Three Cases

Price	$28.00
Labor Cost/Unit	$7.56
Material Cost/Unit	$10.38
Total Unit Cost	$17.94
Contribution Margin	$10.06
	Case 1	Case 2	Case 3
	Stock Out	Just In Time	120 Days
Units Demanded	1,200	1,200	1,200
Units Produced	1,000	1,201	1,594
Units Sold	1,000	1,200	1,200
Units In Inventory	0	1	394
Missed Unit Sales	200	0	0
Cash	$7,068	$7,066	$1
Inventory Value	$0	$2	$7,067
REVENUE	Able	Able	Able
Sales	$28,000	$33,600	$33,600
VARIABLE COSTS
Direct Labor	$7,556	$9,068	$9,068
Direct Material	$10,378	$12,454	$12,454
Inventory Carry	$0	$2	$848
Total Variable Costs	$17,934	$21,523	$22,369
Contribution margin	$10,066	$12,077	$11,231
PERIOD COSTS
Depreciation	$2,880	$2,880	$2,880
SG&A: R&D	$0	$0	$0
Promotion	$800	$800	$800
Sales	$800	$800	$800
Admin	$245	$301	$319
Total Period Costs	$4,725	$4,781	$4,799
Net Margin	$5,341	$7,296	$6,431
Missed Net Margin	$2,013
Inventory Carry	$0
Taxes	$705
Missed Profits	$1,308

In Case 1 you stock out and miss sales of 200 thousand units. Notice that the period costs are already covered by the sales that you did make. Therefore, any missed sales would have gotten a free ride on Depreciation, SG&A expense, even associated interest expenses. The missed sales would only incur taxes. In this example, your missed profits are $1.3 million. In the proformas that drove this example, total profits were $5.2 million. A small stock out can make a significant difference in Net Profit.

In Case 2 your hopes come true. You build 1201 and 1200 are sold. Inventory Carry costs are minuscule.

In Case 3 your fears are realized. You build 1594 but only sell 1200, leaving 120 days of inventory in the warehouse. This incurs an Inventory Carry cost of $848 thousand.

As inventory days increases, so do the carrying costs. For purposes of the Forecasting category, we make a policy decision that anything beyond 120 days is excessive. You might want to set tighter limits, say 90 days. Consider the rows labeled "Cash" and "Inventory Value". In all three cases your Working Capital requirements are the same. When the Inventory is sold, it is converted to Cash. When it does not sell, Cash is converted to Inventory. The combined position of $7.1 million represents a policy decision for 120 days of inventory. As discussed in The Working Capital category, that $7.1 million is not free. If you could invest it at 10% it would earn $710 thousand. If you set a policy of 90 days, you would only require $5.3 million (but you expose yourself to more risk of stock outs.)