Cost-effective inventory management is like walking a tightrope for manufacturers, wholesalers, suppliers, and retailers. Excess inventory drains cash flow, making it challenging to cover operational expenses. In contrast, inadequate stock leads to unmet customer demands.
The solution? Find the sweet spot with just enough stock to meet demand fluctuations without the dreaded burden of overstocking.
To achieve this balance and prevent obsolete stock, looking into a less-obvious but profitability-eroding equally critical expense— the carrying costs is essential.
In this article, we’ll dive into the intricacies of carrying costs. Learn its components, calculation, and implications on businesses. Uncover reasons behind elevated costs and discover five strategies to optimise inventory management and boost profitability. Let's dive in!
What Is the Carrying Cost?
Carrying costs, a.k.a holding costs or inventory carrying costs, are incurred while holding items in stock before fulfilling orders and converting them into liquid capital.
Businesses often express total carrying costs as a percentage of their total inventory during a specific time frame. It's a nifty way to assess potential income based on current inventory levels. You see, inventory is like a non-liquid asset; it needs to be converted to cash through sales to make your business profitable.
This number tells you how long you can hold onto your inventory before it starts biting into your profits with unsellable items. Plus, it tells how much you should sell and buy to keep that inventory game on point. Also, analysing it empowers businesses to make informed decisions about production levels, ensuring a steady income stream.
The cost of carrying inventory typically accounts for 15-30% of the total inventory value. Although, it might vary depending on the industry and business size.
Robust inventory management software helps you keep these costs closer to 15%, boosting your profits. However, with poor inventory control, those carrying costs might shoot up to 30%, putting immense pressure on your cash resources and driving down your Return on Invested Capital.
Components of Carrying Cost
To calculate and minimise inventory carrying costs, business owners should pay attention to the following inventory carrying cost components:
Inventory Cost Component
Cost of Capital
Money invested in business inventory, including interest on purchases and loan maintenance fees. Approx. 25% of total inventory value.
Inventory Storage Cost
Expenses for warehouse management. Fixed costs including warehouse rent or mortgage, space rental. Variable costs including climate control, utilities, physical security and handling the inventory.
Inventory Service Cost
Essential for holding stock at a warehouse. Includes expenses such as insurance premiums, hardware investments, taxes, inventory management software fees, and more.
Inventory Risk Cost
Risk of items in storage becoming unsaleable before conversion to liquid assets. Stem from—
Shrinkage- Costs due to inventory loss through the sources include theft, fraud, transit damage, or record-keeping errors.
Obsolescence-Cost to carry inventory that is obsolete and is no longer sellable due to the end of its lifecycle, leading to increased carrying costs.
Expenses for workforce receiving, organising, picking, auditing inventory, and moving products.
Costs of holding ageing inventory that could be better utilised in marketing, hiring, real estate, and other valuable investments.
Costs of insurance policy to safeguard inventory when a disaster like flood or fire strikes.The more inventory you hold, higher are the taxes.
Includes property taxes, maintenance, transportation, and equipment depreciation.
Labour expenses, from warehousing to shipping labels. Also includes machinery, equipment, and product damage during handling.
Consistently carrying too much inventory diverts focus from innovation and customer requests and can hinder progress. Optimised stock levels frees up resources for research and development.
How to Calculate Inventory Carrying Cost: Formula and Example
Carrying cost is always represented as a percentage of the total inventory value. To calculate it, divide the inventory holding sum by the total inventory value and multiply the result by 100.
The carrying cost formula is—
Carrying cost (%) = Inventory holding sum / Total value of inventory x 100
Here's the step-by-step calculation of the carrying cost percentage:
Step 1: Determine the value of each inventory cost component, including capital cost, storage cost, inventory service cost, and inventory risk cost.
Step 2: Add up the inventory cost components to get the inventory holding sum.
Inventory Holding Sum = Capital Costs + Inventory Storage Costs + Inventory Service Cost + Inventory Risk Costs
Step 3: Determine the total value of your inventory.
Step 4: Divide the inventory holding sum by the total inventory value.
Step 5: Multiply the result by 100 for the inventory carrying cost percentage.
Use the resulting figure to assess if inventory carrying costs are optimal or can be minimised.
Let's consider an example of a Pet Supplies store with a total inventory value of $70,000. The inventory holding sum amounts to $14,000.
Here's how to calculate the inventory carrying cost percentage:
Step 1: Determine the inventory holding sum, which is $14,000.
Step 2: Calculate the total value of inventory, which is $70,000.
Step 3: Divide the inventory holding sum ($14,000) by the total value of inventory ($70,000):
Carrying cost (%) = 14,000 / 70,000 = 0.2
Step 4: Convert to percentage by multiplying by 100:
Carrying cost (%) = 0.2 x 100
Carrying cost (%) = 20%
So, the carrying cost incurred by the store is 20% of its total inventory value. This means the store company spends 20 cents per dollar of inventory it holds over the year.
By understanding these costs, the company can make informed decisions to optimise its inventory management and boost profitability.
Implications of High Costs of Carrying Inventory on Businesses?
You might wonder, is excess inventory a blessing or a curse?
Well, the truth is excess inventory can play both sides. On one hand, extra stock, known as safety stock, cushions your business against shipping delays and other unknown factors.
