Calculating inventory carrying charge, two case
studies at Lantmännen
Carl Wikner, David Hammarström
Abstract
As a part of a larger project consisting of reducing tied up capital, Lantmännen wishes to have a
clearly defined inventory carrying charge in order to manage their inventory in a cost efficient way
and to gain control over the total costs associated with carrying inventory. The aim of this master
thesis has been to define the inventory carrying charge and its components and further aim has been
to explain how the inventory carrying charge can be used as a management tool in order to gain
control over the total inventory costs. Moreover, have the current carrying charges been calculated
through a case studies for two of Lantmännen’s business units, Cerealia and Swecon. The carrying
charge consists of the cost of capital plus all variable inventory costs divided by the average inventory
value. By variable costs we mean inventory costs that vary continuously with the amount of
inventory. The case studies show that the inventory carrying charge differs greatly between the
different business units studied and between their groups of products. Our results show that the
inventory carrying charge is between 8 % and 29 % for the different product groups where the main
variable costs, apart from cost of capital, are shrinkage costs for Cerealia and inventory write-downs
for Swecon.
Introduction
Lantmännen has recently uncovered a greater
need of decreasing their working capital in
order to free tied up capital and improve
profitability. As a part of this larger project,
Lantmännen need to clearly define inventory
carrying charge in order to manage their
inventory in a cost efficient way and to gain
control over the total costs associated with
carrying inventory. The inventory carrying
charge measures the inventory carrying costs,
meaning the variable costs, for a given
inventory, as a percentage of the inventory
value. It is an important parameter when
analysing the total costs of an inventory
system and is used both on an operational
level as well as on a strategic level. On the
operational level the main objective is to
compute
economically
optimal
order
quantities in order to manage inventory cost
efficiently. Strategically the main objective is
to gain control over the total costs of carrying
inventory and for strategic purchasing
decisions.
The aim of this paper is to put together a
definition of the inventory carrying charge and
its components that works well for all of
Lantmännen’s business units. The aim is also
to explain how the inventory carrying charge
can be used as a management tool in order to
gain control over the total inventory costs. To
exemplify this we have calculated the
inventory carrying charge and its components
for two of Lantmännen’s business units,
Cerealia within their food division and Swecon
within their machine division. We have only
chosen to investigate these two business
areas and within them only to look at the
most relevant sites that represent the whole
business. We have thereby investigated the
sites Malmö, Järna and Laholm at Cerealia and
at Swecon we have investigated new
machines, used machines and equipment.
Figure 2, fixed inventory costs
One of the more detailed models for finding
and calculating these variable costs is stated
by Lambert & Stock (2001), which is also the
basis of our definition:
Carrying cost definition
Many authors have studied inventory costs
and developed different models for calculating
the inventory carrying charge. The main ones
examined in this paper are Aronsson et al.
(2003), Mattson (2002) and Lambert & Stock
(2001). They all present different models of
how to calculate the carrying charge but they
all agree that it generally should be calculated
through the following formula:
𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝑐ℎ𝑎𝑟𝑔𝑒, 𝑟 =
𝑉𝑎𝑟𝑖𝑏𝑙𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑐𝑜𝑠𝑡𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑠𝑡𝑜𝑐𝑘 𝑣𝑎𝑙𝑢𝑒
By examining different theories covering
inventory carrying charge we have come up
with a definition applicable for all of
Lantmännen’s business units. This definition
consists of the cost of capital plus all variable
inventory costs divided by the average
inventory value. By variable costs we mean
inventory costs that vary continuously with
the amount of inventory (see fig. 1) which is
different from fixed inventory cost (see fig.
2).1
𝑟=
𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑟𝑖𝑠𝑘 𝑐𝑜𝑠𝑡𝑠 𝑠𝑒𝑟𝑣𝑖𝑐𝑒 𝑐𝑜𝑠𝑡𝑠
+
+
𝐴𝑣𝑔. 𝑠𝑡𝑜𝑐𝑘
𝐴𝑣𝑔. 𝑠𝑡𝑜𝑐𝑘
𝐴𝑣𝑔. 𝑠𝑡𝑜𝑐𝑘
𝑤𝑎𝑟𝑒ℎ𝑜𝑢𝑠𝑒 𝑐𝑜𝑠𝑡𝑠
+
𝐴𝑣𝑔. 𝑠𝑡𝑜𝑐𝑘
There are different theories of how to
calculate the capital cost which is often
believed to be the main cost of r. One of the
most common used methods is to use the
weighted average cost of capital, WACC,
which states that the capital cost should be
the average claim for yield in the company. It
is calculated through multiplying the
percentage of equity in form of debt with its
average interest rate, and then adding the
percentage of equity in form of shareholders
equity which is multiplied with their expected
return2. Another theory is to use the
opportunity cost of capital which states that
the cost of capital should be the highest
possible return which could be achieved from
another investment (with the same financial
risk).34
A third alternative that often is used is to use
the risk free interest rate as the cost of capital.
