuing inventory in general— standard cost (50•8 per cent), LIFO (28•6 per cent), and FIFO (4•8 per cent). No response equalled 15•8 per cent. However, for finished goods inventory the responses

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Inventory Carrying Costs | 261

Table IV.

Costs Included in Variable

Number of

Per cent

Mentions

Response

Labour

21

84•0

Materials

20

80•0

Overhead

16

64•0

Variable Storage

5

20•0

Fringe

3

12•0

Transportation

2

8•0

Sales and Advertising

4•0

Obsolescence

4•0

Royalties

4•0

Packaging

4•0

Utilities

4•0

Variable Manufacturing

4•0

All of the above

4•0

* A total of 25 firms responded to this question.

were considerably more varied. The three most frequently mentioned methods for valuing finished goods inventory were standard cost (40•9 per cent), LIFO (22•3 per cent), and factory costs (18•5 per cent). The retailing—wholesaling institutions (7•9 per cent) reported using landed cost. Only 8•6 per cent of the manufacturers (7•9 per cent of the total sample) reported that freight was added to the manufactured cost. Not one firm reported that inventory was valued at variable cost delivered and moved into the storage location. However, it is conceivable that the standard cost may have been calculated with a storage and transportation component included (usually standard costs include only manufacturing costs but include both fixed and variable manufacturing costs).

The primary sources offinancingfor inventory investment were internally generated cash (31•6 per cent) and loans (15•8 per cent). The remaining firms either used bonds or equity (3•2 per cent); some combination of cash from operations, bonds, equity and loans (24•0 per cent); or the respondent did not know how inventory was financed (25•4 per cent).

Inventory Carrying Cost Components A total of 68•3 per cent of the respondents indicated that within their firms inventory carrying costs are calculated for finished inventory. However, only 34•9 per cent used inventory carrying costs for raw materials inventory and 28•6 per cent for work in-process inventory (Table V). The costs included in inventory carrying costs are shown in Table VI. Only 37 firms (59 per cent) answered this question but of these the most frequently mentioned components of inventory carrying cost were cost of money (89•2 per cent), variable storage (70•3 per cent), insurance (67•6 per cent), taxes (59•5 per cent), and obsolescence (59•5 per cent). The perceived availability of the cost components of inventory carrying cost was in general disappointing. The average monthly finished goods inventory for each

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Table V.

Types of Inventory Carrying Costs

 

Number of

Per cent

Question

Response

Respondents

Response

Do you calculate inventory

Yes

43

68•3

carrying costs for finished

No

5

7•9

goods inventory?

No Response

15

23•8

Total

100•0

Do you calculate inventory

Yes

63

22

34•9

carrying costs for raw

No

22

34•9

materials inventory?

No Response

19

30•2

Total

100•0

Do you calculate inventory

Yes

63 18

28•6

carrying costs for work

No

24

38•1

in-process inventory?

No Response

21

33•3

Total

100•

 

63

Table VI.

Cost Included in the Inventory

Carrying Cost Calculation*

 

Number of

Per cent

Mentions

Response

Cost of Money

33

89•2

Variable Storage

26

70•3

Insurance

25

67•6

Taxes

22

59•5

Obsolescence

22

59•5

Damage

8

21•6

Shrinkage

7

18•9

Stock Out

2

5•4

Handling

3

8•1

Theft

1

2•7

Scrap

1

2•7

Manufacturing Cost

1

2•7

* A total of 37 firms responded to this question.

Table VII.

Availability of Inventory Carrying Cost

Cost Components Cost of Money Variable manufacturing costs of each product Average monthly finished goods in-

ventory for each product by location Insurance on finished goods inventory Taxes paid onfinishedgoods inventory Obsolescence Shrinkage Damage

to

Relocation

costs

(transhipment

avoid obsolescence)

 

Per cent Response Is Not a

 

Not

Factor for

Don't

No

Available

Available

Our Product s

Know

Response

74•8

4•8

17•5

3•2

58•8

15•9

7•9

6•3

11•1

87•3

6•3

1•6

4•8

41•3

15•9

11•0

15-9

15•9

36•6

11•1

15•9

15•9

20•6

43•0

17•5

6•3

12•7

20•6

39•8

11•1

12•7

14•3

22•2

30•2

14•3

15•9

15•9

23•8

17•5

12•7

31•7

14•3

23•8

 

(n = 63)

