Inventory Cost | 3 mins read

How to Calculate and Manage Inventory Cost in 4 Steps

how to calculate and manage inventory cost in 4 steps
Jin Hyun

By Jin Hyun

For businesses dealing with excess waste, overspending, and lack of efficiency, the first step to fixing these issues is understanding how to manage inventory costs.

Inventory cost is defined as the total expense that a business will incur while holding inventory. When this cost is low, businesses can enjoy an efficient supply chain process and an optimal balance of input vs. output.

The capital will inevitably be affected by its inventory cost, which means that the overall revenue will also be affected. A company can adequately plan for cycles of cash flow to avoid operational problems when the business understands how to create inventory management plans and calculate costs accurately.

Types of Inventory Costs

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The three main categories of inventory expenses are holding, ordering, and shortage costs. Understanding these expenditures is important to create an inventory process that is relevant to your business context.
If a business is unaware of where they are leaking money, it will become more difficult to know how to enhance efficiency.

Holding Costs
This relates to inventory that is stored before it is sold. Holding costs include inventory financing, which is the investment of working capital made in inventory, as well as the opportunity cost loss of tying up funds in the inventory, rather than putting that capital towards scaling operations.

Additionally, inventory service costs in holding inventory could be from handling the goods or other expenses involved with managing those goods. Inventory risk costs are also included here, for example, shrinkage of products due to theft or damage.

Ordering Inventory Costs
These are the costs involved with every order that is placed from the supplier. There are clerical costs involved, such as processing invoices, accounting, and communication. Additionally, finding suppliers and expediting orders are additional expenses for the business.

Transportation costs, like moving from warehouse to stores, receiving costs like unloading and inspecting goods, and the cost of electronic data interchange (EDI) are also costs that a business will incur when ordering inventory.

Shortage Inventory Costs
When popular items go out of stock, this is known as a shortage cost. This can be caused by money being lost if there are continued staff/production payments yet no actual inventory being produced due to disruptions.

Also, emergency shipments to quickly recover from shortages can lead to higher fees. The damage in customer loyalty due to inventory shortages is also a big factor to take into account when assessing these costs.

Calculating Inventory Cost- A General Formula

To calculate the cost of inventory, businesses will need their financial statements of a given period, usually one year. There are 4 key steps to calculating the total inventory cost.

Step 1- Work out the cost of your goods
By counting your stock at the beginning of the period and adding that to the value of the goods purchased during the whole period, you'll get a gross cost of goods' amount. For example, if you had $30,000 worth of goods at the start, and during that period you purchased $50,000 more, the cost of your total goods is $80,000.

Step 2- Calculate your gross profits
When you subtract your gross profits from the total revenue, you'll get the cost of goods sold. Oftentimes, this amount is expressed as a percentage.

To calculate this figure as a dollar amount, simply multiply the percentage by the total sales revenue. For example, if you had a total revenue amount of $100,000 and a gross profit of 75%, this would mean your dollar amount of gross profit is $75,000.

Step 3- Find the cost of goods sold
Now, subtract the gross profit from the total revenue. From the example above, that is 100,000 minus 75,000, the difference being 25,000. This means that the cost of goods sold during that period was $25,000.

Step 4- Determine the cost of inventory
Finally, determine the difference between how much inventory you had at the start of the period and how much was sold during that time.

In our example used, that's the difference between $80,000 and $25,000, which means the inventory cost of the goods remaining at the end of the period is $55,000.

Why it's Essential to Understand Inventory Costs

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The costs relating to inventory can be significant, and businesses must monitor this expense regularly to ensure they are not spending more than what is required to meet consumer demands. In fact, many costs that businesses incur may be completely unnecessary. The benefits of reducing inventory costs include the following-

  • Higher productivity - When businesses have the right understanding of the demand for their inventory, oversupply, and shortages are reduced.
  • Increased efficiency - Workflow operations are simplified and processes become more consistent.
  • Labor management enhances - Successfully predicting demand means fewer costs due to staff being involved in holding, ordering, and managing inventory.
  • Greater planning ease - Scheduling, warehousing, and shipping procedures are optimized and more easily planned for predicting inventory demand.