Understanding Carrying Costs

Is your business losing money owing to the inventory you carry?

Inventory carrying cost is a term that recognizes business expenses associated with storing unsold goods. The final amount of carrying costs should include all the related expenses incurred in warehousing, salaries, shipping, and handling. Furthermore, it also includes the depreciation cost and shrinkage. Also, we cannot forget the opportunity costs, which is the cost a company pays for losing out on an opportunity of potential benefits.

You will need to ask yourself some pinpointed questions:

Q1: Are you losing too much money on just storing the unsold and long-sitting goods?

Q2: Is your working capital falling short when you need it?

Q3: Need to develop strategies to combat the carrying costs?

If the answer is a big yes, then you must calculate your inventory carrying cost.

This article highlights all the significant components associated with the inventory carrying costs, and here is what we shall learn:

• What is Inventory Carrying Cost?
• Importance of Calculating the Cost of Carrying Inventory
• 8 Ingredients of Carrying Cost and Ways to Lower them
• Carrying Cost Formula and Calculation
• Inventory Carrying Cost Example
• Top Reasons Companies Hold Inventory
• 5 Reasons Companies Fail to Lower Carrying Costs
• Strategies to Lower Inventory Carrying Costs
• How can Deskera Help You?
• Key Takeaways

What is Inventory Carrying Cost?

Inventory carrying costs refers to the cost incurred in the process of holding the unsold inventory. One of the topmost problems organizations have with inventory management is carrying costs.

Inventory carrying costs include storage, shipping, handling, labor, insurance, taxes, item replacement, shrinkage, and depreciation. They are incurred when products are kept on the shelves in a warehouse, distribution facility, or retail location. Opportunity cost, or the investment opportunities a business must pass up because its resources are committed to inventory, is another consideration.

Depending on the industry and the size of the organization, inventory carrying expenses often represent up to 30% of the total inventory value. Additionally, these values keep on increasing when the product is kept on hand for long durations before being sold. The ratio will vary based on the amount of merchandise sold and the rate at which inventories are turned over. The location of the warehouse and the required amount of storage also plays a crucial part in estimating the carrying costs.

But why exactly should you estimate the carrying cost of your inventory? Lets catch it in the upcoming section.

Importance of Calculating the Cost of Carrying Inventory

Inventory carrying costs are a significant metric that let you know the efficiency of your business operations. If you incur a higher carrying cost, you are holding a lot more inventory than your business needs. It also helps you know that you will need to sync the demand for the goods with the process of placing the orders with your distributor.

Now, there are four ways in which you can segregate the carrying costs of your inventory. They are as follows:

1. Capital costs: These are the costs the company incurs to pay for the goods. Example: loans or any interest for acquiring the products.
2. Service costs: These are the costs associated with the taxes, insurance, or investing in an inventory management software.
3. Storage costs: These are the costs related to the storage or warehouse expenses. It also includes the cost of labor and other administrative expenses.
4. Inventory risk costs: Depreciation, shrinkage, and product going obsolete are all included in the inventory risk costs.

It is essential for businesses to estimate and keep monitoring these costs as this directly impacts their cash flows and, ultimately, the overall financial report.

Why do Carrying costs Matter?

This section gives you 3 reasons why the carrying costs matter to a business.

Calculating the profitability of the goods held

A business can more accurately gauge how much profit it can anticipate from the existing inventory by computing inventory carrying costs and monitoring the value of each product. After deducting carrying costs, which are significant inventory expenses, it is simpler to calculate the profit. This way, they can access a more accurate profitability report in a time-efficient manner.

Production planning

When a business is aware of the costs associated with inventory storage, it may reconsider and plan its production schedule accordingly. For example, if a specific product takes lesser time to get manufactured, the company might simply wish to retain a modest amount of it on hand. On the other hand, a popular product that has a cheap cost of carrying can have much more space allocation in the warehouse as compared to the other products.

Inventory Accounting

It goes without saying that you need all the costs and expenses report to chart out the financial health of the company. This holds true for inventory accounting, too. The calculated carrying costs can then be used to arrive at accurate financial statements.

8 Ingredients Contributing to Carrying Cost and Ways to Lower them

With most businesses facing exuberant expenses going towards holding inventory, it becomes imperative to take into account the factors that contribute to these increasing costs. Let’s look at them closely and work out some remedial measures for each of them.

