Every business maintains a certain amount of inventory to meet the diverse demands of its wide-ranging clientele. However, there are multiple reasons why some stocks continue to occupy space for long periods. One of the key reasons includes poor anticipation of demand by the seller. This type of storage occupies space which could be used for fast-moving goods. It also adds to the costs of the business. An inventory carrying cost can be best defined as the cost involved in storing the merchandise and serves as an additional cost to the actual cost of purchasing the product. Many consider it a component of the rent being paid for the storage facility. The larger the volume of the inventory, the greater the carrying cost, especially if the inventory remains unsold. Another component of such a cost is the expense involved in keeping it safe and well-maintained at all times. If you add these costs, you could use that amount to purchase a larger quantity of products in demand and whose turnover is really fast. This cost is better known as an opportunity cost. Thus, a carrying cost can be quite expensive for sellers.
Did you know? In 1995, the inventory costs and the total operating margin of the computer company Hewlett-Packard were of equivalent amounts?
Inventory Carrying Costs
Inventory carrying costs entail various other costs which impact negatively on businesses. These refer to the amount of interest businesses lose because of the unsold merchandise in warehouses or other storage facilities. The costs involved in holding stocks depend on the business's inventory management system. Inventory carrying cost (ICC) is a metric that best defines the cost involved in transporting and storing the merchandise until it is shipped.
For every business, avoiding the expenses of additional inventory is of crucial importance. Every business keeps a tab and calculates this cost to understand the amount of profit which can accrue on its existing stocks. Once a business clarifies its holding cost, it can manage its expenses better and curtail unnecessary costs to replenish its finance reserves.
Components Of Inventory Carrying Costs
Multiple components factor into holding costs and form the reason for the money wastage indulged by many companies. Given below are some of the key components of inventory carrying costs.
- Capital cost – This is one of the biggest components of a holding cost. This includes the purchase cost and interest paid, if any, e.g., any debt taken by the seller for payment of that merchandise. Once your money gets blocked in slow-moving stocks, it affects the business's cash flow.
- Storage cost – This serves as a very expensive component. In 2021, the average monthly rent for a warehouse facility was ₹248 per square metre in Pune, making it the most expensive city in this space. A warehouse charges you based on every box and shelf your products occupy. It is up to the business to innovate ways in which the warehouse can stack its products to reduce costs.
- Employee /Labour cost – Every business employs either a few full-time employees or employs labour on wages when goods arrive at their warehouse. There are two ways to reduce these costs. You can store your merchandise in a manner that the fast-moving ones are stored within reach, which will require fewer hands and ease the movement. You can also automate this activity by implementing innovative ’picking’ mechanisms.
- Opportunity cost – Inventory which occupies storage in your warehouse for a long gives rise to this cost. A business can utilise the money blocked due to storing goods occupying shelf space for too long.
- Costs due to stocks nearing their shelf-life – A business has to monitor its inventory to understand the position of its stocks. Obsolete stocks can be disposed of at high discounts if they have not reached the expiry date. Due to carelessness, such goods often end up in the bin adding to the holding inventory carrying cost.
- Insurance cost – Inventory must be protected from contingencies like floods or fire. The larger the volume of your business stocks, the more the insurance amount, and a large inventory also increases taxation costs.
- Administration cost – The storage premises must be regularly cleaned or sanitised depending on the category of goods stored. Administration costs include transportation of these products, including cleaning the storage facility as well.
- Material handling costs – When you store a large inventory, it requires correct labelling, which requires the right type of equipment. An inventory of a smaller size will ease the business of these costs.
- Inventory shrinkage – This occurs after you purchase your goods, which could be stolen in transit or even damaged. The larger the inventory, the more your costs.
Inventory Carrying Cost formula
Every business has to evaluate its inventory management system, which will help determine whether its holding cost exceeds what it should be. The formula for calculating the inventory carrying cost involves adding all the expenses involved, starting from the purchase, storage, transport, insurance, taxes, and administration costs. You divide the sum by the total inventory value, and to procure the percentage, you multiply the number by 100.
