The Real Cost of Carrying Inventory

According to a recent study, on average, inventory represents approximately 15% of total firm assets for public U.S. firms. If you think the cost of your inventory is merely the amount you pay for the items, it won’t take long for you to discover the truth. Running an inventory-focused business means there are some hidden costs not everyone is aware of.  These can include the cost of the space used to warehouse the goods, the cost of insuring them, costs of periodically counting them, shrinkage, breakage, obsolesence, handling of the items, opportunity cost (what you could be earning with the money you have invested in inventory), etc. So, how do you really know the true cost of inventory?   

First, we need to address the elephant in the room – carrying cost. The use of this vague term is incredibly deceptive; it gives a false impression that the cost of holding inventory is one big sum and that little can be done about it. According to the IMS Business Academy, inventory carrying costs are expressed as a percentage of the average dollar value of inventory over a fixed period – usually a year. As a rule of thumb, inventory carrying cost is 25% of a company’s average inventory investment, but when you tally up all the relevant carrying costs, it can run as high as 40% or more. This is understandable, but it perpetuates the false impression that you have little power over the total – you do. Breaking down and identifying each separate cost percentage allows you the opportunity to rein-in those costs and allows you the opportunity to significantly impact your bottom-line – one single bite at a time.

Below are the four, broad categories of inventory carrying cost with descriptions and real-life examples to help you take control over your inventory:

• Capital Cost. Your company’s capital cost is what you spend on carrying inventory, and includes two factors: inventory financing charges and opportunity losses.   Arriving at your total inventory financing charges should be easy and straightforward – this is either the interest lost on the cash used to purchase inventory or the interest paid on a line-of-credit used to purchase inventory. Opportunity costs include both the opportunity missed because your money is invested in obsolete or under-performing inventory, and the opportunity missed for ALL money invested in inventory. Implementing an inventory management solution is a low cost and extremely effective method of identifying obsolete, overstocked or underperforming inventory.  
  

  Example: Maxim Integrated Products’ found that deploying an inventory management solution brought quick results. “Once we deployed an inventory solution in all eight stock rooms, and all 14,000 parts were labeled with barcodes, we discovered we were housing parts that we didn’t need to keep in inventory. As a result we sent those parts back to the vendors or to one of our other U.S. manufacturing sites, reducing the overall cost of our own inventory and freeing up a lot of cash and space,” said Javier Saenz, of Maxim Integrated Products. That freed-up cash can now be invested in a myriad of ways: research and development of new products, additional staff, or monetary investments like mutual funds or money market accounts.

Your capital cost should be the largest portion of your total carrying cost and should typically range between 6-12%.

• Inventory Service Cost. Service costs include insurance to cover your inventory and taxes paid to both local and federal government. Although the idea of purchasing insurance is not sexy, it is a decision that could make or break you. You need to evaluate the various, available premiums and the value of what you are insuring. Here are a few things to consider:

1. Do you want to cover your items at the depreciated value (actual cost value) or do you want to pay a higher premium that would cover full replacement cost?
2. What risks are you taking by purchasing cheaper coverage?
3. You should also evaluate the possibility of loss because of theft or natural causes. If there is likelihood your inventory is attractive to those with access and opportunity, or if your warehouse is geographically located in an area prone to natural disasters – then you need to pay the higher premium. Find other ways to cut costs.
4. Taxes are unavoidable. You do have the ability to decrease taxes levied by decreasing your total inventory. According to logistics expert, Martin Murray, many local authorities tax the level of inventory in the warehouse, so higher levels of inventory will lead to higher taxes paid. Taking the time to effectively manage stock level will have a definite impact on your tax rate. An inventory management solution provides all the necessary information needed to decrease unnecessary, duplicate stock.

Example: Pensacola Junior College’s Warrington Campus was able to significantly decrease stock after implementing an inventory solution. Instead of 5,000 pieces of inventory scattered around campus, the department slashed inventory by 65%, and now stocks just 1,750 items in two centralized supply rooms - for both dollar and time savings.