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Inventory

Carrying

Costs

\

26 3

product by location was reported to be available by 87•3 per cent of the respondents. The corresponding figures for cost of money, variable manufacturing costs for each product, insurance, taxes, obsolescence, shrinkage and damage were 74•8 per cent 58•8 per cent, 41•3 per cent, 36•6 per cent, 43•0 per cent, 39•8 per cent and 30•2 per cent, respectively. Relocation costs were considered not to be a factor by 31•7 per cent of the respondents and were reported to be available in 17•5 per cent of the companies (see Table VII). When the perceived availability of the cost components was cross tabulated by industry sales no statistically significant differences were found (a ≤ 0 05). Part of the questionnaire itemised seven components of inventory carrying cost and asked for the per cent used for these components in the respondent's firm. Only forty-four people answered the cost of money portion. Of these, 50 per cent of the respondents reported using a cost of money component of 10 per cent or less. Clearly, in these companies, the opportunity cost of capital (minimum acceptable rate of return on new investments) is not being used. Only 27•3 per cent used a cost of money equal to or in excess of 15 per cent (see Table VIII). When cost of capital data were collapsed into the above categories, no statistically significant differences were found by industry sales (α ≤ 0•05). Most of the other percentages reported were less than 1 per cent. However, for obsolescence the per cent ranged as high as 25•0 per cent and for shrinkage up to 9•0 per cent. Almost 78 per cent did not give the percentage used for the insurance component of inventory carrying costs. Corres­ ponding percentages for taxes, obsolescence, shrinkage, damage and relocation

Table VIII.

Cost of Money:

Inventory Carrying Cost Components

Cost of Money

Number of

Per cent

Cumulative

Percentage

Respondents

Response

Per cent

6

1

7

1

8

6

9

6

10

8

11

1

12

3

13

3

14

3

15

5

17

1

19

2

20

2

24

1

30

1

44

Don't Know 14

No Response 5

63

2•3

2•3

2•3

4•6

13•6

18•2

13•6

31•8.

18•2

50•0

2•3

52•3

6•8

59•1

6•8

65•9

6•8

72•7

11•4

84•1

2•3

86•4

4•5 4-5

90•9 95-4

2•3

97•7

2•3

100•0

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Insurance on Finished Goods Inventory:

Percentage

Used

Number of

Respondents

Per cent

Response

0•1

1

1•6

0•2

4

6•3

0•5

4

6•3

0•9

1

1•6

1•0

2

3•2

1•7

1

1•6

9•0

1

1•6

Per cent Not Given

49

77•8

63

Taxes Paid on Finished Goods Inventory:

Percentage

Number of

Per cent

Used

Respondents

Response

0•2

1

1•6

0•3

3

4•8

0•4

2

3•2

0•5

1

1•6

10

5

7•9

2•5

1

1•6

Per cent Not Given

50

79•3

63

Obsolescence:

Percentage

Number of

Per cent

Used

Respondents

Response

0•20

1

1•6

0'25

1

1•6

0•50

2

3•2

1•00

1

1•6

2•00

4

6•3

3•00

2

3•2

4•20

1

1•6

5•00

1

1•6

9•00

1

1•6

17•00

1

1•6

24•00

1

1•6

25•00

1

1•6

Per cent Not Given

46

72•9

63

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Inventory Carrying Costs | 165

Shrinkage:

 

Percentage

Number of

Per cent

Used

Respondents

Response

0•2

1

1•6

04

1

1•6

0•5

2

3•2

10

2

3•2

30

1

1•6

4•2

1

1•6

4•4

1

1•6

5•0

1

1•6

5•6

1

1•6

9•0

1

1•6

Per cent Not Given

51

63

80•8

Damage:

Percentage

Number of

Per cent

Used

Respondents

Response

0•1

1

1•6

0•5

2

3•2

1•0

2

3•2

3•0

1

1•6

Per cent Not Given

57

90•4

63

Relocation Costs (Trans-shipment to Avoid Obsolescence):

Percentage

Used

Number of

Per cent

Respondents

Response

0•5

1

1•6

5•2

1

1•6

Per cent Not Given

61

96•8

63

costs were 79•3, 72•9, 80•8, 90•4 and 96•8, respectively. None of the respondents reported that all of the cost components required to compute inventory carrying costs were available. The total inventory carrying cost percentage used by the respondent firms ranged from 10 per cent to 35 per cent with 66•6 per cent reporting a carrying cost in the range of 20 to 25 per cent. However, only 45 of the 63 respondents (71•4 per cent) answered this question. The complete results are summarised in Table IX.

Current and Perceived Uses of Inventory Carrying Costs One of the objectives of the research was to determine the current uses of inventory carrying costs within the respondent firms. Table X contains 15 types of decisions for which inventory carrying costs may be a useful input and shows if inventory carrying cost currently are used when making these decisions. Inventory carrying

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Table IX.

