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INVENTORY CARRYING COSTS

What is Inventory Carrying Cost and Why Your eCommerce Business Should Know?

If you are an eCommerce business owner, here are the top reasons you should know about Inventory carrying costs.

  • Inventory carrying costs help you to calculate “optimal” inventory levels.
  • It also helps to minimize such costs.
  • These costs help you to decide whether to reduce production or supply or to increase the same to increase revenues and profits.

One of the standard practices in managing the e-commerce supply chain is to determine and use Inventory carrying costs. As per a study, more than 78% of the respondents indicated that they calculate and use this metric. Then, more than 50% indicated that they use this metric to make inventory management decisions.

Likewise, as per a supply chain management software study, the inventory optimization and replenishment module was the most frequently used module. Such a module used Inventory carrying costs to estimate optimum inventory levels for each item. 

This showcases how important a metric carries a cost in any leading supply chain operation. Thus, it is important for businesses involving supply chain operations like e-commerce to calculate “optimal” inventory levels. And to calculate optimal inventory levels, businesses need to derive and apply an estimate of Inventory carrying costs.

Inventory is optimized when the least Inventory is on hand to meet

the desired service level. This means that the main objective of inventory management for supply chain operations like e-commerce should not be to reduce Inventory.

On the other hand, Inventory over the optimized inventory level is surplus Inventory. Such surplus inventory increases the costs related to maintenance, shrinkage, damage, insurance, and tracking.

Thus, e-commerce businesses, like any other supply chain operation, always have a trade-off between holding inventory costs and the impact on desired service levels. In other words, an e-commerce business must determine the amount it should invest in Inventory holding Cost to meet its desired service level?”

This article will discuss Inventory carrying costs, the types of carrying costs, and how to calculate Inventory carrying costs for an e-commerce business.

What is Inventory Carrying Cost?

Inventory Carrying Cost is also called Inventory Holding Cost. It is the Cost incurred in keeping an inventory of one product SKU. Inventory Carrying Cost considers investments involved in storing and holding unsold goods.

Such costs may be associated with inventory storage facilities such as material handling equipment and personnel, warehouse costs, inventory management systems, etc. It may also include costs associated with the risk of damage, loss, scrap, wear and tear, and obsolescence, along with the Cost of insuring against some of these risks. However, it does not include the costs of holding Inventory due to insurance, scrap, etc.

Inventory carrying Cost is the effective “interest rate” at which inventory costs are carried. It is the Cost that is incurred as a result of carrying Inventory. In short, Inventory Holding Costs or Inventory Carrying Costs include storage, handling, insurance, taxes, obsolescence, theft, and interest on funds financing the goods.

Note that all these charges increase with the increase in the level of Inventory. Thus, businesses frequently order small quantities to minimize Inventory carrying costs.

Types of Inventory Carrying Cost

Types of Inventory Carrying Costs 1

Since carrying Cost considers all the costs involved in storing and holding the unsold goods, it is a combined figure that includes the following expenses.

Operational Costs

1. Warehouse Storage 

This Cost includes the Cost of storing Inventory until it is finally sold. It may include rent of the warehouse space, operating, or financial lease amounts paid towards storing the Inventory within the warehouse. 

One of the major operating expenses of an e-commerce business is the rent, lease, and overheads for the properties the company rents. It must reduce this Cost by ceasing warehouses that are underutilized or unutilized.

This may also include the costs related to the stocking of Inventory. Such a cost depends upon the turnover of an e-commerce business. As the turnover increases, the stocking costs also increase.

2. Warehouse Labor 

Warehouse labor includes the Cost incurred on the full-time equivalents (FTEs) or personnel needed to count and maintain the Inventory. It may include labor costs in receiving, putting away, and issuing Inventory. 

Thus, the warehouse labor expenses primarily consist of employee compensation and employer payroll taxes. An e-commerce business may make efforts to reduce this administrative Cost by restructuring the workforce in all the warehouses.

3. Transportation Costs 

Transportation costs are incurred in moving Inventory from suppliers to the warehouse and handling any returns back to the suppliers. A business may typically estimate this Cost by allocating the total annual transportation cost to Inventory based on either dollar value or weight. This Cost applies to utilities as well as non-utilities.

For an e-commerce business, the transportation costs cover the inbound and outbound shipping costs, including the transportation service provider costs. Optimizing Inventory reduces the frequency of orders and the volume ordered. As a result, it reduces transportation costs. 

