written by | May 17, 2022

What are Inventory Costs and their Types?

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Table of Content


The costs of ordering and holding goods and the associated documentation are included in inventory costs. This cost is considered by management when deciding how much inventory to maintain on hand. Some of the most common inventory-related expenditures include ordering, holding, carrying, shortages, and spoiling. These classifications are used to categorise the many distinct inventory expenses that exist.

Did you know?

Types of prices related to Inventory – Ordering, Costs, the cost associated with inventory, Inventory Holding prices, Shortage prices, Spoilage prices, and Inventory Carrying prices. Inventory holding prices are the rent paid to carry stocks within the warehouses. Inventory holding prices directly impact the Profit & Loss statement, whereas Inventory Carrying prices are rarely considered.

Also Read: What is Inventory Accounting? A Comprehensive Guide

Inventory Costs Meaning

The costs of inventory purchase, storage, and management are referred to as inventory costs. It comprises expenses such as ordering, carrying, and shortage / stock-out charges. Inventory is one of a company's or manufacturer's most valuable assets. They must manage it well, and it comes at a cost in terms of inventory maintenance, storage, replacement, and movement. All of these expenses are referred to as inventory costs.

Inventory Costs Types

The three basic categories of inventory-related costs are ordering, holding, and shortage costs. These categories serve to categorise the many various inventory costs that exist, and we will identify and describe some of the numerous sorts of expenses below.

1. Ordering Costs

Ordering costs embrace payroll taxes, advantages, the procurement department's wages, labour costs, etc. These costs area units are sometimes engulfed within the Associate in Nursing overhead price pool and assigned to the number of units created in each amount.

  • Transportation costs
  • Cost of finding suppliers and expediting orders
  • Receiving costs
  • Clerical costs of preparing to get orders
  • Cost of electronic info interchange

2. Inventory Holding Costs

The total cost of maintaining unsold inventory is known as inventory holding costs. Within a single supply chain, inventory holding costs are considered as part of the total inventory costs. Warehousing, insurance, labour, transportation, depreciation, inventory shrinkage, damaged or spoilt goods, obsolescence, and opportunity expenses are all expenditures that must be considered.

  • Inventory services costs
  • Inventory risk costs
  • Opportunity cost - money invested within Inventory
  • Storage space costs
  • Inventory funding costs

3. Shortage Costs

Shortage costs are the expenses experienced by a company when it does not have enough inventory on hand. These expenses include lost revenues from clients who go elsewhere to make purchases, lost margin on unfinished orders, and overnight shipping charges to acquire goods, not in stock. This is a crucial factor when selecting how much inventory to keep on hand, especially for businesses that compete on customer service.

  • Emergency shipments costs
  • Disrupted production costs
  • Customer loyalty and name

4. Spoilage Costs

If perishable goods are not sold quickly enough, they can decay or spoil; hence inventory control is critical to avoid spoilage. Many sectors are concerned about products that expire. The expiration and use-by dates of their products have an impact on businesses such as food and beverage, pharmaceutical, healthcare, and cosmetics.

5. Inventory Carrying Costs

This is a facet of inventory cost that is less well-known. To determine the magnitude of this cost's influence on your P&L statement, you'll need to do some math. The amount of interest a company loses on unsold stock sitting in warehouses is referred to as inventory carrying costs. When considering the impact of inventory on a business, business owners sometimes overlook the impact of the above aspects. The inventory holding expenses appear on the Profit & Loss statement as part of the rental charge. 

While inventory carrying costs are rarely considered when calculating gross profit, we normally only consider the principle cost of products stored in warehouses.

Inventory Carrying Costs Examples

Let's use the example of a commodities importer to understand better about inventory carrying costs. When he brings items into his country, they must first pass via a dock. Before they can be transferred to the firm warehouse, they must clear many customs departments. Let's imagine the products are held up in the customs clearance department due to discrepancies in the documentation. As everyone is aware, there are costs levied by the customs agency to keep items until they are processed, and these charges climb dramatically. The charges are also determined by the value of the items being kept and the amount of space required to hold them at the dock.

We may compare this by comparing the additional costs that a business owner must pay on items to the interest charges that a business owner must pay, which is a common but unseen circumstance. The dock may be likened to the interest income the business loses on the principal value of the products. At the same time, the customs department's fees can be compared to the interest income the business loses on the principal value of the items. The only distinction is that the interest a business loses on the stock is never considered when these customs department fines are applied.

