Holding excess inventory can be an expensive business decision. A major component of this cost is the cost of initially acquiring the inventory, although the cost of carrying inventory is not just limited to its procurement. There are ranges of carrying costs, some of which go beyond the obvious. Often small or new businesses struggle for visibility of carrying costs. Understanding these costs is key to effectively managing them. Let’s take a look at what carrying costs are and the impact that they can have on your business’ books.
A carrying cost is essentially any cost that arises out of holding an item of inventory. Some inventory carrying costs are ‘accounting costs’ (in other words an actual financial expense). Other carrying costs might be ‘economic costs’ such as the lost opportunity of being able to invest committed capital. Experts identify four major categories of carrying costs, although these are not exhaustive.
Any inventory-based business will rely on at least some stock, which will cost money to purchase. On the other hand, purchasing extra stock in excess of what is actually needed ties up capital, which could be invested elsewhere in the business. Unnecessarily investing in excess inventory can mean that your business misses out on new opportunities; especially those that require the ability to quickly access liquid capital. This is especially the case in businesses that have slow inventory turnover. In the event of a capital crunch, it can take an unacceptably long time to sell down stock.
Simply touching an item of inventory costs your business money. The limited time that it takes staff to receive and process inventory throughout the supply chain really adds up. The cost to the business could be the need to employ extra staff or invest in expensive warehouse equipment such as a forklift or goods elevator. These costs can be more extensive than they first seem – for example, by bringing in more machinery to handle excess inventory, staff training costs increase, as more staff need to be trained as safe operators.
Facilities and storage costs
In addition to more staff and machinery, increasing the size of your inventory will also impose greater demands for warehouse space. Whether you own or lease a warehouse, increasing space usage is a cost to your business. Even if your business owned excess space, tying this up in inventory storage represents an economic cost to your business – even if there is no expense on the books. Related costs such as rates, electricity and insurance will also increase with stock levels.
Depreciation and shrinkage
In most industries, stock will become obsolete over time as newer products are released and older products are worth less. Moreover, as inventory size increases, so does the incidence of shrinkage (that is where employees, customers or contractors damage or dishonestly take stock).
Failing to take account of every inventory carrying cost can lead to inefficient procurement and inventory management decisions. By understanding the handling, capital, storage and obsolescence costs (as well as any other holding costs that might apply in your industry), you can then take steps to reduce excess inventory as well as to fully capture and account for unavoidable inventory carrying costs. Drop shipping may be an option subject to the required business model changes being feasible.