In 2015, the Brazilian economy faces great difficulties. According to Focus Market Report, we will go through the biggest recession in republican history, which will surpass negative 3 percentage points, and double-digit inflation, more than twice the target of 4,5%.
This degradation of the macroeconomic scenario, marked by the drop in consumption and acceleration of inflation, makes government agents act actively in monetary and fiscal policy to try to reverse the situation. These government measures, in turn, influence the decisions of companies' operations, so it is necessary to understand them to direct the paths of organizations.
Without making judgments about the quality and assertiveness of the government's measures, in order to drive inflation towards the target, the Central Bank of Brazil has resorted to a contractionary monetary policy, increasing the basic Selic interest rate.
Figure 1 – Evolution of the Selic Rate in the last 5 years
Source: Central Bank of Brazil
In addition to the considerable impact on companies' investment decisions, as it is used as a reference for credit operations in the country, the increase in the Selic rate increases the cost of fixed capital. Thus, the increase in interest rates has a perverse impact on companies' cash flow, as it considerably increases the opportunity costs of assets, especially costs related to maintaining inventories.
Inventory costs are divided into several groups, among which we can highlight: Outage Cost, Product Loss Cost and Opportunity Cost, as shown below:
Figure 2 - Examples of inventory costs
Source: ILOS
The downward trend in aggregate demand and the increase in interest rates directly affect the opportunity cost component of inventories, which has as its factors the value of inventory and the opportunity rate.
On the side of the volume in stock, it is known that a good part is associated with the variability of demand and supply. The slowdown of the Brazilian economy caused an inversion in the trends of the demand series, making them more irregular and difficult to predict, given that the history does not foresee a downward movement. Thus, even when seeking new extrapolative methods, companies need to deal with the increase in sales forecasting errors.. This unpredictability, materialized in the decrease in forecast accuracy, is a direct injection into safety stocks, which act as protection against demand (and supply) uncertainties.
In addition, there is a doubly negative effect on inventory turnover: on the one hand, unpredictability causes inventory levels to rise, on the other hand, the contraction in demand means that the same quantity of products takes longer to be consumed, or that is, there is an increase in inventory coverage and a consequent reduction in inventory turnover, the heart of many companies' business. In other words, a stock that took 10 days to be consumed will be consumed in 15 days.
Now considering the impacts on opportunity rates, in 3 years the basic interest rate practically doubled, going from 7,25% to 14,25%. This means that, for the same amount of stock, today, the associated opportunity cost would be twice as high. Having capital invested in the form of inventories, whether of raw materials or finished products, becomes more expensive and, therefore, less attractive.
Figure 3 – Influence of the economic recession on the opportunity cost of inventories
Source: ILOS
Conclusions
Even with an unfavorable scenario for maintaining inventories, as a result of the deterioration of the business environment, simply trying to force a reduction in inventory levels is not the best solution, since this inconsequential reduction would lead to an increase in stockouts, generating lost sales and an increase in the cost of inventories via the cost of shortages. Thus, for each location-product pair, there is an ideal service level, based on a fine-tuning that minimizes the total cost of inventories, sum of the cost of excess and cost of shortage.
Figure 4 - Ideal service level in relation to the cost of excess and cost of shortage
Source: ILOS
Finally, the best way to minimize the total cost associated with inventories is to review not only inventory management, but also statistical methods and sales forecasting processes. Improved forecasting accuracy will reduce demand uncertainties, while the new inventory policy will seek to align inventory levels for each location-product pair, based on the optimal service level defined by balancing the unit cost of excess and the lack.
In this way, the resizing of inventory levels would ensure a reduction in inventory levels of products that are in excess and an increase in the provisioned quantity of products that present a higher than desired chance of shortages, always taking into account the ideal service level to minimize the total cost of inventories.
References
<https://www3.bcb.gov.br/expectativas/publico/consulta/serieestatisticas>
