Chapter 13 • Management of working capital
While the costs of holding inventories tend to be fairly certain, if difficult to quantify,
those of failing to hold sufficient inventories may or may not occur: in other words,
there is a risk. Thus such costs are in the nature of expected values, where costs are
combined with their probability of occurrence.The costs and risks of holding inventories
Some of the costs and risks of holding inventories are described below.Financing cost
There is a cost of the finance tied up in inventories. For example, for Associated British
Foods plcfor 2007, the cost of holding inventories was £82 million, an amount equal
to about 15 per cent of the business’s operating profit for that year. In other words, had
the business been able to trade without the necessity to hold inventories, the share-
holders would be richer by £82 million. Given the nature of ABF’s business, it would
not be possible to avoid holding some level of inventories, but it is nevertheless
a costly matter. See page 355 for an explanation of how the cost of financing ABF’s
working capital is derived.
The inventories financing cost is partly mitigated by a certain amount of free credit
granted by suppliers of the inventories, which would only be available if inventories
are bought. The existence of this aspect is very important to some types of business.
Food supermarkets, because their inventories turnover is rapid, typically have their
entire inventories financed by suppliers of these inventories (see, for example, the
position of Tesco plcin Table 13.1 on page 354). For other types of businesses, where
the suppliers do not finance inventories, the opportunity cost of finance should
be based on the returns from an investment of risk similar to that of investing in
inventories.Storage costs
Storage costs include rent of space occupied by the inventories and the cost of
employing people to guard and manage them. With some types of inventories, the
cost might include that of keeping them in some particular environment necessary for
their preservation. This is likely to be particularly true for perishables such as food.Insurance costs
Holding valuable inventories exposes businesses to risk from fire, theft, and so forth,
against which they will usually insure, at a cost.Obsolescence
Inventories can become obsolete, for example because they go out of fashion or lose
their value owing to changes in the design of the product in whose manufacture they
were intended to be used. Thus apparently perfectly good inventories, in terms of
their physical condition, can become little more than scrap. The business holding no
inventories is clearly not exposed to the risk of this cost.The costs and risks of holding insufficient inventories
The costs and risks of holding low (or no) inventories can also be substantial. The more
common ones are described below.