The argument to use the risk free interest rate
is that generally investments in inventory are
considered a low risk investment and
Figure 1, variable inventory costs
2
Timme et al. (2003)
Nilsson et al. (1993)
4
Lambert & Stock (2001)
3
1
Aronsson et al. (2003)
therefore the cost of capital should be lower
than a general investment.5
The risk costs could be e.g. costs for
obsolesce, theft, shrinkage, waste etc. And is
often one of the main variable costs. Service
costs are costs for taxes, insurances etc., if
they are variable. Warehouse costs are cost
for
personnel,
warehouse,
handling
equipment etc., if they are variable and
increase with a marginal increase of volume.
Costs for personnel and warehouses are often
fixed costs but could be variable e.g. if you
rent warehouse space per pallet at an external
warehouse. 6
Combined, all of these costs constitute the
inventory carrying charge, where the focus is
to find all the variable costs associated with
the inventory system.
Figure 3, Carrying charge for Cerealia - Laholm
Figure 4, Carrying charge Cerealia - Malmö
Results from case studies
To exemplify this we have calculated the
inventory carrying charge and its components
for two of Lantmännen’s business units,
Cerealia within their food division and Swecon
within their machine division. Cerealia is a
producer of food mainly based of grain, while
Swecon is a distributor of installation
machines made by Volvo CE. These two
business units are quite different and the
reason for choosing them is to show
Lantmännen what range the inventory
carrying charge has.
For Cerealia we can see that the businesses in
Järna and Laholm have significantly higher
shrinkage costs than the business in Malmö
(see fig. 3). This is because the groups of
products stored in Malmö are more standard
and generally consists of grain (73%) which is
easier to store. Below are the detailed results
for each site.
5
6
Berling (2005)
Lambert & Stock (2001)
Figure 5, Carrying charge Cerealia - Järna
The reason for the higher carrying charge in
Laholm is that variable warehousing costs
exist. These costs occur since Laholm uses an
external warehouse, owned by Frigoscandia,
for some of their products. Frigoscandia
charges Cerealia for all handling of their
products but also for the warehouse space
Cerealia uses and for the amount of time the
products are stored.
From the detailed results we can determine
that the shrinkage differs significantly
between product groups, resulting in a large
variation of the carrying charge. The reason
for high shrinkage could be one-time events,
but also if the product group is sensitive e.g.
products with short shelf-life, which is
common in the food industry. The important
thing is to define the shrinkage that
represents the typical behavior of the product
group, meaning that one-time events should
be excluded.
The same investigation was done for Swecon
with the following result.
Figure 6, Carrying charge Swecon
Apart from the cost of capital, the write-down
cost is the main variable inventory cost for
Swecon. By write-down cost we mean
reduction of inventory value due to decline of
market value. We can see that new machines
have no write-downs since Swecon only places
an order after first receiving an order from
their customers. There is still however a
payment gap meaning that the cost of capital
exists. The test machines, which are new
machines used for customer demonstrations,
have the largest write-downs.
Summary
We have concluded that Lantmännen should
use the model presented by Lambert & Stock
(2001) to calculate their inventory carrying
charge. When calculating the cost of capital
they should use a WACC which for
Lantmännen today is 8%. The reason is mainly
that the responsible for each business unit is
measured on tied up capital where the WACC
on 8% is used, indifferent on business unit.
Through the case studies we have discovered
that the inventory carrying charge differs
greatly between the different business units
studied and between their groups of products.
A discussion has been raised in the theses if
the inventory carrying charge should be the
same for all groups of products within a
business unit or if it should be differentiated
among them and if so, how complex this
differentiation should be. Our results show
that the inventory carrying charge is between
8 % and 29 % for the different product groups
where the main variable costs, apart from cost
of capital, are shrinkage costs for Cerealia and
inventory write-downs for Swecon.
We recommend Lantmännen to differentiate
among product groups in order to find a
carrying charge that represents the true costs
of carrying inventory. When managing
inventory levels for certain product groups, it
is important to use the specific carrying charge
for that given group. For an entire business
unit an average inventory carrying charge can
be used. This charge is computed by
calculating a mean value of the specific
product group inventory carrying charges.
Figure 7, Carrying charge for Cerealia
Regarding the inventory carrying charge as a
management tool, we have come up with the
conclusion that it should be used both on a
strategic and operational level with emphasis
on managing inventory levels, where the
inventory carrying charge should be a
parameter when computing economic order
quantities.
References:
Aronsson H, Ekdahl B & Oskarsson B (2003). Modern
logistik, Liber Ekonomi, Malmö.
Berling P (2005). On Determination of Inventory Cost
Parameters, Lund Institute of Technology, Department
of industrial management and logistics, Lund.
Lambert D, Stock J (2001). Strategic Logistics
Management, McGraw-Hill Publishing Co.; 4th edition.
Mattson S-A, Jonsson P (2005). Logistik: Läran om
effektiva materialflöden, Studentlitteratur, Lund.