Inventory is one of the largest expenses retailers incur. However, if you only think about the price of your inventory, you have an incomplete picture of how much you’re spending to stock up. To understand inventory costs, you need to factor in all the expenses related to ordering, storing, and managing stock.
But where do you start?
In this article, you’ll learn what inventory costs are and how to accurately calculate them to get a realistic overview of your inventory-related expenses. You’ll also learn the different types of costs associated with managing inventory, how to reduce inventory costs, and some common inventory cost mistakes to avoid.
What are inventory costs?
Inventory costs are the costs associated with ordering and holding inventory.Evaluating these costs is important to determine how much inventory should be kept on hand.
Inventory is the largest expense retailers have. For every dollar US retailers make, they have $1.40 of inventory in stock. When you have a holistic understanding of your inventory costs, you can control them more easily.
“Knowing inventory costs is extremely important because they affect the majority of decisions one makes as a retailer,” says Abir Syed, co-founder of ecommerce accounting firm UpCounting. “They influence pricing decisions because that affects your margin. They influence purchasing decisions because they affect how much cash you need to purchase a certain volume of inventory.”
Types of inventory costs
- Purchase costs
- Ordering costs
- Holding costs
- Shortage costs
Inventory costs more than the product’s purchase price. You also need to factor ordering, holding, and shortage costs into the equation.
Purchase cost is the price a supplier charges you to buy its products. For example, if you’re buying 100 pairs of sneakers from a footwear wholesaler at $12 a pair, your purchase cost is $1,200. This figure excludes expenses like processing, shipping, and handling fees.
“Ordering costs include the labor expenses for the buying department, including wages, related taxes and benefits, and the costs of transporting and receiving inventory,” according to Frances Gunn, associate professor at Toronto Metropolitan University’s Ted Rogers School of Retail Management.
Let’s look at an example:
Imagine you own a fashion boutique that carries a line of designer handbags. The process of ordering these bags from your supplier would involve a series of expenses, all of which can be classified as ordering costs.
- Purchasing department costs. If you have a buyer or an assistant who helps with purchasing products for your retail store, the salaries, benefits, and taxes associated with these employees would form a part of your ordering costs.
- Transportation costs. The costs oftransporting the handbags from your supplier’s location to your store could involve charges such as freight or courier fees, import duties (if applicable), and insurance costs to protect against any damage or loss during transportation. These are all factored into ordering costs.
- Receiving and inspecting costs. When the handbags arrive at your store, there are costs associated with receiving and inspecting the inventory. Your staff needs to spend time checking the delivered items against the purchase order, examining the quality, and arranging for any returns if necessary. The labor costs involved in these activities would also be included in your ordering costs.
Ordering costs vary depending on the retailer, but they encompass the expenses involved at every step of the procurement process, from placing an order with your supplier to receiving the items in your store. For this example, you could use the following formula:
Total ordering costs = Purchase department costs + [Number of orders per month x (Transportation costs + Receiving and inspecting costs)]
Let’s say you place five orders per month and your costs are as follows:
- Purchase department costs = $3,000
- Transportation costs = $200
- Receiving and inspecting costs = $75
Total ordering costs = $3,000 + [5 x ($200 + $75)] = $4,375
It’s crucial to accurately account for these costs when calculating total inventory costs, as they can represent a significant portion of overall expenses.
“Holding costs include the cost of the space where inventory is held, the interest cost related to the inventory purchase funds, and the cost of inventory which is not used or damaged,” Frances explains.
This includes warehouse or storage rental costs and obsolescence costs related to liquidating inventory.Let’s use an example of a furniture store to illustrate inventory holding costs:
Let’s say your furniture store has a warehouse where you store your inventory. You rent this warehouse for $5,000 per month. This rental fee is a part of your holding costs.
Suppose you took out a business loan to purchase your inventory. The interest you pay on that loan is also a part of your holding costs. If the annual interest on your inventory loan is $2,400 (i.e., $200 per month), this is another component of your holding costs.
Inventory damage or obsolescence costs
Over time, some of your inventory might get damaged or become obsolete. For example, a chair could get scratched during handling, or a particular style of table might go out of fashion, forcing you to sell it at a discounted price. If you find that you lose an average of $1,000 per month to damaged goods and another $1,000 per month to discounts on obsolete items, these costs also contribute to your holding costs.
