Inventory Carrying Cost - Components, Calculation & Profitability
Business leaders frequently have a laser-like concentration on revenue expansion. However, because of their focus, they can overlook less evident costs, which would hurt their profitability. In this regard, the inventory carrying cost, or the costs associated with keeping inventory until it is sold, are among the expensive hidden expenses.
Keep reading to learn about this carrying cost in detail.
What Is Inventory Carrying Cost?
The term "inventory carrying cost," sometimes known as "carrying costs," is frequently used in accounting to refer to all expenses in relation to the storage of unsold goods. This includes intangible expenses like lost opportunity expenses, warehousing expenses and depreciation, i.e., the varied cost paid by a business for storing inventory.
What Are the Components of Inventory Carrying Cost?
Inventory carrying costs have several components, which include the following:
1. Capital Costs
Capital expenses are what businesses incur when they buy products, along with any loans they sign out to do so.
2. Storage Costs
Companies must pay storage expenses, such as warehouse mortgages, in order to store their products. Storage costs could also include variable expenses like labour and utilities.
3. Opportunity Cost
This expense is caused by inventory that stays in the warehouse for an extended period. Therefore, a company can use the money that was restricted to keep goods on shelves for an extended period.
4. Labour or Employee Cost
Every company either employs a small number of full-time workers or hires labour for a wage when commodities arrive at its warehouse. There are two methods to cut these expenses. First, you can arrange your inventory so that the items that move quickly are close at hand, making transporting them more accessible and requiring fewer hands.
Otherwise, by using creative "picking" processes, you can potentially automate this process.
5. Costs Due to Stocks Nearing their Shelf-Life
To know where goods stand, a company must keep track of its inventory. If the stocks have yet to reach their expiration date, they can be sold at substantial discounts. But unfortunately, such commodities frequently end up in the trash due to carelessness, raising the carrying cost of the holding inventory.
6. Administration Cost
Depending on the type of items held, the storage area needs to be frequently cleaned or sanitised. Transportation of these goods is covered by administrative expenses, as is facility upkeep.
7. Insurance Cost
Inventory needs to be safeguarded against emergencies like fires and floods. The insurance amount rises proportionately to the size of your company's stock, and a high inventory also raises tax rates.
8. Material Handling Costs
Extensive inventories demand accurate labelling, which necessitates the use of the proper equipment. A reduced inventory will relieve the company of these expenses.
9. Inventory Risk Costs
Costs associated with inventory risk, such as depreciation, shrinkage, and outmoded products, can cause businesses to incur losses on the value of their products. In addition, these inventory risk charges might make businesses lose money on the price of the goods.
10. Delayed Innovation
A business is unlikely to innovate and come up with new ideas if it is always focused on getting rid of excess stock rather than adding a feature or a new product that customers have demanded. Also, if businesses routinely carry too much inventory, they may become trapped in this cycle. On the other hand, resources will be freed up for research and development if stock levels are optimised.
How to Calculate Inventory Carrying Cost?
To calculate inventory carrying cost, organisations have to abide by a few steps:
1. Calculate Different Inventory Costs
The first step is to calculate the cost to the business of each inventory item. This can be accomplished by calculating all costs associated with things like physical storage, labour required to run a warehouse, insurance, opportunity costs, and other connected expenditures.
You might also need to determine whether any objects have lost value or if you've lost any as a result of theft or damage.
2. Calculate Inventory Holding Cost
The inventory holding cost is the first component in the formula for inventory carrying costs. The total of all possible inventory expense categories is the holding cost. To arrive at this sum, you can add up all of the previously computed individual expenditures.
3. Determine Inventory Value
The second and final component of the inventory carrying cost calculation is the total cost of your current inventory. As a general rule, you can evaluate the value of your inventory by multiplying the worth of all goods in your inventory by their unit price. However, the specific formula varies based on the firm and the nature of its inventory.
Regardless, this illustrates the potential revenue you may get if you sell every item in your inventory.
4. Use Formula
You can compute all the evaluated values to calculate using the inventory carrying cost formula, which is –
Carrying cost percentage = (total inventory holding cost / total inventory value) X 100
For example, if a particular business has a total inventory value of ₹ 2,00,000 and bore the following annual cost expenditures.
Capital cost = ₹ 12,000
Service cost = ₹ 3,500
Inventory Costs due to Risks = ₹ 4,500
Thus, inventory holding cost will come to be ₹ 12000 + ₹ 3500 + ₹ 4500 = ₹ 20,000
Now, to find out inventory carrying cost, one has to divide ₹ 20,000 by annual value of inventory and multiply the result by 100.
Inventory carrying cost = ₹ 20,000 / ₹ 2,00,000 x 100 = 10%
How to Reduce Inventory Carrying Expenses?
There are several strategies to reduce inventory carrying expenses. A few of those include the following:
1 Improve your Storage Capacity
Making adjustments to your storage area can increase its effectiveness and lower the cost of maintaining your goods. You can start by making little changes, such as reducing the aisles or adding shelving to generate more vertical space. You might also consider other ways to save money, such as reducing your monthly payments.
2. Increase the Turnover of Your Inventory
Your carrying costs will likely increase the longer your goods remain unsold, and you lose money. You can solve this by cutting down on the amount of time your merchandise spends in storage. Among the methods to do this is to keep the quantity of inventory you need for a specific sales season and eliminate additional stock through sales and product packaging.
You may be able to sell your goods at their optimum price and reduce high carrying costs by raising your sell-through rate and inventory turnover.
3. Choose the Ideal Inventory Supply Levels
While buying bulk from your supplier may entitle you to discounts, keeping stock in storage for an extended period may result in higher carrying costs.
Hence, determine your ideal inventory stock levels and reorder points by analysing past data on how your stocks have been performing before you buy any inventory stock. This can help you fulfil consumer requests and finish transactions while minimising your carrying costs.
4. Use Software for Inventory Management
You can think about employing inventory management software in place of managing your inventory by hand. Since you have access to what you have in storage, what you intend to order, and where the things are in your warehouse, a digital inventory management system makes inventory supervision easier.
A few digital inventory management systems can combine information from sales fulfilment and purchase orders to create reports on demand projection. Utilising this technology can help you lower the cost of carrying inventory by optimising your inventory stock levels, adjusting your prices appropriately, and choosing the best storage plan.
What Are the Reasons for High Inventory Carrying Costs?
A few primary reasons behind high inventory holding costs include the following:
- Slow-moving inventory
- Excessive safety stock
- Poor forecasting
- Restricted tools for inventory management and planning
- Faulty inventory/order management processes
Since the distinction between profit and loss is often hazy, it will be necessary to thoroughly track these expenses in order to determine if they represent a wasteful fraction of the annual inventory value. If this is the case, the company must evaluate its variables of a profitable inventory carrying cost.