One option that recovered fiber mills have for hedging volatile fiber prices is to increase the number of days of inventory they have on hand when prices are lower. How does a mill determine, though, whether carrying additional days of inventory is actually saving them money? Because of the cost of holding more inventory, recovered fiber mills should analyze a series of factors before making this decision. These factors include:
Because the answers to these questions vary by mill, no single answer to the question of whether to build inventory exists. If a mill has an optimal environment, in which adequate storage is adjacent to the pulper, the savings realized when holding additional inventory could be minimal. Like with all other fiber purchases, costs would include fiber, freight and the cost of capital. When a mill’s circumstances diverge from this optimal setting, however, the costs could quickly outstrip any savings realized from holding more inventory. If the additional inventory is stored in another area of mill, for instance, additional labor and handling costs will be necessary. If storage is offsite, the costs accumulate more quickly. These additional costs include:
In addition, the more the bales are handled the more susceptible they are to breakage and fiber loss. This loss generally falls somewhere between 1-5 percent. The additional inventory will also require rotating over a longer period of time than inventory acquired in a more timely fashion. Other potentially costly factors include:
Let’s look at a hypothetical example, one that shows the potential costs of holding additional inventory.
The mill: A 750 tons per day (TPD) mill typically holds 7 days of inventory on hand or 5,250 tons.
The decision: Mill management decides to increase that inventory by 3 days or 2,250 tons. The recovered fiber cost is $150/ton and the freight costs are $22.50 per ton.
The question: What is the cost of holding this additional 3 days of inventory, and is it saving the mill money overall?
To answer these questions, three cost categories should be examined: incremental working capital costs, incremental storage costs and the cost of fiber loss during the storage due to additional handling.
Incremental Working Capital Costs
The working capital requirement to purchase the additional inventory is $388,125 (2,250 tons at $172.50). The financial cost of carrying inventory is typically expressed as an opportunity cost and estimated by using the business’s cost of capital. In this case, if the mill’s cost of capital is 8 percent, the financial carrying costs would equal $2,588 per month.
Incremental Storage Costs
The costs associated with storing additional inventory vary depending on bale size. If the mill’s average bale weight is 1500 lbs., the additional inventory equates to 3,000 bales. (Typical weights and storage costs are shown in Table 1.)The cost of carrying this inventory for a month is $15,000.
*Does not include a square footage allowance for aisles/fire lanes; bale dimensions are estimated.
Cost of Fiber Loss
Excess handling for the additional inventory is likely to increase fiber loss, in the amount of 1-5 percent. Table 2 outlines the cost of this fiber loss for our example.
Total Cost of Carrying an Additional 3 Days of Inventory for 3 Months
Assuming a conservative 2 percent fiber loss, the total carrying costs of the additional 3 days of inventory for this mill are outlined in Table 3.
The impact on mill cost would be $60,527, bringing the cost of these tons to a total of $448,652 ($388,125 + $60,527) or $199.40 per ton. This is 15.6 percent more than the landed cost of the fiber. Even if we exclude the inventory carrying cost (or opportunity cost), the incremental tons cost $195.95 per ton, which is still 13.6 percent more than the landed fiber cost.
As this example shows, laying in the additional inventory is only an effective hedge if the landed fiber cost rose more than 13.6 percent (or 15.6 percent if opportunity costs are considered) during the three month period. Otherwise, the inventory build would be detrimental to the mill’s bottom line.
Barbara, very interesting article. I see your price level for material at $172.00 In today`s market with low output of material, would you not agree that having inventory would be logical?