What are the types of inventory costs?

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In this guide to inventory costs, and inventory control best practice, we explain the main types of inventory cost, and how they’re kept in check with inventory management software.

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Let’s start by looking at the main major driver for improving stock control: the cost of holding inventory.

What are the types of inventory costs?

Ordering, holding, and shortage costs make up the three main categories of inventory-related costs. These groupings broadly separate the many different inventory costs that exist, and below we will identify and describe some examples of the different types of cost in each category.

Ordering costs

Ordering costs, also known as setup costs, are essentially costs incurred every time you place an order from your supplier. Examples include:

  • Clerical costs of preparing purchase orders — there are many kinds of clerical costs, such as invoice processing, accounting, and communication costs
  • Cost of finding suppliers and expediting orders — costs spent on these will likely be inconsistent, but they are important expenses for the business
  • Transportation costs — the costs of moving the goods to the warehouse or store. These costs are highly variable across different industries and items
  • Receiving costs — these include costs of unloading goods at the warehouse and inspecting them to make sure they are the correct items and free of defects
  • Cost of electronic data interchange (EDI) — These are systems used by large businesses and especially retailers, which allow ordering process costs to be significantly reduced.
    There will be an ordering cost of some amount, no matter how small your order might be. The more orders placed, the greater the ordering costs. This ordering cost can be spread out if you placed a bulk order to use goods over a long period of time. However, if your business orders raw materials only as needed so that it keeps little stock on hand, you might be able to tolerate high ordering costs as this is balanced by an overall lower holding cost

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Holding costs

Also known as carrying costs, these are costs involved with storing inventory before it is sold.

  • Inventory financing costs — this includes everything related to the investment made in inventory, including costs like interest on working capital. Financing costs can be complex depending on the business
  • Opportunity cost of the money invested in inventory — this is found by factoring in the lost alternatives of tying money up in inventory, such as investing in term deposits or mutual funds
  • Storage space costs — these are costs related to the place where the inventory is stored and will vary by location. There will be the cost of the storage facility itself, or lease payments if it is not owned. Then there are facility maintenance costs like lighting, heating, and ventilation. Depreciation and property taxes are also included in this
  • Inventory services costs — this includes the cost of the physical handling of the goods, as well as insurance, security, and IT hardware, and applications if these are used. Expenses related to inventory control and cycle counting are further examples
  • Inventory risk costs — a major cost is shrinkage, which is the loss of products between purchasing from the supplier and final sale due to any number of reasons: theft, vendor fraud, shipping errors, damage in transit or storage. The other main example is dead stock

Shortage costs

These costs, also called stock-out costs, occur when businesses become out of stock for whatever reason.

  • Disrupted production — when the business involves producing goods as well as selling them, a shortage will mean the business will have to pay for things like idle workers and factory overhead, even when nothing is being produced
  • Emergency shipments — for retailers, stock-outs could mean paying extra to get a shipment on time, or changing suppliers
  • Customer loyalty and reputation — aside from the loss of business from customers who go elsewhere to make purchases, the company takes a hit to customer loyalty and reputation when their customers are unhappy

Spoilage costs

Perishable inventory stock can rot or spoil if not sold in time, so controlling inventory to prevent spoilage is essential. Perishability is a concern for many industries such as the food and beverage, pharmaceutical, healthcare and cosmetic industries, all of which are affected by the expiration and use-by dates of their products. Spoilage not only costs money but also means you fail to realise a return on your initial investment.

Inventory spoilage and waste is not simply a result of isolated cases of poor inventory control, spoilage is now a global environmental concern. When you consider that in the United States alone, an estimated $200 billion is spent growing, processing, transporting and disposing of food that is never eaten.

Solid inventory control is your front line to preventing spoilage and waste. With the right inventory system, you can improve forecasting, boost efficiency, access real-time inventory data and up-to-date information on the lifecycle of your stock, enabling staff to rotate and manage stock to ensure older products get sold first.

This approach is used in the grocery and FMCG sectors where products with shorter expiry dates are rotated to the front of the shelf. Items that are due to expire are often heavily discounted to clear the inventory stock.

Part 1. Inventory Control Worst Practice: What to Avoid

Now that we have a handle on the importance of good Inventory Control in keeping the (many and varied) costs of holding stock under control, let’s look at some of the major pitfalls that businesses fall into.

Using Excel for Inventory Management

If you run a small business – or if you used to run one and your business has gotten bigger – you’re probably familiar with Excel. This versatile little piece of software is great for budgeting, accounting, scheduling, project management, customer relationship management and more.

In particular, Excel can be a really handy tool for inventory control and management when you’re just starting out. Whether you’re operating out of a garage or a small retail shopfront, Excel is great for small businesses with small staff, small inventories and a small customer bases.

At this point in your business’ life, it can seem counter-intuitive to spend what feels like a large amount of money on a specialist online inventory management software – and sometimes it is! Sometimes your business just isn’t big enough for you to justifying absorbing that cost, and that’s fine.