Adding all these costs together, your total holding costs would be:
Total holding costs = Storage costs + Monthly interest costs + Damage + Obsolescence
Plugging in the numbers from this example:
Total holding costs = $5,000 (Storage) + $200 (Interest) + $1,000 (Damage) + $1,000 (Obsolescence) = $7,200 per month
Note: This is a simplified example. In reality, inventory holding costs might also include costs like insurance, taxes, and utilities associated with storing the inventory, and costs might fluctuate from month to month. But this gives you a basic understanding of how holding costs work in a retail environment.
There are also expenses incurred when you don’t have enough inventory in stock. Any costs related to managing stockouts, such as payroll for your customer service team or expenses related to reordering, are considered shortage costs.
Let’s consider an example of an electronics store that sells high-demand items like smartphones. Shortage costs would come into play when there’s a stockout situation.
Customer service costs
Let’s say a new smartphone model launches, and you run out of stock due to high demand. As a result, your customer service team spends a lot of time answering customer inquiries, managing complaints, and updating customers about when the product will be back in stock. If you have two customer service employees who each spend an extra 10 hours a week dealing with stockout-related issues, and they earn $20 per hour, the additional customer service costs due to the stockout would be: 2 employees x (10 hours/week x $20/hour) = $400 per week.
Additionally, you might incur rush shipping fees to replenish your stock as quickly as possible. If the rush shipping fee is $200 per order and you have to place two rush orders due to the stockout, that’s an additional $400 in costs.
This isn’t a direct cost, but it’s a significant consequence of stockouts. If you estimate that you lost 10 sales of the smartphone because of the stockout, and each smartphone would have given you a profit of $100, then you missed out on $1,000 in profits.
Adding these up, your total shortage costs would be:
Total shortage costs = Customer service costs + Reordering costs + Lost sales
Plugging in the numbers from the example:
Total shortage costs = $400 (Customer service) + $400 (Reordering) + $1,000 (Lost sales) = $1,800 per week
Note: This is a simplified example and doesn’t account for indirect costs like potential damage to your brand reputation or lost customers who may have switched to a competitor. But it does provide a basic understanding of how shortage costs can impact your retail business.
💡 PRO TIP: Try ship-to-customer order fulfillment to lower shortage costs associated with stockouts. Rather than being limited to selling products you have in stock, you can sell products in-store and ship them to customers from your warehouse or another store location that has inventory.
How to calculate inventory costs
The formula for calculating inventory costs at any given period is:
Calculating inventory costs is simple once you’ve gathered all these data points. Not sure where to find these figures? Check reports from your POS system, inventory management software, and payroll provider.
Note: While it’s not the formula we’re focusing on in this article, another inventory cost calculation that you may have seen is:
Inventory cost = (Beginning inventory + Inventory purchases) – Ending inventory
This formula is generally used for calculating the cost of inventory in an accounting period versus during any given period.
Sample inventory costs calculation
Let’s see how easy it is to calculate inventory costs using this formula:
Inventory costs = Purchase costs + Ordering costs + Holding costs + Shortage costs
Let’s pretend you run a sneaker store and need to reorder inventory after a stockout during your anniversary sale.
You need 100 pairs of sneakers. The supplier charges $12 per pair, which makes your purchasing costs $1,200.
Your wholesaler is in China and charges $100 for express shipping to North America, which you need to fill backorders.
You need to hire a truck to transport the shipment from your store to your warehouse. Truck rental for three hours costs $60.
According to reports, payroll costs associated with recording this inventory totaled $200.
Combine all of those figures together and your total ordering costs are $360.
You pay $800 each month for your warehouse. This sneaker order represents one-tenth of your total inventory, and your inventory days on hand is 30 days. Therefore, your holding costs are $80.
This shipment is a reorder because you sold out of these sneakers during your sale, so there are shortage costs associated with it. Your main expense was payroll for your customer service and marketing teams, who fielded customer questions about the stockout. That cost your business $400.