• Storage Space Cost. Storage space costs include all fees associated with renting or purchasing space to store your inventory: rent or mortgage, lighting, heating, air conditioning, janitorial services, equipment upkeep and all of the costs included in the handling of your inventory. Inventory needs a place to sit and it doesn’t put itself on a shelf. Whether you own the space or rent, you are still paying monthly to store your product. Your inventory also determines the space you need and whether you require specialized storage equipment. You will need to consider the cost to secure your facility. Security systems – low or high-end – cost money and many insurance policies require this securing of your inventory. According to Hurlbut & Associates, these expenses may also be made up primarily of wages and benefits, but may also include the depreciation or expense on hand-held radio frequency (RF) units, and other related equipment, as well as any miscellaneous expenses directly related to your inventory control team.
  

• Example: The Ambient Monitoring group eliminated tens of thousands of dollars in wasted time and significantly improved its inventory process by implementing an inventory management solution, including, up to $30,000 per year of time saved that was formerly used searching for parts, over $6,000 per year of time saved that was formerly consumed by managing and replenishing the stockroom and better use of inventory dollars. Now, the Ambient Monitoring group stores a broader variety of items and an ideal number of each part. Needed items are always on hand, eliminating delays in equipment repairs. Overstock has also been eliminated, ensuring that a wider and more effective mix of parts is always available.

  Your carrying cost for handling (including clerical tasks and cycle counting) will range between 3-8% and your carrying cost for warehousing and storage will range between 2-5% (9 Proven Tips to Control Your SMB Inventory).

  • Inventory Risk Cost. Holding inventory inherently comes with risk, and you need to acknowledge the potential cost. Product you carry, that has not yet been sold, is a gamble. If you carry inventory that quickly depreciates in value or quickly becomes obsolete, there is considerably more pressure to turn-over stock. If you’ve miscalculated the need for an item, and your turn-over is slower than expected, you could be carrying inventory that has lost a large percentage, or worse, all of its value. This inventory mismanagement significantly impacts your risk cost. The potential for inventory obsolescence is the greatest portion of your inventory risk cost with a range of 6-12% of your carrying cost. Included in your total risk cost is inventory shrinkage and damage. Inventory shrinkage is the loss of products between the point of manufacture or purchase from a supplier and the point of sale. The term shrink relates to the difference in the amount of margin or profit a retailer can obtain. If the amount of shrink is large, then profits go down. While most shrinkage is attribute to theft, other causes include administrative errors, vendor fraud or cashier and price check errors.

  According toThe Global Retail Theft Barometer, published by the Center for Retail Research, the estimated annual retail shrinkage in North America was at 1.58 percent in 2011, representing a dollar loss of $45 billion.

  Example: Orthopedic Solutions, a third-party consulting service, found their clients lost a significant amount of inventory specifically to inventory shrinkage. Clients had a hard time tracking inventory. Manual tracking was slow and increased the amount of errors in data, on top of that, inventory was misplaced or lost – they had a huge inventory shrinkage issue. After implementing an inventory management solution, Orthopedic Solution’s clients reported a 90% decrease in inventory shrink.

  Why worry about inventory management at all? The lack of proper management will result in a loss of revenue. Stocking items customers don’t want or having a shortage of the items they do want all lead to your inability to provide prompt, quality customer service.

  You will be at a significant disadvantage if your competitors are able to out-market or adopt emerging technology more quickly than you. Level the playing field by reclaiming the costs associated with poor inventory management and reinvest in your business.

Written by Brian Sutter of WASP Barcode Technologies.

About Wasp Barcode Technologies: Wasp Barcode Technologies headquartered in Plano, Texas, manufactures barcode software and solutions. Solutions include barcode scanners, barcode printers, inventory software, asset tracking, time and attendance systems, Point of Sale (POS) Systems and a range of barcode labels and barcode accessories.

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