Inventory is a non-liquid resource that needs to be transformed into money through sales for firms that sell physical things. The efficiency with which a company controls this process determines its revenue. However, this obsession may cause them to miss less evident expenditures, even as these charges erode profitability. Inventory carrying costs, the fees associated with maintaining inventory until it is sold, are one of the most expensive under-the-radar disbursements.
Let’s learn about inventory carrying cost and the way to calculate it to help your business avoid losing profit just because of inventory.
Inventory carrying cost meaning
The Definition Of Inventory Carrying Cost
The cost of maintaining things in hand until using them to fill orders and convert them to invest cash is known as inventory carrying cost. This cost is usually stated as a percentage of the entire inventory value. Carrying costs are a substantial expenditure in the supply chain, and they have a direct influence on your cost of sales and bottom line.
You’ll get a fuller view to make intelligent decisions on ideal inventory levels, inventory planning throughout time, and pre-ordered shipping schedules whether you utilize inventory management software to monitor the carrying cost of goods over time.
Furthermore, keeping track of this cost guarantees that you don’t incur significant losses as a result of retaining inventory for an extended period of time.
Top 10 Critical Inventory Carrying Cost Components
Here is the most important inventory carrying cost components that you should know.
Capital Expense
The cost of capital, which is often the largest component of inventory carrying costs, comprises the purchasing price of the items as well as any interests and some other charges if the company borrowed money to pay for the stock. Locking money up in goods may impair working capital, increasing the demand for the price of more capital. Invest in predicting to lower the cost of capital, which results in lower or more strategic acquisitions. You might also bargain with vendors for a cheaper buying price.
Inventory Storage Fees
The space things occupy in a warehouse or shop is valuable: Storage space charges $6.53 per square meter on average, so every shelf, bin, and box matters. It is simpler to estimate this fee if you utilize a third-party logistics (3PL) supplier, since that partner may pay for the rack, pallet, or item.
To cut warehousing expenses, a corporation might frequently rethink its warehouse structure or the way it keeps items of various shapes and sizes. Inventory reduction may even enable a corporation to relocate to a smaller warehouse, which is an additional approach to reduce storage expenses.
Inventory storage fees
Employee Expenses
This is just the expense of receiving and storing items, completing orders, as well as other touchpoints. Companies may frequently reconfigure their warehouses to boost staff efficiency by placing the most popular commodities near packaging sites, for instance, or complementing human employees with robots. If labor expenses are growing, it is worthwhile to experiment with alternative picking techniques and use software that links the most effective pick pathways for personnel.
Cost Of Opportunity
Overspending on inventory locks up funds that could have been utilized for advertising, new hiring, property investment, and a variety of other expenditures, many of which are more beneficial to the company than products lying on a shelf.
Cost Of Outdated Inventory
Obsolete inventory or outdated stock that cannot be sold as it has ended its useful life can generate an increase in inventory carrying costs. Goods become outdated when their value has depreciated to the level where they must be paid off. Businesses can reduce outmoded inventory by identifying ways to dump inventory while it is still worth it, such as steep discounts, giving it, or selling it to a liquidation. Instead, you’ll probably have to pay to get rid of it.
Without completing frequent checks, businesses may be retaining outdated stock in the warehouse, incurring additional expenses and taking up space. Thus, products must be dispatched immediately before they become outdated.
Taxes/Insurance
Many businesses get insurance to safeguard one of their most important resources: inventory. Therefore, even though a fire or flood ruins a shop or warehouse, not everything is lost. However, the higher the stock in the warehouse, the higher the cost of the insurance coverage. Likewise, the higher level of inventory you keep, the greater the taxes you need to pay. By storing fewer goods or keeping only the highest-performing commodities in the warehouse, a business may save both tax and insurance expenditures.
Tax and insurance
Administrative Fees
Real estate taxes, building upkeep and cleaning, transport, and machine depreciation are all examples of administrative expenditures. Generally, a firm with greater inventory has high administrative costs, partly due to its larger building requirement.
