How Do Excessive Inventories Erode Corporate Profitability?

Excess inventories erode profitability in several ways. First, they tie up working capital. I once had a senior supply chain executive at one of the world’s largest consumer package goods (CPG) companies tell me his firm had $1 billion in inventory that it couldn’t locate at any given time. That doesn’t mean it was lost or stolen—just that it didn’t know where its goods were. If that company could employ RFID cost-effectively to locate and eliminate that inventory, it would have an additional $1 billion in working capital, which could then be invested in new product research or other projects.

Excess inventory has to be stored and maintained, so there are inventory carrying costs involved. A standard rule of thumb is that inventory carrying costs are approximately 25 percent of the value of the total inventory a company has on hand. So carrying an extra $1 billion in inventory would cost our CPG manufacturer $250 million annually. Eliminating that excess would mean that some of that money would flow directly to the bottom line.

Excessive inventory might mean that money is tied up in facilities. If a company can reduce that excess, it might be possible to close a warehouse or distribution center (though not necessarily, since these are often needed to serve a geographic purpose). But in facilities that house both a manufacturing center and a warehouse, additional space could be dedicated to manufacturing, thus enabling a company to increase output without investing in a new building. We ran a story, for instance, about an automaker that eliminated excess parts inventory, thereby freeing up space on its factory floor to increase production.

It’s also worth noting that excess inventory is often sold at large discounts, which hurts a company’s margin and, thus, its profitability. Sometimes, inventory has to be written off altogether. A speaker at our recent RFID in Health Care—Boston event discussed how expensive implants were often thrown away because they had passed their expiration date. Now, she uses an RFID system to alert her whenever implants are nearing that date. Vendors then replace these devices at no cost, saving her hospital tens of thousands of dollars every year.