You want your company to be as profitable as possible. But sneaky overhead expenses and hidden costs might be stopping you from achieving your financial goals.
One place you might be underestimating spending is your inventory costs, which quickly erode profit margins if you aren’t careful.
In this article, we’ll break down the different types of inventory costs, show you how to calculate them, and explore how they impact your bottom line. Keep reading to discover strategies for managing inventory costs more efficiently, or jump to the bottom to learn how Fishbowl can help you take control of your spending today.
Inventory costs: An overview
Inventory costs are more than just the cost of goods you manufacture or purchase — they encompass all the expenses related to storing, handling, and managing your inventory.
Understanding your inventory costs is vital because they play a massive role in your company’s profitability. When you know the full extent of these costs, you can make more informed decisions about operations, pricing, and financial strategies.
Types of inventory costs
There are several different kinds of inventory costs. Let’s explore six of the most common.
1. Purchase costs
Purchase costs are the sum of the prices of the raw materials and finished goods you purchase in an order. For example, if you buy 300 units of a product at $10 each, your purchase cost would be $3,000.
2. Ordering costs
Ordering costs are the expenses you incur every time you order inventory. This includes shipping and handling charges as well as any order processing costs, like what you pay for the software you use to create purchase orders. These costs can add up quickly, especially if you frequently reorder in small quantities.
3. Carrying costs
Carrying costs, or holding costs, are the costs of keeping inventory in storage. You can divide your carrying costs into two categories: storage costs and capital costs.
Storage costs are the expenses associated with physically maintaining your stored inventory. This includes warehouse payments (including rent or mortgage payments, utilities, and packing materials), warehouse employee pay, taxes, insurance, security systems, and essential maintenance.
Capital costs refer to the financial impact of holding inventory. This includes depreciation — how much value your inventory loses while in storage — and the opportunity cost of tying up capital in stored inventory when it could be invested elsewhere.
Some companies separate storage and capital costs to better track and manage each expense category. However, you can combine them into one category — carrying costs — if that suits your company better. Regardless of how you track them, you want to keep these costs as low as possible to optimize profitability.
4. Stockout costs
Stockout costs arise when you can’t meet customer demand because you run out of inventory. This includes lost sales and backorder costs — for example, you may need to pay extra for expedited shipping to replenish your stock quickly and fill orders.
5. Shrinkage costs
Shrinkage costs occur when the amount of usable or sellable inventory decreases. Unfortunately, it’s not uncommon for inventory items to spoil, become damaged, or get stolen.
A related cost to watch out for is obsolescence, which happens when inventory loses value because it’s outdated. Usually, obsolescence occurs due to seasonal changes, shifting trends, or technological advancements.
Shrinkage includes the cost of discarding and replacing these damaged or obsolete goods. You can also incur shrinkage costs if your inventory records are wrong: When your actual inventory in stock doesn’t match what’s recorded, it’s hard to tell the actual value of your inventory. Your updated and accurate records might have a lower value than what you thought.
6. Landed costs
Landed costs, also known as the true cost, are the total cost of getting inventory from the supplier to your warehouse. This includes the purchase price, shipping fees, taxes and customs duties, operating expenses, and the cost of risk management (insurance, quality checks, compliance costs, and so forth). Landed costs can quickly add up, especially if you source products internationally.
How to calculate inventory costs
To calculate inventory costs, add up all the expenses associated with acquiring, storing, and managing your inventory. The most common expenses are purchase, ordering, and carrying costs, so always factor those into the equation. Here’s the essential formula for calculating inventory cost:
Inventory cost = Purchase costs + Ordering costs + Carrying costs
If you need to account for stockouts, inventory shrinkage, and landed costs, include those in your calculation, too.
It’s crucial to avoid double-counting any expenses. For example, ordering and landed costs both include shipping and handling fees. When calculating your inventory cost, ensure each expense is only included once to get an accurate total.