5. Property insurance 

Typically, businesses insure their stock inventory against any damage and loss covered under the company’s overall casualty and loss insurance. In certain cases, this Cost may be specifically identified in the policy. However, in most cases, the insurance cost for Inventory is not identified separately within the policy.

It is combined into the company’s overall property values. Thus, one may wonder why reducing Inventory alone would not reduce the company’s overall property values. That’s because, in such cases, the insurance premiums may be tied to broad property value ranges. As a result, one may think that optimizing Inventory may not lead to actual cash savings. 

However, if multiple property items are taken together, they would lower the overall property values. As a result, such a reduction in property values may be sufficient to impact the insurance premium costs.

6. Commodity Devaluation

This refers to the loss in value of Inventory on hand due to its reduced market value. Commodity devaluation is the largest component of Inventory carrying costs in the case of some industries.

Inventory items not sold over time become worthless in the marketplace. Such a loss is added to the Cost of holding the unsold Inventory. Typically a business may calculate commodity devaluation costs by determining any difference between current and historical unit prices.

Such a difference can be positive or negative. These changes can have an impact on the value of Inventory. And it would depend upon the nature of the business.

7. Inventory Damage

There is an increased probability that the stored Inventory may be subject to damage in the warehouse due to wear and tear. For instance, there are increased chances that the inventory items are dropped or are damaged in accidents like fire. Thus, idle Inventory in the warehouse is subject to such potential risks. 

An e-commerce business must determine the Cost of such potential risks. Typically, businesses determine the inventory damage cost by measuring the damage and repair costs over the past year.

8. Obsolescence

Another major component of Inventory carrying Cost can be the Cost of obsolescence. An inventory item becomes obsolete when it can no longer be used productively within the company. Typically, an e-commerce business’s Inventory may become obsolete due to improper storage in the warehouse. 

This Cost can be a major contributor to the Inventory carrying Cost of an e-commerce business. An e-commerce business must include the Cost of obsolete Inventory in the total Inventory carrying Cost since any acquired inventory risks becoming obsolete at some point.

Typically, businesses determine this Cost by reviewing their inventory write-off values for

a particular year or range of years. Such analysis can also be performed on different commodities. As a result of such analysis, the business can apply different obsolescence rates to actual inventory values for each commodity category.

9. Shrinkage Adjustments

Shrinkage refers to the losses a business may incur due to pilferage of Inventory or other “unexplained” discrepancies in the physical inventory count. Businesses typically rely on inventory count records and adjustments to calculate such costs. 

Such costs represent a small portion of the company’s total Inventory holding costs but must be included in the overall holding costs to arrive at an accurate figure.

10. Inventory Management Fees

Another component of Inventory carrying costs includes the inventory management fees that the company pays to third parties. These may be related to Vendor Management Inventory (VMI) or other arrangements wherein the suppliers hold or manage Inventory on behalf of the company. 

The number of such costs may depend upon the degree to which a business depends on third-party services. E-commerce stores practicing the dropshipping model do not bear such costs. In fact, in such a business model, the inventories of the third-party suppliers are managed by the suppliers themselves. And costs about the inventory management fees are also borne by the third-party sellers themselves.

2. Property Taxes

Inventory is a physical asset on a business’s balance sheet. As a result, it may be subject to local or state property tax. If this is the case, a business must try to optimize Inventory. 

Note that a dollar inventory decrease may decrease a business’s property taxes. Many businesses do not have to pay state or local property taxes on their Inventory. In such cases, the property tax on Inventory should be excluded from calculating Inventory carrying costs.

3. Opportunity Cost

Investing funds in Inventory means working capital gets tied up in Inventory. However, if a business optimizes Inventory by eliminating surplus items, it frees up capital that can be used elsewhere. 

This ​​may improve the company’s productive use of assets and overall profitability. A business may calculate the opportunity cost by considering the Average Weighted Cost of Capital. Such a cost is financing an asset on a balance sheet using either equity, debt, or a combination of both.

Inventory Carrying Cost Formula

The simple Inventory carrying cost formula considers all the following annual expenses into consideration:

  • Cost of carrying Inventory
  • Inventory insurance costs
  • Inventory storage costs
  • Costs to track Inventory
  • Opportunity cost
  • Taxes on Inventory
  • Inventory damage, obsolescence, shrinkage, pilferage costs
  • Transportation costs
  • Warehouse labor costs

Thus, the total carrying cost formula is:

Total Carrying Costs = Storage Costs + Employee Salaries + Other Operational Costs + Inventory Taxes and Other Ramifications + Opportunity Costs + Depreciation Costs

The total annual Inventory carrying Cost is apportioned among each product SKU by dividing the Annual Inventory Holding Cost by the total annual inventory value.

