One of the first things that come to mind regarding businesses is sales. Since business revenue largely depends on sales, it’s understandable that it receives more focus than any other area in day-to-day operations, including inventory. But forgetting inventory can be counterproductive, as can this part be converted into sales to drive profitability.
Failing to manage your warehouse items could mean losing a significant portion of your company’s earnings to inventory carrying costs. If you’re not familiar with the term, here’s everything you need to know about inventory carrying cost—what it is, why it is important, how to calculate it, and how to maintain it at healthy levels for your business.
What is Inventory Carrying Cost?
When you account for the money you need to spend to store or hold your physical products in stock, that’s your cost of carrying inventory. Also known as inventory holding cost, it represents expenses related to warehousing, employee salaries, insurance, and damage, among others.
Ideally, your inventory carrying cost should be 20%–30% of the value of your on-hand inventory. For example, if your inventory’s average annual value is $100,000, the cost of keeping it should not exceed $30,000.
Your inventory carrying costs—or simply carrying costs—can be a great source of information regarding:
Profit. Based on your current inventory, you can get an idea of how much profit you’ll make once you convert it into cash through sales.
Production. By looking into your inventory holding costs, you’ll know if there’s a good balance between company revenue and expenses. Then, you can determine if you need to increase or decrease production to address any imbalance.
Staying on top of your carrying costs is therefore vital in improving or maintaining business sustainability. Yet, studies indicate that more than 65% of companies calculate their inventory holding costs based only on rough estimates instead of actual computations. It’s also common for companies to stock up to four weeks’ worth of inventory to ensure they won’t run into problems in their supply chain.
However, it can be equally challenging to deal with potential losses from excess inventory.
The 4 Main Components of Inventory Carrying Cost
Learn what exactly comprises carrying costs. With that knowledge, you can better identify how much of your money goes where in holding inventory.
- Capital Cost
This makes up the bulk of inventory carrying costs. Here, you should include the amount of money you used to acquire goods and pay any interest that came with the purchase. The monetary value lost when cash is converted into inventory also counts as capital cost.
- Storage Space Cost
The expenses you incur in managing a warehouse fall under this category. Part of those expenses—which can be fixed or fluctuating, depending on certain factors like the amount of inventory and warehouse ownership—may include the following:
- Rent or purchase of warehouse space. This monthly expense is necessary to let you store your inventory all in one place.
- Utilities. Lighting, air conditioning or heating mechanisms, water supply, and the like are services essential in organizing and managing your inventory.
- Workforce. Salaries used to pay your warehouse management staff also involve costs.
- Security system. You’ll need to safeguard your stock inventory by hiring security personnel or installing surveillance video systems.
- Handling fees in moving items in and out of storage. This includes all the costs associated with fulfilling sales orders: preparing the invoice, printing the shipping label, packaging the product, and so on.
- Inventory Service Cost
This covers expenses such as taxes and insurance premiums needed to comply with government regulations and provide general protection for your inventory. Software and hardware expenses also form part of your inventory service costs, as you need these tools to perform regular inventory management and monitoring processes.
- Inventory Risk Cost
Holding stock comes with risks, and this is where inventory risk cost comes into play. Products may be mishandled or unaccounted for, get stolen, or incur damage due to disasters or other uncontrollable factors—all of which can result in shrinkage. This means you no longer have a saleable product in your hands, causing you to lose money.
Inventory risk costs also account for when your inventory’s value depreciates. Perhaps your product line has a newly released version or model. Your current inventory will then fetch a lower price than its original value. Finally, you need to factor in obsolescence or the risk of your inventory becoming obsolete. This applies to goods that have sell-by or best-by dates, making them difficult to liquidate.
Whatever the case may be, the cost of any of these inventory risks can negatively affect your bottom line.
How to Calculate Your Inventory Carrying Cost?
Now that you know the main components of stockkeeping, you can easily calculate the inventory carrying cost with this formula:
Inventory Carrying Costs = Cost of Storage ÷ Total Annual Inventory Value x 100
This formula can be represented by these steps:
Step 1: To determine the cost of storage, add the expenses for each of the four components: capital, storage, inventory service, and inventory risk.
Step 2: Divide those costs by total inventory value—this is the cost of your inventory multiplied by the number of available stocks.
Step 3: Multiply the number by 100 to get the percentage of inventory carrying costs. As mentioned previously, the ideal range is 20% to 30% of your current inventory’s value.
Suppose your depot’s annual inventory is worth $100,000 with the cost of storage at $20,000, broken down into four areas:
- Capital costs: $10,000
- Storage space costs: $4,000
- Inventory service costs: $4,000
- Inventory risk costs: $2,000
Now, you can apply the formula.
Cost of Storage ($20,000) ÷ Total Annual Inventory Value ($100,000) x 100
= 20% Inventory Carrying Costs
Having a 20% carrying cost is within the acceptable range. If you go beyond 30%, you must look for ways to cut your inventory carrying costs.
How to Limit Inventory Carrying Cost
Reducing the cost of your inventory begins with these steps:
- Understand your reorder point
Reorder point simply means the time in which you need to replenish your stock. Besides knowing when to order, it’s also vital to purchase the right amount of inventory. High inventory levels can lead to obsolescence, while running out of stock may result from pushing for low inventory levels.
To ensure there’s balance in your reorder processes, keeping track of your sales volume is a must. You can review your past month’s performance to look for sales patterns. Alternatively, you can set a reorder point based on what’s being done by businesses with sales models or cycles that are similar to yours.
- Organize or redesign your warehouse space
A poorly organized warehouse is a recipe for disaster, as it increases the likelihood of misplacing or damaging your inventory. If you have a huge warehouse, the time it will take for your staff to retrieve a major piece of inventory might only add to your cost of inventory risks.
Strategies you can implement to add efficiency into your warehouse design include sorting slow- and fast-moving items, color coding areas, using stock-keeping unit (SKU) labels, and the like.
- Forecast accurately
Forecasting involves determining your inventory needs based on market trends and demands. You want to address customer expectations by ensuring your inventory has an adequate supply of the products most consumers are interested in while being lean on slow-selling items.
Here, you must look into both your warehouse records and sales reports. You can get a wealth of information from these documents—including how much inventory you have or how your business has been performing—and use that to come up with accurate forecasts.
- Reduce supplier lead time
Supplier lead time refers to the period it takes to receive purchases from third parties. A reduced lead time can contribute to a lower inventory cost by allowing you to order less stock but with more frequency.
So, even if you have large shipment needs, you won’t have to look for a major warehouse with a lot of storage space because you’re confident your supplier will deliver even with shorter lead times.
- Use an inventory management software
An inventory management software offers multiple benefits in bringing down your company’s holding inventory costs. These tools are not only designed to track your purchase orders and sales in real-time but also automate a wide range of processes, including creating and updating the product listing in the system, printing shipping labels, and inventory reporting, among others.
- Liquidate excess inventory
Sometimes, a surplus in your inventory can’t be avoided. Perhaps the busy season has ended, and it won’t be until a few months or so before things pick up again.
Rather than let your excess stock sit and collect dust in your warehouse, you can work with companies that will let you offload your deadstock. This way, you can free up valuable space in your warehouse and reclaim some of your capital costs.
Related Article: How to Liquidate Your Surplus Inventory?
Limit Your Inventory Carrying Cost
Good inventory management plays a major role in a company’s growth, stability, and sustainability. It lets you hit the sweet spot between reducing the costs of operating your business and making your product available to customers when they need it.
For proper management of your business assets and additional profits, consider selling overstock inventory to Surplus Inventory Buyers. Learn more about our inventory liquidation services. Contact us now!