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The real cost of holding inventory. (Decisions).

Most companies don't really know how much it's costing them to hold inventory. But knowing that total cost is essential to making the right supply chain decisions. It's also key to getting approval for inventory-management initiatives that might otherwise be rejected. The methodology presented here can help managers ensure that they're painting a true picture of their total inventory-carrying costs.

Management of inventory is a powerful driver of financial performance. In response to slowing growth and pressures on profitability, many companies today are exploring new ways to manage inventory better. Improved inventory management frees up cash to be invested elsewhere, allows products to be sold at lower prices, facilitates entrance into new markets, and delivers other benefits that improve financial performance and create competitive advantage.

Yet despite the importance of inventory management, there appears to be little consensus on how to estimate the real cost of holding inventory--the total cost. Yet knowing that cost is key to analyzing the benefits and costs associated with any inventory management initiative.

This article explores the main factors comprising the total cost of holding inventory, which include both noncapital carrying costs and the capital carrying charge. We explain why supply chain management professionals need to develop better estimates of noncapital carrying costs to calculate the true value of projects designed to reduce inventory. Exclusion or minimization of these costs can understate the value of supply chain initiatives and can result in rejection of projects that should be accepted. The article also explains that many companies are using a cost of capital that significantly understates the inventory capital carrying charge and thereby leads to nonoptimal decisions in such areas as transportation, sourcing, and network design. We demonstrate why use of a weighted average cost of capital is a better approach and how, in the end, it leads to better inventory-management decisions.

Total Cost of Holding Inventory

The elements that make up the total cost of holding inventory (inventory noncapital carrying costs plus inventory capital charge) are shown in Exhibit 1. This total cost is often expressed as a percentage of the overall investment in inventory to facilitate comparison over time and across companies. We've found that many companies use a noncapital carrying cost of around 10 percent. The challenge that they have is making credible estimates of the noncapital carrying cost components for decision-making purposes.

Another major challenge centers on the cost-of-capital figures used. Many companies apply a rate in the neighborhood of 5 percent, which significantly understates the reality. For the great majority of companies, an inventory capital charge of least 15 percent (meaning before-tax cost of capital) is more appropriate. Before laying out the methodology for arriving at a more accurate capital-charge number, we first briefly review issues related to estimating inventory noncapital carrying costs.

Inventory Noncapital Carrying Costs

The Annual State of Logistics Report produced by Robert V. Delaney of Cass Information Systems estimates that at a macrolevel, noncapital carrying costs are approximately 19 percent of inventory. Our experience, however, is that the average rate applied in U.S. companies is closer to 10 percent. This percentage tends to vary by industry with a key driver being risk of obsolescence. One retailer we studied, for example, used a rate of 6 percent while an electronics company used a 15-percent rate.

There are several challenges in estimating inventory noncapital carrying costs. For one, many companies' information systems do not capture these costs in a way that provides useful information for decision making. While this cost information may be captured at an enterprise-wide level and applied to total inventory, often it is not available for a product line, geography, customer group, or channel. Another challenge is understanding how these costs, which can be fixed or variable, vary with changes in inventory. For example, a reduction in inventory resulting from improved supply chain management tends to reduce obsolescence, insurance, and taxes. But unless there is a significant change in the network design, warehousing and other inventory-related costs tend to remain about the same.

When evaluating supply chain initiatives, companies often discount or even omit the benefits of reducing inventory noncapital carrying costs because they do not possess credible estimates of these costs. Most agree that these benefits exist. But without credible estimates, the benefits typically are excluded from the analysis. This practice is understandable. Nevertheless, if the impact on these costs cannot be reasonably measured, the true value of many supply chain initiatives will be understated.

For example, suppose an initiative is expected to permanently reduce inventory by $10 million. The variable noncapital carrying costs as a percentage of inventory are 10 percent. The marginal tax rate is 40 percent and the after-tax cost of capital is 9 percent. The equation below shows that the value of this initiative is the change in the total value of inventory. That value is $10 million if noncapital carrying costs are excluded. However, the value is substantially higher--almost $7 million higher--when the impact on noncapital carrying costs is included.