Carrying

Inventory Carry ing Costs Used

Number

Cost

of

Per cent

Percentage

Respondents

Response

10

2

4•4

12

2

4•4

14

1

2•2

15

4

8•9

18

1

2•2

20

6

13•3

21

3

6•7

22

1

2•2

24

9

20•0

25

11

24•4

30

1

2•2

33

1

2•2

35

3

6•7

45

Table X.

Current Uses of Inventory Carrying Cost*

Type of Decision

Yes

Per cent Response No

Don't Know

1. Design of warehousing and distribution systems

57

32

11

2. Setting finished goods inventory levels

65

21

14

3. Cost trade-off decisions

67

22

11

4. Determination of shipment sizes

35

54

11

5. Plant-warehouse expansion

49

40

11

6. Balancing production schedules

41

40

19

7. Setting levels of in-process inventories

25

53

22

8. Produce internally or contract outside (make versus buy)

33

44

23

9. To measure the ability to hedge against inflation in the purchase of raw materials, component parts or finished goods inventory

37

38

25

10. EOQ analysis
11.

12. New product evaluation

13. Decisions regarding customer service levels or

Product line profitability analysis

Evaluation of price deals

15. Evaluation of quantity discounts

62

38

29

49

43

45

27

45

46

11

17

25

objectives

38

13

14.

40

41

17

14

* Question: Please indicate if within your company inventory carrying costs currently are used as an input to the following decision (check the appropriate response):

costs are used most frequently when making the following decisions: (a) cost trade-off analysis (67 per cent); (b) setting finished goods inventory levels (65 per cent); (c) EOQ analysis (62 per cent)[6]; and (d) design of warehousing and distribution systems (57 per cent). Table XI contains the same 15 types of decisions but in this case the respondents were asked to express their agreement or disagreement with the statement: "inventory carrying costs are a necessary component for the following types of decisions

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Table XI.

Inventory Carrying Costs \ 267

Perceived Uses of Inventory Carrying Costs*

Type of Decision

Strongly

Per cent Response Strongly

No

Mean

Agree

Neutral

Disagree

Response

Response

1. Design of warehousing and distribution systems
2.

Settingfinishedgoods inventory levels

1

38

60

2

25

24

3

21

8

4

13

4

5

3

2

6

7

2

2•175

1•698

3. Cost tradeoff decisions

55

24

11

8

— — —

2

1•683

4. Determination of shipment sizes

21

11

18

35

5

6

3

2

3•190

5. Plant/warehouse expansion

35

19

20

19

5

2

2•349

6. Balancing production schedules

25

21

24

20

3

2

2

3

2•571

7. Setting levels of in-process inventories

17

22

19

29

2

3

3

5

2•825

8. Produce internally or contract outside (make versus buy)

9. To measure the ability to hedge against inflation in the purchase of raw ma­ terials, component parts or finished

19

29

22

16

24

7

3

3

6

2•794

goods inventory

19

17

19

5

5

3

3

2•698

10. EOQ analysis

57

20

8

9

2

2

2

1•794

11. Product line profitability analysis

36

27

16

14

3

2

2

2•317

12. New product evaluation

18

16

22

30

6

2

3

3

3•000

13. Decisions regarding customer service levels or objectives

27

24

24

14

6

5

2•635

14. Evaluation of price deals

Evaluation of quantity discounts

27

19

22

14

24

6

2

5

2•524

15.

6

6

11

2

56

1•063

* Question: In the following question please indicate your agreement or disagreement with the statements as they related to your firms by circling the appropriate response.

With only one exception, the percentage of respondents who believed that inventory carrying costs were a necessary component for each of the decisions was significantly larger than the percentage of respondents currently using inventory carrying costs when making these decisions (test of two proportions, α ≤ 0•05). The one exception was "evaluation of quantity discounts", but this question was affected by the high no response rate (56 per cent). Some progress has been made insofar as the majoiity of respondents believed that inventory carrying costs should be included when making the 15 decisions. However, considerable work still must be undertaken in the majority of firms to make sure that these costs are available for decision making and that they are accepted by other members of the management team. One might expect that larger firms would have more sophisticated management and therefore would be more likely to use inventory carrying costs when making these decisions. But, statistical cross tabulations re­ vealed no significant differences (α ≤ 0•05) in response to the questions on the current and perceived uses of inventory carrying cost based on corporate sales.

Other Physical Distribution Costs In addition to inventory carrying costs, a number of other cost categories are re­ quired if distribution cost trade-off analysis is to be successfully implemented with the firm[l]. Consequently, respondents were asked to indicate the availability of a num­ ber of cost components in their companies.

