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INVENTORY CARRYING COSTS

If you are an eCommerce business owner, then here are the top reasons why 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 study of supply chain management software, the inventory optimization and replenishment module was the most frequently used module. Such a module used inventory carrying costs to estimate optimum levels of inventory for each item. 

This showcases how important a metric is carrying 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, it is important for businesses to derive and apply an estimate of inventory carrying costs.

Inventory is considered optimized when the least amount of 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 in itself.

On the other hand, inventory in excess of 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 the cost of holding inventory 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?”

In this article, we are going to discuss what is inventory carrying cost, the types of carrying costs, and how to calculate inventory carrying cost 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 SKU of product. Inventory Carrying Cost considers investments involved in storing and holding unsold goods.

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Such costs may associate with inventory storage facilities such as material handling equipment and personnel, warehouse costs, the cost of 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 also defined as 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 such as 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, to minimize inventory carrying costs, businesses make frequent orders of small quantities.

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, overheads for the properties rented by the company. It must make an effort to 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 costs of labor that are involved in receiving, putting away, and issuing inventory. 

Thus, the warehouse labor expenses primarily consist of employee compensation,  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 upon either dollar value or weight. This cost is applicable 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 get their stock inventory insured 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.

In fact, it is combined into the company’s overall property values. Thus, one may wonder that 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 ranges of property value. 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 enough 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. The commodity devaluation is the largest component of inventory carrying costs in the case of some industries.

Inventory items that are not sold over a period of 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 unit prices 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, any inventory lying idle 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 cost of inventory damage by measuring the actual cost of 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 as a result of 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 runs the risk of 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 of those commodity categories.

9. Shrinkage Adjustments

The term shrinkage refers to the losses that a business may incur on account of pilferage of inventory or other “unexplained” discrepancies in the physical count of inventory. To calculate such costs, businesses typically rely on inventory count records and adjustments. 

Though such costs represent a very small portion of the company’s total inventory holding costs. But, it must be included to the overall holding costs in order 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 is dependent 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 pertaining to 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, then a business must make an effort to optimize inventory. 

Note that a dollar decrease in inventory may decrease the property taxes of a business. There are many businesses that do not have to pay state or local property taxes on their inventory. In such cases, the element of property tax on inventory should be excluded from the calculation of 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 results in freeing up capital that can be used elsewhere. 

This ​​may in turn 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 nothing but the cost of financing an asset on a balance sheet by either using equity or 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 SKU of the product by dividing the Annual Inventory Holding Cost by the total value of annual inventory.

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:

  • 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

Let’s 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 each of the above costs.

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

AB
30
Annual Inventory Costs for ‘Zapin’
Amount ($)
31
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. Whereas, cell E32 showcases the calculation of 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 nothing but 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 nothing but 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.

DE
30Total 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 Carrying Cost and Ordering Cost?

As mentioned earlier, the inventory carrying cost refers to the cost that is associated with holding or carrying the inventory in proper conditions. Such costs may include expenses like those of warehousing, security, insurance, interest, pilferage, obsolescence, etc.

On the other hand, the ordering cost refers to the cost that is 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 the related paperwork. Unlike the carrying costs that are 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 the third-party suppliers or from internal setups.

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

AttributeOrdering CostHolding cost
DefinitionOrdering 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 the cost of storing and maintaining the inventory.
ExamplesCost of finding suppliers, preparing purchase orders, inspection costs, and transportation costs.Warehouse labor, storage, pilferage, shrinkage, insurance, taxes on inventory, capital costs
FormulaFixed Ordering Cost per Order * Number of Orders per Year(Total Annual Carrying Cost/Annual Cost of Inventory)*100
Unit of ExpressionIt is expressed in monetary value per order. It is expressed in percentage.
Factors Influencing CostThe ordering costs depend upon the number of orders placed. This means the ordering cost increases with the increase in 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 to determine the amount of money they can earn taking into account the given level of inventory.
  • 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 spending money in holding inventory unnecessarily. 
  • Also, inventory carrying costs are used for a variety of purposes in some of the leading materials management practices. These include determining lot sizes; determining order quantities, performing price break analysis, making make-to-order vs. make-to-stock decisions, etc.
  • Besides this, inventory holding costs help a business to decide whether to reduce production or supply or to increase the same to increase revenues and hence 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 is an indication that if such costs are overlooked, it may certainly 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’s because it may lead to working capital getting tied up in inventory that can be used somewhere else. 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 in saving time that gets wasted in doing everything manually, right from tracking inventory to forecasting demand.

An effective inventory management software helps a business to determine the optimal level of inventory it needs to maintain without running out of stock. The demand forecasts are accurate, unlike manual calculations where the chances of error are extremely high. Further, such levels of inventory ensure that the holding costs are not too high.

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 hence 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 a track of each SKU and determine the performance of each of the SKUs. 

As a result, an e-commerce business can get rid of products that are non-performing. Likewise, it can increase the supply of performing products to generate higher revenues and to 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 a longer period of time. 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 referred to as minimum order size, can be measured in either 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 cost.

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