This example highlights the need for supply chain professionals to build more credible estimates of inventory noncapital carrying costs. Failure to do so results in understating the real value of supply chain initiatives, which can lead to rejection of projects that should be accepted. As a starting point, we recommend focusing the estimates on the noncapital carrying costs components of obsolescence, insurance, and taxes for these reasons: (1) these typically are most likely variable, (2) data for these components are often available or can be extracted without significant effort, and (3) they do not require allocation of fixed overhead costs.

Inventory Capital Charge

The inventory capital charge is calculated as: inventory x cost of capital. When calculated correctly, this charge often exceeds the noncapital carrying costs. Unfortunately, the capital charge often is underestimated because the wrong cost of capital is applied. Typically, this is the result of one of two factors: (1) a mismatch between the risk of inventory and the cost of capital, or (2) the mixing of after-tax capital charges with before-tax noncapital carrying charges. Let's first explore how to properly match the risk of inventory with the appropriate cost of capital.

The cost of capital is one of the most important concepts in finance and a key building block in valuation and in estimating total costs. Unfortunately, it is often viewed as one of the more esoteric financial concepts. Plus, it's one of the most confusing for those who must use it for decision making. This confusion often stems from a lack of understanding of what comprises the cost of capital and the nature of risk-return relationships.

Simply stated, the cost of capital is the opportunity cost of investing in an asset relative to the expected return on assets of similar risk. This is comparable to how we evaluate investments in our personal lives. For example, suppose that over the last year you earned 8 percent on a portfolio of stocks. How well did your portfolio perform? To answer this question, many of us compare the return on our portfolio to the performance of an index of stocks of similar risk. If our portfolio is comprised of a well-diversified group of stocks, we likely would use an index like the S&P 500. Suppose that over the last year, the S&P 500 returned 6 percent. Then our return of 8 percent compares favorably. If the S&P 500 returned 10 percent, on the other hand, then that 8-percent return was less favorable.

In this example, the return on the S&P 500 is the opportunity cost of money. If we expected the S&P 500 to earn 10 percent in the future, then we would use this benchmark in evaluating investments with similar risk in planning for retirement, children's education, and so forth.

Now let's suppose that our risk tolerance was much lower than that required of stock investments. Suppose that we are retired and focused more on income generation and maintaining the value of our investment principle. In this case, the benchmark--opportunity cost of capital--might be the return on corporate bonds, which currently yield approximately 6.5 percent. If we were even less risk tolerant, the opportunity cost of capital may be the return on U.S. Government Treasury bonds, currently around 5 percent. Suppose we were extremely risk averse and placed a high value on maintaining the worth of principle value and, at the same time, wanted a very high degree of liquidity because we are going to make a down payment on a house or other major purchase in a few months. In this example, the opportunity cost of capital likely would be the return on a short-term certificate of deposit, or about 1.25 percent.

Ascertaining the risk of inventory is key to deciding what cost of capital should be used to calculate the inventory capital charge. The major risk of holding inventory is that its value becomes impaired because of price reductions, lower demand, and obsolescence. Recent events in the high-tech industry have underscored the risk of holding inventory.

To illustrate, memory giant Micron Technology in its fourth quarter of 2002 wrote-off $174 million of inventory because the market had shifted to double-data-rate DRAM from SDRAM. In 2001, Cisco Systems declared $2.2 billion in inventory to be worthless. Substantial write-downs also were reported by bellwethers like Nortel Networks, Lucent Technologies, Corning, and JDS Uniphase. While these write-downs may be extreme, they underscore the fact that investment in inventory is not without risk.

The Weighted Average Cost of Capital

Given the inherent risk of inventory, we recommend that companies use a weighted average cost of capital (WACC) to calculate the inventory capital charge. WACC is the opportunity cost for a company's average risk investment. Theoretically, a different WACC should be applied to investments of different risk. But as a practical matter, the same weighted average cost typically is applied internally to all investments unless there is a substantial difference in risk.