The inventory cost formula that adds these expenses together would look like this:
Inventory cost = Purchase costs + Ordering costs + Carrying costs + Stockout costs + Shrinkage costs + Landed costs
Inventory cost calculation example
Here’s an example of the inventory cost formula in action to help you understand how it works:
Let’s say you manage inventory for a retail store. You buy 500 units of a product at $20 each, so your purchase cost is $10,000. Each order costs $300 to process and ship, and you place 5 orders in a period. That means your ordering cost is $1,500. Finally, your carrying cost amounts to $2,000. You don’t have any stockouts, shrinkage, or landed costs to worry about for this period, so you can use the simple version of the inventory cost formula.
Inventory cost = $10,000 + $1,500 + $2,000
Inventory cost = $13,500
How to reduce inventory costs
Reducing inventory costs improves your bottom line and enhances efficiency. Here are five tips that can help you cut inventory costs.
1. Find your ideal economic order quantity (EOQ)
Ordering and carrying costs add up quickly, especially if you need to frequently reorder stock. To reduce these costs, find your EOQ — the optimal number of units to purchase per order.
The EOQ minimizes your total inventory cost by balancing ordering costs with carrying costs. Ordering too frequently increases ordering costs, since there are more order processing and shipping and handling fees. On the other hand, ordering too much inventory at once leads to higher carrying costs, since you store larger quantities of inventory.
Finding your EOQ allows you to optimize your order size to reduce both types of costs. Plus, you may be able to pair your EOQ with bulk purchasing strategies that further reduce your ordering costs.
2. Automate your inventory management
Managing inventory efficiently is easier with automation. Using technology like barcode scanners and real-time reporting, you can streamline inventory tracking and reduce human error. You can also automate your inventory replenishment system — when you’re low on essential stock, software will automatically generate and place orders to restock. This prevents both stockout costs and overstocks.
Another way to reduce stockout costs is dropshipping or transfer orders, since these can fulfill an order by sending the item that’s short.
3. Use inventory forecasting tools
Accurate inventory forecasting predicts future demand based on historical data, seasonal trends, and market conditions. By leveraging forecasting tools and software, you can make more informed decisions about inventory levels and order quantities. Over time, this leads to better inventory management. You’ll be less likely to lose inventory items to damage, spoilage, and obsolescence, reducing your shrinkage costs.
4. Strengthen your supplier relationships
Building strong relationships with suppliers can help you negotiate better prices to lower purchasing costs. Suppliers may offer discounts for bulk purchases or improved payment terms if you have a reliable, mutually beneficial history with them.
Some suppliers may also be open to renegotiating your shipping agreements to reduce your ordering and landed costs. For example, if you settle on a delivered duty paid (DDP) shipping agreement, the supplier would cover all costs associated with shipping, including customs duties and taxes. This would reduce your landed costs tremendously if you frequently order from overseas suppliers.
5. Cut down on storage costs
As a rule of thumb, you don’t want to spend any more than you have to when it comes to storing inventory. To reduce these costs, consider whether it’s possible to use a smaller warehouse or rent space in a storage facility instead of paying for the whole building. Smaller warehouses are generally less expensive, and you want to make sure you’re getting full use of every square foot.
And, if your business is growing and you need to house more inventory, consider optimizing your warehouse layout before deciding to expand to multiple warehouses.
Manage your inventory costs more effectively with Fishbowl
Does it seem like your inventory costs are out of control? Fishbowl has solutions.
Fishbowl’s powerful software helps you track, monitor, and find ways to reduce inventory expenses, whether it’s calculating your EOQ or optimal reorder points. Real-time updates about stock levels alert you when inventory is getting low, and automated purchase orders save you the stress of finding the right suppliers to reach out to. Fishbowl assigns a default vendor and reorder level to each part, generate the purchase order, and send it out for you.
Plus, seamless integration with QuickBooks syncs your financial data so you can always keep an eye on the financial big picture.
Discover how Fishbowl can help you reach peak operational efficiency and profitability by booking a demo today.