Cost of capital

This is the cost incurred by the business in acquiring or buying the products. This is by far the most enormous cost the businesses incur. The cost of capital also includes any loans or debts (including the interest amount) the company borrowed for purchasing the goods. Fundamentally, this money is committed to the goods affecting the overall cash flow; it may ultimately necessitate additional capital.

Remedy: Forecasting can be an effective tool here in combating the increasing cost of capital. When you invest in forecasting, you are better positioned for strategic purchases rather than directionless purchases. This will eventually help in bringing down the cost of capital.

Employee Cost

Simply put, this is the labor cost involved in the transfer of inventory from one place to the other. Labor is commonly deployed in the processes such as receiving the inventory, fulfilling and packaging goods, and so on.

Remedy: Direct labor costs are integral part of inventory accounts of a firm till the time the goods are sold. A warehouse management system clears the air around inventory management.. Consequently, this results in a better customer service and dramatically reduce the costs incurred in employing workforce.

Trying out different picking techniques and utilizing technology and new-age software could further advance employee productivity, thereby bringing down the labor costs.

Cost of Storage

The space occupied by each box or carton can be really expensive, and therefore, each box that goes in counts. With the average warehousing cost on the rise, businesses need to implement strict measures to curb the cost of storage.

Remedy: A thorough look at the space available or the warehouse where you keep your goods can help you store the boxes, packets, and cartons in a specific way; this would help in maximum utilization of the space. Additionally, the company may hire a third-party provider as they would charge only for the space used up. This would help in cutting down the costs.

Opportunity Cost

This is the cost a company has paid for the opportunities that it missed. It simply means that the amount that they put in or overspent on the inventory could have been used wisely for other important operations of the business.

Remedy: Work out your inventory charts and maintain a long-term view of things when you are planning to spend on stocking up your inventory. Ask, how would the things look a month or two down the line? Will you need this cash for other significant aspects such as marketing, real estate, new hiring, and so on? If the answer is yes, avoid spending on the surplus inventory.

Obsolescence

An obsolete inventory is the one that has reached the end of its product lifecycle and that which is not expected to be sold in the near future. Such sitting products can remarkably damage financial growth and lead to a steep increase in carrying costs. Such products need to be written off as they have depreciated beyond the point of having any value.

Remedy: You can minimize the obsolete inventory by attempting to sell the goods while they can still be sold. You could work out a discounted price to attract more customers.

Administrative Costs, Insurance, or Taxes

Investing in insurance is a way to minimize the loss in case of an unforeseen event or accident. The same goes for inventory. When you insure your inventory, fire and floods may damage it, but you still have the insurance amount. However, you must remember: the more the inventory, the higher the premiums of insurance. Likewise, the more the inventory, the higher the taxes levied. You could be losing out so much money just because you have surplus inventory.

Remedy: Organizing your inventory and keeping only the amount of stocks as needed to pull down the tax amounts would be the best solution.

Material Handling

In simple terms, material handling can be explained as the number of touch-points your material or goods have. The more the number of touch points, the more labor needs to be deployed, which eventually implies a higher cost of labor and material handling.

Remedy: This cost can be reduced by keeping an organized inventory. There are times when the stored machinery is damaged, and repairing the same also qualifies as a cost under the material handling category. The heavy machinery or hefty equipment that you do not deploy regularly can be done away with, and only the ones that are frequently required can be kept, thus, lessening the expenditure.

Shrinkage

Inventory shrinkage is a term used in accounting to describe when a merchant has fewer things in stock than on the inventory list as a result of a typing error; it could also be a result of the products that have been harmed, stolen, or lost between the place of manufacture and the place of sale.    

Remedy: Implement methods to eliminate any chances of theft or damage to the inventory. Identify the areas which have displayed frequent damage or loss of goods. You can also involve efficient workers to physically keep a count of the stocks to minimize shrinkage.

Carrying Cost Formula and Calculation Inventory

The profit you're earning on your inventory can be determined by calculating your carrying cost percentage. The following points describe the steps for calculating the carrying costs:

1. Determine the value of each component of your inventory cost in order to calculate your carrying cost. These components are inventory risk cost, service cost, capital cost, and storage cost.