WACC is comprised of the cost of equity and the after-tax cost of debt. The cost of equity is the cost of providing shareholders competitive returns on their invested dollars. The cost of debt is simply the overall interest rate on the debt taken on to finance the project, reduced by the tax benefit of interest expense. Expressed as a percentage, cost of capital is the average of the required return on equity and the interest rate on debt, weighted by the proportion of equity and debt, respectively, to total capitalization.

The concept of the weighted average cost of capital can be explained within the context of one's personal investment portfolio.

* Suppose your portfolio has 30 percent invested in corporate bonds that have an expected return of 6 percent.

* The remaining 70 percent is invested in stocks with a long-term expected return of 11 percent.

* The weighted average expected return on your portfolio is approximately 9.5 percent (30% x 6% + 70% x 11%).

* In evaluating the future value of retirement savings and other decisions, you would use the blended rate of 9.5 percent.

A company's weighted average cost of capital is calculated as: WACC = % Equity x Cost of Equity + % Debt x Cost of Debt x (100%-Marginal Tax Rate)

where:

% Equity is the targeted percentage of capital financed by equity

% Debt is the targeted percentage of capital financed by debt

% Equity + % Debt = 100%

Estimating the cost of equity is the most challenging part of deriving the weighted average cost of capital. A review of the various methodologies used to estimate the cost of equity is beyond the scope of this article. But suffice it to say that most companies update the cost of equity estimate as well as the other WACC components once a year. While the WACC may range anywhere from 7 to 15 percent depending on the company's operating risk and financial risk (percentage of debt financing), the average for U.S. companies is approximately 9 percent, as determined below:

70% Equity x 11% Cost of Equity

+ 30% Debt x 6.5 Cost of Debt x (100%-40% Marginal Tax Rate)

= 9.0% Weighted Average Cost of Capital

It is important to note that the WACC is an after-tax rate. The 11-percent cost of equity used here is an after-tax cost because it comprises dividends paid to shareholders and growth in stock price, neither of which are tax deductible. The 6.5-percent cost of debt is a before-tax cost that is adjusted to an after-tax rate by multiplying it by the term (100%-40% marginal tax rate). This adjustment accounts for the tax-deductibility of interest.

Why Use WACC?

The overall weighted average cost of capital is driven by the risk of the company's assets like inventory, property, plant and equipment, and accounts receivable. For many industries, inventory is a significant portion of its net operating assets. Exhibit 2 shows inventory as a percentage of net operating assets for a sample of companies from manufacturing, distribution, and retail. From an investor's perspective, inventory is a significant contributor to overall risk, given its underlying risks and its percentage of operating assets. Consequently, it is reasonable to apply the overall weighted average cost of capital in calculating the inventory capital charge.

Use of the weighted average cost of capital is common practice in those companies using a financial management system like economic value added (EVA). However, many other companies apply a cost of capital that is substantially lower than the WACC. For example, they often use a short-term borrowing rate like the bank prime loan rate, which is currently at 4.25 percent. Or they use a short-term investment rate like commercial paper, currently around 1.25 percent. Both of these rates understate the capital charge that is commensurate with the underlying risk of inventory. This can lead to nonoptimal decisions for activities such as transportation mode selection, network design, and sourcing that balance inventory investment against operating expenses. The discussion below lays out the shortcomings of these common approaches to setting the costs of capital.

The Short-Term Borrowing Rate

One rationale for using the short-term borrowing rate is that inventory is a short-term asset that is financed by short-term loans. Technically, inventory is a short-term asset, or what is called a "current asset." For example, suppose a company has $100 million in inventory, which represents a 60-day supply of goods. On average the $100 million in inventory is converted into either cash and/or accounts receivable every 60 days. However, the flaw in the short-term asset argument is that as long as the company continues to have 60 days in inventory, it will need to invest $100 million in inventory to maintain its current sales. In this case, inventory should be viewed as a "permanent current asset" even though it turns over every 60 days. Therefore, a long-term cost of capital should be used in calculating the inventory carrying charge.

