How Do You Calculate Inventory Carrying Costs?
September 13, 2022
Inventory carrying costs generally represent part of the total inventory value of a business selling physical goods.
In this article, we discuss everything you need to know about inventory costs—how to calculate them and how to eliminate or reduce these expenses. When you know how to calculate inventory carrying costs, you can decide what to do with unsold inventory.
What Is Inventory Carrying Cost?
Inventory carrying cost refers to the amount spent on holding and storing goods. Also referred to as holding cost, it is an encompassing expense that covers the use of the warehouse and all related costs, such as transportation, taxes, insurance, and employee expenses. Moreover, it covers intangibles, like the cost of lost opportunity and depreciation.
The inventory carrying cost is expressed in percentage, not a dollar amount. It is a crucial calculation because it helps companies forecast how much they can earn from their current inventory. These data points are also crucial for determining if it should be manufacturing or ordering more or less stock in the coming weeks.
This expense is often taken for granted—many business owners can be hyper-focused on sales and revenue growth. Of course, those are important financial factors that determine business success, but overlooking carrying costs may lead to overshooting profit projections.
On average, it represents about 15% to 30% of the inventory value.
Factors That Affect Carrying Cost
These factors influence the total costs of holding physical inventory:
- Capital – This is the biggest component of the inventory carrying cost and refers to the amount invested in the unsold inventory, plus the interest paid on the purchase. The cost of the capital is tied up in inventory, and as long as the items are unsold, you will be paying for the annual interest. Another element is the opportunity lost because capital was spent on unsold inventory rather than other money-making investments.
- Inventory Service – This covers tax expenses or the tax levied on unsold goods at the end of the year, IT hardware, applications used in managing inventory, and other similar costs based on the type of inventory. Insurance is also part of this component, and it depends on the type of goods and level of inventory—the higher the level, the higher the premiums.
- Storage Space – This is the cost of renting a warehouse to store inventory, along with other related expenses, such as utilities and transportation fees.
- Inventory Risk – This refers to the risk of unmoving inventory stored for extended periods. There is no one way to compute inventory risk because it depends on various factors: perishable inventory has a higher inventory risk, and so do products that quickly become obsolete. This also involves shrinkage or the loss due to administrative errors, damage, and theft.
Calculating Inventory Carrying Costs
When you calculate inventory carrying costs, you can properly determine how much profit you can make from your remaining inventory. By doing so, you will avoid losses by continuously leaving them in storage.
Every day there is inventory in storage means a significant dent in the company funds and holdups in overall cash flow.
Here are the steps to calculate holding costs:
1. Put a Value on Each Inventory Cost Component
How much are the costs for the capital, inventory service, storage, and inventory risk? Once you have these numbers, you can start the computation for your extra inventory.
2. Calculate the Holding Sum
|Holding Sum = Capital Cost + Service Cost + Storage Space Cost + Inventory Risk|
3. Know the Total Value of the Inventory
How much unsold inventory does your business have in storage? You can calculate the inventory value by multiplying the number of items in the inventory with the retail price of the items. The total value of inventory in essence represents the amount you can get if all of the items in the inventory were sold to your customers.
Here is the formula:
|Inventory Value = Price of Item × Number of Items|
4. Calculate the Carrying Cost
To get the value you are looking for, divide the holding sum by the inventory value and multiply by 100. The carrying cost is in percentage form.
|Carrying/Holding Cost (%) = (Holding Sum / Inventory Value) × 100|
To better understand these equations, let’s get into specifics.
Fashion is always changing, so it is understandable that there are times when inventory is left unsold. Now, let’s take into consideration a company with a small brick-and-mortar store with no online component.
Here, we calculate the carrying cost components of these t-shirts:
- Capital: $31,500
Since it’s just a small company, let’s suppose that there are only 2,000 unsold T-shirts stored in a small warehouse. The shirts are manufactured at $15 each. The selling price for the t-shirt is $30 each. Add some associated costs into the equation.
Capital cost: 2,000 unsold T-shirts x $15 each = $30,000 + $1,500 (5% annual interest) = $31,500
- Inventory Service: $3,000
The cost of inventory service is difficult to estimate because it is highly dependent on various factors specific to the company. Taxes and insurance premiums vary significantly too. Here is an example of the computation:
Taxes – $1,000
Insurance premiums – $600
IT hardware investments – $600
Employees and other costs – $800
- Storage Space: $8,500
The amount covers rent for a very small warehouse, based on current averages. Plus utilities and transportation costs, among other attached expenses.
Rent for warehouse space – $5,400 ($450/month)
Utilities – $1,600 ($133/month)
Transportation – $1,500 ($125/month)
- Inventory Risk: $1,200
For the T-shirt company, the estimated risk is $100 per month.
Holding Sum = Capital Cost + Service Cost + Storage Space Cost + Inventory Risk
= $31,500 + $3,000 + $8,500 + $1,200
Holding Sum = $44,200
Inventory Value = Price of Item × Number of Items
= $30 x 2,000
Inventory Value = 60,000
Carrying Cost (%) = (Holding Sum / Inventory Value) × 100
Carrying Cost (%) = ( 44,200 / 60,000 ) × 100
Carrying Cost = 74%
This means that the small t-shirt company incurs a carrying cost of 74% of its total inventory value. This is an exceptionally high inventory carrying cost, which should only be between 15% and 30%.