But, on the flip side, too much inventory can also become a burden. Imagine those products sitting there, untouched and unsold, taking up valuable space and tying up your capital.
The high cost of carrying excess inventory can lead to the following:
1. Cash Flow Crunch
Holding too much inventory ties up valuable capital, slowing down your cash flow.
The longer items sit in stock, the lower their value and quality become.
3. Storage Struggles
Excess inventory demands more space, leading to higher storage costs. If you pass these costs onto consumers, you might lose out to competitors with lower prices.
4. Disaster Dangers
Large inventory puts you at higher risk for significant losses if disasters strike.
5. Hefty Insurance Premiums
The more extensive your inventory and the longer you keep it, the higher your insurance expenses.
What Are the Reasons for High Inventory Carrying Costs?
While maintaining sufficient inventory is crucial to meet market demands, the following pitfalls can cause bloated inventory carrying costs. Keep an eye out for these potential issues and steer your business toward optimal profitability—
1. Ineffective Inventory Management
Without a solid inventory management system, businesses fall into the over-ordering trap. The lack of real-time visibility and precise reorder points lead to bloated inventory and inefficient fulfilment. Constrained warehouse capacity also increases inventory carrying costs.
2. Excel and Outdated Methods
Relying on legacy systems for inventory tracking leads to inaccuracies and a lack of real-time updates. This can result in over-purchasing and incorrect inventory decisions, driving up carrying costs.
3. Disorganised Warehouse Layout
Wasted space, lost time, and frustrated employees are the norm in a chaotic warehouse. Not only does this lead to higher labour costs, but also misplaced inventory and damaged goods.
4. Too Much Safety Stock
While safety stock helps buffer against unforeseen demand fluctuations or supply chain disruptions. But too much of it ties up capital and valuable storage space, which can lead to higher inventory carrying costs.
5. Flawed Demand Forecasting
Poor data-driven demand forecasting leads to excessive inventory buildup. Overestimating demand or misjudging sales trends can leave businesses with surplus stock, tying up cash and valuable storage space.
6. Ignoring Trends
Failing to analyse industry trends and consumer behaviour can lead to obsolete inventory. Unaware of changing demands, companies may stock products that no longer sell, incurring unnecessary carrying costs.
7. Misjudged Sales Projections
Accurate sales projections are crucial for determining the right inventory levels. If a business consistently overestimates sales, excess inventory sits idle, resulting in potential obsolescence and higher inventory carrying costs.
8. Slow-Moving Products
Slow-moving items that have low turnover rates tie up capital. They sit in valuable warehouse space for extended periods. To mitigate the risk of obsolescence, you may require frequent markdowns to sell, reducing profitability.
Top 5 Ways to Reduce Inventory Carrying Costs
1. Optimise Inventory Levels: Balance Demand and Supply
Evaluate sales patterns to determine optimal inventory levels. Avoid excess stock that ties up capital and increases holding costs.
2. Increase Sell-through Rate: Faster Turnover
Improve the rate at which items are sold to reduce holding time. Adjust inventory levels based on real-time data and use promotions strategically.
3. Efficient Warehouse Redesign: Maximise Space
Redesign your warehouse layout to make better use of space. Container storage and vertical shelving can cut labour and storage costs.
4. Implement Inventory Management System: Real-Time Visibility
Use technology for real-time inventory visibility. Make informed decisions on reordering to minimise excess stock and avoid stockouts.
5. Smart Supplier/Customer Negotiations: Cost-Sharing
Negotiate with suppliers and customers to share inventory holding costs. Structure contracts to hold suppliers accountable for damages or administrative costs.
Bonus Tip: Eliminating Deadstock: Minimise Losses
Recoup value from deadstock through returns or donations. Offer customer freebies or organise clearance sales to reduce holding costs.
In conclusion, managing inventory carrying costs is crucial for businesses aiming to optimise their operations and financial performance. Companies can significantly reduce unnecessary expenses and improve their bottom line by adopting smart strategies such as—
Optimising inventory levels
Increasing sell-through rates
Implementing inventory management systems, and
Negotiating with suppliers and customers
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Frequently Asked Questions (FAQs)
What is the significance of carrying costs in inventory management?
Carrying cost is crucial in inventory management as it represents the expenses associated with holding and storing inventory. Understanding and optimising carrying costs can improve businesses' profitability and financial health.
How can businesses calculate carrying costs accurately?
Businesses can calculate inventory carrying costs using the formula:
Carrying Cost = (Average Inventory Value) x (Carrying Cost Rate).
By determining the carrying cost accurately, companies can make informed decisions to reduce expenses and enhance inventory management.
How can businesses minimise high carrying costs?
To minimise carrying costs, businesses can adopt various strategies—
Optimising inventory levels
Improving inventory management processes
Negotiating with suppliers
Leveraging technology, and
Liquidating slow-moving or obsolete inventory.
What are the consequences of neglecting carrying costs in inventory management?
Neglecting carrying costs can lead to excess inventory levels, reduced cash flow, increased financial risks, and decreased competitiveness in the market. It may also result in inefficient use of capital and missed opportunities for investment.
How can technology aid in optimising carrying costs?
Inventory management software provides real-time visibility into inventory levels, demand forecasts, and sales data, enabling businesses to make data-driven decisions to minimise carrying costs and improve overall efficiency.
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