Guide to Inventory Costs & Types

When calculating inventory costs, not all stock is alike. Knowing the different types of inventory, and how they impact your costs is key to accurate stock control and best-practice inventory management. With the importance of keeping accurate stock levels being directly connected to managing cost, lets explore the types of inventory you may need to consider, such as inventory used in manufacturing, the types of inventory stored on-premises and off-premises, as well as unseen inventory, that you need to be aware of, to calculate accurate inventory costs.

Manufacturing and production businesses deal with a greater range of inventory types than most industries. Here are seven of the main types of inventory used in a manufacturing business.

Direct raw materials

Raw materials are the goods your business uses to manufacture final products. They can be classified as either ‘direct’ or ‘indirect’. Direct raw materials are the materials which are directly used to create the final product, such as the flour that goes into bread or the plastic that goes into a drink bottle.

Indirect raw materials

Indirect raw materials are any materials that are used to produce goods but are not integrated into the final product. This includes items such as personal safety equipment, fuel for gas-powered tools, and replacement drill bits.

Work-in-progress (WIP)

WIP inventory refers to any goods or materials which are part-way through the manufacturing process but haven’t yet been converted into a finished product. Some manufacturers include labour and related overheads in their WIP costs to ensure accuracy.

Learn more: The complete guide to calculating manufacturing costs

Finished goods inventory

Finished goods are inventory items that have completed the manufacturing process and are ready for sale. These are the products you would find on the shelves of retail stores or in a warehouse ready to be picked and shipped once sold.

Maintenance, repair, and operations (MRO) inventory

MRO inventory refers to all the goods your business consumes to make products that do not go into the final product. It includes indirect raw materials, tools and equipment, and anything used to repair or maintain your facilities.

Some examples of MRO inventory:

• Spare parts
• Power tool batteries
• Light bulbs
• Hard hats
• Cleaning supplies
• Office stationery
• Components

Components are parts or subassemblies which have been manufactured but aren’t themselves the final product.

In a boatbuilding business, the sail and hull of the boat can be considered two commonly used components. In an automobile factory, the car doors and chassis could be considered components of the cars being manufactured.

Packaging inventory

At the end of your accounting period, packaging materials which haven’t yet been utilised in a final product are considered packaging inventory. Packaging inventory is all the material ready to use in your product packaging. This can include items such as branded cardboard boxes, product labels, and containers.

Some organisations break packaging materials into three further subtypes:

Primary: The packaging that’s in direct contact with your product. For example, a sealed plastic bag containing cornflakes.

Secondary: The packaging which goes around primary packaging (the cornflake box).

Tertiary: The packaging used to transport SKUs in bulk, like boxes and shrink wrap. Tertiary packaging may also be known as bulk or transit packaging.

Learn more: Eco-friendly Food Packaging: 8 Trends in Food & Bev Explained

In addition to finished goods inventory, there are several types of saleable stock that a business may keep in its storage location. And as you'll learn below, not all of these inventory types are welcome.

Cycle inventory

Cycle inventory is your main supply of on-hand stock. This is the inventory you’ll pick from first when producing new goods or shipping finished products that have been sold. It excludes safety stock and other inventory types kept in case your cycle inventory runs dry.

Vendor-managed inventory (VMI)

A vendor-managed inventory system is where the inventory of one company is supplied and managed by another. In this relationship, if the vendor knows the buyer running low on stock, they’ll supply it without prompting. Vendor-managed inventory levels are maintained by the seller instead of the buyer.

For VMI to work, the buyer needs to communicate regularly with the vendor, keeping them up to date on stock levels, sales data, forecasted trends, and other key business details.

Consignment inventory

Consignment inventory, like vendor-managed inventory, is inventory managed by the supplier on behalf of the buyer. It differs from VMI in that the vendor also retains ownership of the items up until the point of sale. The buyer doesn’t pay for consignment stock until that sale is made.

Retailers often use consignment inventory as a way to test out unproven products or trial unfamiliar relationships with a new manufacturer. Consignment stock can also be provided to a buyer on a vendor-managed basis.

Learn more: Consignment Inventory Accounting Defined

Obsolete inventory

Obsolete inventory, also called dead stock, refers to finished goods that are unable to be sold. This includes products for which there is no longer customer demand, older iterations of improved products, the remaining on-hand stock of a recalled product, and products that are no longer legal to sell.

Excess inventory

Excess inventory, also called inventory waste, is stock which has not been sold and may take longer to sell than is efficient for a business. The major risk of excess inventory is that it ties up cash flow and consumes valuable storage space.

Zero inventory

Zero inventory is the stock kept on hand by a business practising the zero-inventory strategy. This is a tactic that involves keeping the bare minimum of inventory stock on hand – in some cases, that means none. Stock is effectively pushed back up the supply chain until it is necessary.

For example, e-book authors utilising Amazon’s on-demand book printing sell their products to customers all over the world but generally hold no stock unless they need it for an event.

Just-in-case stock control is a strategy for managing inventory with minimal risk of stockouts. Similarly, just-in-case inventory refers to stock kept in case production or customer demand exceeds your predicted stock requirements.

Anticipation inventory

Anticipation inventory refers to stock purchased or manufactured to prepare for an expected spike in demand. For example, a chocolate retailer may rely on anticipation inventory ahead of Valentine’s Day and Christmas because they know sales are likely to spike around those periods.

Some manufacturers also use anticipation inventory to prepare for supply chain issues, including price increases. If the chocolate retailer knows the price of cocoa will go up on December 1st, they might buy extra (anticipation) stock in November while the price is more desirable.

