Inventory costs typically account for 15-30 of the total inventory value of a business
For a selling entity, inventory represents a non-current asset that must be converted into cash through sales. How effectively a business manages this process will have a direct impact on its profitability.
Inventory cost is an accounting term, also known as carrying cost and inventory carrying cost, which is the cost paid by a business to hold inventory. This includes costs related to warehousing, payroll, transportation and handling, taxes, insurance, and depreciation, inventory shrinkage, and opportunity costs. Even the cost of capital, which helps generate revenue for a business, is a cost of ownership.
Through an efficient inventory management process, companies can control inventory costs to about 15% of total inventory, thereby maximizing profits. However, if inventory is poorly controlled, inventory costs can reach or exceed 30% of total inventory, negatively impacting profitability.
1. Cost of capital:This is the highest percentage of expenses in the four categories. The cost of capital is the expense required to purchase raw materials or inventory items, including any associated financing charges, loan maintenance charges, and interest.
2. Inventory service cost:This is not directly related to inventory items, but it is necessary to store them in warehouses or warehousing. These costs include insurance premiums, taxes, hardware investment, and warehouse management software (WMS) fees. 3. Inventory risk cost:Inventory risk refers to the risk that stored items may become unsellable and converted into liquid assets before they are sold. This risk often comes from shrinking inventories and obsolescence. Shrinkage refers to the loss of saleable products due to damage, theft, or recording errors. Obsolescence refers to the loss of a saleable product due to the product being expired or withdrawn from the market.
4. Cost of inventory storage space:Storage space costs include the expenses required to manage the warehouse, including leasing or purchasing warehouse space, climate control and utility fees, physical security, and handling fees to move items in and out of the warehouse.
5. Labor costs: It's just the labor costs associated with receiving and storing products, fulfilling orders, and other touchpoints.
6. Opportunity cost:If overspent on inventory, this takes away money that could otherwise be spent on marketing, new hires, real estate, and other investments that are more valuable than items that sit on shelves.
1. Inventory cost guides business decision-makingInventory costs occupy an important chain (the four core elements of chain management) expenditure, and directly affect the cost of sales, which in turn directly affects profitability. With a more accurate understanding of the cost of holding inventory, business leaders can make more informed decisions about optimal inventory levels, reorder points, and when to fill orders rather than stocking them. 2. Long-term inventory planningBy monitoring inventory costs over time, organizations can also gain insights for long-term inventory planning. For example, can using a third-party logistics service provider (3PL) reduce inventory costs?Are sales sufficient to support holding certain short-lived products?When will it be rolled out to avoid inventory reversals?
To calculate the cost of inventory, divide your total inventory holdings by the total value of your inventory and multiply by 100 to get a percentage of the total inventory value.
Inventory carrying cost is the sum of the four components described earlier:
Inventory carrying cost = capital cost + service cost + risk cost + storage space cost + labor cost + opportunity cost
The total inventory value is the total amount of inventory cost multiplied by available inventory:
Total Inventory Value = (Inventory Cost Inventory of Available Items).
It is important to note that the total inventory value discussed here is only used to calculate internal costs and does not represent the market value of the inventory. By combining the above formulas, it is possible to calculate the cost of inventory as a percentage of the total inventory value.
Inventory carrying cost ratio = inventory carrying cost Total inventory value 100
The holding cost formula can be used to calculate annual carrying costs, quarterly carrying costs, or smaller increments of your choosing. It's a good idea to do an annual inventory carrying cost calculation and do incremental calculations at intervals that align with your sales cycle.
For example, the cost of SmartWMS is as follows:
Ice cream inventory carrying costs:
Cost of Capital:The purchase of dairy raw materials and related costs totaled $10,000.
Cost of service:$3,000 was spent on insurance, financing and warehouse management software for refrigeration equipment.
Cost of Risk:$1,000 for the risk of ice cream spoiling or melting.
Storage space cost:The cost of renting space and keeping the ice cream frozen is $4,000.
Labor Costs:Labor cost 2000 USD.
Inventory cost = capital cost + service cost + risk cost + storage space cost + labor cost
= $20,000
Let's assume that the total value of the ice cream inventory is $100,000.
Inventory Carry Cost Ratio = $20,000 100,000 x 100 = 20%.
