BUSINESS MANAGEMENT: NOTES ON INVENTORY HOLDING/CARRYING COSTS

 
Revenue growth may be largely affected by  inventory carrying costs, the expenses that come
with holding inventory until it is sold.

Too high holding cost may mean inventories stayed too long in the warehouse. Some strategies,
then, are need in order to keep stock moving.

Carrying costs or holding costs include:

 Storage
 Labor
 transportation
 handling
 insurance
 taxes
 item replacement,
 shrinkage
 depreciation. 

The length of time the inventories are held in the warehouse is one factor that affects
holding costs. The percentage will vary based on the number of items a business sells, its
inventory turnover ratio, the location of its warehouse or store and its storage
requirements.

Reasons for high holding cost:

 excessive safety stock
 slow-moving inventory
 inadequate tools for inventory management and planning
 poor forecasting
 erroneous inventory/order management processes.

Ways to reduce inventory carrying costs:

 keep less inventory on hand

 adopt a suitable warehouse management system
 think of strategies to increase inventory turnover rate
 adopt an effective warehouse layout

Inventory Carrying Costs, as a KPI:

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  Inventory carrying cost is metric to determine whether you’re running an efficient
operation.
 High carrying costs could mean your organization has more inventory on hand than it
needs based on demand.
 High holding cost may indicate the need to adjust the frequency with which you place
orders with manufacturers or distributors

Four categories of inventory carrying costs:

 capital costs- money spent in purchasing products; loan interests

 storage costs- may include labor, utility and administrative expenses
 service costs – include taxes, insurance and inventory management software
 inventory risk costs- includes shrinkage, depreciation and product obsolescence.

Importance of Calculating the Cost of Carrying Inventory

 The company may miss other opportunities that it can invest in, because
it has too much money tied up in inventory
 Understanding the company ‘s holding costs may properly lead to more accurate
production schedule.
 an organization can better estimate how much profit it can expect to earn from existing
inventory.
 this cos is needed to produce accurate financial statements.

Components of Inventory Carrying Cost and How to Reduce Them:

1. Cost of Capital-includes the purchase price of the products plus any interest and other fees if
the business took on debt to pay for that inventory.
To reduce the cost of capital, invest in forecasting that leads to smaller or more strategic
purchases. You could also negotiate a lower purchase price with suppliers.

2. Cost of Storing Inventory. Warehouse space costs include the space used to shelf, bin and
box and even machines for sale

3. Employee Cost includes the cost of labor associated with receiving and putting away products,
fulfilling orders and other touchpoints

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4. Opportunity Cost- costs associated with having marketing, new hires, real estate and other
investments that are more valuable to the organization than items sitting on a shelf.
5. Obsolescence- costs associated with cost of holding stock that can no longer be sold because
it’s reached the end of its lifecycle—can lead to a spike in inventory carrying costs. Products
become obsolete after they depreciate to the point of having no value and must be written-off.

Organizations can minimize obsolete inventory by sales discounting, donating it or by selling it

to a liquidator.

6. Insurance/Taxes- insurance policy is needed to protect warehouse inventory. The more

product in the warehouse, the more that insurance policy will cost. The more inventory you hold,
the higher your taxes. An organization can reduce insurance and tax expenses by keeping fewer
products or only its highest-performing goods in the warehouse.

7. Administrative Costs -include property taxes, facility maintenance and cleaning,

transportation and equipment depreciation. The more inventory, the higher the administrative
costs, in part because it needs a larger facility.

8. Material Handling costs- include labor cost and costs that involve product “touches” required
—from putting it in a warehouse bin to printing a shipping label—is a big part of the money
spent on material handling.

A company may not need as much machinery or equipment, or it may use them less frequently
and reduce the need for maintenance and repair, if it stores fewer items in its facility.

9. Shrinkage Costs is the cost involved when inventory is lost after your company purchased it
but before it’s sold to a customer. May include theft, fraud, damage in transit or record-keeping
mistakes. The more stock a business holds, the more money it will commonly lose to shrinkage.
An organization could identify and terminate employees who are stealing, talk to vendors about
common causes of damaged goods and perform more frequent physical inventory counts to
reduce shrinkage.

10. Delayed Innovation Cost is cost involved if there is no added feature or new product
requested by customers.

Optimizing stock levels will free up resources for research and development.

Inventory Carrying Cost Formula and Calculation

To determine inventory carrying costs follow the steps below:

1.Add up the expenses outlined above—capital, storage, labor, transportation, insurance, taxes,
administrative, depreciation, obsolescence, shrinkage—over one year

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2.Divide those carrying costs by total inventory value

3. Then multiply the number you obtained from step 2, by 100 for a percentage.

Inventory Carrying Costs = Cost of Storage / Total Annual Inventory Value x 100

To get a rough estimate of carrying costs, divide your total annual inventory value by four.

Carrying Cost Computation, Example

A retailer of apparel Shop X, has two warehouses which are full of winter clothing. It wants to
better understand the price of having so much inventory on its shelves as it tries to make room for
spring apparel.

The retailer calculates storage costs of $11,000, labor expenses of $2,000, $3,000 for shipping,
$2,500 for insurance and $1,500 for shrinkage and depreciation. That puts total inventory
carrying costs at $20,000, and that inventory has a cost of goods of $75,000.

Inventory carrying cost percentage =$20,000 / 75,000 x 100 = 26.67%

Reference: From Online Logistics Course at Shipping College, May 2020