Maintaining cost-effective inventory levels is critical for any manufacturer, wholesaler, supplier or retailer. But just how much inventory is the right amount to hold? How can you ensure you have enough to cover fluctuating demand without over-stocking? How long can you hold ‘healthy’ stock until it becomes excess or even obsolete? Most businesses struggle to find an optimized balance between these two costly challenges.
Inventory carrying costs (or inventory holding costs) refer to the overall expenses associated with holding or carrying items of inventory. It’s an umbrella term used to cover these four specific costs:
1. Capital costs
2. Storage space costs
3. Inventory service costs
4. Inventory risk costs
Each cost can have a serious impact on the profitability of your inventory, eating away into the profit margins of every item you sell. In this blog, we’ll take the four types of carrying costs in turn and understand their real impact on your bottom line.
Capital costs are the largest component of inventory carrying costs. They include everything related to the investment in buying stock. This includes the money spent procuring the goods, the interest lost when working capital is turned into stock and the opportunity cost of the money invested. Opportunity costs are intangible and in accounting terms they refer to the lost opportunity of investing money in other ventures e.g. assets or business projects.
Purchasing teams need to ensure they procure inventory in the right volumes, at the right time and at the right cost. Otherwise capital costs could rise, because they’re tying up capital in over-priced and unnecessary goods at the expense of losing interest on money in the bank and the opportunity to invest in other areas of the business.
Capital costs are also affected by external factors, such as the supply and demand of raw materials which can cause prices to rise and fall, something that purchasing teams will have little control over.
Storage space costs are the cost of keeping your inventory safe and in top condition, ready for sale. They can be split in fixed and variable costs. Fixed costs include the warehouse rent or mortgage; variable costs include lighting, heating, air conditioning, plus the costs of physically handling the inventory.
Storage costs will vary dependent on your type of storage; for example if you own your own warehouse, you may have more control over your costs than if you use a Third Party Logistics (3PL) provider. In both cases it makes sense to ensure you’re holding the right products in the right volumes to meet demand without carrying too much to take up valuable warehouse space. ABC analysis or more sophisticated inventory classification techniques will help identify which stock items you should hold more of and those that should either be carried in smaller amounts or not at all.
Automating your inventory handling will also help improve productivity and reduce operational costs.
Inventory service costs cover insurance, IT hardware and, in some countries, taxation. Also in this category are the expenses related to inventory control and management.
The more inventory you carry, the higher your insurance premium will be, therefore having a high inventory turnover rate will help keep these costs low.
While inventory management software is obviously a cost to your business, if you have the right solution that is used correctly by your team, it should bring a good return on its investment. Inventory optimization software such as EazyStock will deliver an ROI within months of implementation, reducing stock levels by up to 30% and therefore dramatically cutting carrying costs.
There is a risk associated with carrying inventory and a cost associated with that risk. This includes the risk of shrinkage, e.g. a loss of items while in storage that doesn’t relate to sales. Shrinkage is often due to administrative errors (shipping errors, misplaced goods, systems not updated etc.), theft (including employee theft) or damage in transit.
Inventory risk costs also take into account that inventory may fall in value while being stored. This can happen due to product deterioration or because items become obsolete and no longer in demand from customers, which means they have to be sold off at a lower market value.
Inventory holding costs are typically between 20-30% of your stock value, so need to be taken seriously. Businesses should always monitor these costs as they can have a significant impact on how much profit you can make from the stock you’re holding.
When profit margins are tight, getting your carrying costs as low as possible can have a significant impact on overall profitability. Contact our team of inventory optimization experts and consultants who will analyze your current inventory data to help you identify how to improve your demand forecasting, supplier management, inventory optimization and procurement planning processes.
Originally published Oct 2015; updated Nov 2020.