Methods to Track Inventory Costs

Forecasting, purchasing decisions, customer relationships, and accounting are all affected by how inventory is tracked in the organisation. Depending on the sort of inventory and how it moves, businesses can use various strategies to track it. The methods listed below can be used to track inventory costs:

  • Manual inventory tracking: A card system is an outdated form of inventory management. It entails classifying products for storage based on their types and allocating cards to each group. These cards keep track of inventory and alert you when it's time to replenish. The required facts, including entry, exit, location, and time of the event, must be entered by a store representative.
  • Spreadsheets: In this manner, data is manually entered into spreadsheet software, similar to the method described above. Because it is prone to errors and omissions, this must be done with caution.
  • Inventory management systems: Businesses can use dedicated inventory tracking and management systems to combine accounting and payment procedures. They aid inventory management, demand forecasting, and report generation. Businesses can purchase inventory management systems online and customise them to meet their specific needs. Offline software or cloud-based solutions are also viable options.
  • Third-party providers: Inventory management can be outsourced to third-party logistics companies or 3PLs. Receiving, storing, shipping, and tracking merchandise are all aspects of inventory management. This saves organisations money on storage and gives them more time to focus on other things. However, there is a risk of losing inventory management and communication problems.

Also Read: Different Inventory Valuation Methods: What Are They?

Understanding Stock Categorization in Inventory Costs

All stock items must be classified into the four brackets listed below.

  • High worth – Fast Moving
  • High worth - Slow Moving
  • Low worth – Fast Moving
  • Low worth - Slow Moving

High worth – Fast Moving

You'll need to look at the sales trends for these things and figure out how much they sell on a daily basis. Based on this criterion, we should have stock in the warehouse equal to the lead time.

High worth - Slow Moving

Because such things have a high value despite selling infrequently, the inventory team can consider ordering them only when the consumer requests them. It is also vital to examine the clients' ordering patterns for this type of product.

Low worth – Fast Moving

Because the value of these stocks is minimal, keeping them in stock will not significantly increase costs. However, a wise method is to anticipate their lead time and per-day sales and keep at least as much stock as is needed until the lead time.

Low worth - Slow Moving

This is the category that causes the least damage to the business. Still, depending on the type of your firm, it may be the most important, as it can include spare parts for machinery or products that are unlikely to be available from any dealer.

Conclusion

Inventory costs are often a major part of your product price. You need to contemplate all variables to ascertain the Economic Order quantity to look out for the optimum inventory level.

Inventory management may be difficult, but it is essential to the supply chain. A decent inventory management system helps cut back stock-related costs like storage, carrying, and ordering costs. Tracking different types of inventory costs is also essential due to its need to calculate the value of products sold (COGS). COGS determines profits for a business that sells products, and it's used on each business form, whether or not the business could be sole ownership, partnership, LLC, or corporation.
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FAQs

Q: How does one manage the cost associated with inventory?

Ans:

  • Get the correct reorder purpose.
  • Make minimum order quantities work for you.
  • Avoid overstocking.
  • Get eliminate your deadstock.
  • Decrease provider interval.
  • Use inventory management code.

Q: What is the purpose of inventory, and what are its costs?

Ans:

These costs are connected to the amount of space needed to store inventory, the cost of the money needed to acquire inventory, and the risk of inventory obsolescence-related loss. The majority of these expenses are grouped together in an overhead cost pool and assigned to the number of units produced each month.

Q: What does an Inventory Unit Cost mean?

Ans:

A unit cost is a total cost incurred by a business to manufacture, store, and sell one unit of a product or service. The terms "unit costs" and "cost of goods sold" are interchangeable (COGS)

Q: What expenses are not included in the inventory costs?

Ans:

Abnormal expenses incurred due to material waste, labour or other production conversion inputs, storage costs (unless necessary as part of the manufacturing process), and all administrative overhead and selling costs are all excluded from inventory under IFRS and US GAAP.

Q: What does the inventory cost mean?

Ans:

Ordering, holding, and lack of prices compose the 3 main inventory costs categories. These groupings, broadly speaking, separate the numerous different inventory prices that exist.

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Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.