Increasing profits isn’t always about selling more products. Sometimes, you can greatly increase your company’s profitability by simply cutting down on costs.
For instance, one of the most expensive costs for any company are inventory carrying costs. Something as simple as controlling your inventory in storage can cut your annual costs drastically.
What Are Inventory Carrying Costs?
Inventory carrying costs are something that every organization is going to run into. Inventory carrying costs are basically every type of cost that you could face when your products are stored.
That could be just the storage itself, as well as transportation, taxes, insurance, depreciation, handling fees and so much more. But all of them can be summed up in four basic ideas of ordering, holding, carrying and shortage or spoilage.
Why Is it Important To Calculate the Cost of Carrying Inventory?
To determine anything in a business it is best to make calculated decisions. Part of making decisions is being informed. You’ll need to stay informed about the costs associated with carrying so that you can accurately plan and forecast your financial decisions for the future.
- Production Planning: When a company knows how to properly forecast their market and store their inventory, they can properly determine their production schedule. Things like speed of production or popularity can determine how much stock is kept on hand. All of this and more should be taken into consideration as you seek to properly plan out the production process.
- Inventory Accounting: As you will see, inventory and capital is one of the biggest costs for any business. The cost of carrying inventory can offset any profit you make defeating the entire reason for selling the product. It is important to account for all costs based around inventory to find out what price is worth it.
- Profitability of Existing Inventory: Just as you need to account for the cost of new inventory and restocking, you also need to know what your current inventory can do for you. When you track the value of your products as well as calculate the carrying costs, you can create a fairly accurate estimate of what profit you might receive.
10 Components That Affect Inventory Carrying Cost
Everything that affects inventory carrying costs can be categorized into these 10 components. Learning what they are and how to manage them will help you to turn your spending around.
Cost of Capital
One of the biggest costs in inventory carrying costs is the stock itself. Paying for the items in stock to be made, any interest and any additional fees for a company to receive their products is going to come out as a larger cost.
Unfortunately, the cash flow will not always be immediate once you have your items in stock. You may find that you’ve stocked a certain item and then its popularity drops to a point. Then, you’ll have to sit on it and continue to pay for storage for the item when you thought you would have sold it already.
Cost of Storing Inventory
Every square foot of a warehouse is valuable. Whether you are using your own storage facility or you’re paying a third party for storage space, there will always be a cost attached to the space.
It is best to look at every square foot of warehouse space as costing anywhere from $6.53 to $7.79, as this is the average range of costs of a warehouse space. If you go with a third-party logistics company, otherwise known as 3PL, you will be given a base cost.
Whether that be per-shelf costs, per-item pricing or per another measurement of their choosing, you should receive a quote or an estimate of some sort. Either way, you will have some sort of cost for your inventory just sitting.
Employee Cost
The cost of employees is one not overlooked but not necessarily associated with inventory carrying costs. For every item to be brought in, sent out, organized or packaged, you have to have a paid employee.
This cost is unavoidable but you can optimize the whole process by streamlining and upping the ease of the job with technological savvy and proper organization such as with a mapped layout of the inventory.
Administrative Costs
Administrative costs are the upkeep of the overall building in which your inventory is stored. With larger buildings you will of course see higher administrative costs because there is more to manage and upkeep. Within administrative costs also is maintenance, cleaning, security and literally anything to do with keeping your building running.
Obsolete Inventory
Obsolete inventory is just inventory that the company decides that it can no longer use or sell. This most often is due to a lack of demand for an item by the customers.
When the item is then obsolete you have to determine what to do with whatever is left in storage. If the item was restocked before the fall off, it can lead to unnecessary inventory carrying costs since those items will sit in storage as well as a loss on those items that will not be sold.
Material Handling
Every time something needs to be moved whether that be from one geographical location to another or even from one part of a warehouse to another, that is considered material handling. Every time that happens that means that there is some cost to that item being moved.
Whether it be the cost of machinery or even just depreciation and risk of damage to the item being moved. When in your possession, if an item is damaged it is then considered a loss both for profit as well as a loss in the inventory carrying cost.
Insurance and Taxes
In the event that disaster strikes and the warehouse goes up in flames or is destroyed in a storm, you would have insurance. It is designed to protect valuable assets, and nothing is more valuable for a company than its inventory.
Granted, the more inventory you have on hand the higher your insurance payments will be. There is a reason that companies will offer higher sales and savings at the end of the year and that is to move products out of storage.
That is because you will be taxed for how much inventory you have. Just like with insurance, the less inventory you have, the lower your taxes will be.