The holding sum must be minimized because it’s part of the reason why the carrying cost is so high. There’s little to be done with the manufacturing cost, but if more products from the inventory were sold, then the capital cost would be lower. Plus, there must be a way to maximize the use of a warehouse or find another way to store inventory.
Being aware of inventory carrying costs will help you go back to the drawing board and find ways to lower these expenses. Moreover, it helps when the business scales up and you already have an estimate of recurring costs.
Many businesses don’t calculate inventory carrying costs because they just include them in the regular expenses of running a business. However, if the t-shirt company went on without knowing how high these costs were, it would have been difficult to determine where the cash bottleneck was.
Keeping track of these costs is crucial to ensure the business’s profitability and minimize potential losses.
How To Reduce Carrying Costs
The example above shows how important it is to calculate inventory carrying costs. If you don’t do anything about your extra inventory for weeks or months at a time, expenses will continue to grow.
So, how do you reduce holdings costs?
1. Understand the Reason
There are several reasons why companies stock a lot of inventory in their warehouses:
Companies maintain a generally positive outlook on their business performance, so they have extra products on hand to cover an unexpected surge in demand. This is not a bad thing per se, but overestimating the sale potential of certain items can lead to high carrying costs.
Seasonal products are in high demand only during certain times of the year, which is why some businesses stock up on them to prepare. For the given example of a t-shirt store, the business may increase its stock of products made of thin materials during summer and reduce them come autumn. By then, the stock flying off shelves will be shirts made of thick fabrics like corduroy or wool.
Companies have sales forecasts, which is why there is a cycle inventory—the minimum quota that must be fulfilled based on the contract. Even when demand is low, there is already a certain number of products to be delivered.
This refers to the products en-route to the store or warehouse. It’s the inventory that hasn’t arrived but must be included when you calculate inventory carrying costs. This usually happens when items are imported or manufactured with imported raw materials.
Products that can no longer be sold because of damage or they have become obsolete are still part of the inventory count.
Based on the example of the small business selling t-shirts, the pandemic was an unexpected occurrence that was the main reason for unsold inventory. Since brand new clothing was not a necessity at the time and the business did not have an online storefront, sales stagnated, and inventory remained unmoving.
Many others can lead to excess inventory, and it’s up to the business to truly understand the situation so they can arrive at an appropriate remedy. Again, going back to the t-shirt business, the carrying cost is almost 50% of the total inventory value, which is much too high.
Another issue with the situation is the expenses incurred by renting a warehouse, which may be too large for 1,000 t-shirts.
Warehouse sizes have more than doubled in the last few years because of the increase in e-commerce activities worldwide. Some small companies are compelled to rent out warehouses with more space than they need, leading to wasted resources.
Fortunately, there is another option for smaller companies: fulfillment centers.
2. Partner With a Fulfillment Center
A fulfillment center is an outsourcing service where businesses can store their stocks instead of buying or renting their own warehouses. These centers have teams of people who handle all steps of order fulfillment, including order processing, packing, and shipping. Nowadays, many fulfillment centers cater to small businesses.
Small businesses can optimize their operations—physically and financially—through fulfillment centers. They can significantly lower storage expenses and the total holding cost.
3. Improve Demand Forecasting
It’s best to prepare stock levels according to customer demand. This entails analyzing past sales reports and noting the average number of items sold historically per day, week, or month.
If your business needs to maintain buffer stock in case of an unexpected deluge of orders, it must be done within reason. Improved demand forecasting and more thorough market research will drastically limit overstocking and the expenses that come with it.
4. Improve Physical Organization of Stockrooms
Perhaps you may not even need a warehouse or fulfillment center if you can keep the inventory within your brick-and-mortar store—granting that everything will fit inside the storeroom. Sometimes, it’s all about proper organization. When you maximize available space through the practical layout of supplies, you may not need to seek third-party storage solutions.
5. Subscribe to Long-Term Arrangements
Small businesses should get into long-term contracts and develop good relationships with suppliers to reduce production costs. For example, some manufacturers hold inventory for their distributors and business partners. Taking advantage of such connections can lead to lower expenses.
6. Invest in a Reliable Software
In the digital age, it’s past time for companies to invest in top-notch inventory management software. Such robust tools help businesses to track and manage inventory at every step of the procurement and delivery process. There’s no longer a need to settle for error-ridden, manual processes that take a lot of time and man-hours. Instead, business owners and managers can just log into their accounts and track inventory from the comfort of their offices.
Inventory management software automates stock movement to maximize efficiency and productivity. The right software can even track demand, emerging industry trends, and other factors that affect stock levels.
For business owners worried about learning complex technical details, these cloud-based products are easy to navigate, even for beginners. Intuitive interfaces make it easy for all types of workers to access, manage, and analyze inventory.
7. Evaluate Emerging Trends
To avoid accumulating excess stock, businesses must have a deep understanding of trends in their industry. This can be done through the collection, analysis, and interpretation of available market data. Proper evaluation of trends leads to a highly accurate demand forecast for production or ordering.
Companies should track micro and macro sales trends regularly. Some inventory management software can generate data for trend analysis—another reason to invest in them.
All business owners want to maximize profits and prevent losses. One way to do so is to calculate inventory carrying costs, which are among the most overlooked elements of a company’s financials.
On average, the carrying cost or holding cost should only be around 15% to 30%, or even lower. Businesses must adopt strategies to continually reduce the carrying cost by investing in management software or partnering with fulfillment centers. In some cases, it’s just a matter of accurate market forecasting. You’ll easily find the best solution when you get to the bottom of the issue.
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