Safety stock

Safety stock is an extra quantity of goods held in your warehouse as a buffer against unexpected spikes in demand or supply chain disruptions. It differs from anticipation inventory in that it is bought in case it is needed, whereas anticipation inventory is bought because a business expects it will be needed.

Decoupling inventory

Decoupling inventory is a stock of materials your business keeps on hand to allow for unforeseen problems in the production process. In the same way that safety stock protects against supply chain and demand issues, decoupling inventory protects against manufacturing issues, such as lost or broken subassemblies.  

Spare parts inventory

Spare parts inventory is a supply of extra parts that can be dipped into to maintain or repair your organisation’s equipment. This includes physical things like belts, gears, batteries, and also consumables like oil or duct tape.

An important consideration in inventory management is accounting for stock that is not currently inside your storage facility. This can mean goods that are on the move or stored in a third-party location.

Pipeline inventory

Pipeline inventory, also known as in-transit inventory, refers to goods you’ve bought but haven’t yet received. They’ve been shipped by the seller and are on their way to their destination. This can mean goods purchased by a retailer from a wholesaler or goods purchased by a customer from a retailer.

Reverse inventory

Reverse inventory is any goods which are coming back up the supply chain as a part of reverse logistics. This includes items being returned to a business by a customer, either for a refund or a repair. It can also refer to unsold goods that are returned to manufacturers, the return of rented equipment, and the return of failed deliveries.

Reverse inventory has already been sold once and may need to be sold again. It can cause complications such as adding more holding costs or taking up warehouse space which could have gone to a more valuable product.

Dropshipping inventory

Dropshipping inventory is stock that, upon being purchased, will be shipped directly from the selling business’s supplier to their customer, never landing in the merchant’s warehouse. From a cost calculations perspective, dropshipping inventory is not a held inventory but rather the availability of stock from a third party.

Some types of inventory are intangible – but still important – meaning they’re easily forgotten. To wrap up this list, let’s look at three kinds of unseen inventory.

Service inventory

Service inventory is how much of a particular service your organisation can provide customers in each inventory accounting period. It accounts for staff hours as well as the availability of resources. If you have three technicians who can do five installations a day, your service inventory will be 75 installations per week.

Theoretical inventory

Theoretical inventory is used mainly by food businesses and is a calculation used to determine the quantity of stock needed to produce finished products. It’s sometimes also described as the amount of stock expected to be left over after a set of predefined production tasks.

Cloud-based inventory

Cloud-based inventory refers to goods managed by a cloud-based inventory management system. Rather than recording your inventory data on spreadsheets or clipboards, cloud-based inventory puts your data on the Internet.

This has two major benefits:

• You can access it from anywhere, at any time.
• You can more easily share it between warehouse locations.

Now we have an holistic view of the types of inventory you need to consider keeping track of, lets explore how this translates to calculating inventory costs.

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.

It is commonly accepted that the carrying costs alone represent 25% of inventory value on hand.

To determine how much your inventory is costing the business, it's important to break each product down into its individual costs. To help with this, we've identified the main categories of costs associated with stock.

The 5 types of inventory costs include:

• Ordering costs
• Carrying costs
• Shortage costs
• Spoilage costs
• Service costs

Let's explore each of these in more detail.

Knowing which inventory costs can be reduced will help you improve cash flow and efficiency in your business

Inventory 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.

Inventory carrying costs

Also known as holding costs, inventory carrying costs 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 such as stock that is spoiled, or goes past it’s use-by date.

Inventory shortage costs

These costs, also called stock-out costs, occur when businesses become out of stock. Inventory shortage costs can include:

• Time lost when raw materials are not available
• Cost of shrinkage, pilferage and obsolescence
• Idle employees
• Lost sales
• Machinery set up costs

Businesses face consequences when they run out of stock, and this affects the business’ bottom-line both directly and indirectly.

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. To keep customers happy that are waiting for their delivery, a business may need to use expedited shipping which will likely cost more than their usual shipping rates.

Inventory spoilage costs

Perishable inventory stock can rot or spoil if not sold in time, so controlling inventory to prevent spoilage is essential.

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.

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.

Inventory costing impacts on almost every facet of the business. 

Perhaps the most obvious impact is on product pricing. While a number of factors, including supply and consumer demand in the market, will determine the price your business charges for its products, one of the most important factors is inventory cost.

Inventory costing also has significant tax implications. If you are failing to capture all of your inventory costs, you are likely paying more in tax each year than you are required to. In the unlikely event that you are materially overestimating inventory costs, then you may be paying too little tax.

Effective inventory management begins with understanding and reducing all the costs associated with your products and materials.

By understanding your inventory types and costs, you are then able to provide an analysis of your current position. Negative relationships will often exist between ordering costs and carrying costs. Larger orders, placed less frequently will minimise ordering costs but will lead to an increase in carrying costs. In turn, reducing your carrying costs means placing smaller more frequent orders, which subsequently increases ordering costs for the period. If that’s not enough to give you a headache, you can run into shortage costs if the smaller orders are not covering current demand.

Sound confusing? It doesn’t need to be. A good inventory management system will give you a clear picture of where costs are being incurred with regards to inventory. An inventory management system can also:

• Streamline operations and monitor inventory levels in real-time to improve forecasting
• Increase efficiency and reduce the ordering, carrying and shortage costs of inventory
• Hassle-free stocktakes that can be immediately reflected in your inventory records without interrupting other staff members’ workflow
• Reduced admin time by automates many of the manual tasks involved in stock control, improving accuracy, speed, and cost of fulfilment
• Easily assemble components ahead of time with production planning and auto-populated bill of materials. Records are updated as assemblies are marked complete

To get started with inventory management software and reduce inventory costs, try Unleashed free for 14 days to see if it’s the right fit for your business.