Shrinkage
Shrinkage is something that could be as simple as a clerical error, misplacement or even theft. Whenever the number in your inventory documentation is larger than the number of actual physical inventory, that is considered shrinkage.
This can affect your inventory carrying cost and overall profit. This means that you will have already paid for the missing items, which then tampers with your storage data, and it also costs you money because you cannot sell what is not there.
Delayed Innovation
A company can only put so much focus and energy towards its workers. When all of the focus and energy is on pushing product and managing excessive inventory, new and innovative ideas cannot arise. When you limit the focus placed on current problems, you cannot create new ideas that would otherwise elevate your business.
Opportunity Cost
The cost of capital has another way of affecting businesses. Not only will it tie up your finances by filling inventory, but it will also prevent the directing of finances to that which would help your company, such as marketing, research or investments. When your finances are dumped into creating a surplus of inventory you will have to wait to see the return before you can then put it into those areas.
How To Calculate Inventory Carrying Costs
To calculate inventory carrying costs, you need to know the cost of all 10 components of inventory carrying costs: capital, storage, transportation, administrative, labor, taxes, insurance, depreciation, shrinkage and obsolescence. All of those combined will represent the cost of storage.
To then calculate the inventory carrying cost, you need to follow this formula:
Inventory Carrying Costs = Cost of Storage / Annual Inventory Value x 100
By following this formula, you will get a fairly accurate representation of your annual inventory carrying costs.
How You Can Reduce Inventory Carrying Costs
Knowing what your inventory carrying costs are is one thing, but you also need to know that you can reduce them. Saving money on inventory carrying costs is one of the best ways to improve your company’s financial performance and overall effectiveness. Here is how you can get started.
Minimize Inventory On Hand
One of the biggest mistakes that increases carrying costs is overstocking. When you overestimate the demand for a product, you’ll be stuck with too much of it on hand, which can cost you money due to the limited space it will take up.
When you properly track a slate of inventory key performance indicators (KPIs), you can evaluate each SKU for every product to determine the popularity and demand of a product. Once that is uncovered, you can more accurately determine the necessity of having it on hand and how much to store.
Speed Up Inventory Turnover Times
Speeding up inventory turnover times simply means cutting down on how long any of your products sit in inventory. Again, by properly forecasting sales, you can figure out how to properly prepare your inventory.
This could mean ordering more products or even just adjusting how many of each product you need to have available at all times. To accurately prepare your inventory, figure out your sell-through rate with this equation:
Sell-Through Rate = (Number of Units Sold During Period / Number of Units Received at Start of Period) x 100
When you apply this formula to each product and evaluate the results, you will start to see patterns that you can follow to limit the inventory turnover time of each of your items.
Renegotiate with Suppliers and Customers
There are many different facets to contracts, which can work for or against you. Some will involve your inventory carrying costs. It is always important to reevaluate contracts with your suppliers, storage facilities and even your customers.
Contracts should reflect things like who will be responsible for theft or damage. It doesn’t make sense for you to take the hit when your products are in their hands, so make it a point to address liability issues. When evaluating deals with retailers and storefronts, you can look into requirements like maximum holding time to prevent overstocking as well.
Change Your Warehouse Design
One of the biggest keys to efficiency in any business is its layout. Stores will determine the best layout for their customers just as offices will design a layout that best fits their workflow. So, it only makes sense that a warehouse will set itself up to work more efficiently as well.
When popular items are easily accessible and inventory is stored effectively, you may find that you have more space than you initially thought. Although the inverse is just as likely, you can also decrease your effectiveness by hiding less popular inventory.
Inventory Management Software
Technology is always advancing, so you need to take advantage of it. By implementing or even updating your inventory management software, you can make better use of your inventory.
By keeping up with a real-time look at what you have in stock, you will know the current state of your inventory at all times. This will help you to determine when to restock, how much to restock and what not to restock. You’ll reduce your holding costs by preventing an overabundance of unnecessary inventory as well.
Proper Inventory Strategies
Once you have implemented the proper systems to monitor your inventory carrying costs and better manage your inventory, you can start to see how your business will excel. By managing inventory and monitoring sales, you can prevent unnecessary overstocking as well as prepare for increases in sales. Once you have mastered how to calculate your inventory carrying costs, you will see just how effective storing inventory can be for your business.
FAQ
There are many things that are considered inventory carrying costs such as warehouse fees, employees, insurance and taxes to name a few.
The four main components are capital cost, inventory service cost, inventory risk cost and storage space cost.
Ordering costs are the costs of new inventory coming in while carrying costs are the costs of inventory being held in storage.
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