When we add our purchase costs ($1,200), ordering costs ($360), holding costs ($80), and shortage costs ($400) together, we discover that our total inventory costs for this shipment of sneakers is $2,040.
Inventory costs = $1,200 + $360 + $80 + $400 = $2,040
How to reduce inventory costs
- Leverage data for accurate forecasting
- Find the right balance between purchasing, ordering, and storage costs
- Optimize storage costs
- Leverage auto replenishment
- Increase your inventory turnover rate
- Get rid of dead stock
“When continuously monitored, inventory costs can be adjusted, thereby reducing their impact on profits,” Frances says.
The better you understand your inventory costs, the more control you have over them, and the more you can improve your margins. You can follow these tips to reduce your total inventory costs:
Leverage data for accurate forecasting
“With the new data analytics tools that we have available, you can do a very good job of understanding how demand works,” says Javad Nasiry, associate professor at McGill University’s Desautels Faculty of Management.
Find the right balance between purchasing, ordering, and storage costs
Finding the sweet spot between purchasing, ordering, and storage costs can help you reduce inventory costs.
One way to reduce purchasing and ordering costs is to order larger volumes of inventory.
“If you make bigger purchases, that will usually lead to volume discounts. And bigger purchases can often mean big savings on shipping too,” Abir says.
Think about it: As a consumer, you can usually get free shipping by spending a minimum amount or by committing to a subscription. Suppliers can offer retailers similar discounts.
There are other ways to save money on inventory.
However, it may not always be in your best interest to order a high volume of inventory from a supplier.
“When you are buying inventory, your money is tied to inventory that is sitting in the warehouse,” Javad says. “You are paying something to buy these products, and your customers are going to later pay you for those products.”
Javad suggests using a strategic plan to purchase only the inventory you need so you can use money that would otherwise go toward purchasing and storing inventory for other projects that will grow your business.
With more inventory, your storage costs go up. So you need to find the sweet spot between how much inventory you order and how much you keep in storage.
If you’re ordering inventory from halfway around the world, there are additional considerations. “You will have to arrange for either air freight or maybe an ocean container, so your ordering cost may be high, Javad says. “The higher that cost is, the more you will be inclined to order a higher volume, because you want to avoid incurring that cost again and again.”
However, Javad says that if the supplies are produced nearby, they may have a lower inventory ordering cost. That might push you to order more often. So, in this scenario, you’ll spend less on ordering costs and more on storage costs.
Optimize storage costs
“Inventory costs can also be reduced by ensuring that inventory space is not in a costly location, is well-organized, is efficiently used, and is properly maintained to reduce obsolescence costs,” Frances says.
Instead of choosing a warehouse that’s near your store, consider using one in a more affordable area, even if it’s a half an hour away. Justify the distance by making fewer trips.
If you follow best practices for storing your inventory, you’ll be able to reduce the risk of spoilage.
Leverage auto replenishment
“I am a huge proponent of auto replenishment,” says Nilesh Mehta, founder of Independence Bridge Consulting. “By defining products that need to remain stocked and associating the minimum quantity available, businesses can save themselves headaches and save valuable time by putting reordering on auto-pilot.”
To take advantage of auto replenishment, calculate reorder points for your inventory and set up recurring orders. If your vendors only accept manual orders, consider switching to one that lets you automate repetitive processes.
💡 PRO TIP: Want to take the guesswork out of restocking? Set reorder points in Shopify Admin to get low stock notifications and ensure you have enough lead time to replenish inventory of a product before quantities reach zero.
Increase your inventory turnover rate
The longer you hold onto inventory, the more you need to spend on storage costs. Calculate your inventory turnover rate to better understand how quickly you’re selling inventory. Knowing this figure can help you set benchmarks and help you gauge which products are performing well and which ones are struggling. Use this data to make decisions about pricing, promotions, and inventory order volumes.
For example, let’s say you run a bike store. After calculating inventory turnover rate for all of the bike models you sell, you realize that children’s bikes sell more slowly than adult bikes. With these insights, you decide to pause orders on new kids’ bikes and create family bike bundles to incentivize sales of your existing stock.
Get rid of dead stock
If you calculate your inventory turnover rate and find some products just aren’t selling, you have dead stock on your hands. Get rid of dead stock by discounting it or making an in-kind donation in exchange for a tax write-off.