But if your business starts growing (and that’s really the goal, right?) then it should quickly become obvious that Excel isn’t made to scale and grow with you. What kind of problems might Excel create for your inventory control as your business grows?

Data entry errors

The larger your inventory grows, the more likely you are to experience data entry errors. It’s tough enough to keep track of small volumes of inventory, but with larger volumes of product flowing in and out of your business premises it becomes more difficult to keep track of the correct numbers of what’s come in, what’s gone out and what’s still to arrive – and it also becomes more difficult to find the time to double-check those numbers and catch any errors. The end result is that you might end up recording incorrect figures in your Excel spreadsheet, and those incorrect figures might stick around for days, weeks, months or even years.

Shortages and overages

When you’ve got incorrect figures recorded in your inventory software it’s difficult to accurately forecast how much stock you need to order and how often you need to order it. You might end up ordering too much of a certain product and be forced to sell it at a discount to reduce your inventory, reducing your profits in the process. You might also order too little of a certain product, resulting in shortages and forcing your customers to look elsewhere for the product.

Confusion in the office

Unlike a lot of online inventory management solutions that use the cloud to sync across a range of different devices, Excel spreadsheets have to be saved locally and distributed. As your business grows, more people will need to be able to access and alter your inventory management data. This can get difficult to keep track of, especially if you haven’t set up clear chains of command for communicating and entering inventory data. It could even result in you using out of date inventory data as the basis for all your future orders!

Confusion across offices

Take all of these problems, and imagine how much bigger those problems would become if you were using one Excel file to manage inventories across two or more warehouses — the stress would get unbearable!

There will always come a point in a business’ growth where Excel becomes inefficient, confusing, unreliable, more trouble than it’s worth. At that point, your best bet is to move on to a cloud-based online inventory management solution. These software solutions can sync up across different devices, making it easier to keep your employees up to date with what’s happening with your inventory. They create certainty and make it easier to catch unforced errors, and often come with lots of other features and perks that can streamline your business further, like:

  • Intelligence reports on your inventory data;
  • Business-to-business eCommerce;
  • CRM management; and
  • The ability to sync across other platforms and software solutions

Part 2: Inventory Control Best Practice

Now that we’ve covered some of the important pitfalls to avoid, let’s examine some of the best practices and procedures in effective inventory control in your business. After all, while there is no way to control uncertainty, you can plan for it and there are steps you can take to minimise its impact.

12 Ways to Take Control and Optimise Inventory Flow

1. Employ Intelligent Demand Forecasts

How dependable is your data? Keep good records. Have systems that utilise reliable historical data and sales information, to produce more accurate forecasts. Incorporate and integrate plans from cross-functional teams for best results.

The following steps should be taken to help facilitate best practice demand forecasting.
Best practices for demand forecasting:

  • Create repeatable monthly processes. Improved demand forecasting accuracy requires a consistent, timely process that systematically analyses previous forecasts to compare with actual market results. The data will identify when your predictions were right or not, and what the market demand was. By following a monthly process and evaluating results, you can minimise future errors
  • Decide what to measure and how often you will measure it. To accurately forecast demand, you should focus on the most relevant data. Points to consider include POS data, frequency of stockouts, any amounts of obsolete stock, shipping and dispatch and even competitor sales information
  • Be sure to integrate data from all sales channel and combine the data from each individual product for all channels. Once this is done for all SKUs, you can see what channels offer the highest ROI for each product. This, in turn, will guide smarter decisions for inventory control
  • Measure forecast accuracy at the SKU, location and customer planning levels because a key driver of demand volatility is augmented consumer requirements

Data is crucial, it is impossible to forecast demand if you don’t have accurate data. Best practice demand forecasting revolves around precise, up-to-date sales data, and utilising the first-hand knowledge of sales staff.

2. Know what you have and where it is kept

How many widgets do you have in stock, in what varieties/size and where can you find them? A well-managed warehouse or storage system should make it easy for staff to know quantities on hand, to quickly locate items and accurately record stock movements.

One way of doing this is deploying mobile technology in the warehouse. This makes it possible for warehouse staff to continuously update inventory and logistics information as product is received and dispatched – while equipping sales staff in the field with a mobile device and internet access means they can log orders faster, preventing stock-outs and reducing lead times. Unleashed Software has a mobile sales app that your business’ sales team can use to view inventory and make sales on the go.

3. Use your space efficiently

Is it easy to access high turnover or perishable goods? Improve the layout of your store to optimise the inward/outward flow of inventory. Have a fixed-location storage system with clearly marked positions for stock keeping units.

4. Rethink order cycles and quantities

Can you reduce the size and frequency of stock orders? Smaller, more regular deliveries will free up space and minimise the risks of potential waste. Reducing the dimensions of an order has the potential to provide savings in the cost of transportation.

5. Keep good records

Are your widgets on the shelf or on the loading bay? Ensure that records can be trusted to correctly reflect physical inventory. Product barcodes, information, stock counts and movement should be timely and accurate.

6. Set par levels

Setting par levels or the minimum on-hand quantities of inventory stock for your business helps you to reduce the risk of overstocking while helping to avoid stock outs.

