Any business that manages inventory must understand and appreciate the impact inventory carrying costs have on their bottom line. In the complex and dynamic world of inventory management the costs you do see are not nearly as dangerous as the costs you don’t.
Many companies, particularly small or relatively inexperienced ones, fail to take into account the numerous ways carrying inventory contributes to significant cost increases. This is because they make the mistake of believing the costs associated to their inventory end at its purchase. However, the fact of the matter is that the burden of holding inventory begins only once it moves into the supply chain. From this point on, every item of inventory is slowly and steadily eating away at the bottom line. The first step to proactively managing inventory carrying costs is to understand just what they are and what we mean when we talk about them.
Basically, any cost associated with the carrying or holding of inventory is termed a carrying cost. Generally, inventory carrying costs are calculated as the sum of the following four major inventory costs:
- Working capital and opportunity capital costs. These costs are attributed to any money that is tied up in the holding of inventory as well as the affiliated losses the business faces as a result. These include lost chances through not being able to utilize its working capital. Every item of inventory purchased siphons off liquidity that can only be recouped once that item of inventory is sold. For businesses with a low rate of inventory turnover, the period their cash flow is tied up can be long and therefore costly. A business with a large part of its working capital invested in its inventory means that they are unable to invest that working capital elsewhere. This is what is meant by inventory capital cost.
- Space and storage costs. Holding inventory requires space and space costs money. Typically, space and storage costs include rent, utility costs, insurance, taxes, depreciation etc. Unless a business is operating a JIT (Just In Time) inventory management system, it will incur costs related to the safe storage of its inventory. It is important to ensure that inventory is stored in a clean, organized and protected environment. Maintaining an organized, clean and safe storage facility for inventory requires investing in labor, including janitors, warehouse workers, security guards, as well as actual storage and surveillance facilities.
- Handling costs. Labor and handling costs to pick, pack, move, organize and protect inventory all need to be taken into account. Depending on the nature, size, weight and quantity of the inventory, handling costs can have an unexpected impact on margins. If a business regularly handles large quantities and large or heavy loads of inventory it can expect to incur greater costs. These are as a result of large capital outlays for purchasing and maintaining heavy warehouse materials handling equipment such as forklifts. Also, one cannot discount losses incurred as a result of workplace injuries and worker’s compensation.
- Obsolescence, damage and criminal activity. Obsolescence is a major cost that can occur when inventory is poorly managed and overstock issues result. Furthermore, losses as a result of damage or criminal activities such as theft, fraud, bribery and collusion can all drive the costs of holding inventory up significantly. All of these features require money, yet none of them are completely failsafe. Inventory stored over a long period is prone to damage, obsolescence, tampering and theft. Taxes and insurance costs also factor in, with higher quantities and value of the inventory incurring higher insurance premiums and taxes.
Carrying Costs Implications
Inventory carrying costs are most commonly calculated over a yearly period and reflected as a percentage of the overall inventory value. Typically, inventory carrying costs range between 20% to 30% of the total inventory value. A business that records inventory valued at $100,000 can expect to have to pay between $20,000 and $30,000 in carrying costs.
It is worth noting that the costs of carrying inventory will vary depending on the nature of the company and the nature of its inventory. Nevertheless, calculating and reducing inventory carrying costs remains a critical component to any inventory management system.
A business that fails to take the time to calculate its inventory carrying costs is putting its ability to operate optimally in jeopardy. Operating a business without knowing the true carrying cost on inventory will inevitably lead to poor business decisions. This will in turn set off a destructive domino effect down the entire supply chain, from purchasing through to storage and distribution and on to sales.
Inventory, its purchase, handling and distribution, is one of the largest expenses a business must manage. Calculating the carrying costs incurred with any purchase of inventory is an essential component to optimizing supply chain operations. The effects on business can be profound which is why it is recommended to invest in an inventory management software solution that gives the business the ability to accurately track, trace and account for its inventory in real-time across multiple nodes in its supply chain.
Article by Melanie Chan in collaboration with our team of Unleashed Software inventory and business specialists. When not writing about inventory management, you can find her eating her way through Auckland.