2. To calculate the inventory holding amount, add the inventory cost components.

3. Ascertain the inventory's overall value.

4. Multiply the inventory holding amount by the inventory's total value by 100.

Here is the formula for calculating the carrying costs:

Here, the Inventory Holding Sum is given as follows:

Inventory Carrying Cost Example

A bicycle dealer wants to estimate the total carrying cost of his inventory. Here is how his other costs look:

Total Inventory Cost = $80,000

Labor expenses: $2,000

Shipping charges: $3,000

Insurance amount: $1,000

Depreciation: $1,000

Inventory Holding Sum = $7,000

Applying the Carrying Cost Formula:

Thus, we come to know that the dealer will experience a carrying cost of 8.75%

Top Reasons Companies Hold Inventory

Finding the perfect inventory balance can be easier said than done. Many businesses believe that it is preferable to have too many products on hand than to run out and lose a transaction. After all, losing out on a deal may imply losing a customer and affecting the professional relationship. Apart from impacting customer relationships, there are several other why businesses keep too much stock, which raises carrying costs.

Let’s take a closer look at these reasons here:

Provides protection against Stock-out

Keeping just enough merchandise on hand to meet anticipated demand can be dangerous and may result in a lot of disappointment. Because of this, most businesses maintain a safety stock or additional inventory to prepare for unforeseen occurrences. A spike in demand, an unanticipated supplier delay, a delayed delivery, or a damaged shipment could all be the reasons why companies need to keep a stock.

Having a safety supply is a wise decision to avoid a stock-out situation, but be mindful of an overabundance of safety stock, as that would only result in unreasonably high holding costs.

Provides benefit from order cycles

Every company that sells products needs cycle inventory to meet client demand, increase sales, and win more deals. The stock, also known as working stock, is needed to meet expected demand for a variety of products, and therefore, a business buys cycle inventory after developing sales estimates. However, unlike safety stock, it is not intended to cover the unforeseen. Yet, businesses can benefit from the order cycles to address an increase in demand or to boost their sales.

Helps meet anticipated demand untimely manner

Any business' ability to sell to clients on time is essential to its success. Likewise, fulfilling their request within a timeframe is equally important. All these factors are crucial for flourishing the sales cycle and pushing up the chances of customer retention. Your happy consumers are your best endorsers and will tell others about how quickly you can close a deal. Additionally, their endorsement will help you attract new clients and expand your customer base.

Offer advantages of quantity discounts

Keeping inventory allow your company to purchase goods or raw materials in large quantities and helps with logistical management as well. For instance, the company you are buying from would sell to you at the best price when you buy in bulk, letting you avail of the big discounts. Furthermore, the seller may offer transportation for large buyers as an additional incentive to draw in and retain customers. This drastically will lower transportation costs.

Facilitates efficient tracking of goods available for sale

When you frequently conduct inventory as a firm, you will be aware of the products that are stockpiled. Additionally, the issue of some things not being offered when buyers wish to purchase them will get better. Additionally, you convey to your clients that they can depend on you to supply them with things whenever they want to make a purchase. This creates a favorable impression among your clients and for your company.

5 Reasons Companies Fail to Lower Carrying Costs

While every company makes effort to bring down the carrying costs, some of them face a tough time in succeeding at that. This primarily happens due to reasons they haven’t identified yet. This section gets to you some of the common areas where the companies default and put themselves in the situation of high carrying costs.

Inaccurate Demand Prediction

Poor forecasting of inventory demand is a common cause of high holding costs. A corporation may anticipate a surge in demand for a specific stock keeping unit and stock up on inventory only to find sales fall far short if it uses inaccurate data to make estimates. Or it can mistakenly believe that because a certain product sold well the previous quarter, it will do so again. In either case, the business ends up with a lot of extra inventory that takes up valuable space and costs money that could be used more wisely elsewhere.

Using outdated techniques

A company is much more likely to overbuy or purchase the incorrect products when it is unaware of what it currently owns. When they base their decisions on gut instinct or guesses rather than strategy and research, they are bound to suffer at a later stage.

Moreover, in some scenarios, spreadsheets may not be useful due to their limited capability and lack of automation. Inventory reports generated by a corporation using Excel spreadsheets, paper records, or other antiquated monitoring techniques are frequently erroneous and unable to update in real-time. This calls for the development and adaptation of modern techniques for assessing the overall inventory at hand.

Too much inventory and a low inventory turnover rate

A crucial indicator of how frequently specific products are sold and refilled over the course of a year is the inventory turnover ratio. Purchase decisions are influenced and drawn out by this ratio. An organization's inventory carrying costs increase as a result of a poor turnover ratio for too many products, which leads to obsolete inventory. This results in a warehouse that is overflowing with inventory that is almost stagnant and also quickly depreciating.

