Every product has a journey. And between the factory floor and a customer’s doorstep, that product spends time in a warehouse.
But warehouses aren’t free, and the cost of storing products adds up. Those are your inventory carrying costs.
Understanding and managing where this money goes isn’t just about saving money. It’s about unlocking several benefits — from optimized inventory levels and improved cash flow to smarter pricing strategies and data-driven decision-making. Here’s our guide to carrying costs and how to calculate the hidden expense in managing stock.
Essential components of inventory carrying costs
The cost of holding unsold goods extends far beyond what you paid to acquire them. Carrying costs include every expense made to store an item, starting when a product enters your warehouse and ending as it leaves.
Let’s break down the essential components that make up these costs.
Storage costs
Storage is a significant component of carrying costs. Storage costs include the rent for the warehouse, utilities such as electricity and heating, and maintenance expenses. Rent is usually a fixed cost, while the bill for utilities and maintenance will vary.
Capital costs
Capital costs refer to the money tied up in goods that you could invest elsewhere. Think of them as your opportunity cost, or money you missed the opportunity to spend elsewhere. Calculate them by multiplying the average inventory value by the annual interest rate.
Let’s say a company has an average inventory value of $100,000 and the interest rate (determined by the market) is 10%. The capital cost is $10,000.
Service costs
Service costs include the expenses related to managing inventory effectively. These include insurance, taxes, and administrative expenses. Insurance prices depend on the type of goods and stock levels but easily raise the service cost. Higher inventory levels make meeting customer demand easy but lead to higher insurance premiums and taxes, for example.
Risk costs
Risk costs are associated with the uncertainties of holding goods. These include inventory shrinkage (the loss of products due to factors other than sale), theft, and administrative errors. Plus, a product’s value could drop if it’s stored for too long and becomes obsolete, out of season, or off-trend.
An example of carrying costs
Let’s dissect these hidden costs with the example of a $10 T-shirt:
- Storage and facility expenses: Your warehouse isn’t free. A portion of the overhead costs related to your facility, including your rent, utilities (like electricity and heating), and maintenance, are allocated to each item in your inventory. For our T-shirt, this might add $0.50 to its cost each month.
- Property management fees: If you lease warehouse space, you may incur fees for property management services, including overseeing maintenance, handling lease agreements, and managing the overall property.
- Employee wages: Someone’s responsible for keeping your storage facility organized and clean, which means you might be paying extra for someone to move stock from shelf to shelf.
- Insurance and security: Protecting your assets from theft, damage, or natural disasters requires insurance. This crucial safeguard adds another layer to your carrying costs, perhaps $0.10 per month per T-shirt.
- The risk factor: Inventory isn’t risk-free. Shrinkage due to damage, obsolescence, or administrative errors can occur. A portion of these losses, like $0.10, is attributed to each individual item.
Our $10 T-shirt has an additional $0.80 per month in hidden costs, bringing its total cost to $10.80. This might seem insignificant, but multiply that by hundreds or thousands of items, and the impact on your profit margins is substantial.
Understanding these hidden costs empowers you to make strategic decisions about how you manage your storage. By optimizing storage space, negotiating better warehouse terms, implementing robust inventory management software, and accurately forecasting demand, you can minimize carrying costs and enhance your profitability.
The benefits of calculating inventory carrying costs
In business, every penny counts. But what if you could turn these expenses into an opportunity? By understanding and calculating these costs, you unlock a treasure trove of benefits that can transform your business operations and financial performance.
Improved cash flow management
By meticulously tracking and analyzing carrying costs, businesses can understand the financial resources tied up in raw materials or finished goods. This makes it easier to identify excess stock, enabling companies to liquidate slow-moving or obsolete items. The influx of cash can go to other areas, such as marketing initiatives, research and development, or debt reduction.
Optimized inventory levels
Calculating carrying costs is instrumental to maintaining optimal inventory levels. You need to strike a delicate balance between having enough goods to meet customer demand (and a little extra as safety stock) and avoiding the financial burden of overstocking.
By analyzing sales data and forecasting demand, businesses can tailor inventory levels to specific locations and product lines, ensuring that products are available in the right quantities at the right time. This approach not only minimizes carrying costs but also reduces the risk of stockouts, which can lead to lost sales and dissatisfied customers.
