4 Inventory Carrying Costs That Kill Profits

3 min read

Tags: Blog, Demand forecasting, Inventory management, Purchasing & replenishment, Technology

Daniel Fritsch   October 22 2015

Finance team crunching numbers


  1. 4 Inventory Carrying Costs That Kill Profits
  2. Take Action To Reduce Inventory Carrying Costs

According to a recent study by IBM, rising customer demands ranks as the third highest supply chain challenge behind cost containment and visibility, and two out of every three companies struggle to accurately identify customer needs.

While having out-of-stock items means that some shelves and warehouse racks are empty, the irony is that there are billions of dollars wasted each year in excess stock. And most businesses struggle to find an optimized balance between the two costly challenges.

Maintaining inventories is necessary for any company dealing with physical products, including manufacturers, wholesalers, suppliers, distributors and retailers. In the US alone the manufacturing and trade inventory on-hand was estimated at $1.812 trillion in June of 2015.

With that much inventory on-hand, it begs the question, how much of that inventory is excess stock or even obsolete stock?

4 Inventory Carrying Costs That Kill Profits

Inventory carrying costs include all of the costs you incur by stocking material in your warehouse or in your store. These costs are split in four parts:

  1. Capital costs
  2. Storage space costs
  3. Inventory services costs
  4. Inventory risk costs

The annual amount of these costs is accumulated and divided by the average inventory investment. The carrying cost is expressed as a percentage and the values currently range on average between 15–20 percent.

1. Capital Costs

It is the largest component of the total costs of carrying inventory. It includes everything related to the investment, the interests on working capital and the opportunity cost of the money invested in the inventory.

One way to determine the capital costs is to use a weighted average cost of capital (WACC). This is the rate a company is expected to pay on average to all its security holders to finance its asset.

Typically, capital costs tend to be vastly underestimated by inventory buyers. A common mistake to avoid is to reduce them to short-term borrowing rates since rates can fluctuate over time and hurt profitability.

2. Storage Space Costs

warehouse worker counting inventory carrying costsStorage space costs are 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. These costs are dependent on your type of storage and if you have a privately owned warehouse or use Third Party Logistics (3PL) providers.

3. Inventory Services Costs

Inventory service costs include insurance, IT hardware and applications, and tax in some countries, but also physical handling with the corresponding human resources and management personnel. Also in this category are the expenses related to inventory control and cycle counting.

The insurance that a company pays is dependent on the type of goods in the warehouse as well as the inventory levels. The higher the level of inventory is in the warehouse, the higher the insurance premium will be which can also eat away at profit margins.

4. Inventory Risk Costs

This cost covers the risk that items might fall in value over the period they are stored or that they become obsolescent.

Risks first include shrinkage, which basically is the loss of products between the recorded inventory and the actual inventory. The difference is caused by administrative errors (shipping errors, misplaced goods, systems not updated, etc.), pilferage, theft (including employee theft), damage in transit or during the period of storage (because of incorrect storage, water or heat damage, etc.).

Inventory risk costs also take into account the obsolescence factor, that is, the costs occurring when items are no longer wanted by the market.

Take Action To Reduce Inventory Carrying Costs

Today there have evolved multiple best practice approaches to increase the inventory profitability. An example would be the systematical reduction of excess stock or the optimization of the order management via forecasting to minimize order costs. In total we gathered 6 different possibilities for this purpose in one guidebook:

6 Ways to Increase Inventory Profitability