Handling Of Materials
Manpower and the amount of “touches” an item needs to place it in a warehouse container to generate a shipping label—make up a significant portion of the cost of handling materials. However, equipment, machinery, and damaged products after you acquire control are all included in this expenditure category. If a corporation holds fewer products in its building, perhaps it does not require quite so much equipment or machinery or it may utilize them less regularly, reducing the requirement for repair and maintenance.
Shrinkage
Shrinkage occurs when inventory is missing after your organization has acquired it but just before it is sold to a client. Inventory shrinkage can be caused by robbery, theft, damages in transportation, or faults in record-keeping. Similar to all inventory holding expenses, the more inventory a company has, the more cash it is likely to lose due to shrinking. To prevent shrinkage, a business might detect and fire thieving personnel, speak with suppliers about frequent causes of damaged items, and conduct more regular physical inventory checks.
Inventory shrinkage
Innovation Delay
If a corporation is continuously concentrated on shifting surplus inventory, it is unlikely to be inventing and discussing ways to add an attribute or new product sought by buyers. Businesses might become trapped in this cycle if they continuously hold too much stock. Inventory optimization will liberate funds for development and research.
Ways And Example To Calculate The Inventory Carrying Cost
Businesses must analyze their inventory carrying costs frequently to determine if carrying expenses constitute an excessive fraction of inventory cost. This formula will assist firms in determining when it is necessary to reassess their procedures and practices.
Inventory carrying costs formula
The inventory carrying cost is calculated by summing the capital costs, service costs, risk costs, and storage space costs together. The total annual inventory value is equal to inventory costs multiplied by the stock of available items.
For instance, a hat store has a total inventory worth $100000. Their inventory holdings total $30000. Then, we will have the following inventory carrying costs:
Inventory carrying costs example
As a result, the carrying cost for this merchant is 30% of the entire inventory value. Carrying costs enable you to evaluate your earnings against those paid as a result of the stock you keep. So, remember that your average inventory carry cost should range from 15-30% of your overall inventory value.
5 Important Mistakes You Should Avoid When Reducing Inventory Carrying Costs
There are some main causes of excessive holding costs, and any of them might make it more challenging for firms to reduce this charge. If your inventory expenses appear out of control and you’re unsure exactly why check into the following probable problems:
Inventory carrying cost reduction
Application With Restricted Function
Spreadsheets are quickly outgrown by companies due to their restricted capability and shortage of automation. Inventory reports generated by Worksheets, paper records, or other archaic tracking techniques are frequently erroneous and cannot be updated in real-time. When a company doesn’t recognize what it currently has, it is significantly more probable to overspend or buy the incorrect things. Instead of strategies and facts, decisions are governed by gut instinct or best estimates.
Mistakes In Sales Forecasts
Poor prediction of inventory needs is a typical cause of high holding costs. If a corporation utilizes faulty data to generate projections, it may anticipate a surge in demand for a specific SKU and stockpile inventory, only to find sales far below expectations. Or it may mistakenly believe that simply because a particular item was a top seller in the previous quarter, it would continue to go off from the racks in the following two quarters.
In any case, the corporation finishes with a significant amount of surplus inventory taking up precious space and locking up money that could be invested elsewhere. Consider the opportunity cost.
Inability To Recognize Trends
Reliable inventory and manufacturing rely not just on reliable statistics but also on personnel who can successfully evaluate and understand that data. Employees need to be able to identify trends in data and evaluate their implications.
If a buying manager does not see that sales for multiple items have slowed in the final month of the third period, for instance, he/she may make a large order for the fourth period, resulting in outdated inventory. Managers must also consider how industry developments or larger economic movements may impact demand for their products.
Overstuffing
The inventory turnover ratio is an important indicator that illustrates how frequently particular items are sold and refilled over a year. This percentage influences purchase decisions. A low turnover percentage for a large number of items leads to higher inventory carrying costs and, ultimately, outdated inventory. This results in an overcrowded warehouse full of merchandise that is not moving swiftly and as profitable as it previously was.