You can deduct up to half the difference between the selling price and cost of goods sold (COGS), as long as it doesn’t exceed twice the COGS.
Let’s say you purchase a piece of inventory for $10 and sell it for $30. The difference between the COGS ($10) and selling price ($30) is $20. Because half of $20 is $10, which doesn’t exceed it twofold, you can deduct $20 for the item for tax purposes.
Making an in-kind donation can help you reduce losses on dead stock.
10 inventory cost mistakes to avoid
- Miscalculating carrying costs: Carrying costs, including expenses like storage, insurance, and depreciation, are frequently underestimated by retailers. When they’re miscalculated, the total inventory cost can be significantly skewed, which can lead to poor decision making. Diligently calculate carrying costs, considering all the associated factors and regularly update these figures, as costs may fluctuate.
- Ignoring the cost of dead stock:Dead stock—items that have been in inventory for a long period without being sold—can silently drain your finances. Paying to store and manage these items, only for them not to generate any income, leads to increased inventory costs. Regularly reviewing your inventory and identifying products that are not moving can help avoid this mistake.
- Neglecting supplier cost variations: In the retail business, it’s common for supplier costs to vary. Neglecting to account for these fluctuations can result in inaccurate inventory cost calculations. Regular communication with suppliers and keeping track of price changes are crucial steps for accurate inventory management.
- Overlooking the cost of damaged goods: Goods can be damaged during handling, storage, or transport, and failing to account for these losses can lead to significant cost mistakes. Make sure you have a proper system in place for tracking and recording damaged goods, ensuring these costs are accounted for in your total inventory costs.
- Inaccurate stock counts: Retailers sometimes underestimate the importance of accurate stock counts. Any discrepancies between actual and recorded inventory can lead to miscalculations in inventory costs. Regular physical counts and reconciliations with recorded inventory can help avoid this mistake.
- Failing to factor in the cost of stockouts: Stockouts, or instances where you run out of a particular product, have indirect costs that are often overlooked. These costs can include lost sales, tarnished reputation, and increased administrative work. It’s important to factor these costs into your inventory management strategy.
- Overstocking: While having enough inventory is crucial, overstocking can lead to increased costs through extra storage, handling, and potential spoilage or obsolescence. Inventory forecasting and just-in-time (JIT) strategies can help prevent overstocking.
- Not considering seasonal fluctuations: Seasonal fluctuations can significantly impact inventory costs, and failure to account for these can result in mistakes. Adjust your inventory forecasts and stock levels according to seasonal demand patterns to ensure accurate cost calculations.
- Ignoring shrinkage costs: Shrinkage, the loss of products due to theft, fraud, or error, can considerably affect inventory costs. Retailers often overlook this aspect, leading to significant cost miscalculations. It’s crucial to implement strategies for shrinkage reduction and factor these costs into inventory cost calculations.
- Inefficient inventory management systems: An outdated or inefficient inventory management system can lead to numerous errors and increased costs. Inaccurate data, missed sales opportunities, and poor forecasting are all potential outcomes of a poor system. Invest in modern, comprehensive inventory management systems to ensure cost-effective inventory handling.
💡 PRO TIP: Shopify POS comes with tools to help you control and manage your inventory across multiple store locations, your online store, and warehouse. Forecast demand, set low-stock alerts, create purchase orders, know which items are selling or sitting on shelves, count inventory, and more.
Get control of your inventory costs
Inventory costs comprise more than just purchasing costs. When you know your ordering, holding, and shortage costs, you should have a holistic understanding of the true price of storing and managing stock. This knowledge can help you gain control over this major business expense.
Additional research and content from Alexis Damen.
Inventory costs FAQ
What is the meaning of inventory costs?
Why are inventory costs important?
How can technology help manage inventory costs?
What are the 4 inventory costs?
- Acquisition costs: These are the costs associated with purchasing and receiving inventory items.
- Holding costs: These are the costs associated with storing and maintaining inventory items.
- Ordering costs: These are the costs associated with ordering and preparing inventory items for sale.
- Stockout costs: These are the costs associated with not having the inventory items available when customers want them.