Based on this calculation, we can see that the inventory cost of the ice cream merchant accounts for 20% of the inventory value, which is a decent inventory cost level. In order to achieve such low inventory costs, ice cream merchants must have proper inventory control, minimizing depreciation and product write-offs.
1. Safety stock
Stocking only enough product to meet anticipated demand can be a risky task. That's why most companies stock up on some safety stock, i.e., extra stock, in case of unavoidable events, such as a surge in demand, unexpected merchant delays, or damage to goods. It's usually a good idea to have safety stock for popular items, but be cautious as too much safety stock can lead to unnecessarily high carrying costs.
2. Cyclical or seasonal demand
Some businesses, especially retailers, only realize most of their annual revenue in a matter of months, which makes retail inventory management even more important. E-tailers are likely to see a surge in orders in the months leading up to the winter holidays, while inflatable swim toy manufacturers are likely to do most of their business in the spring and early summer. To prepare for this critical period, these companies are likely to build up a large inventory reserve before the start of the busy season.
3. Cycle inventory
After formulating the sale**, the company buys the cycle inventory. This is the inventory required to meet the expected demand for a variety of products;It's not meant to deal with unexpected situations, such as safety stock. Every product-based business must have a cycle inventory or operational inventory to meet customer demand and generate sales. Accurate** and cycle counts are critical to storing the correct amount of cycle inventory.
4. In-transit inventory
In-transit inventory refers to products that a company has purchased but has not yet received. Depending on the merchant's location and product type, lead times can be up to several months, so inventory can be in transit for a long time. Businesses need to consider these in-transit goods when planning future purchases – however, it's easy to overlook them as they haven't made it to the warehouse yet. This is especially true if you don't use a warehouse management system that displays the status of all purchase orders.
5. Abandoned inventory
"Obsolete inventory" is another way of saying obsolete inventory. These are goods that the company no longer considers capable of selling and are often treated as losses for scrapping. Abandoned inventory can be stuck in distribution centers or warehouses, quietly but continuously raising inventory carrying costs without leadership even realizing it.
If left unchecked, businesses may end up facing exorbitant inventory costs, tying down their cash flow. While it's important to have enough inventory to meet market demand, the following reasons can lead to excessive inventory carrying costs:
1. Improper inventory management:
This can include failure to organize and optimize inventory levels or poor warehouse design, resulting in misplaced items and damaged or wasted space. Just like organizations that use Excel or other traditional methods, those that don't have a detailed inventory management strategy over-order to protect themselves. Without a solution that lists reorder points based on lead times and current demand, and provides real-time visibility down to the SKU level, this is inevitable.
Similarly, inefficient fulfillment methods increase labor costs, while poor warehouse design or storage technology can increase storage costs and make it easier to overlook on-hand inventory. This results in obsolete inventory, depreciation, and higher insurance, tax, and administrative costs.
2. Holding too much inventory and low inventory turnover:
Inventory turnover (what is inventory turnover) is a key metric that shows how many products are sold in a yearfrequency. This ratio informs the purchase decision. Low turnover rates for too many products can lead to high inventory carrying costs for organizations and ultimately lead to inventory obsolescence. This results in a stuffed warehouse full of inventory that is neither as fast-moving nor as valuable as it used to be. 3. Inaccurate sales**:
Sales** aren't always 100% accurate. However, if a business makes mistakes too often, it can lead to a lot of unrealized revenue and increased carrying costs. Overestimating sales can lead to renting large storage space or placing large orders that are difficult to sell. Poor inventory demand** is a common driver of high carrying costs. If a company uses flawed data to create**, it may expect a surge in demand for a SKU and increase inventory, only to find that sales are far below expectations. Or, it may mistakenly believe that a particular product will continue to be removed for the next two quarters because it was the best-selling product in the last quarter. In either case, companies end up with a lot of excess inventory that consumes valuable space and takes away cash that could have been better spent elsewhere.
4. Poor grasp of the trend
Accurate inventory and production planning is built not only on accurate data, but also on people who can analyze and interpret that data effectively. Employees must be able to spot digital trends and explain their impact. For example, if a purchasing manager is not aware of the gradual reduction in sales of several products in the last month of the third quarter, he may place large orders in the fourth quarter, resulting in obsolete inventory. Leaders must also consider how industry trends or broader economic changes affect the demand for their products.
