Carrying Costs Reductions with Supply Contracts
The right supply contract can effectively reduce your carrying costs, improve your vendor relationships and improve your company’s market position. Most Companies don’t take the time to define what their inventory carrying really are. Are you aware of what’s included in these carrying costs and how they impact your bottom line? More importantly, do you use supply agreements with vendors to reduce the impact of theses costs, shorten turn times on material and improve your own product to market lead times? Perhaps you’re unaware of how these contracts work and their ability to streamline your supply chain. If that’s the case, don’t despair!
Summarizing your inventory carrying costs
Before delving into how supply contracts can help, it’s probably best to review what constitutes your company’s carry costs of inventory. First, there are the costs associated with inventory obsolescence, the costs of inventory damage and the high costs of ruined inventory. In most cases, companies must sell their ruined inventory as scrap due to the high costs of rework. These carrying costs also include your company’s financing costs of inventory, the costs of rent, costs of electricity and the salaries paid to warehouse employees. In addition, there are costs pertaining to losing sales and customers because of low inventory counts. Last but not least, there is the cost of freight on incoming and outgoing shipments of finished goods. Each of these aforementioned cost drivers plays a vital role in your company’s costs of inventory. So how can supply contracts help to reduce the impact of these carrying costs?
The benefits of supply contracts
Most companies use 3% as their monthly carrying cost. This 3% is then applied to their inventory value for every month the company holds inventory. Vendor supply contracts help to reduce these monthly expenses by sharing the burden of carrying costs. For instance, the impact of ruined inventory and inventory damage is less severe when vendors retain inventory on behalf of their customers. In this case, the longer the vendor retains the inventory, the less impact these costs have. In addition, the company is able to reduce its per-unit freight costs on incoming parts & materials because it isn’t rushing vendor deliveries in order to meet its own customer demand. The company is less likely to order higher volume than needed, or to “stock up” on supply, because it knows its vendors will retain inventory on their behalf. Knowing they won’t have to rush parts in at the last minute makes planning inventory a much easier process.
Other benefits include a reduction in the company’s daily cost of money through reduced financing costs. For instance, most companies pay for their inventory through business financing vehicles like business credit lines and loans. Each of these financing options charge a yearly interest rate that can be converted to a daily interest rate. Every day the company holds inventory it doesn’t sell, is yet another day they must cover this interest rate. However, the right contractual agreement defeats the company’s daily cost of money because that inventory is only taken when the company needs it. Until then, the vendor will simply wait for the customer to make a release. If properly managed, a company can effectively cut their monthly carrying costs in half by using the right supply contracts.
- Lower incidence of ruined inventory & inventory damage
- Lower per-unit freight costs on incoming parts
- Shorter turn times on material and faster product to market lead times
- Lower financing costs
- Easier to manage inventory
The right contractual agreement can make all the difference. However, it’s wrong to assume that the contract should be one-sided and only in favor of the customer. Remember, the purpose of these agreements is to reduce the company’s carrying costs by sharing the burden of holding inventory. It’s simply not feasible to expect the vendor to retain inventory indefinitely and for the customer to dictate all terms of service. After all, the vendor is just as concerned about carrying costs as their customer and likely not interested in absorbing all the cost themselves. As such, be open to discussing these expenses with your vendor. Be willing to split those aforementioned carrying costs of 3%. It will ensure that both sides have an incentive to see the agreement to its successful conclusion.