INVENTORY CARRYING COST – 9 PAINFUL CONTRIBUTORS YOU SHOULD TRACK

Inventory carrying cost describes the cost incurred by a business for holding inventory over a particular period of time. Similarly, inventory carry cost is the sum total of expenses which a company acquires as a result of storage. The costs include taxes, insurance, cost of obsolesce, shrinkage, warehouse, damage and relocation. As long there is a need to store stocks, these costs will directly or indirectly affect profit and loss balancing at the end of a business year. The best a company can do is to have a clear calculation for inventory carrying cost.  The contributors are hereby considered below:

Inventory Carrying Cost is Hidden Cost?

 

Inventory carrying limits the capital expansion of business because the money that could be used to invest in other projects gets tied down. There is a risk because of fluctuations. What happens if the stocks no longer sell at the value for which it was purchased or manufactured? If an equipment manufacturing company stocks part of its products, if the parts were no longer sellable, it could be sold at a worthless price.

During my 14 years of inventory management, I have seen few firesell events for Excess & Obsolete inventory turnaround and for an average return of 20% of original prices. Therefore, it is important to have clear Excess and Obsolete Inventory Policy Guide

In order words Excess and Obsolete Inventory Is Killing Your Business!

Since no real value is likely to be added to the company, it is usually advisable that a company considers the opportunity cost of inventory carrying. If the calculation shows that the company will be losing more at the risk of the cash invested, there is a need to reduce inventory or consider other investment opportunities with the same cash

9 Contributors to Inventory Carrying Cost & Data Sources to Identify Cost

1.    INSURANCE.

 

The costs of insurance do not strictly apply. Hence, companies need to understand insurance policies so as to determine how much profit can be made irrespective of the invention carrying cost. It should be noted however that the insurance paid by a company depends on the level of inventory. Therefore, the higher the inventory carrying cost the higher the insurance premium.

Data Source: For this calculation, standard costs data are from comptroller’s department and freight rate and product specifications are from distribution reports. Average monthly inventory in cases from printout received from sales forecasting was also used.

2.      TAXES.

 

This inventory carrying cost accrues as a result of personal property cost paid on inventory. On the other hand, too, local authorities’ tax a company based on the rate of inventory in the store. Just like insurance, a higher level of inventory will lead to higher taxes paid. Ultimately, the inventory carrying cost will increase.

Source: Through the comptroller’s department.

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3.      PLANT WAREHOUSE.

 

Ordinarily, the costs are fixed. Thus, the storage space is not relevant when considering inventory carrying cost. But this does not mean there are no variable costs. By variable, it means that it varies with the amount of stock that moves through the asset. When this occurs, it has to be included in the inventory carrying cost.

Fixed plant warehouse cost can be calculated with the assumption that if a firm rent out the warehouse space or use it for some other productive purpose instead of using it for storing inventory. An estimate of the appropriate opportunity cost would be appropriate.

Source: Through the logistics services providers

4.       INVENTORY HANDLING COST.

 

The cost incurred here is proportional to the level of stock moved in and out of the warehouse (throughput) and the amount of stored inventory. Usually, the assessment is carried out when stock is moved in from one location to another.

I have seen this happening the most when some business put the excess and slow-moving inventory in 3rd Party warehouse (which is bad idea by the way) and once in a while they need it or out depends on business needs

When relocation occurs as a result of excessive inventory, the relocation cost should be included in inventory carrying. However, the rate of occurrence of relocation will determine which method is appropriate in a particular situation. If the need to relocate hardly happen, the impact on the inventory carrying cost is minimal.

Source: Distribution operations expenses.

5.       RENTED or 3PL WAREHOUSE.

 

This is a storage space which has been contracted for a particular period of time usually as cost/pallet/week. Therefore, cost does not depend on amount of inventory you carry but the amount of pallet space you occupy. Therefore, the expenses may vary from month to month. Similarly, some costs like warehouse labor, equipment operating costs, among others vary with transfer within and without the storage facility depends on your agreement.

I have advised two companies in the last 3-4 years and their practices/arrangement I would recommend you to avoid.

  • One of them has a minimum rental space agreement. Meaning, they were paying for a minimum of 200 pallets every month, despite they only have 154 pallets in stock, this is a bad idea! Never sign a minimum rental space agreement, always go for charge/pallet/week. This is clear and variable.
  • The other company was hiding their excess and obsolete inventory far away in 3PL warehouse and as a result, everyone forgets about that! Again, not a good idea, I would recommend to have this excess and obsolete inventory visible so you don’t forget about it and try to result as much as possible and as quick as possible using as many Inventory Reduction Strategies I have mentioned in this blog.
Learn More About Supply Chain Operations

Source: Distribution operations expenses.

