The Total Cost of Inventory: Exploring Inventory Carrying Costs
For most retailers, wholesalers, and distributors, inventory is the single largest asset on their balance sheet. In many ways, your inventory defines who you are and your strategic position in the market. 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 turnover, gross margin return on investment, gross margin return per square foot, and the like. These are all valuable tools for evaluating inventory productivity, but they are all limited by the fact that they use inventory at cost as the cost basis in their analysis.
The true cost of inventory extends far beyond inventory to cost or cost of goods sold. The cost of managing and holding inventory is a significant 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 in a number of expense items below the gross margin line, almost defying any cost executive, manager, or accountant to extract, quantify, and manage them.
Inventory carrying cost studies have estimated these costs to be approximately 25% per year as a percentage of the average inventory for a typical business. While this information is interesting, it is not particularly useful. To manage the cost of holding an inventory, you must first measure it.
Generally recognized components of inventory carrying cost include inventory finance charges or the opportunity cost of investing in inventory, inventory insurance and taxes, material handling charges, and warehouse overhead not directly associated with picking and shipping customer orders, inventory control and cycle counting expenses, and inventory reduction, 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 sound easy to calculate, but measuring inventory finance charges accurately is not as simple as it might seem at first glance. For some businesses, working capital financing can be essentially inventory financing and little else, but for many others it can 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 fairly straightforward to quantify if they are opening letters of credit before their suppliers ship from overseas. In this case, the cost of LC installation can be easily identified as inventory finance charges. Finally, it is critical 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 by 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 narrowly 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 security 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 straightforward to quantify as a percentage of average inventory value. And because both insurance and taxes are highly variable with the value of inventory, any reduction in average inventory value will lead to savings directly on the bottom line, not to mention improved cash flow.
Material handling expenses – Measuring material handling expenses that are not directly associated with picking and shipping customer orders can be just as complicated. These expenses are primarily made up of salaries and benefits, but also include lease payments or depreciation on material handling equipment, depreciation on 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 your 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 portion of the building associated with receiving and storing inventory. While that part associated with receiving and warehousing 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 expense 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 appears to be fairly straightforward 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 during that period. This assumes, however, that all cancellations were made in a timely manner throughout the year. Were cycle counts done 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 it to accumulate during previous periods. Conversely, if the write-offs were deferred during the current period, resulting in an accumulation of damaged and obsolete inventory that will have to be written off 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 annual average inventory. Now you can see if the 25% annual maintenance cost estimate accurately reflects your business or if your business has unique characteristics that result in a significantly different percentage.
Just as it is not wise to assume that your carrying cost percentage will reflect a composite average of many companies, it is also not appropriate to assume that every item in your inventory has the same carrying cost percentage. Certainly, transportation costs can differ within your company based on distribution center (if you have more than one distribution center), product line, category, subcategory, or even item. Transportation costs may differ for high-volume, high-speed “A” items, slower-turning or supplemental “B” items, or slow-turning “C” items. Large, bulky items can cost significantly different to carry 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 greatest savings might lie.
Once the total inventory costs have been measured and quantified, those costs can be evaluated 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, overstocked, dead, or underperforming, and what a financial drag this inventory is. for the company.
Reducing unnecessary inventory, whether by adjusting front-line stock, 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, and also gives 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, you’re also creating opportunities to reduce expenses, improve profitability, and actually increase cash flow!