INVENTORY: OPPORTUNITY COST AND IMPACT ON FINANCIAL INDICATORS

Despite the process of operational improvement that world-class companies have been going through with significant reductions in inventory costs, these are still considered critical in many of these organizations. Logistics and operations managers are constantly faced with the need to reduce inventories, without jeopardizing the level of service, an apparently impossible task because it goes against the basic teaching of logistics, regarding the trade-offs between the costs of activities and the level of service. .

Inventory stands out as a target item for cost reduction, not only because of its relevance within the total cost compared to the companies' margin, but mainly because of the fixed value in this asset account, which directly affects the return on shareholders' equity .

Another important factor for evidence of the financial cost of stocks is the global market of the last years of the XNUMXth century, which were marked by record real interest rates. In Brazil, the situation has been even more difficult, as the government has repeatedly resorted to raising the basic interest rate as a way of curbing consumption to prevent the return of inflation. However, this measure also increases market interest in general and makes the cost of inventory expensive compared to developed countries.

While high interest rates are putting downward pressure on inventory levels, problems related to demand and supply uncertainties may restrict possibilities for reduction. The non-judicious reduction of the stock level can also negatively interfere with the availability of products, compromising the company's sales.

Within this context, this article will address the main considerations related to the calculation of the financial cost of inventory and the cost of lost sales, which are conceptually treated as opportunity costs. Finally, the impact of inventory levels on the strategic profit model that evaluates the return on shareholders' capital will be analyzed.

2. FINANCIAL COST OF INVENTORY

Before calculating the financial cost of inventory, it is important to note that, as it is an opportunity cost, it is not linked to a disbursement and also does not appear in any bill or payment note.

2.1 opportunity cost

The concept of opportunity cost refers to a possible loss of earnings from choosing a particular alternative over another. Its calculation can be done based on the difference in the result between two alternatives: the one that actually materialized and the one that would have materialized if the option had been different. To analyze this difference, it is necessary to consider the possible revenues and costs of the two alternatives.

Thus, the financial cost of the stock refers to a possible yield that the immobilized capital would have, if it were applied in some other project of the company. In this case, investment in another project would be an alternative to the decision taken to invest the capital in an asset account.

To make the concept clearer, one can imagine an example in which a small trader, owner of the property in his store, must decide whether or not to continue with his business. Of course, for this trade to be worthwhile, your monthly income must be greater than the possible rent for your building, otherwise it would be better to close the store and rent the building. In this example, rent is seen as an alternative and, therefore, its possible value could be considered as an opportunity cost of using the property for your business.

More broadly, it is considered that the opportunity cost of an asset is calculated by multiplying its market value by the company's opportunity rate.

2.2 Opportunity rate

Every investment generates an asset that can be financed either by third parties (with a counterpart in liabilities), or by shareholders (with a counterpart in shareholders' equity), or by a portion of each of these accounts. Thus, the opportunity rate is the weighted average between the average interest rate on liabilities (debts and obligations) and the expected rate of return of shareholders on equity, using the respective proportions of these accounts over assets as weights, as can be seen in figure 1.

Another possibility, instead of using the company's opportunity rate to calculate the financial cost of stock, is to consider the yield rate of a possible investment, in which this capital could be employed, or else, the interest rate of an account of financing the liability that could be deducted, if this amount was not immobilized in inventory. These options are more appropriate in more specific analyzes that involve the concept of marginal cost, in a short-term horizon.

2.3 The calculation of the financial cost of stock

In the case of a company that sells finished products, the financial cost of inventory can be calculated by multiplying the value of products in stock by the company's opportunity rate, regardless of the deadline for the decision to be taken. Because in this case, the stock is valued based on the purchase price, which, in most cases, is a fully variable cost. Thus, in a marginal cost analysis, the same value of the good could not be immobilized, if it were not purchased.

In an industrial company, however, the same may not happen with regard to finished products, because these products are valued based on the cost of the product sold (COGS), which considers all industrial costs, both variable costs and raw materials, and fixed costs, such as depreciation of production equipment. However, when analyzing a short-term decision to produce or not a surplus quantity to be incorporated into the stock, one should consider only the variable production costs, since the fixed costs occur regardless of the production volume.

As the opportunity cost is linked to differences between choosing one alternative over another, it is necessary to analyze what the other alternative would be. In the case of the industrial company, the alternative would be not to produce the surplus and not to immobilize the capital. However, as the fixed cost by definition is independent of the volume produced, a smaller quantity would only result in a lower total variable cost, since only this is proportional to the level of activity (ie production). Thus, the capital that would no longer be immobilized would only correspond to the variable portion of the costs of non-produced products.

In this way, for short-term decisions, the financial cost should only consider the variable costs associated with the products, and not the COGS, which also incorporates fixed costs, which, in the short term, occur independently of the production volume.

In the long term, the division of costs into fixed and variable does not make much sense. This is because over a longer period of time, all costs can become variable due to changes in capacity, with the purchase or sale of machines, or even the hiring or dismissal of labor, for example.

