Accurately calculating inventory costs can be problematic for many businesses. Regardless of the industry you operate in, inventory is often an organisations largest asset and accounts for a significant portion of the business expense account.
Therefore, it is essential for companies to accurately assess factors affecting inventory management to help establish how much profit they can make on their inventory stock. In addition, inventory control enables the business to see where cost reductions can be made and how capital can be efficiently allocated.
What are inventory costs?
Usually, inventory costs are defined as a percentage of the annual average inventory value and will vary depending on the specific business area. Inventory costs are the initial purchase price and any additional expenses directly associated with the maintenance, storage and preparation of inventory for sale, which can include freight, warehousing, labour and overhead expenses. A failure to account for these costs can cause companies to undercharge for their merchandise and finished goods.
For reporting purposes, all these associated costs are generally determined within a set timeframe. Few businesses however, will include anything but the actual purchasing cost of inventory stock on financial statements.
The difficulties of assessing inventory costs
Properly assessing the full costs of inventory is difficult because so many elements make up the true cost of inventory, far beyond raw materials or the cost of goods sold. Equally, accounting systems that are relevant in some areas can be similarly deficient in others. The difficulty in determining inventory costs is further tested by the different terms commonly used to categorise the three basic costs of inventory, which are capital costs, ordering costs and carrying costs.
1. Capital costs
These can form the largest part of inventory costs because they relate to the principal investment made, the interest on working capital and finally the opportunity cost of those finances that could be invested elsewhere if not spent on inventory.
Typically, capital costs tend to be vastly underestimated with companies trusting that regular accounting gives a realistic estimate of their inventory costs. What companies also forget to measure is the risk attached to inventory stock, which can be particularly high relative to perishable products or electronic goods that have a high risk of obsolescence. Goods that lose their entire value if unsold, or quickly outdated consumer goods, have a high opportunity cost. Could the company improve their return on investment if they invested in something different to inventory stock?
2. Ordering costs
Sometimes referred to as setup costs, they refer to the costs associated with the procurement and replenishment of your inventory stock. These costs typically accrue every time an order is placed and include administrative costs such as invoice processing and accounting activities.
Ordering costs can also be very business specific and difficult to estimate given the many elements that make up these costs. In addition, there are the variable costs incurred through inbound logistics which comprise of transportation and freight charges and the inspection and receipting of inward goods.
3. Carrying costs
These can be called anything from holding costs, to service, storage, maintenance costs and even risk costs. They may include the cost of building and facility maintenance or loss through damage, deterioration and obsolescence.
Generally, the three primary carrying costs can be categorised as service (insurance, IT and RFID equipment), storage (insurance, physical handling and human resources) and waste (loss, damage or obsolescence). Carrying costs are typically accepted as representing 25 percent of the value of the companies on hand inventory stock.
The benefits of accurate costing
It is crucial to accurately assess factors affecting inventory management to understand where and how inventory costs can be reduced and to ensure goods are adequately priced to reflect all associated costs.
While not always achievable or even economical to track all inventory costs, measuring the costs as accurately as possible can have significant benefits to your organisation. It can improve profitability and will promote better decision making.
Article by Melanie Chan in collaboration with our team of Unleashed Software inventory and business specialists. Melanie has been writing about inventory management for the past three years. When not writing about inventory management, you can find her eating her way through Auckland.