How to Calculate and Lower Inventory Carrying Cost
Inventory carrying cost refers to the money businesses spend when holding stock and goods in storage while waiting to fulfill sales orders.
Understanding how to calculate these costs and limit them in the future will assist businesses in finding the right balance of inventory to carry. As a result, they will have a streamlined flow of income and expenses by adjusting the production amount to suit demand.
Inventory carrying costs can make up to 20-30% of the inventory's overall value, making this an essential component to optimized inventory control and cost reduction.
The 4 Components of Carrying Cost
When working out how much money a business is spending on carrying inventory to gain an accurate picture of total inventory costs, businesses should take into account the four main sources-
1. Capital cost
This makes up the largest portion of the overall inventory carrying cost and is usually expressed as a percentage of the value of the inventory held.
The capital cost encompasses everything from the money spent buying the goods, the interest lost when cash becomes inventory, interest paid on purchases, and the greater opportunity cost of purchasing inventory.
2. Storage space cost
All businesses will incur some form of costs related to safely storing their inventory. Examples of these include warehouse rent, as well as the variable costs such as utility bills for electricity and heating, and labor costs for staff members handling and organizing the inventory.
3. Service cost
These are indirectly associated costs, which are in place to essentially protect the inventory from issues such as accidents or theft while ensuring regulatory compliance.
Examples of service costs include taxes and insurance payments, or inventory management software used for tracking and replenishing inventory volumes. They help to ensure that all government regulations have been met and the stock is properly managed.
Generally, the more a business carries in a warehouse, the higher their insurance premium price and taxes will be.
4. Inventory risk cost
Inventory risk cost refers to the expenses associated with losing inventory due to instances such as theft or wastage. The following 3 factors are the most common sources of risk involved with carrying stock-
- Shrinkage - This refers to the volume of stock that has been damaged in transit or in storage, as well as products lost due to theft or administrative errors.
- Value decline - This could happen as a result of goods becoming obsolete after a certain product is updated to a newer version or model. Value decline would also apply to products that are favored more when they are fresh, meaning the longer they are held in storage, the less valuable they become. For example, perishable goods such as food or new technology like smartphones would be susceptible to value decline.
- Wastage - This refers to products that have sell-by or use-by dates. Perishable goods such as food or makeup can expire when stored for long periods of time in warehouses.
Inventory Carrying Cost Formula
The following formula may appear complicated; however, when broken down and applied using accurate data, it's a straightforward calculation-
(C + I + T + W + (S - R1) + (O - R2)) / Average Annual Inventory Costs
C = Capital
I = Insurance cost
T = Taxes
W = Warehouse costs
S = Scrap
O = Obsolescence costs
R = Recovery costs
Another helpful formula to calculate the percentage of carrying cost is the following-
Carrying cost (%) = holding sum of inventory / (the total inventory value) x 100
In this formula, you value each carrying cost component (service, risk, capital, and storage costs) and add them together for the inventory holding sum, then find the total inventory value. Divide the holding sum by the inventory total value and multiply that number by 100. This calculation will result in the carrying cost percentage.
Although it differs for every company and its industry, the general rule of thumb is to have the carrying cost total between 20% - 30% of the inventory's total value.
Tips for Lowering Inventory Carrying Costs
Understanding the components of all inventory-related costs and using this knowledge to calculate and lower the overall inventory cost allows businesses to enjoy less wastage in product and capital, leading to more efficiency and greater profit.
When working towards lowering inventory carrying costs, some practical tips to keep in mind include-
- Sustain accurate inventory levels by counting the inventory regularly and utilizing inventory management software for perpetual stock tracking.
- Implement cross-docking and reduce periods of cycle stocking to lower overall inventory costs.
- Optimize space and improve the business' space to reduce carrying cost per unit.
- Reduce transaction costs by optimizing order processing requests.
- Implement inventory forecasting procedures by using data-driven software to eliminate the risk of overstocking and wastage.