What is inventory carrying cost?
Inventory carrying cost, or more simply referred to as “carrying cost,” is something just about everyone who sells a physical product has to deal with in some form or other. If you’re selling a physical product, then that product needs to be held as inventory at some point before it makes it to the final consumer. That act of storing a product as inventory has costs associated with it: from warehouse or storage space to transportation and distribution costs and much more.
Generally, inventory carrying costs can be broken down into one of four categories:
Components of inventory carrying cost
The main components of inventory carrying cost are:
- Storage Space Cost: No matter what kind of inventory you’re keeping on hand, you’re going to need somewhere to store it. That likely means warehouse space, rent, electricity, refrigeration (or another form of temperature or climate control), as well as salaries for the people tasked with maintaining that storage and transportation costs for moving things in and out of storage.
- Capital Cost: This is one of the most abstract costs associated with carrying inventory, and will vary widely based on the nature and quantity of items you are keeping in storage. It’s a reflection of the sum total you’ve invested in that inventory, and as such is most commonly expressed as a fraction of the total value of the inventory (calculated below), plus any interest or insurance that applies.
- Inventory Service Cost: The administrative costs of keeping inventory all fall under inventory service costs. These typically include taxes, fees and other bureaucratic costs; IT hardware, software, and the personnel needed to use them; as well as the space associated with managing all of these assets. If you are running a smaller organization or one that outsources the majority of these services, this cost will likely not apply as much to you as to a full-scale enterprise that manages everything in-house.
- Inventory Risk Cost: Even if you carry insurance for all of your inventory, there are still risks associated with maintaining a large amount of physical goods in storage. We’ll list some examples of inventory risks below, but generally speaking, inventory risk cost can be assessed as the probability of any event occurring which can damage or cause you to lose your investment in that inventory, coupled with the total value of potential lost goods.
Learn more about the ROI of Real-Time Transportation Visibility
What are examples of inventory carrying costs?
Below are some of the most common carrying costs faced by merchants at all levels of the supply chain:
Insurance: Any fees and costs associated with insuring your inventory fall into this category, including the opportunity costs associated with securing coverage or filing a claim.
Opportunity Costs: Opportunity costs are all of the intangible prices or sacrifices associated with doing business or keeping inventory. Safety stock and insurance are two classic examples of opportunity costs, as both are required for doing business but both also require you to tie up funds in ways that are not as productive as they could be otherwise.
Salaries: This is your major human resource cost category, and includes salaries paid out to employees, benefit and severance packages, wages for hourly or contract workers, as well as any administrative tools, software or expenses associated with managing your inventory.
Shrinkage: Any loss in inventory that is not directly related to a sale falls under shrinkage. This is a broad category, and could include theft, spoilage, lost or misplaced inventory, or even obsolescence or depreciation in the value of goods over time, as is common within the fashion and technology industries.
Taxes: Nobody likes paying taxes, but they’re a universal part of doing business, and inventory management is no exception.
Transportation: This most commonly includes shipping. handling and drop-shipping fees for smaller organizations, but can also include transportation management, logistics and distribution costs for larger companies and enterprises.
Warehousing: One of the most obvious costs associated with managing inventory is the space needed to store it, as well as any associated expenses needed for lighting, electricity, refrigeration, security, personnel, administration, etc.
How can you calculate inventory carrying cost?
Though it varies, inventory carrying costs are typically between 15-30% percent of the total cost of the inventory itself. As a rule of thumb, inventory carrying cost can generally be represented as one-fourth of the total value of the inventory.
For example, suppose you have $10,000 worth of inventory currently on-hand. Your capital cost can be estimated as $2,500.
If you wanted to get more granular than that, follow these steps to calculate the carrying cost associated with your inventory:
- Calculate the value of each of the inventory cost components described above (inventory service cost, inventory risk cost, capital cost, and storage cost).
- Add all four calculated values together. This is your inventory holding sum.
- Divide your inventory holding sum by the total value of inventory (what you paid for it).
- Multiply this quotient by 100. This is your total inventory carrying cost.
How can you reduce carrying cost?
Supply chain visibility technology can help businesses reduce inventory carrying costs by allowing them to more accurately predict their inventory needs and thus eliminate any unnecessary amounts of inventory they are keeping on hand, known as safety stock.
Most businesses can’t help but keep a certain amount of inventory on hand and readily available. There’s often no escaping that reality of the business. However, by prioritizing and enhancing agility throughout the organization, any company can reduce its reliance on safety stock and, by extension, reduce their inventory carrying costs along the way.
In other words, having lower inventory levels will likely mean you also save on insurance, storage costs, and other costs from all four sectors described at the beginning of this article.
Using the right tools, technologies and techniques, you can drastically reduce the amount of inventory you need to have on hand to meet customer expectations and ensure productivity throughout your organization. In doing so, you will reduce your carrying costs in all four areas without negatively impacting other areas of your business. Here are a few examples of ways you can reduce inventory carrying costs throughout your organization:
- Watch More Closely: Invest in analytics tools and begin closely tracking the amount of inventory you keep on hand, vs. the amount of inventory you need for your day-to-day operations. How close do you ever come to exceeding your safety margins? Is there room to lower them at certain times of the year or at certain facilities? Once you have a solid base of data showing the performance of your business relative to your inventory for a range of different circumstances, you can begin to adjust and streamline these processes to improve efficiency and lower carrying costs.
- Emphasize Supply Chain Agility: Companies carry more inventory than they need in order to ensure that they never have a line down or a stock-out in the event that demand surges or inbound supply is disrupted. Having real-time visibility into the status of inbound shipments can take all the guesswork out of half of that equation. It allows you to anticipate delayed inbound shipments with plenty of time to make the necessary adjustments and ensure that production can continue, shelves can stay full, and customers stay happy.
- Streamline Yard Operations: Particularly when it comes to eliminating inventory storage and service costs, streamlining your yard management operations can go a long way toward reducing costs. By having up-to-date information not only on the status of shipments in the yard, but inbound shipments as well, you can get the most out of the resources you’ve already allocated toward getting everything unloaded, stored and shipped.
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Inventory is considered a company asset and is recorded on your company’s balance sheet. The better you can manage and track the movement of your goods, the more control you will have over your inventory. Real-time visibility is a key component of any sophisticated inventory management process.
To find out more about how real-time visibility can help you reduce costs throughout your operation, check out our Ultimate Guide to Maximizing ROI With Supply Chain Visibility.