Accordingly, the Inventory carrying cost formula is:

Inventory Carrying Cost (per SKU) = Total Annual Inventory Carrying Cost/Total Value of Annual Inventory

The percentage of Inventory carrying cost formula is:

Inventory Carrying Cost (in %) = (Total Annual Inventory Carrying Cost/Total Value of Annual Inventory)*100

Carrying Cost Example

Say ‘Zapin’ is an online store that sells consumer electronics. It incurs the following expenses in storing its Inventory:

  • The annual average Cost of Inventory: $ 2,000,000
  • Warehousing labor costs: $ 50,000
  • Opportunity costs: $ 25,000
  • Capital costs: $ 15,000
  • Inventory storage costs: $ 65,000
  • Taxes on Inventory: $ 35,000
  • Inventory damage costs: $ 10,000

Total Annual Carrying Cost of ‘Zapin’ = Warehousing labor costs + Opportunity costs + Capital costs + Inventory storage costs + Inventory damage costs + Taxes on Inventory

Total Annual Carrying Cost of ‘Zapin’ = $ 50,000 +  $ 25,000 + $ 15,000 + $ 65,000 + $ 35,000 + $ 10,000

Total Annual Carrying Cost of ‘Zapin’ = $ 200,000

Carrying Cost per SKU = Total Annual Carrying Cost/Annual Cost of Inventory

Carrying Cost (per SKU) = $ 200,000/$ 2,000,000 = $0.1 per SKU

Carrying Cost (in %) = (Total Annual Carrying Cost/Annual Cost of Inventory)*100

Carrying Cost (in %) =  ($ 200,000/$ 2,000,000)*100 = 10%

Inventory Carrying Cost Calculation Excel

Consider the example above to understand the Investnory Carrying Cost calculation in Excel.

Table 1 below showcases all the carrying cost expenses of ‘Zapin’ in Column A. A31 showcases the annual average Cost of Inventory, A32 warehousing labor costs, A33 opportunity costs, A34  capital costs, A35 inventory storage costs, A36 taxes on Inventory, and A37 inventory damage costs.

Whereas B31, B32, B33, B34, B35, B36, and B37 showcase the respective amounts of the above costs.

Then, the second table below showcases the calculation of total carrying costs for ‘Zapin’ in dollars, SKUs, and percentages.

  A B
30
Annual Inventory Costs for ‘Zapin’
Amount ($)
31
The annual average Cost of Inventory
$2,000,000
32
Warehousing labor costs
$50,000
33
Opportunity costs
$25,000
34
Capital costs
$15,000
35
Inventory storage costs
$65,000
36
Taxes on Inventory
$35,000
37
Inventory damage costs
$10,000

As we can see in the table below, cell E31 showcases the total Inventory carrying cost formula. At the same time, cell E32 showcases the calculation of the total carrying Cost in dollars. The formula used in cell E32 is =SUM(B32:B37). B32:B37 represents the rows in Table 1. This showcases each of the carrying cost expenses of ‘Zapin.’

Then, cell E33 in Table 2 showcases the calculation of Inventory carrying Cost for ‘Zapin’ in dollars per SKU. The Excel formula for Carrying Cost (Per SKU in $) is =E32/B31. This is the total carrying costs calculated in cell E32 divided by the average carrying cost depicted in cell B31 in Table 1.

Finally, cell E34 showcases the calculation for Carrying Cost (in %) for ‘Zapin.’ The Excel formula for Carrying Cost (in %) is =(E32/B31)*100. This is the total carrying costs calculated in cell E32 divided by the average carrying cost depicted in cell B31 in Table 1. Then, the resulting figure is multiplied by 100 to calculate the percentage figure.

  D E
30 Total Carrying Cost Of ‘Zapin’  
31
Total Carrying Cost Formula
Capital Costs + Warehousing Costs + Inventory Costs + Opportunity Costs
32
Total Carrying Costs
$200,000
33
Carrying Cost (Per SKU in $)
0.1
34
Carrying Cost (in %)
10

What is the Carrying Cost and Ordering Cost?

As mentioned earlier, the Inventory carrying Cost is the Cost associated with holding or carrying the Inventory in proper conditions. Such costs may include warehousing, security, insurance, interest, pilferage, obsolescence, etc.

On the other hand, the ordering cost refers to the Cost incurred in placing and receiving the order for the Inventory. It includes the Cost of receivers who take in material, the costs of setting up suppliers, the Cost of material planners and buyers, and any other cost associated with placing orders. The orders are either placed with the factory or third-party suppliers. 

