What is Inventory Carrying Costs & How to Calculate It

Urmi Sengupta |Updated on: February 24, 2022

Why should you calculate inventory carrying cost?

How TallyPrime can help manage inventory

What is inventory carrying costs?

Inventory management is a challenging task even for enterprises because of the variety of factors that contribute to the costs. Handling, labor, storage, taxes, shrinkage, and insurance are some of the common costs that are associated with holding inventory in the warehouse. Effective inventory management is required to ensure inventory carrying costs are kept to a minimum. According to some studies, inventory carrying costs can go as high as 30% of the total inventory value. Of course, this can vary from business to business and depends on the business size as well. However, inventory carrying costs must not be underestimated by businesses.

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Components of inventory carrying costs

The components of inventory carrying costs are as follows.

Opportunity cost

The opportunity cost is one of the most important components of inventory carrying costs. When you spend more than necessary on holding inventory, then you are losing other opportunities. For example, that money could be spent on better marketing to get new leads and hiring more people to improve efficiency, and so on. If you feel like you are overspending on your inventory storage, then think of ways to cut down the cost.

Administrative costs

A lot comes under administrative costs which is a part of the inventory carrying costs. It includes depreciation of equipment, cleaning, transportation, and so on. When you have a lot of inventory, then your administrative costs are likely to be higher because you need more space to store all the inventory and maintain the space too. By maximizing the space that is available, you can ensure the administrative costs at kept at a minimum.

Cost of capital

The cost of capital is one of the highest expenses that are part of the inventory carrying costs. The cost of capital includes the interest and product price along with any other fees. Businesses can keep the cost of capital low by forecasting accurately with the right solution and also strategizing their purchases for the highest efficiency. Try and negotiate prices with your long-term suppliers to keep the costs low.

Taxes and insurance

Insurance and taxes are higher when you have more inventory. This means it is best to keep minimal inventory that is sufficient to meet demand. Prioritizing those products that are always in demand and storing them in the warehouse is the first option followed by the next most in-demand product. This way, you can save on insurance and tax costs which will decrease the inventory carrying costs and ensure better cash flow.

Cost of employees

Labor cost is another cost that is factored in when calculating the inventory carrying costs. You need people who will set your products in the warehouse and those who are responsible for getting the product to various places as per the requirements. You can lower the labor cost by adding automation to ensure the most required items are closer to the reach. Additionally, you can ensure the warehouses are designed for high productivity.

Innovation issues

When you are constantly tied up thinking of the inventory you have, there isn’t sufficient time to think of innovation. Your customers might be demanding a particular change but you cannot focus on it when you are always thinking of only the inventory you already have. This can cause you to lose valuable customers. Ensuring you optimize stock levels is one of the ways to ensure you are focusing on your product improvement.

Cost of storage

Where you store your inventory matters too because items take up valuable space in the warehouse and you will need to pay for that space. The method of storage also matters because bigger storage boxes and bins take up more space thereby increasing the overall storage costs. If you have a warehouse then rethink how you store your products so they are easy to retrieve and snugly fit without wasting space.

Handling

The handling of products covers many costs. For instance, it includes the shipping label, product damage, and machinery. When you are trying to bring down handling costs, you can think of whether you need all the machinery that you have at present or not. You want to think if all the equipment is necessary or if you can manage with only some of it. When you cut down on handling costs, you can impact the inventory carrying cost.

Obsolete inventory

Sometimes a situation arises whereby your inventory is obsolete. That is, it has no value when you sell it because it is no longer useful. When this occurs, you have to get rid of it and that also comes attached with a cost. If you want to avoid this scenario, then ensure that you sell the inventory when it is still valuable. You can do this with the help of discounts or donations as it will ensure the inventory doesn’t go to waste.

Shrinkage

Shrinkage is when there is inventory loss after purchase but before you send it to your customer. This can happen when a theft has happened or when the products got damaged in transit. There is likely to be higher shrinkage when you have more stock. You can terminate the employees who have stolen the stock. If damage is the reason for shrinkage then ensure the products are handled with care and they are transported with proper packaging.

Inventory carrying cost formula

The inventory carrying cost formula is as follows.

Inventory carrying costs = (Cost of storage / Total annual inventory value) x 100

The inventory carrying cost is a percentage value.

Example of inventory carrying costs

An example will clarify how to use the inventory carrying cost formula. Let us say that a retailer has found that the cost of storing his items is $15,000 and the cost of paying laborers is $3,000. The cost of insurance is $2,000 while the depreciation cost is $500. He also found that tax and administrative costs amount to a total of $3,000. The cost of goods is $80,000.

If we look at the inventory carrying costs formula, it says that we have to add up all the costs of holding inventory. And so to derive the value of the cost of storage, we have to add the cost of storing items, paying laborers, depreciation, administration, tax, and insurance. This means; $15,000 + $3,000 + $500 + $3,000 + $2,000 which comes to a total of $23,500. Now factoring in the cost of goods, we can calculate the inventory carrying costs as follows.

Cost of storage	$15,000
Cost of paying laborers	$3,000
Insurance cost	$2,000
Depreciation cost	$500
Tax and administrative costs	$3,000
Total cost of storing goods	$23,500
Total inventory value (Cost of goods)	$80,000
Inventory carrying cost	29.4%

Inventory carrying cost = (23,500 / 80,000) x 100

Inventory carrying cost = 29.4%

This means the business has an inventory carrying cost of 29.4% which is quite high.

Why should you calculate inventory carrying cost?

Inventory carrying cost is crucial because it gives insights into how much you are spending on your inventory storage. The following are the top three reasons why you should calculate inventory carrying costs.

Plan production

Inventory carrying costs helps your business rethink production and plan to ensure maximum benefit. For instance, once you understand how much you are spending on inventory storage, you can think of how to schedule the production process and store it accordingly. You can keep only sufficient stock of items that can be produced quickly. Similarly, you can keep more of those items which take more time to get produced. This way, all items are not occupying the warehouse space. Only those which are important and which have lower inventory carrying costs are being stored in the warehouse at any given time.

Accounting

When you know inventory carrying costs, you are at a lower risk of running into cash flow related issues. You must know the cash flow to ensure you are aware of the working capital. Analysis of the cash flow tells you about business liquidity. Inventory carrying costs are also significant costs that many businesses often ignore. This is why calculating the costs is so important because once you know the true value of holding inventory, you can do something about cutting those costs and maximizing profits. It will also ensure you can produce financial statements that are more accurate.

Profits

Inventory carrying costs allow you to know how valuable each product is. This metric can help you determine in detail the profitability of each item you sell because you know the cost it takes to store in the inventory and how much you get when you sell it. Knowing how profitable your inventory allows you to better estimate how much inventory you should keep and whether you should keep extra stock or not. Plus, it enables you to think of strategies to increase your profits while keeping carrying costs in mind so you can improve your profits.

How TallyPrime can help manage inventory

Controlling inventory costs is beneficial to your business’s financial health and has the ability to improve various aspects of your business. With TallyPrime, inventory management becomes easier and more efficient. TallyPrime enables you to choose from various units of measure, record manufacturing activity, set reorder levels, manage product shelf-life, and more. It also has other advanced features such as job work and the bill of material that enable you to manage inventory with ease. TallyPrime is a business management software that makes inventory management simple for all MSMEs. With insightful reports that provide an overview or full in-depth analysis, you can make decisions that matter.