Lean Six Sigma Logistics: Inventories and the Cost of Production

June 30, 2018 at 1:46 pm Leave a comment


Image from ShutterstockFrom a simplistic point of view, a firm must optimize costs in order to achieve maximum profitability. Therefore, focusing on controlling and lowering costs is instrumental to a firm’s long-term profitability. In the automotive industry, for example, competitive pressures have put downward pressure on retail prices, which means that profit margins can be increased only through decreased costs. Additionally, those companies that can maintain competitive pressures on their competitors will in fact see increased sales, which will result in more efficiency through the realization of economies of scale in terms of overhead cost spreading. In essence, companies that gain competitive cost advantage will continue to maintain competitive advantage overall. However, inventory control, and it financial impact, can be challenging for many firms, as it affects the components of both explicit and implicit costs.

 Explicit costs are defined as historical costs or actual costs that are tangible and allocated on a firm’s financial statement. With respect to inventory, these costs can be seen in items such as storage of inventory, transportation, and material handling costs, including all the personnel, warehouse, and PP&E costs. Other explicit costs associated with holding inventory include those costs due to scrap and rework (which are proportional to WIP), shrinkage, obsolescence, taxes, insurance, and damages to inventory. Even though firms recognize that explicit costs exist with inventory, many companies rationalize that these costs are necessary evils and say they should simply be considered a cost of doing business. Even though reducing these explicit costs can appear to be daunting, doing so can truly separate the top performers in a competitive industry.

Implicit costs are those costs that do not involve actual payment by a company, but represent lost opportunity that results from allocating money in one area, thus ultimately abandoning other potential projects. The opportunity cost of such decisions is the return that the abandoned projects may have generated on the invested capital. There are many schools of thought on how to calculate the cost of lost opportunity; however, most financial managers will agree that the financial losses fall somewhere between the actual cost of capital and a firm’s required risk-adjusted rate of return on its equity (the weighted average cost of capital) for that industry.

Explicit cost, then, are not reflective of the whole story relative to inventory. Implicit costs of holding inventory tell the true story of how inventory can have significant financial implications for the firm.

Regardless of how a firm calculates the opportunity cost of holding inventory, there is no question that the cost does exist and must be taken into consideration when making strategic decisions.

How does your firm calculate the Cost of Production?

Stay tuned for my next segment on Lean Six Sigma Logistics…

Dan Trojacek, LSSMBB, CMQ-OE

Vice President | Director | Manufacturing | Operations | P&L | Supply Chain | Quality | Compliance | Lean | Consultant

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Entry filed under: Dan Trojacek.

Lean Six Sigma Inventory Practices

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