Thus, the ordering costs are the costs that are related to placing an order. Such costs may include expenses of personnel in a purchasing department, communications, and the handling of related paperwork. Unlike the carrying costs typically represented in percentages, ordering costs are typically expressed as a monetary value per order.

Furthermore, the ordering costs vary depending upon the number of orders placed with third-party suppliers or from internal setups.

The following table summarizes the difference between inventory ordering costs and holding costs.

Attribute Ordering Cost Holding Cost
Definition Ordering costs are the costs of placing an order with the suppliers. In other words, it is the Cost of purchasing and receiving an order. The Inventory holding Cost refers to storing and maintaining the Inventory.
Examples Cost of finding suppliers, preparing purchase orders, inspection, and transportation costs. Warehouse labor, storage, pilferage, shrinkage, insurance, taxes on Inventory, capital costs
Formula Fixed Ordering Cost per Order * Number of Orders per Year (Total Annual Carrying Cost/Annual Cost of Inventory)*100
Unit of Expression It is expressed in monetary value per order.  It is expressed in percentage.
Factors Influencing Cost The ordering costs depend upon the number of orders placed. This means the ordering cost increases with the number of orders. The holding cost of Inventory depends upon the demand for Inventory. This means the holding cost increases with the increase in demand for Inventory.

Why is the Calculation of Inventory Carrying Cost Important?

It is important for a business to calculate Inventory carrying costs for the following reasons:

  • When represented in the form of a percentage,  the Inventory carrying Cost helps a business to know what percentage of its total inventory cost is the holding Cost. Such a number helps business owners determine the amount of money they can earn considering the given inventory level.
  • The total carrying cost of a business demonstrates the amount of money that a business is spending on Inventory. Such an estimate will help business owners control inventory costs in case it is unnecessarily spending money on holding Inventory. 
  • Also, some leading materials management practices use Inventory carrying costs for various purposes. These include determining lot sizes and order quantities, performing price break analysis, making make-to-order vs. make-to-stock decisions, etc.
  • Besides this, Inventory holding costs help a business decide whether to reduce production or supply or to increase the same to increase revenues and profits.
  • Calculation of inventory holding costs helps a business to know whether the level of Inventory that it is holding is optimal or not. 
  • An increase in inventory holding costs indicates that if such costs are overlooked, it may lead to reduced profits and increased losses.

How to Reduce Inventory Carrying Cost?

As mentioned earlier, increasing Inventory holding costs y may be alarming for a business. That may lead to working capital tied up in Inventory that can be used elsewhere. Increasing holding costs may also result in losses. Thus, it is important to reduce Inventory Carrying Costs. Reducing Inventory Holding Cost does not mean bringing it down to zero. This is not feasible as this would mean the cessation of business altogether.

The ideal situation is to find an optimal level of Inventory where there is a trade-off between the Cost of holding Inventory and the impact on desired service levels. But how can an e-commerce business like yours achieve this?

Well, here are some ways in which a business can reduce its total Inventory carrying Cost.

1. Use An Inventory Management Software

An inventory management software automates the process of managing and controlling Inventory. It helps a business save time wasted in doing everything manually, from tracking Inventory to forecasting demand.

Effective inventory management software helps a business determine the optimal inventory level to maintain without running out of stock. Unlike manual calculations, demand forecasts are accurate with extremely high chances of error. Further, such inventory levels ensure that the holding costs are low.

Also, effective inventory management software makes the order fulfillment process seamless. An efficient order fulfillment means shorter lead times, an increase in perfect order percentage, an increase in inventory turnover ratio, and a decrease in Inventory carrying Cost.

Besides, an e-commerce business can customize the inventory management software based on the number of SKUs a business can handle. Thus, a business can keep track of each SKU and determine the performance of each of the SKUs. 

As a result, an e-commerce business can get rid of non-performing products. Likewise, it can increase the supply of performing products to generate higher revenues and earn greater profits. 

2. Enter Into Long-Term Contracts With Suppliers

An e-commerce business must also consider finding suppliers with whom they can deal for longer. Such a long-term commitment will help the minimum amount of a product a customer must order for the business to be willing to fulfill the order. MOQ, sometimes called minimum order size, can be measured in units or dollars. Whichever best helps the business achieve its target gross profit margin.

Businesses that operate in an online marketplace or manufacturing markets are the most likely to use MOQ. This allows them to avoid receiving low-value orders and ensure they recoup their Inventory carrying costs.

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