2.4 Additional precautions in calculating the financial cost

In addition to considering the decision deadline, when assessing which costs should be included in the inventory value, two additional precautions must be taken regarding the measurement of this value on which the opportunity rate will focus.

The first is related to the addition of the variable portion of the transport cost to the product cost, which must be done as the product moves along the supply chain. When third parties are used, for example, to carry out transport, the cost of this activity normally becomes totally variable and, therefore, can be fully incorporated into the value of the good. Thus, the closer the stock is to the consumer, the greater its value, and consequently, the greater its opportunity cost.

The second care is related to products with an expired expiry date, or obsolete, or with some type of malfunction. The goods, under these conditions, must be posted as a loss (cost), but also deducted from the inventory account. It makes no sense to consider the remuneration of an asset that is no longer in use and cannot be sold. In this case, the asset would become a sunk cost, as the company would not be able to recover its value regardless of any future action. If the damage did not lead to the total loss of the good, only a partial value of the product, related to the damage, should be deducted from the stock account.

3. COST OF LOST SALE

The loss of sales due to lack of product to meet demand affects one of the main dimensions of the logistics service, availability. Among the series of complications arising from the lack of product, the negative result for the brand and the loss of customer loyalty, who end up resorting to other brands and substitute products, can be highlighted. This result could be evaluated as a possible cost of the lost sale, but this would require some discretion in its measurement. A conservative way of evaluating this cost, disregarding issues related to brand image and customer loyalty, is to exclusively evaluate the loss related to the non-sale of the product due to its unavailability.

Returning to the concept of opportunity cost, the alternative to the lost sale would be to have the product and thus make the sale. In this case, the company would have revenue related to the price of the item, but in compensation it would also incur all the variable costs to make the product available for sale. This difference between the selling price and the variable portion of a product's costs is called the product's unit contribution margin (MCU). It is important to note that the MCU differs from the unit profit, since the latter ignores all fixed costs, which are considered irrelevant to this type of analysis because they occur independently of the sale.

Thus, the unit opportunity cost of the lost sale due to the lack of a product is equal to its MCU, even disregarding issues related to service failure and repercussions on the brand image that can be more accurately evaluated by other performance indicators not linked to costs, such as the frequency of stockouts, the average availability, the number of days with stockout, etc.

4. RELATION BETWEEN THE COST OF EXCESS AND THE COST OF SHORTAGE

The cost of excess considers the costs related to the surplus of a unit in stock, so it is equivalent to the cost of keeping an item in stock. The cost of shortages corresponds to the inverse case, being equivalent to the cost of lost sales.

The trade-off between the cost of excess and the cost of shortage is key for parameterizing any inventory management model, regardless of the method adopted. The greater the cost of excess of a product in relation to the cost of shortages, the smaller the safety stock must be to meet possible variations in sales and supply or production failures. On the other hand, the lower the cost of excess in relation to the cost of shortages, the greater the safety stock of the product must be to prevent possible uncertainties. As a result of this relationship the product availability target should vary according to the relationship between the financial unit cost of inventory and the MCU of the product.

Industries with a high share of fixed costs and a small share of variable costs have a low excess cost in relation to the shortage cost, since the cost of excess strictly speaking must be calculated based on the variable portion of product costs. At the same time, the smaller the variable cost portion, the higher the MCU tends to be, since it represents the price minus the variable costs and, therefore, the higher the shortage cost. Industries with high fixed costs and low variable costs, such as steelworks, normally produce at full capacity in the short term, storing the surplus or sending it to export, since the cost of the excess becomes quite low in the short term.

When comparing industrial companies with retailers, or with wholesalers, or with distributors, it is clear that in industries in general, fixed costs assume a significant portion of the COGS to the detriment of the variable cost portion. In retail, as well as wholesalers and distributors, the situation is quite different, as COGS (cost of goods sold) is normally almost entirely made up of variable costs.

Thus, companies at the end of the supply chain, close to the consumer, such as wholesalers, distributors and retailers, tend to have an excess cost, which is quite expressive in relation to the cost of shortages, when compared to industries.

To make this concept clearer, we can resort to a hypothetical example in which an industry and a retailer sell only one product to each other. Assuming that the unit cost of the factory was R$10,00 (with R$6,00 referring to fixed costs and R$4,00 referring to variable costs) and that it sold the product at retail for R$12,00 that, in turn, sold to the consumer for R$ 14,00. Considering a capital opportunity rate of 2,5% per month for both companies and that the excess inventory could only be sold in the following month, the following results would be obtained.

• in the industry

Missing cost = 12,00 – 4,00 = BRL 8,00

Excess cost = 4,00*0,025 = BRL 0,10

The cost of shortage would be 80 times greater than the cost of excess

• in retail

Missing cost = 14,00 – 12,00 = BRL 2,00

Excess cost = 12,00 x 0,025 = BRL 0,30

The cost of shortages, in this case, would be about 6,6 times greater than the cost of excess, although in absolute terms this difference is significant, in relative terms it would be 12 times lower than in the industry.