Order Fulfillment Procedure Flaws
Companies that do not have a thorough inventory management plan, such as those that utilize Excel or other antiquated systems, will over-order to safeguard themselves. It’s inescapable unless you have a system that gives real-time insight down to the SKU level and shows reordering points depending on lead times and trends of the market.
Likewise, ineffective fulfillment techniques can boost labor costs, while bad warehouse architecture or storing procedures can increase warehousing costs and make current inventory more difficult to overlook. As a result, inventory becomes outmoded, depreciation occurs, and tax, insurance, and administration costs rise.
Order fulfillment process flaws
5 Ways To Lower Inventory Carrying Costs In 2022
Businesses may reduce inventory carrying costs in a variety of methods, some of which take little time and resources. Smart ways to save money on inventory management include:
Put In Place An Automatic System For Inventory Management
Technology is critical in providing supply chain professionals with the inventory tracking they require to make sound choices. A perpetual inventory system, or a system that updates in live time, is perfect since it offers a true real-time snapshot of stock levels, rather than what they were yesterday night or hours ago.
Since this allows staff to precisely time new orders and watches indicators such as inventory turnover and sales volume, the insight provided by an inventory management technology makes striking an optimum inventory balance a considerably more realistic expectation. A warehouse management system is useful in making fulfillment and shipment more efficient and cost-efficient.
Inventory Optimization
Even though the coronavirus epidemic has highlighted the hazards of a just-in-time inventory approach, businesses frequently keep too much stock or incorrect items. Begin by recording a set of stock KPIs that will assist you in evaluating each SKU to decide whether it warrants a spot in the shop or warehouse, and then determining the proper number to have on hand.
While precise predicting is essential, thus, software that notifies buyers whenever it’s time to restock and recommends the amount they should buy. It may take time and effort to find the correct balance, but it will be worthwhile—optimized inventory levels can save a significant amount of money.
Increase Inventory Turnover Rates
Improving your sell-through ratio is yet another effective strategy to reduce the cost of inventory holding since things have a shorter time on your shelf. Use the following calculation to get your sell-through percentage:
sell through rate formula
Every month, evaluate the sales of all items to check if they are selling at the desired pace. Alter as needed if turnover is either higher or lower than predicted. Likewise, precise forecasting will help you reduce excess stock that stays around and depreciates. Your inventory turnover rate will increase if you can comprehend the market and industry trends. Whenever a company’s inventory is flowing too slowly, discounts and bundling can help to move it out.
Warehouse Renovation
Companies frequently fail to utilize the most effective use of their free space. Physical modifications to a warehouse or shop may shock you as far as how substantially they may lower holding expenses. Modifications might include the use of boxes for more effective storage, the addition of shelves to improve vertical space or the placement of popular products in a central area. Each of these solutions has the potential to reduce labor and storage expenses.
Furthermore, restructuring a manufacturing facility or warehouse may reduce the likelihood that accessible inventory is overlooked, cutting capital, depreciation, expiration, insurance, and tax expenditures.
Warehouse renovation
Contact With Vendors
Another way to reduce inventory costs is to negotiate contracts with your suppliers and/or clients. Before clients purchase these things, ensure that you are not facing the majority of the inevitable risks and expenditures. Arrange contracts with vendors, for instance, such that they are liable for any damage, loss, or administrative fees incurred while the products are in their custody.
Manufacturers and suppliers should look at alternatives to paying high inventory costs. For instance, in the contract, define a maximum holding duration for goods and charge fees for every day further than that period to collect a part of the carrying expenses. Retailers should follow suit.
Conclusion
Inventory carrying cost is an essential measure that may be used by a corporation to estimate how much money can be made based on existing inventory levels. It covers both direct and indirect expenses, including such opportunity costs. It also assists a company in determining whether it has to increase or decrease output to keep a steady stream of income.
