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As any supply chain company owner knows, sustained success is at least partly determined by the quality of that business’s inventory management systems and processes. Poor inventory management can produce outcomes that drive down profits and threaten the long term viability of the business. A key part of effective inventory management lies in having a solid understanding of the true cost’ of that business’s inventory.

What is meant by the ‘true cost’ of inventory? Essentially the true cost is arrived at when you factor in expenses that extend beyond the dollar amounts you pay for your inventory. These (largely under-the-radar) factors can include ordering costs, stock-out/shortage costs, and inventory carrying (or holding) costs. By far the most important of these is carrying costs – which can represent up to 40% of a business’s inventory investment – and that will be the focus of this article.

Carrying costs typically include inventory capital costs, inventory service expenses, inventory risk costs, and storage space costs. It is worth taking the time and making the effort to determine your inventory carrying costs because doing so will enable you to know which items are worth keeping in stock in which should be discontinued.

You can also use your inventory cost data to help you decide what new products to bring on board, the price points at which they should be sold and the duration of time that particular stocked items can remain in the warehouse before they become a drain on the business’s resources. Ultimately it’s all about creating new opportunities to lower expenses, increase customer satisfaction, improve cash flow and boost profits.

Unfortunately a sizeable proportion of wholesalers, manufacturers and distributors simply don’t know the carrying costs of their inventory. There can be many reasons for that, and a big one is that they can be tricky things to work out. There are so many variables and some are easier to quantify than others. Let’s take a look at each of them.

Capital Costs

Capital Costs represent the largest component of the total carrying cost. It covers just about everything relating to the capital investment, including the purchase cost and the interest paid to purchase the inventory and other financing charges associated with the working capital.

Inventory Risk Costs

Holding inventory carries certain risks. There is the risk that a stocked item you anticipated would sell quickly instead sits on the shelf for an extended period, possibly depreciating in value or threatening to become obsolete. There is also, potentially, the opposite problem: the risk that you’ve understocked an item, leading to shortages and a higher level of customer dissatisfaction.
There is also the risk of inventory shrinkage through theft, expiration, administrative errors or vendor fraud.

Inventory Service Costs

Inventory Service Costs include taxes, loan maintenance fees, IT hardware and software applications, insurance to cover the inventory, and the labour costs that come with stocktaking, cycle counting and the physical handling of inventory.

Storage Space Costs

Storage Space Costs includes rent or mortgage on the warehouse, property taxes, air conditioning, heating, security, lighting, janitorial services, and transportation. Some of these costs are fixed, such as rent or mortgage, whereas others are variable, for example when you require extra storage space to meet peak seasonal demand.
stock discrepancies

Bringing it all Together - The Formula

There are a variety of formulas you can apply to calculating the carrying costs of your inventory, some more complicated than others. Arguably the best approach is to apply a formula that is not so complex that it requires a PhD in Mathematics but not so elementary that it yields results that can’t be confidently relied upon.

A fairly straightforward formula for calculating carrying cost – which is comprised of your capital costs, storage space costs, risk costs and service costs – is to divide the inventory holding sum by the total value of your inventory. Then multiply that figure by 100 to arrive at a percentage of the value of your total inventory, which is the cost of your inventory multiplied by the stock you have on hand. Your total inventory value will equal the sum of your inventory costs multiplied by your stock of available items.

For a business with, say, $20,000 tied up in capital costs, the carrying cost formula would play out like this:

Inventory service costs: $5,500 for insurance, business management technology and financing fees.

Inventory risk costs: $1,500 loss because they’ve depreciated in value.

Inventory storage costs: $6,000 for rent, utilities and warehouse maintenance.

In this scenario that’s $32,000 worth of carrying costs. Assuming that the total inventory value of all the items stored in the warehouse is $185,000, the inventory carrying cost is $32,000 ÷ $185,000 x 100 = 17.29%.

A result of around 17% is pretty good when it’s considered that carrying costs are usually, according to people who research this type of thing, 15% to 30% of a business’s inventory.

Once you have worked out your business’s carrying cost the question is, what can you do with that information? The good news is that the data acquired from calculating your carrying cost can very useful for the insights the exercise can provide into your operations (as an esteemed British mathematician once said, ‘Data is the new oil’). Your ongoing goal should of course be to keep carrying costs to a minimum.

You may for example, discover that you’re not making the best use of the warehouse space you’re renting. Or that you have too many slow-moving items, or that you’re overspending on business technology, labour or insurance. Maybe you’ll find some of your inventory depreciates in value far quicker than you realised, or that you’re constantly holding excess inventory. Any fresh insight should provide the opportunity for an improvement in the way things are done, and any future increase or decrease in your carrying cost percentage over time should serve as a marker as to how your business is performing.

The Bottom Line

When it comes to running a successful supply chain company, inventory carrying cost is an important metric. It represents a significant expenditure which directly impacts the cost of goods sold and the income that is being generated from your product lines. By undertaking regular carrying cost checks (annually should suit most businesses) you’ll be better placed to make sound business decisions – decisions that can lead to a smoother run operation, improved cash flow and a healthy increase in revenue and profits.