In talking with a number of companies in the electronics industry, I have many times heard the sad tale of excess inventory worth $2 million or so. The parts are high value/high volume electronic components that were bought during the time of great supply chain uncertainty that never materialized. (They are not obsolete, they are not defective–they just are taking up space and money each month.) The image of a very expensive car that you are not even allowed to drive but have to keep insured is one that has stayed with me. It is an image that captures the feeling of terrible sunk cost that seems to render the normal rational person into a sort of a frozen catatonia–inability to act in the best interest of the company.

What’s described above is like having a car that you can’t drive but you have to keep insuring it.

This problem still continues to fascinate/disgust me as it represents a perfect example of a Sunk Cost Fallacy. Yes people understand that a car that they can’t use to generate more revenue has to continue to be paid off however the same can not be said for the depreciating asset that is stock in inventory. All of the costs for a depreciating asset continue to decline over time. The largest cost of all is the Opportunity Cost of not using that money to purchase other stock / assets that would be able to generate much higher returns.

Why companies end up here in the first place

Note that typically excess inventory has not been caused by a single mistake but rather a cumulative effect of several errors over time that increase inventory dollars until a point of crisis. Some examples of these errors include: 1) a demand forecast greater than actual demand; 2) a procurement department purchasing for the sake of meeting a volume discount outlined in a spreadsheet; 3) a product change that makes a component (or components) previously in stock obsolete; 4) a large order with 6 weeks of lead time from a major customer that is canceled prior to shipment and the company is left holding excess inventory that is no longer required.

Components for the electronics industry in particular have a very short life, as the design groups are creating new products on a regular basis utilizing the latest available parts. Therefore, even though an excess component may be totally functional, it can become obsolete in as little as 18 months after initial release to the market.

The real cost of inventory

The biggest misconception in the inventory management world is that the biggest cost of excess inventory management is the cost of the goods themselves. While this is a big component of the cost of the excess inventory that a company is holding, it is by no means the largest component of the cost. The largest cost of excess inventory is the opportunity cost of that capital. What else could have been done with that money to make more? The second biggest component of the cost of excess inventory would be the carrying costs of the excess inventory. This could include the cost of warehousing space to hold the excess inventory, insurance to cover the excess inventory against loss or damage, etc. The cost of the labor to count and manage the excess inventory would also be included in this category of cost. In the example above, the carrying costs of the $2 million worth of excess inventory would be $400,000 to $600,000 per year. And that would be on top of the opportunity cost of that capital.

This carrying cost is typically between 20% to 30% of the purchase price per year to hold non-revenue generating- inventory. So, in our example above, the carrying cost of the $2 million worth of excess inventory would be $400,000 to $600,000 per year.

I see this situation time and time again. Companies have too much inventory on hand and they try to make the best of it. They continue to allow the inventory to decay in value and in a month or two, the problem has gotten worse. In the end, they are left with a huge amount of inventory that will only be sold for a fraction of its original value.

Tactical moves that actually help

However, there are some things that you can do to help to mitigate and recover value from excess inventory, no matter how it was created. The key is to act as soon as possible to start to make and implement a plan to dispose of excess inventory and then work as fast as possible to try to sell off as much of the excess inventory as you can for as much money as possible.

• Reallocate internally first. Before anything else, check whether other product lines or divisions can absorb the surplus. Sounds obvious. It’s remarkable how rarely it happens in any systematic way, usually because interdepartmental communication around inventory is, to put it charitably, not a priority.
• Sell back to authorized distributors. Many distributors will buy back excess stock, particularly for current-generation components. You won’t recover full price, but you’ll recover something and free up working capital in the process.
• Explore spot market and broker channels. Independent brokers operate in the secondary electronics market and can move volume that authorized channels simply won’t touch. Vet them carefully, because counterfeiting is a real concern in these markets, but don’t dismiss the channel entirely.
• Approach customers or suppliers directly. If you have a solid relationship with a supplier who uses the same components, they may be willing to buy back or exchange. A little awkward to initiate. Often worth doing anyway.

Recovering value from excess inventory will differ between companies but the key point is speed. Those who get the most value from their excess stock are not typically those with the greatest options, but rather those who have ceased to be sentimental about the stock and start to treat it as the depreciating asset that it is.

Structured programs vs. ad hoc firefighting

Don’t let your excess inventory simply dwindle down until it reaches rock bottom and then try to get the best possible price to dispose of it. Such an approach is commonly referred to as “reactive” and, in general, enables the seller to recoup only a few cents on the dollar for their excess stock. It is commonly observed that the seller appears to be in a hurry to dispose of their excess stock and the buyer can thus negotiate an excellent price to purchase the stock.

We have customers that on an ongoing basis go through a process for the disposition of excess inventory. This is in opposition to a stockpile of inventory bursting at the seams of warehouses across the country waiting for a catastrophic liquidation of excess inventory to try and recoup as much as possible on the excess stock. These customers have an ongoing process for the management of excess and disposition of excess inventory to get the best value for their excess inventory. We work with them on a structured plan to liquidate excess inventory to get the highest return for the excess stock. The terms of a liquidation of excess inventory versus a managed disposition of excess inventory can differ by as much as 30-40% in terms of the value that is returned for the excess inventory.

A quick comparison: liquidation vs. managed disposition

How Much of This Can We Prevent?

How much of this can be prevented? More than most procurement teams want to admit.

Now I want to look at the other side of the problem: how to prevent excess inventory in the first place. To prevent excess inventory, you must make sure your demand forecasting is accurate, you need to have short lead times, and you must have supplier agreements that are flexible. The discipline that procurement bring to their job is not as respected as that of the engineers who design the products. However, by having the same level of respect for their work, they can try to avoid the situation of having excess inventory that they need to get rid of. Of course, even the best companies will occasionally have excess inventory that they need to get rid of, but that is not the point. The point is to try to avoid it as much as possible.

(As an aside, even the very best procurement organizations will from time to time have stock of inventory that will go bad before it can be sold. The very best of the very best organizations will have a few very large losers every now and then. But even these very best organizations will on occasion have a surprise in the demand forecasting department. The best of the best are less frequently plagued with excess inventory problems than the rest of us. And, indeed, the best of the very best of the very best (i.e., those who are in the very top echelon of all procurement organizations) will have a few very large losses every now and then as markets go through cycles and the very best demand forecasters in the business are occasionally surprised by events. But, even these organizations are not frequently plagued with excess inventory problems as are the rest of us.

It wasn’t what he had hoped for but in the end he had managed to sell off most of his stock of excess inventory. In total he had been able to retrieve 58% of the inventory’s value from a number of sales over the course of a few months. Of course it wasn’t exactly what he had been hoping for but in the end that is what really mattered, it was better than nothing after all.

Sometimes that’s the win. Not elegant. Real.