Another common argument for the short-term borrowing rate is that inventory is used as collateral in asset-based lending arrangements. It is true that loans against inventory are common. However, there are several flaws in using the short-term borrowing rate as the overall cost of capital for inventory. One is that creditors seldom lend funds up to 100 percent of the inventory's value. A more typical lending arrangement is up to 50 percent of the value. The percentage may be lower (like for high tech) or higher (commodities), based on the inventory's underlying risk. Also, a lending arrangement often requires that a company commit cash flow from all other sources as a means to repay the loan, even if inventory is used as collateral.

Suppose that a company with $100 million in inventory finances 50 percent ($50 million) with a bank loan. This leaves 50 percent to be financed through other sources like trade credit, bonds, and equity--all of which have significantly higher costs than the short-term borrowing rate. Trade credit, in particular, is commonly viewed as providing funding for inventory. Trade credit increases the purchasing company's accounts payable (a liability) that funds the inventory asset. In recent years, however, many purchasing companies have demanded longer trade-credit terms from suppliers. Our research shows the following ratio of accounts payable to inventory for a sample group of companies: manufacturing (57 percent), distribution (62 percent), and retail (53 percent). The results suggest that trade credit is 50 percent or more of inventory, which argues against using a short-term rate.

Another flaw in the use of the short-term borrowing cost for the inventory cost of capital is that it does not consider the company's "targeted capital structure"--that is, what percentage the company desires in the long term to finance with debt (the sum of short-term and long-term debt) and what percentage to finance by equity. The targeted capital structure is a senior management decision that is driven by such factors as asset risk, product lifecycle, and useful economic life of fixed assets. The level and percentage of debt financing that creditors are willing to provide are important factors as well. For example, many loans include restrictions on the total amount of overall debt financing.

Earlier, we showed that for the average company, the capital structure is approximately 70-percent equity and 30-percent debt. However, this structure varies by industry. High-tech companies in computers, storage devices, and computer peripheral devices sell products with very short lifecycles and volatile demand. Their average capital structure is approximately 95-percent equity and 5-percent debt. At the other end are companies providing electric and gas services, which have an average capital structure of approximately 50-percent equity and 50-percent debt. The higher percentage of debt reflects the more stable demand for utility services and the long useful lives of its generation and transmission plant and equipment. Exhibit 3 shows the 5-year average capital structure for sample manufacturing, distribution and retail companies. The results suggest that the targeted capital structure for these companies, on average, is comprised, of 70 percent or more equity.

The calculation below for a sample distribution company illustrates the need to account for the impact of financing inventory with debt and, in turn, to apply the correct cost of capital in estimating the inventory carrying cost.

This calculation is based on the results in Exhibits 2 and 3 for a distribution company with $100 million in inventory. Inventory is 60 percent of total capital, and the capital structure is 70-percent equity and 30-percent debt. All other capital of $67 million is composed of net investment in accounts receivable, property, plant and equipment, and other assets. The $50 million in debt is a loan on the $100 million in inventory. The terms specify that 50 percent of inventory may be financed by the loan ($50 million loan = $100 million inventory x 50% loan financing).

This example highlights the need to account for the impact of inventory debt financing on a company's debt capacity. The company's total debt capacity is $50 million ($167m capital x 30% debt) with a 30% debt/70% equity capital structure. If the company finances 50 percent of inventory with a loan of $50 million, then no additional debt is available to finance other assets like accounts receivables, property, plant, and equipment. These assets must therefore be 100 percent financed by equity in addition to the $50 million in inventory financed by equity. For decision-making purposes, it is unreasonable to apply 100 percent of the cost of equity to these assets. This is why modern financial practice is to apply the weighted average cost of capital to most assets since this methodology allocates the costs of debt and equity, accounts for the targeted capital structure, and compensates for an asset's risk if it is not significantly different from the company's average risk.