The great difference in the relationship between the opportunity costs of inventory – excess and shortage – in the different links in the supply chain has a direct influence on the inventory policy of each of these companies. Industries usually have their production more focused on inventory, admitting a safety stock that covers part of their uncertainties, enabling high availability. On the other hand, retail operates with a safety stock that is often smaller, not only because of the greater concern with high turnover – obtained through the low level of inventory -, but also because of the lesser importance given to eventual product shortages. Even because retail has a faster response speed to replenish items in stockout.

The tendency to centralize retail inventories, which reduce the effect of demand variability, combined with continuous replenishment programs, has allowed for a significant reduction in inventory levels. In addition, the high availability of products from the industry most concerned with availability also helps retail resupply, avoiding product shortages.

It is clear that some important products from major brands serve as a “call-out” for retailers, in addition, the lack of these items may result in the loss of customer loyalty on the part of retailers. Thus, in view of this situation, the dimension of availability gains greater importance compared to the cost of inventory.

5. THE IMPACT OF INVENTORY ON THE STRATEGIC PROFIT MODEL

More and more financial indicators are gaining importance in the management of companies. The capital restriction for new investments means that companies have to maximize the return on capital employed. For this, it is necessary to generate the maximum possible result with the minimum possible capital. From an operational standpoint, this is equivalent to maximizing profit while minimizing assets. Thus, the idea of ​​demobilizing assets has gained strength within companies.

For this, some practices have become common over the last few years, such as:

• Sell ​​fixed assets, such as buildings and choose to rent them out;
• Outsource intensive activities in the use of assets that are not part of the company's core business;
• Opt for leasing or renting means of production;
• Reduce inventory levels, consequently decreasing this asset account.

Decreasing the level of inventory is, at least apparently, among the topics cited, the easiest and fastest way to reduce assets. Furthermore, in the longer term, when the other asset accounts manage to be reduced, the inventory account must decrease at least as much as the others. Otherwise, it becomes more representative of total assets, making the return on equity more sensitive to changes in the stock account, forcing its reduction even further.

The strategic profit model allows you to evaluate the relationship between inventory and financial indicators. This model is used to calculate the return on equity (RSPL), which represents the return on equity of the shareholder. The RSPL is the result of the return on assets (RSA) multiplied by the financial leverage of the company. This model is generally used to generate scenarios and test sensitivity analyzes of the impact of changes in asset accounts, such as inventory, on return indicators, which have become the most important performance measurers for large companies.

With this, inventory management began to be analyzed not only for its cost result but mainly for its financial impact, as inventory is an asset and consequently its variation ends up affecting the RSA and consequently the RSPL.

Figures 2a and 2b illustrate how the strategic profit model can be used to assess the impact of a reduction in inventories. The example in Figure 2a considers data from a fictitious company with annual revenues of BRL 2 billion, shareholders' equity of BRL 0,5 billion, total assets of BRL 1 billion, of which BRL 400 million are related to inventory and profit. net income of R$ 100 million. If this same company managed to reduce its stock level by 25%, as shown in Figure 3b, the return on ROI would increase from 20% to 22,2%, a significant increase from the shareholder's point of view. Another possibility would be to consider that the reduction in the asset's stock account could be used to finance another company project that could be increasing sales or decreasing costs.

6. CONCLUSION

One of the main functions of logistics directors and managers is to reconcile the financial area's interest in reducing inventories to minimize costs and maximize returns with the commercial area's interest in maximizing product availability. Many management programs and practices have been and continue to be developed and implemented to reduce inventory levels without compromising service levels. However, as long as there is stock, there will continue to be a need to measure its cost and assess its trade-off with product availability.

Among the precautions that must be taken when calculating the financial cost of inventory, the following stand out:

• Consider that this is an opportunity cost that affects the total cost of products in stock in long-term analyses, and only on the variable portion of costs in the short term;
• Remember that the financial cost of stock should not apply to products with an expired shelf life, obsolete or with damage that prevent their use or sale;
• Include possible aggregated variable costs along the supply chain, such as transportation costs.

Finally, it is worth noting that basic knowledge of the main cost concepts is of fundamental importance both for the application of a costing methodology for inventories and for the use of this cost information in decisions relating to inventory management and demand planning. In turn, the financial view of the influence of stock on return on equity is also important to understand stock from the perspective of shareholders and senior management.

BIBLIOGRAPHY

• BOWERSOX, DJ, CLOSS, DJ, 1996, Logistical Management: the integrated supply chain process. New York: McGraw Hill.
• LAMBERT, DM, STOCK, JR, Strategic Logistics Management, Third Edition, Richard D. Irwin Inc., Boston, 1993.
• MARTIN Christopher, Integrating Logistics Strategy in the Corporate Financial Plan, in JFRobenson (eds), The Logistics Handbook, chapter 11.