Whether your retail business is holding holiday items in March or summer seasonal goods as the weather cools, a warehouse of unsold products costs you money. With every passing day, unsold goods incur not just storage fees, but an array of expenses known as inventory carrying costs. These costs can accumulate quickly and, if unchecked, significantly erode a retailer’s profit margins.
This article will delve into the significance of inventory carrying costs and show how to calculate and manage them to protect the success of your retail business.
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What are inventory carrying costs?
Inventory carrying costs, also known as holding costs, are the total expenses that a retailer incurs for storing unsold goods. This includes direct and indirect expenses such as storage costs, insurance, taxes, handling costs, depreciation, spoilage, obsolescence, and the opportunity cost of money invested in the inventory.
Excess inventory can increase your capital costs, tying up money that could have been allocated to other growth-driving activities. Calculating inventory carrying costs reveals the various expenses and can inform strategies to streamline your inventory, optimize stock levels, and minimize financial strain.
How to calculate inventory carrying costs
Inventory costs include expenses like the capital costs tied up in goods, storage, handling, and insurance. They also include inventory risk costs associated with obsolescence, depreciation, spoilage, and theft. By accurately calculating these costs, you can make informed decisions to manage your resources efficiently and maintain profitability.
The following factors typically figure in the inventory carrying cost formula:
- Storage costs. These are the direct costs associated with storing your inventory, such as rent or property taxes for warehouse space, utilities, and maintenance.
- Handling costs. This includes labor costs for inventory management tasks like receiving, stocking, retrieving, and relocating items.
- Insurance and taxes. Inventory is typically insured against loss or damage and there may also be tax costs associated with holding inventory.
- Depreciation. Over time, certain types of inventory may lose value due to expiration, obsolescence, or wear and tear.
- Opportunity cost. This is the potential earnings lost by investing money in inventory instead of other business opportunities.
- Cost of spoilage or shrinkage. For certain kinds of inventory, there may be costs associated with items becoming obsolete, spoiled, lost, or stolen.
Once you’ve determined these factors, you can calculate your inventory carrying cost using the following formula:
Inventory carrying cost = Inventory holding sum / Total inventory value x 100
- Inventory holding sum: This is the dollar total of all costs mentioned above during a given period (usually a year).
- Total inventory value: This is the monetary value of the inventory held during the period.
The result will provide you with the cost of carrying inventory per period. This information can be invaluable in strategic decision-making regarding inventory management and overall business operations, allowing for greater visibility into your total inventory costs.
Here’s an example of how to calculate inventory carrying cost using the inventory carrying cost formula.
Suppose a clothing retail business has the following annual costs associated with holding inventory:
- Storage space: $20,000
- Handling: $15,000
- Insurance and taxes: $5,000
- Depreciation: $3,000
- Opportunity cost: $7,000
- Spoilage or shrinkage: $2,000
Therefore the inventory holding sum would be $20,000 + $15,000 + $5,000 + $3,000 + $7,000 + $2,000 = $52,000
Let's assume that the total inventory value is $200,000.
Using the formula for inventory carrying cost we can calculate:
$52,000 / $200,000 = 0.26 x 100
The clothing store’s annual carrying cost equals 26% of the inventory’s value.
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7 ways to reduce inventory carrying costs
- Regularly review your inventory
- Improve inventory turnover
- Invest in an inventory management system
- Optimize warehouse operations
- Negotiate better terms with suppliers
- Reduce shrinkage
- Consider the showroom approach
Holding too much stock can lead to high carrying costs that reduce your company’s cash flow and hurt your business’s profitability. Below are seven ways to lower your company’s inventory carrying costs.
1. Regularly review your inventory
Conducting an annual inventory audit helps you determine if you’re storing more inventory than necessary, identify obsolete or slow-moving stock, and take timely action to avert stockouts. If you have too much stock, clearance sales can recover a portion of the investment, and write-offs can free up warehouse space for more profitable items.
As part of your inventory audit, review your retail sales reports. This will help you find your sell-through rate—the percentage of inventory sold in a period versus the amount of inventory received from suppliers—to see which products are selling and which ones are lingering.
2. Improve inventory turnover
Storing too much stock increases your inventory holding costs because carrying costs vary depending on the volume and duration of storage. Increasing inventory turnover reduces the time that products stay in the warehouse, thus lowering associated carrying costs. Retailers can raise turnover rates by sharpening their demand forecasting using historical sales data, market trends, and predictive analytics. Offering targeted sales or promotions on slow-moving items can also clear out aging stock. Additionally, discontinuing underperforming products can prevent build-up of unsold goods.
3. Invest in an inventory management system
Inventory management software provides real-time data on stock levels, sales trends, and other critical metrics. This information allows you to avoid overstocking, rapidly identify slow-moving items, and fine-tune demand forecasting. While there is an upfront investment, an inventory management solution can help you reduce high inventory carrying costs and minimize inventory service costs.
4. Optimize warehouse operations
Effective warehouse management can lower storage and handling costs. This might involve reorganizing the warehouse layout for better space utilization, ensuring efficient stocking and retrieval of items. Automated inventory management systems can streamline processes and reduce labor costs. Consolidating storage space or improving energy efficiency can also help cut utility expenses.
5. Negotiate better terms with suppliers
Reducing carrying costs may also involve working out advantageous agreements with suppliers. Longer payment terms can improve cash flow, allowing you more time to sell inventory before bills are due. Alternatively, arranging for smaller but more frequent deliveries can keep inventory levels—and therefore carrying costs—down. Prioritizing good relationships with suppliers can open the door to these more favorable terms.
6. Reduce shrinkage
Shrinkage—loss of inventory due to damage, theft, or administrative errors—can add to carrying costs. You can reduce inventory shrinkage by enhancing security measures, improving handling procedures, and ensuring optimal storage conditions to minimize spoilage. Regular staff training on inventory management can also help to prevent costly mistakes.
7. Consider the showroom approach
The retail showroom approach can help you reduce your carrying costs. Instead of storing inventory on-site in a large store, for instance, you can display a handful of products for customers to examine in a smaller space. Purchased items then are fulfilled through ship-to-customer and sent directly from the warehouse of a manufacturer or supplier. This reduces on-site storage costs and mitigates risks associated with carrying excess inventory. This approach is particularly useful for businesses selling bulky or high-ticket items—furniture, home appliances, fitness equipment—balancing improved customer experience with efficient inventory management.
Inventory Carrying Costs FAQ
Is inventory carrying cost part of COGS?
No, inventory carrying costs are not part of the cost of goods sold (COGS). COGS represents the direct costs of producing goods, including material costs, direct labor costs, and factory overheads like utilities. It does not include costs associated with storing unsold inventory.
Do inventory carrying costs impact a company’s profitability?
Yes, inventory carrying costs can significantly affect a company’s profitability. Higher carrying costs increase the total expense related to the inventory, reducing the profit margin on each item sold.
Are inventory carrying costs considered a fixed cost for a company?
Inventory carrying costs are not typically considered fixed costs. They can vary based on the level of inventory, how long the inventory is held, and fluctuating costs related to storage, handling, insurance, and more.
Is it possible for a company to incur inventory carrying costs even if its inventory turnover is high?
Yes, even with high inventory turnover, a company can still incur carrying costs. These costs are incurred whether inventory moves quickly or not, and includes expenses for storage, handling, and insurance.