Formula = The cost of storage /the value of the total annual inventory x 100
Example of inventory carrying costs
- Industry name – Reliable Computers
- Storage costs - ₹100000
- Labour cost - ₹2000
- Transportation cost - ₹3000
- Insurance cost - ₹2000
- Shrinkage cost depreciation - ₹1000
- Total costs - ₹108000
- Value of the inventory - ₹200000
- Total inventory cost = 108000/200000x100 = 54%
Thus, Reliable computers have inventory carrying costs of 54%
Why Should You Calculate Inventory Carrying Cost?
An inventory carrying cost indicates the business profit you experience against the stocks held in the storage facilities. This cost is representative of the merchandise which lies unsold in the warehouse. It also gives you an understanding of the cost of labour involved in maintaining such stocks, the insurance payable, and the taxes accompanying the stocks. All businesses have to analyse the costs of carrying stocks to understand whether changes can be implemented to lower the expenses and prevent the organisation from unnecessary expenses.
If a business is keen to maximise its supply chain, it must first understand its supply chain's entire cost. Several business owners tend to overlook inventory carrying costs, not realising that they form a crucial part of the operations. If a business can understand and lower its inventory carrying costs, it can make a marked improvement in its profits. A high inventory carrying cost is a sign of the organisation having more than the required inventory. You must manage the frequency of order placements with the concerned distributors or the manufacturers. The inventory management software enables all businesses to improve the movement of their respective stocks and manage their inventory more practically and realistically.
How To Reduce Inventory Carrying Costs:
There are various ways in which you can reduce inventory carrying costs. Some of these are as follows:
Reduce Existing Inventory
Most businesses resort to a distinct software that aids in tracking excess storage units of specific goods. This helps to evaluate and even understand the necessity of storing that merchandise category. Many individuals store excess inventory for fear of losing out on business if they don’t have them. If the products don’t sell quickly, it adds to your costs. The right software will estimate what stocks are at a minimum level and need to be ordered if they are in demand. This way, you save on unnecessary inventory costs.
Expedite Your Inventory Turnover Time
Every type of merchandise has to sell within a specific time from the date of purchase. You should thoroughly review your monthly inventory to understand whether sales are taking place within the time frame set. Once you understand these details, you can incorporate appropriate measures to prevent ordering goods whose turnover is really slack.
Reduce The Lead Time Of Suppliers
You have to negotiate with suppliers for this. For example, if you can get an order delivered to your warehouse in 6 days instead of 9. This will help you reduce the inventory you hold on hand because of this new lead time agreed upon. With an increase in shipments, you can reduce the quantities per shipment. This, in turn, will reduce the carrying costs as you won’t require large storage.
You can resort to drop shipping. This process involves a business accepting orders, but the business does not have to hold the said stocks. The business sends the orders directly to the concerned manufacturer or another supplier, and they make a shipment of the orders to the clients. You are free of bearing inventory costs and still earn a portion of the profit.
Inventory Management Software
A technology-backed inventory management system will furnish you with the real-time status of the stocks in your warehouse. It will help the warehouse manager resort to more effective timing measures for new orders, which will help maintain the ideal stock balance.
When you realise a specific stock is not moving at all and has been occupying your storage space, you have to devise ways to monetise it. One way is to return it to the suppliers. If you have an agreement on a timeframe with your suppliers, they may take it back. You can also give that stock as a complimentary gift to those clients who place a very large volume of orders. You can donate deadstock to NGOs and even get a tax deduction.
This article gives you a detailed understanding of inventory carrying costs and why it is important to understand them well. It also helps you understand the importance of TallyPrime in inventory management and how it enables you to fulfil client requirements promptly and efficiently. You start managing your inventory better without over-stocking any particular category while maintaining a reasonable level of stocks to meet the demands of your various clients. These reports also furnish you with a comparative analysis of different organisations for a specific financial year.
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