To reduce inventory costs, businesses need to re-evaluate their processes and eliminate any inefficiencies. The following recommendations:
1. Improve warehouse layout: (Warehouse layout) As inventory increases and sales grow, companies may not focus too much on reorganizing their warehouse operations. However, since the warehouse is the center of all inventory, taking the time to improve its layout and workflow is a great opportunity to reduce costs and improve overall efficiency. 2. Determine the best stock level and reorder point:Buying a large amount of inventory may result in savings on the initial unit cost, but it may incur more expenses in the long run if it ends up stuck in the warehouse. Instead, look at historical data and calculate optimal stock levels and reorder points. This will allow you to avoid overstocking while meeting sales and customer demand.
3. Accelerate inventory week**When inventory is not sold and can no longer be profitable, inventory costs can add up quickly. The best way to combat this is to reduce the amount of time your inventory stays in the warehouse. This includes keeping only the inventory needed during the sale, negotiating favorable lead times or minimum order quantities with merchants, and dealing with slow-moving or excess inventory.
4. Use warehouse management softwareConsider the benefits of using warehouse management software compared to manually tracking inventory and taking manual counts. With a digital warehouse management system, you can extend visibility across the chain, keeping an eye on inventory, orders, and the location of items at any time. By integrating data from purchase orders, sales fulfillment, and demand**, you can leverage customized reports to optimize inventory levels, fine-tune pricing strategies, and identify the best warehousing strategy to reduce inventory costs.
5. Renegotiate with the best business customersAnother way to reduce the cost of ownership is to renegotiate the agreement with your business or customer. Before a customer buys these items, make sure you're not taking on most of the unavoidable risks and costs. For example, enter into a contract with a merchant so that they are responsible for damage, theft, or overhead costs while in possession of the goods.
Manufacturers and distributors should explore ways to avoid paying excessively high carrying costs. For example, specify the maximum holding time of inventory in the agreement and charge a fee for each day beyond that period to recover some of the holding costs. Retailers should also consider doing the same: there's no reason to have a batch of meltable Halloween candy in June.
Businesses can reduce inventory carrying costs by investing in a warehouse management system (WMS)What is a Warehouse Management System (WMS) – Last Update 2023-08-028), which is a powerful step. Warehouse management systems provide a variety of ways to optimize inventory levels to reduce all related expenses such as capital costs, service costs, risk costs, storage space costs, labor costs, and opportunity costs, in the following seven areas. 1.Provide visibility and decision support:WMS provides businesses with complete visibility into their inventory, enabling procurement, operations, and chain professionals to make better decisions. By tracking current inventory levels and the status of all outstanding purchases and customer orders, businesses are able to plan and execute inventory management strategies more accurately.
2.Prevent inventory omissions:WMS ensures that the inventory in the container is no longer "forgotten" while the product is on its way to the warehouse. This helps to avoid losses due to missing inventory and improves the accuracy of inventory.
3.Establish a consistent process:Warehouse management software will establish consistent receiving, putaway, and fulfillment processes, ensuring that every item is traceable from the moment it enters the warehouse to the time the customer receives it. This helps improve operational efficiency, reduce errors, and ultimately reduce inventory carrying costs.
4.Proactive Inventory Management:Warehouse management software enables businesses to proactively adjust purchase orders, sales strategies, and warehouse layouts to resolve issues before costs accrue. It provides real-time inventory visibility, enabling businesses to make timely adjustments and decisions.
5.The value of the reporting tool:The reporting tools in an inventory management solution are invaluable for monitoring inventory turnover, sales figures, and lost money. This data provides decision-makers with the insights they need to control inventory carrying costs, helping them make more informed business decisions.
6.Smart Inventory Decisions:By interfacing with a larger ERP platform, WMS can do it better and provide real-time visibility to help every product-based business make intelligent inventory decisions. This is essential to avoid stockouts and backlogs.
7.Constant Inventory Balance:Ultimately, leaders should be critical of what and how much they have stored in their stores and warehouses. By making inventory more strategic to business strategy, businesses can reduce their inventory carrying costs. Avoiding stockouts and backlogs is an ongoing balancing act, and WMS provides key support for this balance.
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