How to reduce inventory cost by identifying cost creep
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What is inventory?
The IRS generally defines inventory as any merchandise, raw materials, finished products, or supplies included as part of an item intended for sale. Let’s say you own a business that roasts and sells coffee. Your inventory could include green (or raw) coffee beans, roasted coffee beans, labeling, and the small bags that you fill with finished coffee beans. Essentially, inventory includes any materials you purchase that are intended to be included in a product for sale, even if they change form before the sale.
In the coffee example, the green coffee beans are still considered inventory even though they haven't been roasted yet. These beans are considered a raw material that'll be categorized into a “work in process” workflow and ultimately transformed into the wonderful, dark, nutty aroma we all know and love. And more obviously, the finished, roasted coffee beans that are sitting on your shelves and ready to sell to customers are also considered inventory. Your freshly roasted Arabica or Robusta coffee beans can be labeled as a “finished good” type of inventory.
What is cost creep and why is it important?
Cost creep is the steadily increasing cost per unit of an inventory component. Common causes include global supply chain constraints pushing ingredient and material costs higher and rising fuel prices increasing the cost of shipping and freight. These incremental cost increases might not be materially noticeable in a single month, but over time, can compound to cause a substantial impact to your bottom line.
The concept of inflation can also help us illustrate cost creep on a broader level. Inflation has risen dramatically over the last few years. Defined as the average rise in overall prices of goods and services throughout the economy, most businesses can probably attest that they have noticed some form of inflation on their overall costs. According to the Federal Reserve Bank of Minneapolis, the inflation rates over the past few years were:
● 8.0% in 2022
● 4.7% in 2021
● 1.2% in 2020
Essentially, this means the average prices of goods and services, including inventory costs, rose by 1.2% in 2020, another 4.7% in 2021, and an additional 8.0% in 2022.
What does this mean for your business? In short, if something costs you $1.00 at the beginning of 2020, and those costs increase by the inflation rate each year, you'll end up with goods that cost you $1.14 in 2022. Notice the calculation below:
$1.00 x (1.012 x 1.047 x 1.08) = $1.144
+14.4% increase from 2019 to 2022
By compounding these percentages together over a 3-year period, between 2019 and 2022, average prices for goods and services rose by about 14.4%. This means that if your inventory costs were $100 at the beginning of 2020, the same components would cost you $114.40 at the end of 2022.
Now, let’s put this into further context. If you were to keep your product sales prices stable, what would happen to your gross margin, or product profitability, over that same 3-year period, knowing that your inventory costs were steadily increasing?
Gross Margin = Sales - Cost of Goods Sold
Here's an example:
- In 2019, you sold a bag of high-quality coffee for $15. If it cost you $10 to make that coffee, bag it up, and hand it to the customer, your gross margin would be $5 or 33.3% ($15 - $10 = $5).
- Fast forward to 2022. You still sell that same bag of coffee for $15; however, now it costs you $11.44 to roast and bag that coffee you just sold, assuming 14.4% cost inflation (all else being equal). Your gross margin now is $3.56 per bag of coffee or 23.7% ($15 - $11.44 = $3.56).
- By simply paying for your inventory and roasting the way you have always done, your gross margins have decreased by -9.6% (33.3% - 23.7%).
Now think about the impact on a larger scale. If you had sold 1,000,000 bags of coffee beans, then you'd be leaving $1,440,000 in cash on the table simply from cost creep
($5 - $3.56) x 1,000,000 bags
How can I track my inventory cost creep?
For most businesses with a manageable list of cost inputs and inventory items, this process can be handled in a few simple ways. First, many accounting systems and Enterprise Resource Planning (ERP) software packages track inventory at the item level. Usually, if accounting is keeping up with accounts payable invoice entry at the item level, unit costs can be tracked relatively easily. Using Oracle NetSuite as an example, you can log in to the system, search for an inventory item or inventory component, click on the invoice history, and review each invoice and corresponding unit cost you have received over time for that particular item. Compare unit costs with this easy formula:
Unit Cost Inflation % = [ (Newest Unit Cost – Oldest Unit Cost) / (Oldest Unit Cost) ] x 100
This method is a very quick way to calculate the inflation creeping through your inventory costs. What if you don't have ERP software? Not to worry. Quantifying the impact of inflation and cost creep would be more manual, but still very doable. Either go into your inventory management system to export a list of all the invoices that show item-level detail and unit costs, or simply go into your files and find each one of your supplier or manufacturer bills the old-fashioned way.
The goal is to find or create a report that looks like Exhibit A. Notice that while the total invoice amount jumps around and can be inconsistent, the unit costs are steadily increasing. Now, use the data from Exhibit A to create a graph like Exhibit B, and you (or your leadership team) can visualize how cost increases have impacted the business.
How to reduce inventory costs and save money by identifying cost creep
1. Renegotiate lower prices with current suppliers.
If you have long-standing relationships with any suppliers, there's usually room to come back to the table to renegotiate. I've seen a lot of clients stay with vendors for five to ten years (or more) and never think to renegotiate prices on key inventory components. They assume a good relationship means a good price.
If you know you've consistently ordered higher volumes from a particular vendor or supplier over time, you can try to negotiate better economies of scale with the goal of decreasing the average cost per unit. Once you understand the impacts of cost creep, sometimes all it takes to protect your business is a phone call to talk pricing.
2. Shop around for new supplier discounts to lower costs of components, ingredients, or parts.
If renegotiating with current suppliers yields no cost-saving results, it might be time to search for a new supplier. Keep in mind that recipes and other intellectual property confidentiality agreements might limit your ability to easily find new suppliers.
However, if possible, it’s best to take advantage of even small opportunities to find a new supplier for a single component or ingredient. New suppliers often offer discounts to win your business, so stay diligent in this process. You might be surprised at how small wins can stack up into substantial material company cost savings.
3. Consider new freight, transportation, or logistics partners.
Traditionally, freight-in costs should be capitalized into inventory according to US Generally Accepted Accounting Principles (GAAP) and expensed through Cost of Goods Sold (COGS). While shipping and freight costs can be a more material inventory component in some businesses compared to others, it is an important area that I recommend companies investigate annually.
Global supply chain constraints in recent years have caused freight costs to increase in many countries, so it is best practice to investigate new freight brokers, systems, or logistics providers on an annual basis to make sure you are getting the best deal. Again, shop around. It never hurts to have a conversation.
Reduce inventory costs with Ramp
Ramp helps you control costs by simplifying and automating your expense tracking and reporting. Key features of Ramp include:
- Automated receipt processing: Submit expenses effortlessly through the Ramp mobile app, using AI to provide accurate and precise transaction recording.
- Intelligent transaction categorization: Ramp automatically categorizes transactions and highlights duplicates, ensuring error-free expense submissions.
- Proactive expense control: Implement spending limits and approval steps on company cards, maintaining strict adherence to company policies.
- Instant alert system: Receive real-time notifications for any charges that deviate from policy, with options for immediate correction.
- Customizable approval processes: Set up clear and adjustable approval pathways for each transaction to foster greater accountability.
- Accelerated financial closing: With Ramp, close your books up to 22% faster, turning expense management into a more efficient and less burdensome process.
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