6.      COST OF OBSOLESCENCE.

 

Cost of obsolesce is the difference between the original purchase price of each unit of product and the reduced selling price. Usually, reducing the selling price of a product against the original price may be needed in order to move the product or firesale. As a form of sales forecast, costs of obsolesce are included in the costs of manufactured goods account or cost of goods sold. However, it is relevant to inventory carrying cost as long as products go through depreciation when held beyond their useful life.

I recommend to you use my Excess and Obsolete Inventory Policy Guide

Source: Inventory Records from the finance function

7.      DAMAGE COSTS.

 

Irrespective of the inventory level, damage costs cannot be avoided. Also, it is an inventory cost related to perishable products. Damage could occur during shipping, transportation and even while being handled in the warehouse. Since they will continue irrespective of the inventory level, it should be taken as a throughput cost.

It should, however, be noted that only the part attributable to inventory carrying needs to be included. There are instances when damage costs are not included in the inventory carrying cost. If the damage is as a result of your own warehousing operator’s or 3PL negligence and it is at the same time above an amount specified in the contract, it is taken from the fee payable. Damage cost is the net value after claims have been settled to be included in inventory carrying cost.

Source: Distribution operations expenses.

8.      SHRINKAGE COSTS.

 

Shrinkage is becoming an observable occurrence with today’s businesses. It is a loss of merchandise which mostly occurs through theft and embezzlement. Occasionally, it occurs as a result of poor record keeping, shipping wrong products or incorrect quantities to customers. On the other hand, some edible and liquid products may undergo shrinking and spillage while being transferred from one point to the other.

However, theft is a seriously common situation when it comes to expenses and easily sellable products, it could be hard to manage effectively without resulting to dismissal. The success of shrinkage as a result of theft and misappropriation could be blamed on the poor security measures put in place by the business. Not all can be attributed to inventory carrying cost even though the level of shrinkage varies with the number of warehouse centers. While some of them are at best charged to the warehouse than the cost of inventory, the ones attributable to inventory carrying should be included.

Source: Distribution operations expenses.

9.      CAPITAL COST

 

This is generally applied by financial controllers, but probably the most strange one for me. They mostly calculate as if the amount of $ value invested in inventory if invested with a bank or any other investment opportunity to earn a return, then the return should be comparable to this investment. If it is not then this is the cost of carrying inventory.

This is a strange one for me as it changes very abruptly from country to country and from situation to situation so I never really able to make the full sense to this. But one thing is super clear this should be part of inventory carrying cost calculation, somehow!

The other contributors which are important to consider but difficult to calculate to include in inventory carrying cost are:

Source: Financial Controller!

CONCLUSION

 

Inventory carrying cost depends on how you want to manage your logistics cost overall and it varies from business to business. However, it is good if managements attempt to put in place appropriate logistics cost management structure to have a full view of logistics cost.

For example, if there is just one product line then inventory carrying cost may not be hard to calculate against the financial performance of the business. That is, costs like transportation and storage are included based on average occurrence. If the case is otherwise, let’s say diverse product lines, inventory carrying cost has to be calculated for each product line. That means, costs like transportation and storage would be added on a particular product. Generally, this is hard work!

More importantly, attention should be paid to inventory turnover. This is because there is a relationship between inventory carrying cost and inventory turnover. For inventory turns to improve annually there must be a logistic cost system for inventory carrying costs. In the absence of no effective logistic cost structure, improved turnover will only endanger the financial performance of the business. If for example, there is a desire to increase inventory turnover from 25% to 30%, the management must put in place appropriate logistics cost structure to ensure that handling cost, taxes, insurance, relocation costs, warehousing, among others reduces with the same proportion.

So, are you going to continue to focus on Inventory Carrying Cost

Recommended Books:

Operational Logistics: The Art and Science of Sustaining Military Operations (Management for Professionals)

 

Operations, Logistics and Supply Chain Management (Lecture Notes in Logistics)

Reference:

Lambert, D. M; Stock, J.M and Ellram, L. M 1998, Fundamentals of Logistics Management, Irwin/McGraw-Hill, Singapore.


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