What is Inventory Carrying Cost?
About 20%-30% of the total inventory value is spent in holding the inventory for the period of time before making an actual sale. Referred to as inventory carrying cost, or inventory holding cost, they can be expensive!
Let’s use an example. Dave is a beginner in the apparel retail industry. He buys clothes worth $10,000 and is planning to sell them on Amazon by marking the price up by 30%. When he starts out, he is pretty excited about the profits that are expected to come. He lists his products online and waits for the miracle to happen.
However, said profits never come, at least not on the balance sheet at the end of the year. It is only then that he realizes the long list of other costs that he had to incur for holding and maintaining his inventory. Ignoring inventory carrying cost proved costly for Dave.
The Real Cost of Carrying Inventory
You may be tempted to think of inventory carrying cost as the cumulative of the cost price of all your products. After all, that is what inventory is, right?
However, your products occupy physical space, which probably means you cannot keep them in boxes at home. You need warehouse space which you will pay for. There’s also the fact that you paid for them irrespective of whether you made a sale or not.
Inventory Carrying Cost Formula
Inventory carrying costs can be calculated for larger businesses. For smaller holdings, the run-up to the tune of 20-30% of the total inventory cost. For example, if you have $100,000 in inventory, your inventory carrying costs will likely be in the range of $20,000 to $30,000 per annum.
However, it is worth comparing your percentage with the industry standard and finding ways of reducing your carrying costs.
The inventory carrying cost includes components such as
- the cost of insuring your products, and replacing them
- employee costs
- taxes and depreciation
The formula for calculating inventory carrying costs is
Inventory Carrying Cost = Capital Costs + Taxes +Insurance + Warehouse Costs + Recovery Costs)/ Average Annual Inventory Costs
Some ways to reduce these costs are outlined below. Let us spend a moment to think about recovery costs. These costs include the cost of selling inventory at no premium, the risk of losing stock as well as the value that may be obtained by selling the inventory as scrap.
Components Of Inventory Carrying Cost And How To Reduce Them
1. Cost Of Capital
This cost includes the entire cost that is used to finance a business. Simply put, this is the return amount you provide to the person/company that invests in your business. It refers to the cost of equity if the business is financed through equity, or the cost of debt if it is financed through debt.
For a retail business, this includes aspects such as the rent of your office space, the utilities you use across warehouse locations, the construction you might undertake to make operations easier, the inventory that you’re holding, items that you intend to sell, and stuff such as stationery, furniture, and computers. All of these expenses can only be recovered when you make substantial sales.
How to reduce: For one, never buy anything for your business that you don’t need. If you’re a pure online seller, you probably don’t need a posh office space and the trinkets that come with it. Consider how many employees you need as well- employees must come in to complement growing business, or because you see potential in them to scale up your business. Hiring for any other reason is pointless.
2. Costs To Keep The Items In Storage
This includes factors like warehouse rent, building insurance, utility costs like electricity or heating fuel for the building, maintenance, etc.
How to reduce: How can you reduce inventory cost when warehouse space is a prerequisite? Through efficient inventory management of course! By staying on top of calculations that tell you when to reorder, when you’ve touched the maximum limit, etc. you can ensure that your inventory never takes up more space than it should, and most importantly, that it always keeps moving out the door.
When the value of an asset decreases over a period of time, it’s called depreciation. Machinery, equipment, currency, etc. are assets that are likely to depreciate over time. If you are a retailer who also manufactures your products, your machinery would be subject to depreciation.
When taken far away from a book of accounting, depreciation literally means how soon you will be replacing machinery. The sooner you need to replace, the worse it is for you.
How to reduce: You can reduce the depreciation of equipment by maintaining them well. Some heavy machinery needs regular maintenance, which is perhaps a smaller expense than buying a new one if it is destroyed.
4. Employee Cost
Even a warehouse needs employees, both to keep track of inventory and to handle it when need be. As we mentioned above, only put in extra employees in a warehouse when there is a real need. For example, during a sales spike or Christmas, you may need more contract employees on hand.
How to reduce: Keeping employee hiring to a minimum and hiring contract workers from time to time is the best way to reduce expenses on this front.
5. Opportunity Cost
Having too low inventory is how you would incur this fairly qualitative cost. For example, you sell in an online marketplace. Your product is also sold by other retailers in the same place. By having your products out of stock, you have already lost out to the competition. Having too few products may save inventory costs, but will result in the lost opportunity to sell to a consumer, and gain their trust in the process.
How to reduce: Here is where the minimum order quantity comes in. This is the minimum number of products you need to order to avoid running out of stock.
When goods become unusable over time or fall behind in the race of changing preferences, you have no option but to discard it for little to no amount. As a seller, you want to push your products out fast enough to avoid overstocking. However, if you sell niche products like selfie sticks, your sales dry up when the fad is over.
How to reduce the risk: Your first option is to sell as much as possible before the fad runs out. Your second option is to play safe and only stock a small number of products such as this. So if on one day, you wake up to find the world has changed, you don’t have products from another era.
Keeping an eye on these costs can tell you how you can minimize them. Using techniques to minimize carrying costs such as the Just-In-Time inventory, can help you save immensely on warehouse space.
The crux of avoiding most, if not all, of these costs, lies in efficient inventory management. Always keep track of levels of various products, and predict how these levels may fluctuate over time.
Recommended Read: The Complete Guide To Inventory Management For Retailers