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268 | IJPD & MM 9,6

Total transportation costs were the most readily available costs and were reported by 89 per cent of the respondents. However, transportation costs by channel, product and customer were reported to be available in only 52 per cent, 54 per cent and 33 per cent of the firms, respectively, which means that profitability analysis by these segments would not be possible. Knowledge of total order processing costs was re- ported by 60 per cent of the companies and the availability of fixed and variable order processing costs were reported by 51 per cent and 50 per cent of the respondents, respectively. Variable order processing costs are required for setting minimum order quantities and for customer profitability analysis. Expediting costs were available in 22 per cent of the firms and the number of expedited shipments was known by 30 per cent of the respondents. Surprisingly, many of the production related costs which are often assumed to be available to the distribution executive were not available to the respondents. For example, of set-up time, inspection, set-up scrap, inefficiency of beginning opera- tions, lost capacity due to changeover, materials handling costs and scheduling costs, only set-up time was reported to be available in more than 50 per cent of the firms. These production cost standards are required for the implementation of cost trade-off analysis. A total of 62•0 per cent of the respondents reported that physical distribution costs were included in product and/or product line profitability analysis. Of the 35 respondents who reported specific costs that were included in product/product line

Table XII.

Physical Distribution Costs and Product/Product Line Profitability Analysis

Inventory carrying costs are a necessary component for the following types of decisions:

 

Number of

Per cent

Response

Respondents

Response

Yes

39

62•0

No

19

30•2

Don't Know

1

1•5

No Response

4

6•3

Total If Yes, Which Cost are Included?*

63

100•0

 

Number of

Per cent

Cost Category

Respondents

Response

Transportation

25

71•4

Warehousing

18

51•4

All P.D. Costs-Distribution Operating Costs

6

17•1

Inventory Carrying Costs

4

11•4

Handling

4

11•4

Order Processing

3

8•6

Overhead

3

8•6

Inventory Control

1

2•9

Packaging

1

2•9

Don't Know * A total of 35 firms responded to this question.

3

8•6

Inventory Carrying Costs \ 26 9

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profitability analysis, 71•4 per cent mentioned transportation costs, 51•4 per cent mentioned warehousing, and 17•1 per cent said that all physical distribution costs/ distribution operating costs were considered. Other cost categories mentioned were inventory carrying costs (11•4 per cent), handling costs (11•4 per cent), order pro- cessing costs (8•6 per cent), overhead costs (8•6 per cent), inventory control costs (2•9 per cent) and packaging costs (2•9 per cent—see Table XII). These results suggest that much more work is required before the accurate re- porting of segment profitability becomes a reality.

Conclusions Based on the preceding findings, the following conclusions seem to be warranted:

1. A wide range of corporate size was exhibited in the questionnaire response, and many reported that their firm experienced some form of seasonal sales fluctua- tion. However, no statistically significant differences in response were found based on corporate size or seasonality. Consequently, larger companies do not appear to have the more sophisticated accounting systems which might be ex- pected. (The major impact of the seasonality question will be discussed in con- clusion six which follows).

2. A large percentage of the respondents reported that the cost of money was determined by management fiat. This response may be partially explained by the fact that most firms reported the use of different costs of money depending upon the decision. Also, setting the cost of money was an upper management decision with heavy influence from the finance area. The distribution executive may be isolated from thefinancialexecutive and/or top management and, conse- quently, may not be aware of the process for determining the corporate hurdle rate.

3. The major source of financing for the inventory investment was believed to be cash from operations. Short-term loans also represented a significant source of cash. However, the source of thefinancingis not the significant factor affecting the cost of money. It is the opportunity to invest the money in non-inventory investments that should determine the cost of capital component for inventory carrying costs.

4. Although most firms reported calculating inventory carrying costs for finished goods inventory, a considerably smaller portion said that such costs were cal- culated for work-in-process and raw materials inventories.

5. In the calculation of inventory carrying cost, the components mentioned were most often those advocated in the carrying cost methodology[2]. However, no firms reported using all of the recommended cost components. [1].

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270 | IJPD & MM 9,6

that does not truly reflect the corporate cost of money as measured by the hurdle rate. A low cost of money (current interest rate) can be justified if the carrying cost is being applied to a seasonal build-up of inventory. Usually, a seasonal build-up of inventory would be financed by short-term bank credit rather than the long-term investment capital used to fund long-term assets. However, there were not statistically significant differences (•≤α 0 05) between the cost of money used byfirmsexperiencing seasonality and those which did not experience seasonality.