Inability to gauge the Trends

It needs competent analysts and interpreters to build precise inventory and production planning. With careful observation and interpretation of the data, there should be a study of the patterns identified. These analyses and interpretations carry a lot of importance as they help in assessing the implications.

All these factors are essential for considering how changes in the general economy or trends in the business may affect the demand for the company’s products.

Strategies to Lower Inventory Carrying Costs

All businesses strive hard to cut down the inventory carrying costs; we bring to you the methods that require negligible effort to accomplish the same.

Reduce your stock on hand

Companies tend to keep too much stock or the wrong products, which is detrimental to the health of their business. You can start by monitoring a set of inventory key performance indicators. These KPIs may be used to assess each SKU to determine whether it belongs in the store. Furthermore, it assists you in determining the right amount to stock.

Finding the ideal balance will take some time and trial and error, but the savings from optimal inventory levels make an effort worthwhile. Accurate forecasting is important; at the same time, it would be a wise decision to invest in software that notifies you when it's time to place another order and offers quantity recommendations.

Renegotiate with vendors

Before clients purchase these things, make sure you are not bearing the majority of the risks and expenses. Establish contracts with suppliers such that they are liable for theft, damage, or other expenses while the products are in their care. Retailers,  Distributors, and manufacturers should look for ways to reduce their carrying costs. For instance, to collect some of those carrying expenses, include a maximum holding time for inventory in the contract and add penalties for each additional day. To sum up, renegotiating contracts with your suppliers and/or customers is another effective way to keep holding costs low.

Upgrade Your Warehouse

Businesses frequently fail to maximize their available space. The amounts saved on warehousing can present incredible numbers. Modifications could involve utilizing containers for more effective storage. You could also consider installing shelves to create extra vertical space. In other words, look up methods and designs that help you make efficient utilization of the warehouse space. Labor and storage costs can be drastically reduced using these techniques.

Investing in Inventory Management Software

An inventory management system can remarkably improve the way you make decisions and can genuinely be a gamechanger here. Technological advancement can pave new ways to offer better visibility to supply chain experts in your company. You would agree that the best possible inventory management system is one that updates in real-time and gives a  realistic view of inventory levels. Looking at the numbers that are not updated or were updated yesterday will serve no purpose now.

You will be able to achieve a lot, including improving the time to place new orders, measure KPIs, and strike a perfect stock balance. With all this, an inventory management system can expedite and reduce the cost of shipment and fulfillment.

How can Deskera Help You?

Deskera can assist with inventory management, customer relationship management, human resource management, attendance management, and payroll administration.

Try Deskera to alleviate your business workload. For a range of sectors, use free, downloadable, and customizable invoice templates, automated invoicing, billing, expenses, payments, accounting, inventory, recording all deposits, and much more.

We're here to help you with the process of growing your company.

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Key Takeaways

• Inventory carrying costs can be defined as the cost incurred in the process of holding the unsold inventory.
• Inventory carrying cost is a term that recognizes business expenses associated with storing unsold goods.
• The final amount of carrying costs should include all the related expenses incurred in warehousing, salaries, shipping, and handling. Furthermore, it also includes the depreciation cost and shrinkage.
• Depending on the industry and the size of the organization, inventory carrying expenses often represent 20% to 30% of the total inventory value.
• The ratio will vary based on the amount of merchandise sold and the rate at which inventories are turned over. The location of the warehouse or store and the required amount of storage also plays a crucial part in estimating the carrying costs.
• Inventory carrying costs are a significant metric that lets you know the efficiency of your business operations. If you incur a higher carrying cost, you are holding a lot more inventory than your business needs.
• Capital costs, service costs, inventory risk costs, and storage costs are the ways in which inventory carrying cost can be categorized.
• Calculating inventory carrying costs helps in production planning, calculating profitability of the goods held, and inventory accounting.
• Cost of capital, employee cost, cost of storage, opportunity cost, obsolescence, shrinkage are some of the reasons that contribute to the carrying cost of inventory.
• Companies hole inventory for a variety of reasons that include protection against stock-out, benefit from order cycles, helps meet anticipated demand, advantage of bulk quantity discounts, and so on.
• Reducing stock on hand, renegotiating with the vendors, upgrading the warehouse, and purchasing an inventory management system are some of the effective ways to combat and lower the inventory carrying costs.

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