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The Total Cost of Inventory: Exploring Inventory Carrying Costs

For most retailers, wholesalers, and distributors, inventory is the largest single asset on their balance sheet. In many ways, your inventory defines who you are and your strategic position in the marketplace. Define your customer’s needs and their expectations of you. Legions of cost accountants are employed to accurately capture and capitalize all direct inventory costs. The cost of that inventory is the largest expense item on most income statements.

Most companies assess the productivity of their inventories through criteria such as inventory turns, gross margin return on investment, gross margin return per square foot, and the like. All of these are valuable tools for assessing inventory productivity, but all are limited by the fact that they use inventory at cost as the cost basis in their analysis.

The true cost of inventory extends well beyond inventory at cost or cost of goods sold. The cost of managing and holding inventory is a major expense in its own right, but the true cost of inventory doesn’t even stop there. The total cost of inventory, in fact, is buried deep within a series of expense items below the gross margin line, almost challenging any executive, manager, or cost accountant to extract, quantify, and manage.

Inventory carrying cost studies have estimated these costs to be approximately 25% per year as a percentage of average inventory for a typical business. While this information is interesting, it is not particularly useful. To manage the cost of holding an inventory, it must first be measured.

Generally recognized components of inventory carrying cost include inventory finance charges or the opportunity cost of inventory investment, inventory insurance and taxes, material handling expenses, and warehouse overhead not directly associated with picking and shipping customer orders, controlling inventory and cycle counting expenses, and reducing inventory, damage, and obsolescence.

Let’s take a closer look at each of these components to better understand how they can be measured and managed.

Inventory Finance Charges – This may seem easy to calculate, but measuring inventory finance charges accurately isn’t as simple as it might seem at first glance. For some businesses, working capital financing may be essentially inventory financing and little else, but for many others it may also be accounts receivable financing. In fact, the float between accounts payable and accounts receivable may also be partially financing inventory. For importers, this can be quite easy to quantify if they are opening letters of credit before their suppliers ship from abroad. In this case, the cost of the LC installation can be easily identified as the inventory finance charges. Finally, it is essential to be able to measure how much of the inventory is financed externally and how much is financed through internal cash flow. For that part that is financed with the cash flow, the opportunity costs of that investment must be measured.

Opportunity Costs – When thinking about the opportunity cost associated with investing in inventory, it’s easy to focus strictly on the opportunity cost of dead or underperforming inventory. In fact, the opportunity cost is related to the value of the total inventory. If this value were not invested in inventory, what return could be expected if it were invested in something else, such as Treasuries, mutual funds, or even a money market account?

Inventory Insurance and Taxes – These items should be fairly easy to quantify as a percentage of the average inventory value. And because both insurance and taxes are highly variable with inventory value, any reduction in average inventory value will directly drive savings to your bottom line, not to mention improved cash flow.

Material Handling Expenses – Measuring material handling expenses that aren’t directly associated with picking and shipping customer orders can be just as tricky. These expenses are comprised primarily of salaries and benefits, but also include lease payments or depreciation for material handling equipment, depreciation for automation, robotics, and systems, as well as miscellaneous expenses for supplies such as pallets, corrugated cardboard, UPC labeling materials, and Similar. .

General Warehouse Expenses: The quickest way to measure this is to divide the total expenses for rent, utilities, repairs and maintenance, and property taxes by the percentage of the building associated with processing customer orders, picking and shipping, and the part of the building associated with receiving and storing inventory. While that part associated with receiving and putting away may seem fixed, in fact, it quickly becomes much more variable when you consider what you might rent the space for as contract storage if your inventory wasn’t there.

Inventory Control and Cycle Counting: Expenses These may also be comprised primarily of salaries and benefits, but may also include depreciation or spending on portable radio frequency (RF) units and other related equipment, as well as any miscellaneous expenses directly related to your inventory control team.

Inventory reduction, damage and obsolescence – Capturing and measuring these costs seems to be quite simple at first glance. Shrinkage, damage, and obsolescence costs are the value of write-offs taken, or expressed in percentage terms, the value of those write-offs during a given time period divided by the average inventory over that period. This assumes, however, that all cancellations were made in a timely manner throughout the year. Were cycle counts performed on a regular basis? Was everything counted according to a schedule, was that schedule followed, and were the higher speed items counted more frequently? Were they terminated in a timely manner? Damaged and obsolete inventory written off in the current period allowed to accumulate during prior periods. Conversely, if the cancellations were deferred during the current period, resulting in a backlog of damaged and obsolete inventory that will have to be canceled in a future period. Experience has taught us that in some extreme cases, these cancellations are avoided for years!

To determine your inventory carrying cost, these components are accumulated on an annual basis and expressed as a percentage of your average annual inventory. Now you can see if the 25% annual maintenance cost estimate accurately reflects your business, or if your business has particular characteristics that result in a significantly different percentage.

Just as it’s not wise to assume that your carrying cost percentage will reflect a composite average of many companies, it’s also not wise to assume that every item in your inventory has the same carrying cost percentage. Certainly, transportation costs may differ within your company based on distribution center (if you have more than one distribution center), product line, category, subcategory, or even item. Freight costs may differ for high-volume, high-speed “A” items, slower-turning or complementary “B” items, or slow-turning “C” items. Large, bulky items can have a significantly different transportation cost than smaller items that take up much less space per dollar of inventory. Understanding the different carrying costs within your inventory helps you identify where the opportunities for the biggest savings might be.

Once the total costs of inventory have been measured and quantified, those costs can be assessed and managed. And what becomes immediately apparent is not just the cost of inventory that is essential to the business, but the cost of inventory that is non-essential, excess, dead, or underperforming, and what a financial drag this inventory is. for the company.

Reducing unnecessary inventory, whether by adjusting front-line stocks, essential inventory, or liquidating dead or underperforming inventory, has the benefit of freeing up capital for other uses and reducing costs directly variable with inventory levels, as well as helping you provides an opportunity to re-evaluate mixed and fixed costs to identify other potential cost savings. When you reduce inventory, you’re not only freeing up invested capital, but you’re also creating opportunities to reduce expenses, improve profitability, and actually increase cash flow!

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