Business leaders often prioritize revenue growth, which is understandable. However, this singular focus may cause them to overlook hidden expenses that can erode profitability. Among these costly and often unnoticed outlays are inventory carrying costs – the expenses associated with holding inventory until it is sold.
In marketing, carrying cost, carrying cost of inventory or holding cost refers to the total cost of holding inventory.
If you’re losing money due to this, you’re not alone, many businesses struggle with inventory. The good news, that doesn’t have to be a permanent fixture in your company. Are you incurring monthly expenses to store an abundance of unsold goods? Are you occasionally faced with insufficient working capital? Are you being forced to reduce prices on items due to extended periods of storage in a warehouse?
If you answered “yes,” to those, keep reading this guide and discover time-proven strategies to make it a thing of the past.
What Are Inventory Carrying Costs?
One of the top challenges in inventory management is the cost of carrying inventory. These expenses arise from storing products in warehouses, distribution centers, or stores, and include storage, labor, transportation, handling, insurance, taxes, item replacement, shrinkage, and depreciation. Additionally, companies must consider the opportunity cost—the potential investments they cannot pursue because their resources are tied up in inventory.
Inventory carrying costs, also known as typical holding costs, can differ across industries and business sizes. Generally, these costs account for around 15% to 30% of the total inventory value. Moreover, the longer an item is stored before being sold, the higher these costs become. The actual percentage may vary depending on factors such as the number of items sold by the business, its inventory turnover ratio, the geographical location of its warehouse or store, and its specific storage requirements.
Inventory Carrying Costs Simplified
Inventory carrying costs play a vital role in assessing the efficiency of your operations. Elevated carrying costs may indicate excess inventory, prompting the need to adjust order frequency with manufacturers or distributors, or improve stock turnover. By optimizing these factors, you can ensure a smoother and more cost-effective inventory management system.
There are four main categories of inventory carrying costs: capital costs, storage costs, service costs, and inventory risk costs. Managing these costs is crucial for efficient inventory management.
Capital expenditures refer to the funds allocated towards purchasing products, including any associated interest and fees if the company opts for a loan. Storage costs can be categorized as fixed, such as a mortgage for a store or warehouse, or variable, like labor, utility, and administrative expenses. Service costs encompass taxes, insurance, and inventory management software, among others. These factors collectively contribute to the overall financial landscape of a business.
Inventory risk encompasses shrinkage, depreciation, and the possibility of product obsolescence.
Calculating The Costs Of Carrying Inventory
Since holding costs can account for a significant portion of a business’s inventory expenditure, they have the potential to impact the overall financial well-being of the organization. Failing to accurately assess the expenses associated with maintaining stock, such as through the implementation of an inventory or stock control system, may result in cash flow challenges.
A company may also overlook a potential investment or growth opportunity due to excessive inventory and unawareness of the detrimental impact of carrying costs on the business’s progress.
Here are other reasons holding costs matter:
- Inventory Accounting: Inventory poses a significant financial burden for numerous companies, making it crucial to precisely determine the cost of inventory holding and the value of the products. The accounting team heavily relies on this data to generate precise and reliable financial statements.
- Production Planning: Once a company comprehends the expenditures associated with inventory storage, it may reassess its production schedule. Specifically, if a particular product can be manufactured swiftly, the business may opt to maintain only a limited quantity in stock. Conversely, an item with high demand and a low carrying cost would warrant allocating more warehouse space to it. Gaining valuable insights is possible through the implementation of a material requirements planning (MRP) process.
Profitability of Existing Inventory: By calculating the costs associated with inventory management and tracking the value of each product, an organization can gain a clearer understanding of the potential profit that can be derived from existing inventory. Carrying costs represent a significant expense in inventory management, and by deducting these costs, it becomes simpler to assess the profitability of each individual item.
Pillars Of Inventory Carrying Costs And How To Reduce Them
Numerous expenses contribute to the equation of inventory carrying costs, and when combined, they often result in a significant waste of resources for businesses.
Inventory Carrying Costs Calculation And Formula
To ensure efficient inventory management, companies must regularly assess their inventory carrying costs. This evaluation helps identify if holding costs outweigh the inventory value. By conducting this calculation, businesses can determine when to reevaluate their processes and practices.