By setting par levels you know it’s time to order more inventory stock when it dips below those pre-set levels. Minimum stock levels will vary by product and should be based on how quickly the product sells and how long it takes to get it back in stock.

Conditions can change over time, so monitor par levels a few times throughout the business year to ensure they still make sense and to adjust up or down accordingly.

7. Match the inventory control system to the type of product

Inventory control policies should be prioritised around the nature of the inventory moving through the supply chain. Products with a short shelf life, such as perishables, need to turnover at a much higher rate than manufactured goods or textiles. In such cases, a First-In First-Out (FIFO) policy is adopted to ensure that goods move down the supply chain in accordance with their expiry date.

Of course, without the ability to track, trace and account for inventory in real-time by using an online inventory control system, errors in order quantities due to inaccurate data-driven purchases will not be able to be rectified by a FIFO system alone.

Manufactured goods or goods that consist of sub-assemblies and multiple components require more complex inventory management systems. Here it is vital to label, itemise and store goods accurately and efficiently. An inventory management software solution is often the only way businesses dealing with more complex inventory management challenges can cope. This way every component used in the production of a product can accurately be traced, tracked and accounted for in real-time.

8. Monitor lead times

Lead-time is the amount of time it takes for a product to move from order placement to manufacturing to final delivery to your warehouse or facility. Different suppliers have different lead-times, and it pays to research and check with various suppliers what their lead-times are before settling with the right one for your business.

Generally, the shorter the lead-time the better it is for your business, however, sometimes it pays to endure a slightly longer lead-time from a supplier if the quality is notably improved. Knowing the lead-times of your suppliers makes the job of your purchasing managers that much easier.

This helps to ensure that goods are re-ordered in time to meet fluctuations in customer demand. A good inventory management software system can be programmed to alert managers to low or high inventory levels and prompt timely re-ordering based off supplier lead-times.

9. Deploy cloud-based technology

Many small businesses are hesitant to invest in a sophisticated software package to effectively manage their inventory control demands. What they fail to account for however is their business’s capacity to scale as it grows. Whereas top of the line inventory management software used to require a sizeable capital investment up front, today’s cloud-based inventory management software service providers are affordable for businesses of all shapes and sizes.

This is because the paradigm has shifted to offering on-site inventory software that requires a large capital investment, to actually looking at inventory software as a service to be provided. It is now possible for small business owners to instantly integrate their business operations with a sophisticated, constantly evolving inventory management software solution, which is able to manage their inventory with pinpoint accuracy and full functionality.

10. Train your employees

Inventory control doesn’t come without a good team to support the system. A team of employees need proper training in order for it to operate effectively. Training is imperative for employees to understand the implications and importance of inventory control. It also allows employees to develop alongside the business and implement best practices.

With adequate formal training there are many benefits to a business. Inventory control training provides education that keeps employees informed. Training details the intricacies of the system so they have a better understanding of the big picture and how it applies to the whole company. It allows employees to interact with a multitude of tools and capabilities of an online system, which up-skills employees and it is beneficial to the company and the person in training. Moreover, training keeps employees on the same page and sets expectations from the managers.

Another benefit of employee training on inventory control is increased efficiencies within the business. It has the potential to streamline internal procedures. Tasks can get communicated faster across the warehouse, office and to external suppliers. After employees have been trained on the right systems, things can move quicker.

Training can also heighten employee morale. These programmes can support job security, which often leads to job satisfaction. If employees are engaged and are given a purpose through this training, then they are more likely to be satisfied in their role. Happy employees stay motivated and their interest in success does not stagnant as easily. Since training gives them purpose, they are more likely to come to work and less likely to quit.

Once the training has been completed and supervisors are satisfied with the level of performance from the employees, less supervision is required overall. Less supervision means that the supervisor will have more time to spend working on other important tasks across the business. This keeps efficiency high and skill levels continue to improve.

11. Manage relationships

A component of successful inventory control is the ability to adapt quickly. Whether this is the need to return slow-selling stock, quickly restock fast-selling items or troubleshoot manufacturing issues, a strong relationship with your suppliers is crucial to guarantee they are willing to work with you to resolve issues.

You can build a win-win relationship with your supplier. Effective relationships require clear, proactive two-way communication. Let suppliers know when you are expecting an increase in sales to allow them time to adjust production. Have them notify you know if a product is running behind schedule so you can halt promotions or consider a temporary substitute.

12. Strive for continuous improvement

Regularly look at every area of the business to find where you can implement and action continuous improvement: are your sales, production, inventory control and customer service activities fully optimised and running as effectively as they can be?

When looking to eliminate potential bottlenecks, a vital area to investigate is your capacity to deal with any new business. You need reliable technology to run your day-to-day business operations and the technology to provide the product the business is offering.

If you land any new business, do you have the resources available to keep up with the work? Plan for every possibility to help anticipate and eliminate potential threats to organisational growth. This involves having the right tools in place to support business functions, documented processes and the well-trained, qualified staff to undertake the necessary activities.

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Melanie - Unleashed Software

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.

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