7. The majority of respondents reported inventory carrying cost percentages in the range of 20 per cent to 25 per cent. This is not surprising since 25 per cent has been used in most textbooks over the past thirty years. However, the studies previously cited have shown that such percentages may lack accuracy[l, 2, 3].

8. The fact that a large majority of the respondents use the inventory carrying cost information in distribution cost trade-off analysis substantiates the conclusion that an inventory carrying cost which accurately reflects the firm's cost of in­ ventory is essential.

9. In general, there was a significant difference between the perceived and actual

uses of inventory carrying costs in management decision-making. More of the respondents agreed that inventory carrying costs were a necessary component to the 15 decisions named than currently were using such costs when making the decisions. 10. Many of the costs required for implementation of distribution cost trade-off analysis were not reported to be available. These findings are in direct contrast to the results of other studies, in which accounting personnel were interviewed in six and 18 firms, respectively[7]. This leads to the conclusion that it is possible the costs are indeed available within the firm even though they may not be available to the distribution executive.

11. The majority of the responding firms considered at least some physical distri­ bution costs in product and/or product line profitability analysis, especially transportation and warehousing costs. This is to be expected since these two components represent a major portion of physical distribution costs. However, the use of inventory carrying costs in product and/or product line profitability analysis was surprisingly low given that 79 per cent of the respondents thought that they should be included.

Summary In prior studies in which inventory carrying costs were calculated in corporations with the aid of accounting personnel, all of the cost components were found to be avail­ able. However, in this study it was found that distribution executives perceived the inventory carrying cost information to be unavailable. It would appear that the accurate assessment of inventory carrying cost is of vital importance to distribution

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Inventory Carrying Costs | 271

executives, but this need for information is not perceived by corporate accountants. Therefore, the required information is not communicated to distribution personnel. Wilbur Wayman has said that "if cost trade-offs are at the heart of the logistics concept, then adequate cost information is at the heart of cost trade-offs."[8] If the full potential of the logistics concept is to be realised, it is of vital importance for management accountants to expand their attention from the traditional pro- duction activities of the firm to include distribution. There is a real opportunity for the management accountant to bridge the gap between the type of information that is required for distribution decision-making and the information that is currently avail- able to the distribution executive. Thefirstrequirement can be met by talking with the various levels of management who must use or are affected by distribution cost data. By analysing the reports used and discussing the types of decisions being made, or not being made, the management accountant can soon determine the availability of specific accounting data within his firm. The next step is to generate and store the necessary information so that the key functions of planning and control of distri- bution operations can take place. The potential for cost savings in distribution is substantial and the opportunities in distribution accounting are significant. The potential rewards for involvement by the management accountant are great. The time for action is now! Inventory cost control is a substantial portion of that potential. With inventory carrying cost percentages that are developed from accurate accounting information, distribution executives will be one step closer to implementation of the integrated distribution management concept.

References

1. LaLonde, B. J. and Lambert, D. M., "Inventory Carrying Costs: Significance, Components, Means, Functions", International Journal of Physical Distribution, Vol. 6, No. 1,1976, pp. 52-63.

2. Lambert, D. M. and LaLonde, B. J., "Inventory Carrying Costs", Management Accounting, August 1976, pp. 31-35.

3. LaLonde, B. J. and Lambert, D. M., "A Methodology for Calculating Inventory Carrying Costs", International Journal of Physical Distribution, Vol. 7, No. 4, 1977, pp. 195-231.

4. See Bowersox, D. J., Logistical Management, New York: Macmillan Publishing Company, Inc., 1978, pp. 185-6.

5. Lambert, D. M., The Development of an Inventory Costing Methodology: A Study of the Costs Associated with Holding Inventory, Chicago: The National Council of Physical Distribution Management, 1976.

6. The fact that the EOQ function tends to be flat at the bottom allows variation in inventory carrying cost of up to 25 per cent without appreciably affecting the EOQ. However, past studies previously cited have revealed carrying cost errors in excess of 70 per cent.

7. See Lambert, D. M., The Development of an Inventory Costing Methodology: A Study of the Cost Associated with Holding Inventory, Chicago: II: The National Council of Physical Distribu- tion Management, 1976, and Lambert, D. M., The Distribution Channels Decision, New York:

The National Association of Accountants, and Hamilton, Ontario: The Society of Management Accountantr of Canada, 1978.

8. Wayman, W. S., "Harnessing the Corporate Accounting System for Physical Distribution Cost Information", from Distribution System Costing: Concepts and Procedures, Proceedings of the Fourth Annual James R. Riley Symposium on Business Logistics, Grabner, J. R. and Sargent, W. S. (eds.), The Ohio State University, 1972, p. 33.

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