Enhanced pricing strategies
Knowing inventory carrying costs provides the foundation for informed pricing decisions. By factoring in storage, handling, insurance, and other carrying cost components, businesses can set prices that cover these expenses and ensure a healthy profit margin. This comprehensive approach to pricing enables companies to remain competitive in the market while optimizing profitability.
Increased profit margins
Identifying and reducing unnecessary carrying costs contributes to increased profit margins. Every dollar saved on storage, insurance, or risk prevention goes directly to the bottom line. For small businesses with limited resources, efficient inventory management can be the key to profitability and growth.
Informed decision-making
Knowledge of inventory carrying costs empowers businesses to make strategic decisions across operations. By understanding the financial implications of holding stock, companies can more accurately calculate inventory turnover ratios, negotiate better terms with suppliers, and even evaluate the cost-effectiveness of different storage solutions. This data-driven approach ensures that inventory management practices align with broader business goals, leading to improved efficiency, reduced risk, and increased profits.
How to calculate carrying costs
Figuring out your carrying costs might seem daunting, but it’s simpler and more important than you think. It’s like knowing the real price tag of owning a car — not just the vehicle’s selling price, but gas, insurance, and maintenance. Carrying costs show how much your inventory drains income beyond the upfront investment.
Here’s what you need to calculate them:
- Identify and quantify expenses: Begin by categorizing the different types of expenses related to inventory carrying costs. Collect data on each category, such as labor, opportunity, depreciation, and storage space costs.
- Sum up expenses: Sum up the expenses incurred within each cost category over a specific period, such as a month, quarter, or year.
- Determine the average inventory value: Calculate the average value of inventory held during the chosen period by adding the beginning inventory value to the ending inventory value, then dividing by two.
- Use the inventory carrying cost formula: Once you know your average inventory value, you can determine carrying cost as a percentage.
Here’s the inventory carrying cost formula:
Inventory Carrying Cost Percentage = (Total Inventory Carrying Costs / Average Inventory Value) × 100
Having carrying cost represented by a percentage shows you how much it takes to store your inventory for one year as a proportion of its value.
Carrying cost example calculation
Imagine a company that manufactures bicycles. They might keep an average inventory value of $80,000, with a cost breakdown like this:
- Capital costs: $9,000
- Storage costs: $2,000
- Service costs: $6,500
- Inventory risk costs: $2,500
First, add up these variables to get the sum of inventory carrying costs:
Total inventory carrying costs = Capital costs + Storage costs + Service costs + Inventory risk costs
In this case, the total cost is $20,000. Next, divide the inventory holding sum by the $80,000 annual inventory value and multiply the result by 100:
Inventory carrying cost percentage = (20,000/80,000) × 100 = 25%
The resulting 25% is the annual carrying cost. That means that for every $100 worth of inventory held throughout the year, the factory incurred $25 in holding expenses. This $25 includes both direct expenses (like warehouse rent and insurance) and the money the factory could have made by investing that $100 elsewhere (your capital or opportunity costs).
What carrying costs tell you
Knowing your carrying cost percentage is like having a financial compass for inventory management. It helps you:
- Benchmark: See how your spending compares to industry averages or your own past performance.
- Optimize: Pinpoint areas where you can cut costs. That might mean finding a more affordable warehouse or selling slow-moving items faster. Some ways to do that are by kitting items together, giving discounts, or offering incentives for those buying in bulk.
- Make informed decisions: Decide on profitable pricing, optimal inventory levels, and the best suppliers for the best rates.
Remember, the goal isn’t just to calculate your carrying costs but to use that information to make your business more efficient and profitable. And with tools like Fishbowl’s inventory management software, you can streamline this process and gain even deeper insights into your warehouse’s performance.
Ready to lower your carrying costs?
Take control of your inventory to lower holding costs with Fishbowl. Leverage our powerful management capabilities to reduce expenses, enhance operational efficiency, and increase profitability.
Plus, Fishbowl’s robust inventory management system integrates with QuickBooks, syncing your stock and financial information for greater visibility into your entire operation.
Schedule a demo to see how Fishbowl can transform your business.