The Short-Term Investment gate

A short-term investment rate such as the yield on a money-market instrument like commercial paper or a certificate of deposit (currently around 1.25 percent) is also commonly used as the opportunity cost of holding inventory. But short-term investment rates, like short-term borrowing rates, ignore the basic risk/return principle underlying application of the cost of capital. These rates significantly understate the cost of capital that is commensurate with the risk of inventory. Several factors cause commercial paper, certificates of deposits, and other money-market instruments to exhibit lower risk and, therefore, a lower expected return. Specifically:

* There is a legally binding contractual obligation that the issuer will pay to investors a fixed amount on interest and repay principle on specific dates.

* Because the maturity is short term (typically one, three, or six months), investors do not have long-term credit risk exposure.

* Money-market instrument are fairly liquid and can be sold in secondary markets if investors needed to sell the investment prior to the maturity date.

These factors are in sharp contrast to the realities of investment in inventory

* Most investment in inventory is speculative, especially in wholesale/ distribution and retail. There is no legally binding contract that customers will buy the inventory. In cases where inventory is built to order, the purchaser often can change or cancel the order without fully compensating the selling company for the inventory's total value.

* Inventory may turn over every 60 days, for example, but a company must continue to reinvest in inventory in order to maintain sales. This is the "permanent current asset" nature of inventory discussed earlier.

* Inventory typically is not liquid. Disposal of inventory prior to its sale in the normal course of business often results in net proceeds that are substantially less than the original inventory investment. Exceptions to this are raw materials inventory invested in commodities like agricultural products and precious metals.

It is reasonable to assume that for many companies, the risk associated with investment in inventory is substantially higher than the risk of investing in money-market instruments. Using the yield on a money-market instrument as a proxy for the inventory cost of capital, significantly understates the inventory carrying charge. This, in turn, can lead to incorrect inventory-related decisions.

Summarizing our discussion, we believe that neither the short-term borrowing rate nor the short-term investment rate should be used to calculate the capital charge for inventory. Both ignore the fundamental risk/return principle underlying the use of cost of capital for decision-making purposes. Moreover, they both significantly understate the opportunity cost of holding inventory, which, in turn, impairs the decision-making process. The weighted average cost of capital is a much more appropriate rate to use in calculating the inventory capital charge. WACC is commensurate with the risk of holding inventory and the contribution inventory makes to a company's overall operating risk. This methodology also accounts for a company's targeted capital structure and debt capacity.

Before-Tax Total Inventory Carrying Costs

With the WACC in the equation, we can now combine the inventory noncapital carrying charge with the capital total costs to estimate the total cost of holding inventory. In our example, the noncapital carrying cost is 10 percent of the inventory balance. As shown in Exhibit 1, these costs are composed of operations expenses like obsolescence, warehousing, pilferage, insurance, and taxes--all of which are stated on a before-tax basis. The cost of capital is 9 percent and is the after-tax weighted average cost of capital.

Even when they use WACC to calculate the inventory capital carrying charge, companies often make the mistake of adding the before-tax percentage inventory noncapital carrying costs (like our example of 10 percent) to the after-tax cost of capital (say 9 percent) to get the total carrying cost (19 percent). The problem is that combining these before-and after-tax costs understates the total cost of holding inventory and can lead to nonoptimal inventory decisions.

To arrive at that true inventory carrying picture, the two costs must be stated on the same basis--either before-tax or after-tax. There are two options for doing this:

* Option 1: Adjust the before-tax percentage inventory noncapital carrying costs to an after-tax figure and add this to the after-tax cost of capital.

* Option 2: Convert the after-tax cost of capital to a before-tax number and add it to the before-tax percentage noncapital carrying cost.

Total inventory carrying cost is often used for periodic internal reports and for decisions that are evaluated at the operating level on a before-tax basis. For these purposes, we recommend using Option 2 to estimate the total cost of holding inventory. For traditional financial analysis involving the discounting of after-tax cash flow, Option 1 is the required choice.

The following equation shows the derivation of the before-tax cost of capital and total inventory carrying costs.

The 9-percent after-tax weighted average cost of capital restated on a before-tax basis is 15 percent, which is the 9 percent grossed-up for taxes. The rationale is that if a company earns 15 percent before taxes and pays 40 percent of the 15 percent in taxes (6% = 15% x 40%), it earns 9 percent after-tax (15% - 6%).