To calculate inventory carrying costs, start by summing up the aforementioned expenses such as capital, storage, labor, transportation, insurance, taxes, administrative costs, depreciation, obsolescence, and shrinkage for a year. Next, divide these carrying costs by the total value of inventory and multiply the result by 100 to obtain the percentage.
Inventory Carrying Costs = Cost of Storage / Total Annual Inventory Value x 100
Inventory Carrying Cost Examples
As we edge closer to winter, retailer ABC has 3 warehouses that are full of winter clothing. The company wants to understand the price of having a large amount of inventory on its shelves as they want to start making room for spring clothes.
Retailer ABC calculates storage costs of $10,000, labor expenses of $4,000, $3,000 for shipping, $3,000 for insurance and $2,000 for shrinkage and depreciation. That puts total inventory carrying costs at $22,000, and that inventory has a cost of goods of $90,000.
$22,000 / 90,000 x 100 = 24%
Per that calculation, Retailer ABC has inventory carrying costs of 24%.
How To Reduce Inventory Carrying Costs
There are several effective methods that companies can employ to reduce inventory carrying costs, some of which demand minimal time and effort. Implementing intelligent strategies to minimize expenditure on stock maintenance is key.
(1) Reducing Inventory On Hand
Despite the revelations brought about by the coronavirus pandemic regarding the risks of a just-in-time inventory strategy, many companies still find themselves grappling with excessive stock or incorrect product assortments. To address this issue, it is crucial to begin by monitoring a comprehensive set of inventory key performance indicators (KPIs). These KPIs will serve as a valuable tool to evaluate each SKU and determine its suitability for inclusion in the store or warehouse. Moreover, they will aid in making informed decisions regarding the optimal quantity to maintain on hand.
Accurate forecasting is crucial, but equally important is software that notifies purchasers when it’s time to reorder and recommends appropriate quantities. Achieving the right balance will require time and experimentation, but the benefits are substantial—optimized inventory levels result in significant cost savings.
(2) Redesigning Your Warehouse
Many businesses fail to fully utilize their available space, missing out on potential cost savings. It’s surprising how much a simple physical transformation in a warehouse or store can have a significant impact on holding costs. Making small adjustments, such as employing containers for more efficient storage, installing additional shelving to maximize vertical space, or strategically placing popular items in a central location, can lead to reduced labor and storage expenses. These practical methods can help drive down costs while maintaining operational efficiency.
Furthermore, by redesigning a manufacturing plant or warehouse, the risk of overlooked inventory can be minimized, resulting in reduced costs associated with capital, depreciation, obsolescence, insurance, and taxes.
(3) Improve Inventory Turnover Rates
Lowering inventory holding costs can be achieved by increasing your sell-through rate. This is a powerful method as it reduces the time items spend on your shelves. To calculate your sell-through rate, use the following formula:
Sell-through rate = (# of units sold during period / # of units received at start of period) x 100
Every month, it is important to evaluate the performance of all products to determine if they are selling at the anticipated rate. If the turnover is higher or lower than expected, appropriate adjustments should be made. Precise forecasts once again play a crucial role in minimizing excess inventory that remains unused and decreases in value.
Having the skill to analyze trends specific to business and market conditions can greatly enhance your inventory turnover ratio. If companies discover that their inventory is moving too slowly, implementing promotions and bundling strategies can be effective in clearing it out.
Inventory Carrying Costs FAQs
Question: What are some examples of inventory carrying costs?
Answer: Inventory carrying costs encompass various expenses, including capital costs for the products, storage fees, depreciation, labor expenses, insurance, taxes, obsolete inventory, opportunity cost, and administrative overhead. This comprehensive list highlights the significant impact that holding costs can have on a company’s financial performance.
Question: How do you calculate inventory carrying costs?
Answer: Calculating inventory carrying costs is a straightforward process once you have identified all the expenses associated with maintaining these goods in stock. Sum up these expenses to determine the total carrying costs, then divide it by the total value of the inventory. Finally, multiply the result by 100 to obtain the percentage. This method allows for a comprehensive assessment of the financial impact of inventory storage.
Question: What percentage is acceptable for inventory carrying costs?
Answer: Carrying costs typically account for 15% to 30% of a company’s inventory value. This percentage holds great significance as it indicates the duration a company can retain its inventory before facing financial losses from unsold items.