What are carrying costs, and how are they calculated?

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 overstocking? How long can you hold ‘healthy’ stock until it becomes excess or even obsolete? Most businesses struggle to find an optimised balance between these two costly challenges.

What are carrying costs in inventory management?

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 four specific costs:

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

Each cost can seriously impact the profitability of your inventory, eating away at the profit margins of every item you sell. In this blog post, we’ll examine the four types of carrying costs in turn and understand their real impact on your bottom line.

1. Capital costs

Capital costs are the largest component of inventory carrying costs. They include everything related to the investment in buying stock, including 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.

2. Storage space costs

Storage space costs are the cost of keeping your inventory safe and in top condition, ready for sale. They can be split into fixed and variable costs. Fixed costs include the warehouse rent or mortgage; variable costs include lighting, heating, and 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, your 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 inventory 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.

3. Inventory service costs

Inventory service costs cover insurance, IT hardware, and, in some countries, taxation. Expenses related to inventory control and management are also included in this category.

Inventory specialist with high carrying costs and excess inventory

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.

Whilst inventory management software is obviously a cost to your business, if you have the right solution that is utilised well by your team, it should bring a good return on its investment. Inventory optimisation software, such as EazyStock, will deliver an ROI within months of implementation, reducing stock levels by up to 30% and dramatically cutting carrying costs.

4. Inventory risk costs

Carrying inventory involves risk and cost. 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 whilst being stored. This can happen due to product deterioration or because items become obsolete and are no longer in demand from customers, which means they have to be sold off at a lower market value.

Carrying costs and profitability

Inventory carrying costs are typically between 20% and 30% of stock value, so they need to be taken seriously. Businesses should always monitor these costs, as they can significantly impact the profit they can make from the stock they hold.

When profit margins are tight, keeping carrying costs as low as possible can significantly impact overall profitability. Contact our team of inventory optimisation experts, who will analyse your current inventory data to help you identify how to improve your demand forecasting, supplier management and inventory planning processes.

Originally published 22 October 2018, updated April 2020

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