Practical Applications

To illustrate the total cost of inventory approach in action, we will again use the example of the company with $100 million in inventory and with average sales and operating income margin. The following chart compares the difference between using the 25 percent total cost of holding inventory and using the 15-percent figure.

The 15 percent is the sum of the 10 percent for noncapital carrying costs with a 5-percent capital-carrying cost, which is approximately equal to the commonly used short-term borrow rate. The 5 percent is a before-tax figure and therefore does not need to be adjusted for taxes.

Using the more accurate 25 percent reveals that the total-dollar cost of holding inventory is $10 million higher than when the lower 15 percent is applied ($25 million total cost of holding inventory vs. $15 million). To put the $10 million difference in a practical perspective, the calculation shows that the $25 million represents more than 80 percent of operating income being absorbed by total inventory carrying costs. By comparison, when the lower 15 percent is applied, inventory costs represent only 50 percent of operating income.

Communicating an accurate estimate of the percentage of operating income absorbed by total inventory carrying costs is an effective way to:

* Develop a better understanding of the relative cost of holding inventory.

* Motivate an enterprise-wide view of inventory management.

* Stimulate initiatives to improve inventory management. Good communication also creates a greater sense of urgency throughout the organization for better inventory management.

The more accurate 25-percent total-inventory-cost figure can also lead to better transportation management decisions. Consider the following illustration based on the sample company. Suppose that this company is exploring an initiative to lower inventory by 20 percent, or $20 million, by using expedited modes of transportation. Using the 25-percent total-inventory-carrying-cost figure, the estimated annualized gross benefit of this transportation upgrade is $5 million ($20m x 25%). Holding all other factors like service levels the same, this means that the company could spend up to $5 million more in transportation costs and break even. By contrast, using the 15-percent inventory-cost figure, the estimated annual gross benefit and maximum transportation-cost increase is only $3 million ($20m x 15%). To put the $2 million difference in perspective, transportation costs often average approximately 4 percent of sales. Using this average, transportation costs for the sample company are $30 million ($750m sales x 4%). Thus, the $2 million difference represents almost 7 percent of current transportation costs.

Our experience is that use of the more accurate percentage for total cost of holding inventory that incorporates the before-tax weighted average cost of capital has a great impact on transportation decisions and generally supports the use of faster modes. Similarly, this more accurate figure often affects decisions on sourcing and network optimization, which involve balancing operating expense with inventory levels.

The Goal: Better Decision Making

Summing up our discussion, supply chain management professionals must develop better estimates of the components of the total cost of holding inventory--the noncapital carrying costs and the capital carrying charge. Better estimates of these components (which are almost always higher than the current estimates used) provide more accurate insights into the total cost of holding inventory. And knowing this more accurate total cost can be a powerful catalyst for exploring new solutions to manage inventory more effectively.

In particular, supply chain professionals must develop more credible estimates of noncapital carrying costs--obsolescence, warehousing, pilferage, damage, insurance, taxes, and so forth. Current estimates of these costs often cannot be traced to specific line-item costs and incorporated into budgets. Therefore, they are often excluded when calculating the value of inventory-reduction initiatives such as investments in technology to improve forecasting and inventory visibility. Exclusion of these costs understates the return on investment of these initiatives and can result in rejection of projects that should be accepted. Again, we recommend that as a starting point companies focus on estimating the noncapital-carrying-cost components of obsolescence, insurance, and taxes. Information on these costs tends to be more readily available at a product-line, geographical, or line-of-business level than other noncapital carrying costs. Obsolescence, insurance, and taxes also are typically variable costs--varying with the level of inventory investment.

Companies also should be mindful of using a cost of capital that significantly understates the inventory capital charge. Specifically, they often use a short-term borrowing or lend rate instead of the more accurate weighted average cost of capital. Use of the WACC can lead to better inventory-management decisions. Transportation management is just one example. Inventory can be lowered by utilizing faster modes of transportation; for example, by moving to less than truckload (LTL) from full truckload, or to air from LTL. Although using faster modes increases transportation costs, it lowers the total cost of holding inventory. Applying the WACC in calculating the inventory capital charge would justify the initiative. The reason: Although total transportation costs increase, the total cost of holding inventory and total supply chain costs are lowered--driving improvement in overall financial performance.

