Summary
The Problem: Lack of Procurement Coordination & Visibility Impacts Cashflow
Case Study: Delays to planned investment due to supply chain cash flow unpredictability
Benefits of Kavida
Anam Rahman
Cofounder & CEO
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Ever since the pandemic, manufacturers have had to rethink their inventory strategies. Disruptions since, like Houthi attacks in the Red Sea, the Ukraine crisis, semiconductor shortages, and the Suez Canal blockage, have all led to a greater reliance on buffer stock as a safety net.
Extra inventory can be useful, but there’s a tipping point where the costs start to outweigh the benefits, leading to severe financial consequences for manufacturers.
In this article, we’ll dive into various aspects, including:
- The true causes of excess buffer stock
- Why calculating buffer stock is an irrational decision
- What kind of metrics you need to calculate buffer stock accurately
- How Kavida can help reduce excess buffer stock
What is Buffer Stock?
Buffer stock is the excess inventory stored to mitigate risks like supply chain failures, transportation delays, or unexpected surges in demand.
Most manufacturers think that building up excess buffer stock is the best way to create redundancy in the supply chain. Sure, it helps you hedge against risk, but how much inventory you keep and how it’s optimized plays a huge role in your business’s financial health.
It’s an expensive choice and isn’t feasible for everyone.
Calculating the ‘right’ level of buffer inventory brings greater certainty of supply, but the biggest problem we’ve seen is that this calculation often relies on unscientific decisions.
Understanding the Causes of Excess Buffer Stock
At the heart of inventory management is the variability of demand. Forecasting demand is a complex process involving analyzing past trends, anticipating shifts in consumer mindset, and accounting for macroeconomic factors.
Essentially, the amount of inventory to keep for various products and raw materials is determined by:
- The variability of demand for the product
- The reliability of the supply of raw materials
Manufacturers generate demand forecasts based on historical data and anticipated market changes. But, even the best forecasts can falter due to unforeseen circumstances, leading to excess inventory.
Main factors that contribute to the buildup of excess buffer stock:
- Poor demand forecasting capabilities.
- Lack of data around supplier risks & supplier lead times.
- Poor management of complex supply chains.
Each of these factors can be managed by better analytics and reporting capabilities, but manufacturers often end up overcompensating with excess buffer stock to mitigate uncertainty.
The Direct & Hidden Costs of Buffer Stock
It’s important to recognize the financial risks and costs associated with carrying more inventory than necessary.
1. Tied-up Capital
Excess inventory means your money is sitting idle in the form of raw materials or finished goods, reducing liquidity and the ability to invest in other growth opportunities. The opportunity cost of keeping excess inventory is decreased future revenue.
2. Increased Storage Costs
More buffer stock requires additional storage space, leading to higher warehousing costs. This includes expenses for rent, utilities, security, and insurance. Over time, these costs significantly impact your bottom line.
3. Obsolescence and Waste
Holding excess inventory runs the risk of items becoming obsolete or expiring. Products with a limited shelf life or those subject to rapid technological changes can lose value quickly, leading to write-offs and waste.
4. Interest Rate on Working Capital
Inventory of raw materials is often bought on credit and only paid off once the finished goods are sold. Excess inventory means bearing increased interest costs. Taking longer to repay also compromises the company’s credit score, resulting in higher interest rates for future credits.
5. Impact on Profit and Loss (P&L)
Carrying excess buffer stock negatively impacts your P&L statement when you factor the direct costs of holding inventory, combined with potential losses from obsolescence and markdowns.
(Also consider the indirect costs associated with tied-up capital and missed opportunities)
This is seen in quarterly reports and directly impacts share prices and shareholders:
1. Inventory Turnover Ratio | Decreases, indicating slower sales or overstocking. |
|---|---|
| 2. Current Ratio | May increase, but with potentially misleading liquidity implications due to non-liquid assets. |
| 3. Quick Ratio (Acid-Test Ratio) | Decreases, highlighting potential liquidity issues as it excludes inventory. |
| 4. Gross Margin Ratio | Can decrease due to higher costs and possible discounted sales. |
| 5. Return on Assets (ROA) | Decreases, as excess inventory signifies less efficient asset utilization. |
| 6. Working Capital Ratio | Increases, reflecting higher funds tied up in inventory. |
| 7. Days Inventory Outstanding (DIO) | Increases, indicating longer holding periods for inventory. |
| 8. Return on Equity (ROE) | Potentially decreases due to reduced profitability from excess inventory. |
| 9. Total Asset Turnover | Decreases, showing less efficient use of assets in generating sales. |
| 10. Net Profit Margin | Decreases, as excess inventory can lead to higher costs and lower sales efficiency. |
Is Calculating Buffer Stock an Emotional and Irrational Decision?
Millions of dollars are tied up in inventory because of unscientific and irrational calculation of supply risk.
But why does this happen? Here are a few common reasons:
- Built-up bias from past issues
- Assuming the criticality of a material
- Lack of data-driven decisions
Learning from past disruptions and taking precautions is important, and this is why we see most decisions about buffer stock being generally based on gut feelings. While intuition and experience are valuable, relying solely on them without data to back you is what results in inefficient inventory management.
Manufacturers then run the risk of holding too much or too little inventory, both of which are costly.
So, more importantly, how can this be avoided and is there a way to manage buffer stock more efficiently?
Strategies for Reducing Excess Buffer Stock
By focusing on key metrics, and using the right technology, manufacturers can be more efficient when it comes to managing inventory levels.
Let’s start off with data- what type of metrics would help manufacturers make a more informed decision about buffer stock?
1. Supplier lead time
Understanding the typical time it takes for a supplier to deliver goods is crucial. This helps in planning inventory levels that match delivery schedules, reducing the need for excessive buffer stock.
2. Lead time factoring in supplier location and logistics mode
Lead times can vary significantly based on the supplier’s location and the mode of transportation used. This needs to be factored into lead time calculations.
3. Supplier reliability on past orders
Historical data on supplier performance provides insights into their reliability. Metrics such as on-time delivery rates and consistency in order fulfillment help manufacturers assess the dependability of their suppliers.
4. Supplier risk
Evaluating the risk associated with each supplier, including financial stability, geopolitical factors, and past performance issues, helps in determining the appropriate level of buffer stock needed to mitigate potential disruptions.
The challenge lies in properly quantifying these metrics, traditional approaches to doing so are often manual and time-consuming. Manufacturers need end-to-end visibility to pull this data together.
This is where a data-driven approach using technology and automation can make a significant impact.
The Data-Driven Approach to Buffer Stock Management
A Post PO management system is critical for manufacturers to empower smarter decision making when it comes to managing and reducing buffer stock.
Here’s how Kavida can help:
Kavida builds automated workflows to determine when goods need to be ordered based on current inventory levels and incoming shipments, ensuring no stock outs. This ensures that there is no impact to production planning and no impact to customer delivery dates.
Automated workflows enable better visibility and control over inventory coming in. This ensures any calculations around buffer stock are made on scientific data and not based on emotional decisions. Instead of accumulating 3 weeks of buffer stock due to fear, which is tied up capital and increased storage/handling costs, you can maintain more accurate stock levels.
Kavida also combines inventory and supplier data to recommend the optimal supplier to order from based on factors like lead time and cost etc.
If you’re ready to explore how automated purchasing workflows can reduce excess buffer stock and improve the financial health of your manufacturing company, inquire for a demo today.
Anam Rahman
Cofounder & CEO
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