Inventory costs are the costs related to storing and maintaining a business’ inventory over a certain period of time. Typically, inventory costs are described as a percentage of the inventory value on an annualised basis. They vary strongly depend on the business field, but they are always quite high. It is commonly accepted that the carrying costs alone represent generally 25% of inventory value on hand.
Assessing inventory costs is essential and has flow on effects on the finances of a company as well as on its management. It can help businesses determine how much profit can be made on inventory, how costs can be reduced, where changes can be made, how suppliers or items can be chosen and how capital can be allocated. Here, we take a static snapshot of inventory costs and why you need to know why inventory costs matter.
Categorising Inventory Costs
There are typically four types of inventory costs. These are capital costs, inventory service costs, storage space costs and inventory risk costs.
Inventory Capital Cost
Capital costs include the investment in inventory. When you purchase inventory, cash becomes tied up until you get your money back by selling the item, a process that takes vital capital out of your business operations. The cost of capital, typically the largest portion of your total carrying cost, refers to both financing charges (including the money spent, the interest paid on a purchase etc.) and opportunity cost of the money spent (specifically the fact that your money is invested in unsold inventory rather than a different aspect of your business).
Inventory Service Costs
Inventory service costs include insurance, physical handling and taxes. The cost of servicing your inventory means protecting it from issues such as theft or workplace accidents, or keeping it on the right side of the law. Depending on the type of coverage, insurance will cover your inventory in the event of natural disasters, theft or accidents. Taxes must be paid on the levels of inventory kept on hand also, and the higher the inventory, the higher the taxes. Finally, if you have large amounts of inventory that need to be tracked, inventory management systems or applications may be needed to ensure no inventory goes missing.
Storage Space Cost
Storage space costs include public, rented and company owned warehouses. This cost covers everything associated with keeping your inventory organised in one place, as well as secure, safe and in good condition. Storage costs include rent, utilities like lighting and heating, security and upkeep. These costs are primarily seen in the form of wages for janitorial or security workers, as well as securing the physical space for your products.
Inventory Risk Costs
Inventory risk costs are made up of obsolete stock, damage, shrinkage and relocation costs. It is important to factor these costs into your inventory as often they go under the radar.
While inventory costs are different for every business type and model, the purchase of inventory and its subsequent handling are one of the biggest expenditures a small business makes. Considering that growing revenue is a top concern for almost all small business owners, reducing costs whenever possible should be a priority. The first step to reducing the cost of carrying inventory is understanding all the costs associated with that process. A more organised and efficient business will be able to gain a competitive advantage as a result succeed in this increasingly competitive economy.