Inventory Carrying Costs - Components and Considerations
Inventory carrying costs need to be understood to determine profitability
The cost of carrying inventory is used to help companies determine how much profit can be made on current inventory.
The cost is what a business will incur over a certain period of time, to hold and store its inventory. The carrying cost of inventory is often described as a percentage of the inventory value.
This percentage can include:
- Employee costs
- The cost of insuring and replacing items
There are four main components to the carrying cost of inventory:
- Capital cost
- Storage space cost
- Inventory service cost
- Inventory risk cost
The capital cost is the cost that a business expends on carrying inventory. It is the largest component of the total costs of carrying inventory.
A company will express the capital cost as a percentage of the dollar value of the total inventory it is holding.
For example, if a company says that the capital cost is 35 percent of its total inventory costs, and the total inventory held is $6000, then the capital cost is $2100.
Although companies will give a percentage of their capital cost, this figure may be an objective figure, derived from a calculation, or a subjective figure, derived from experience or industry standards.
Storage Space Cost
The storage space cost is a combination of the warehouse rent or mortgage, lighting, heating, air conditioning, plus the handling costs of moving the materials in and out of the warehouse.
Some of the costs are fixed, such as rent or mortgage, but there are variable costs, such as the handling of the materials that will vary with the level of inventory.
When a 3PL is used or a private warehouse, all the costs may be included in a monthly cost so the storage space cost is not relevant when determining the cost of carrying inventory.
Inventory Service Cost
The cost of carrying inventory will include inventory service costs. These costs include insurance paid on the inventory and taxes to local government.
The insurance that a company pays is dependent on the type of goods in the warehouse as well as the level of inventory. The higher the level of inventory in the warehouse, the higher the insurance premium will be.
Many local authorities tax the level of inventory in the warehouse, so higher levels of inventory will lead to higher taxes paid and a higher inventory service cost.
Inventory Risk Cost
Carrying inventory comes with a certain degree of risk. This risk is a component of the cost of carrying inventory.
When a company stocks items in the warehouse there is always the risk that the items may fall in real value during the period they are stored.
For example, an item could become obsolete or superseded by a new model or version.
If a company stored parts for their work centers or equipment, but those parts were replaced with a new version, the parts in the warehouse could be worth far less than the price that was originally paid. In the retail industry, the risk is much higher as finished items may be seasonally specific.
If the items remain in the warehouse too long, the value may be a fraction of the original worth.
Other aspects of inventory risk include the possibility that the stored items may expire, especially with items that have a sell-by date or use-by date. If the items expire then they can become worthless and have to be scraped.
Items in the warehouse can also degrade, by water damage, heat damage, or by incorrect storage.
Pilferage and theft should also be included in the inventory risk cost.
When companies are looking to reduce costs, a great many times they ignore the inventory sitting in their warehouses and the cost of carrying that inventory. It is important for businesses to carefully examine all the costs of carrying inventory and determine where they can make changes to reduce that cost and help with the company’s bottom line.
In order to optimize a company's supply chain, a company needs to understand the total cost of its supply chain. Inventory carrying costs are a large part of that total cost.
This Inventory Carrying Costs - Components and Considerations article has been updated by Gary W. Marion, Logistics and Supply Chain Expert for The Balance.