Network design is another area where use of the weighted average cost of capital in the capital carrying charge calculation leads to better decisions. A part of network design is balancing total transportation expenses against total inventory carrying costs. When the more accurate WACC is used, total inventory carrying costs are higher. This warrants incurring higher transportation costs in order to lower total inventory carrying costs and, in turn, total network costs. Thus, in many cases, a more consolidated network is optimal even though total transportation costs are higher.

Finally, consider the impact of knowing the total cost of inventory on procurement decisions. To illustrate, many companies are switching to Asia-based sourcing because of lower purchase-price costs. However, this practice often leads to increased investment in inventory because of higher in-transit and safety-stock inventories. Use of the weighted average cost of capital provides a more accurate view of the inventory's impact on total landed cost. It turns out that the source with the lowest purchase-price cost doesn't always have the lowest total landed cost when the weighted average cost of capital is utilized. Once again, knowing the real costs of holding inventory leads to a better decision.
Illustrative Valuation of Change in Inventory *

                                               Noncapital Carrying
                                                     Costs

                                               Included   Excluded

Inventory Change                                $10.0m     $10.0m
% Noncapital Carrying                            10.0%      N/A

Change in Noncapital Carrying Costs              $1.0m      N/A
Tax Rate                                         40.0%      N/A
Taxes                                            $0.4m      N/A
Change in Annual After-Tax Profits               $0.60      N/A
Present Value (PV) of After-Tax Profits          $6.7m      N/A
@ 9.0% Cost of Capital ($0.6m/9%)
Total Value                                    $16.7m      $10.0m
(Inventory Change + PV of After-Tax Profits)

* Excludes cost of initiative.

           Capital                  Capital
                                    Structure

              $      %              $     %

Inventory   $100m    60   Debt    $50m    30
All other   $67m     40   Equity  $117m   70

Total       $167m   100%  Total   $167m  100%

Total Inventory Carrying Costs as
Percentage of Inventory

Percentage Noncapital Carrying                   10%
After-Tax Weighted Average Cost of Capital        9%
Marginal Tax Rate                                40%
Before Tax Cost of Capital (9% / (100% - 40%))   15%
Total Inventory Carrying Cost as
Percentage of Inventory                          25%

Total Cost of Holding Inventory Applications

Inventory                                    $100m   $100m
Percentage Total Cost of Holding Inventory    25%     15%

Total Cost of Holding Inventory              $25m    $15m
Sales                                        $750m   $750m
Operating income Margin *                     4%      4%

Operating Income *                           $30m    $30m

Operating Income Absorbed by
Total Cost of Holding Inventory               83%     50%

* Excludes noncapital inventory carrying cost of $10 million
($100m inventory x 10% noncapital carrying costs).

EXHIBIT 1

Total Cost of Holding Inventory

Warehousing
+ Obsolescence
+ Pilferage
+ Damage
+ Insurance
+ Taxes
+ Admistration and Other
= Total Inventory Noncapital Carrying Costs

Plus

Inventory
x Cost of Capital
= Inventory Capital Charge

EXHIBIT 2

Inventory as a Percentage of Net Operation Assets

Manufacturing   37%
Distribution    62%
Retail          56%

Note: Table made from bar graph.

EXHIBIT 3

Average Capital Structure (1998-2002)

                % Equity   % Debt
Manufacturing      71%       29%
Distribution       70%       30%
Retail             77%       23%

Note: Table made from bar graph.


Stephen G. Timme is president of FinListics Solutions and an adjunct professor at Georgia Institute of Technology, where he teaches in the Executive Masters in International Logistics Program. Christine Williams-Timme is CEO of FinListics Solutions.
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Author:Timme, Stephen G.; Williams-Timme, Christine
Publication:Supply Chain Management Review
Geographic Code:1USA
Date:Jul 1, 2003
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