---
title: "Counting the Three Layers of Inventory Losses"
description: "Inventory is a form of corporate assets, and owning inventory shows no loss on the balance sheet. However, from a supply chain management perspective, inventory brings significant losses to the enterprise and the supply chain, manifested in three layers: the first layer is the occupation of working capital, increasing capital costs and operational risks; the second layer is the waste caused by excess inventory from a lean operations perspective; the third layer is the hidden losses from a supply chain perspective, which are larger and more difficult to detect, harming competitiveness."
author: "New Distribution"
publisher: "New Distribution"
email: "zhaobo258@gmail.com"
telephone: "+8615854817671"
published: "2016-08-30"
language: "en"
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---

# Counting the Three Layers of Inventory Losses

> Inventory is a form of corporate assets, and owning inventory shows no loss on the balance sheet. However, from a supply chain management perspective, inventory brings significant losses to the enterprise and the supply chain, manifested in three layers: the first layer is the occupation of working capital, increasing capital costs and operational risks; the second layer is the waste caused by excess inventory from a lean operations perspective; the third layer is the hidden losses from a supply chain perspective, which are larger and more difficult to detect, harming competitiveness.

Inventory is a form of corporate assets, and owning inventory shows no loss on the balance sheet. However, from a supply chain management perspective, inventory brings significant losses to the enterprise and the supply chain, manifested in three layers:
**First Layer Loss**
Inventory occupies working capital, increasing capital costs and operational risks. Inventory ties up working capital. At a working capital loan interest rate of 4.5% per annum, the annual cost is substantial, roughly equivalent to the average market profit margin. Based on our experience, the average net profit margin in the Chinese market is around 4%. For some highly competitive industries, industry profits are only about 2%. In 2005, the average net profit margin in the air conditioning industry was even less than 1%. Therefore, the cost of inventory occupying working capital is a significant expense relative to corporate profits.
For example, based on one of our clients: annual sales of 5 billion yuan, finished goods inventory of 700 million yuan, average 30 days of finished goods inventory, while the industry best is 2 days. If the company achieved the industry best, inventory could be reduced to about 50 million yuan, freeing up approximately 650 million yuan in working capital, saving about 29 million yuan in capital costs annually (calculated at 4.6% interest). If it achieved a good industry level of 20 days of finished goods inventory (466 million yuan), it could free up 233 million yuan in working capital, saving about 10.71 million yuan in capital costs.
Rising inventory can also lead to cash flow interruptions, triggering operational risks. Lower inventory reduces the occupation of funds across the supply chain, facilitating rapid business expansion.
**Second Layer Loss**
From a lean operations perspective, excess inventory causes significant waste. The famous Toyota Production System identified seven wastes in enterprises, with inventory causing the largest waste.
Taiichi Ohno, the founder of the Toyota Production System, summarized the waste caused by excess inventory, including:
If inventory exceeds demand, you have to build warehouses, hire more handlers, and transport products to storage for a period before shipping, rather than shipping directly to customers.
Inventory requires additional management and maintenance costs to prevent theft or damage; once a warehouse is established, a warehouse management department is needed, incurring considerable administrative work; when inventory exceeds a certain limit, someone will think about introducing expensive computers to manage inventory.
Large inventory and many types of materials easily lead to inaccurate inventory data and errors. Inaccurate data leads to stockouts and wrong decisions.
When we are out of stock even with full production, we may think it is a capacity issue and invest in equipment next year, potentially increasing inventory further.
The above are all wastes caused by excess inventory. Clearly, waste from ineffective labor and excess inventory cannot be ignored. Waste eats away the few percent profit in sales.
The second layer loss mainly comes from within the enterprise, manifesting as increased complexity and chaos in internal operations, leading to higher operating costs. The third layer loss mainly comes from outside the enterprise.
**Third Layer Loss**
From a supply chain perspective, inventory brings a third layer of loss, which is larger, harder to detect, and more hidden. It does not directly appear as expenses but severely damages competitiveness. The third layer losses include:
The more inventory in the supply chain, the more constraints on decision-making, and the less able the enterprise is to respond quickly:
Extended inventory time leads to product obsolescence, and product prices tend to decline over time; the longer the inventory, the greater the price reduction and the greater the loss; this is especially evident in the PC, apparel, and food industries. For example, after summer new products launch, since the sales peak has passed and the product life cycle is only about three months, most products become slow-moving, causing huge losses for the enterprise.
The more inventory held, the more promotional expenses are needed. For inventory goods, most promotions are discounts and price reductions, reducing revenue. This is prominent in the apparel industry, where end-of-season sales are the main way to clear stock. Since apparel companies generally have end-of-season clearance, consumer purchasing behavior changes; off-season buying is a new purchasing pattern, affecting revenue and brand image.
The more inventory, the lower the satisfaction of end consumer demand. This is a basic supply chain rule; reduced satisfaction directly impacts the entire supply chain's sales revenue.
**Experts believe:** The three layers of inventory losses are progressive, with the third layer greater than the second, and the second greater than the first. However, in terms of visibility, the first layer is most obvious, the second is less intuitive, and the third is difficult to detect.
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