The Opportunity Cost of Working Capital Tied up in Inventory

Measuring a manufacturer’s financial health involves taking into consideration a variety of factors. Many agree that working capital is often a good indicator of overall financial performance. Working capital takes into account the organization’s current assets and liabilities. At times, working capital may include inventory on hand. So, organizations must know how keeping raw materials or finished goods on hand affects their working capital and overall business health.

What is Working Capital?

Before discussing the effects of working capital tied up in inventory, it’s critical to understand what qualifies as working capital. Essentially working capital refers to the difference between the current assets of an organization and its current liabilities. The most common liabilities include any debt or outstanding amounts due in accounts payable. As for assets – these include everything from cash on hand to accounts receivable to inventory, both raw materials and finished products.

Working capital – often called net working capital(NWC) – is an excellent measure of an organization’s liquidity. Liquidity is the ability of a business to pay off its short-term liabilities. Generally expressed as a ratio or percentage, liquidity is a good indicator of an organization’s current financial health.

Impact of Working Capital Tied Up in Inventory

As previously mentioned, inventory is considered an asset for manufacturers. So, having a lot of inventory on hand is a good thing, right? Not necessarily. Having the raw materials on hand to produce a product on-demand means less time to complete a work order. Similarly, having the inventory of finished goods on hand when an order is placed means less time for the product to reach the end consumer. However, businesses must also take into account the cost of keeping inventory on hand – both in actual costs and opportunity costs. Actual cost refers to what is spent to house inventory on hand, such as warehousing fees, interest paid for funds tied up in inventory, additional insurance required, obsolence and inventory that gets ruined for other reasons. The term opportunity cost generally refers to something positive that was given up by choosing another course of action. So, what is the opportunity cost of keeping inventory on hand for manufacturers?  

When organizations keep too much inventory on hand, the funds they spend to store and maintain that inventory could be alternatively used for other investments. The money it takes to purchase raw materials or produce finished goods is already spent at this point, and more has to be spent to house that inventory. So, it can’t be used for things like updating equipment, marketing efforts, or other important investments for a successful operation. One important note is that not all inventory can be stored in a typical warehouse. Some items require refrigeration or specific lighting to keep their quality. This is even more costly and takes more funds away from liquid assets that could be better served elsewhere. Other examples of costs incurred from housing inventory that could potentially be better served elsewhere include:

• Personnel Costs: Manufacturers need warehouse personnel every time inventory moves from one location to another. When a product is moved to storage after production and then must be moved again once the inventory is purchased – this doubles the work for personnel and increases costs for the business.
• Insurance: Organizations have to carry insurance, and many carriers will charge higher premiums for those keeping excess inventory on hand, as it is determined by the value of that on-hand inventory.  

Many manufacturers are moving towards Just-In-Time (JIT) inventory management practices. With this method, organizations keep only small amounts of inventory on hand at any moment and replace this as items sell. However, businesses must carefully manage this type of inventory system as well. Keeping too little inventory on hand may lead to longer lead times for consumers to receive their product should that inventory deplete before additional production.

Effective Inventory Management

No matter which type of system a manufacturer chooses to manage inventory, it should be driven by data and industry best practices – and carry with it the ability to adapt as needed. At IMCO Software, we take a holistic approach to effective manufacturing and know that effective inventory management is crucial for manufacturers to both meet production demands and invest in other areas of the business rather than keeping excess inventory constantly on hand.

Because of this, we often recommend the implementation of a manufacturing execution system solution, such as the CIMAG MES. The system connected many aspects of the manufacturing process, providing real-time data to drive decisions. With the CIMAG MES, organizations can improve the reliability of their operations and implement a realistic, up-to-date production schedule that keeps inventory at a level that both meets customer demand and doesn’t take too much working capital away from other business operations.

Each manufacturer has unique needs based on the industry and the types of items they produce. So, there is no one blanket approach to managing the manufacturing process effectively. However, with the right combination of customized software solutions, manufacturers can ensure that productivity increases, costs decrease, and inventory is managed properly based on data.  

If you are looking to implement new software solutions to better manage the manufacturing process, the team at IMCO Software is here to help. Our team brings years of extensive experience in manufacturing and supply chain management. We can help identify areas to improve within your organization and recommend the right solutions to better control the process moving forward.  Contact us today to get started.