Accounting for inventory does not end with its purchase; carrying inventory involves much more cost. Businesses accrue carrying costs by holding inventory over a period of time. Holding too much inventory increases costs and affects liquidity. Read on to learn more about inventory costs and how to reduce them.
Understanding inventory carrying costs
Carrying costs include storage costs and other expenses, such as taxes and insurance. Costs can be divided into the following broad categories:
- Capital: This is the cost of purchasing stock, the interest paid on the purchase, and the interest lost when cash becomes inventory. It also includes opportunity costs, which indicate the value of lost opportunities in investing money elsewhere.
- Storage space: This includes warehouse rent and utilities, such as lighting, air conditioning, and security. While some of the costs are fixed, others vary with the amount of inventory or seasonal changes.
- Inventory risk: When some items are stored for long, they might become outdated, pass the expiry date, or become useless with seasonal changes. They can also be damaged by water, heat, or incorrect storage. Theft and accidents are also inventory risks.
- Inventory service: This refers to the taxes on the inventory and the insurance paid against inventory risks. The more precious and larger the inventory, the higher the insurance premium and the taxes will be.
Businesses also lose money when inventory is insufficient to complete orders, or when emergency shipping is needed. Communications with suppliers and improvements in processes can also cost money.
Impact of carrying costs
Inventory carrying costs constitute a major part of supply chain expenses. Sometimes excess, wasted, lost, or damaged inventory necessitate write-downs or even write-offs. Inventory write-downs happen when the current market price of unsold items is lower than their purchase price. The difference between the purchase price and current price is considered a loss. When the inventory loses all value, write-downs turn into write-offs, which have a far more devastating effect on businesses.
Reducing inventory carrying costs
Businesses can do the following to make their inventories fast-moving so that they incur lesser carrying costs and bring in greater returns:
- Improve warehouse or storage space: If businesses organize their warehouses, inventory is less likely to be misplaced, damaged, or stolen. They are able to track obsolete items and get rid of them. Well-maintained warehouses also make picking, packing, and shipping efficient.
- Forecast accurately: Businesses that track their inventories uncover low-stock situations instantly. They also know in-demand trends and their best-selling and worst-selling items and can update their inventories.
- Avoid minimum order quantities: Suppliers usually insist on a minimum order quantity (MOQ). As this can be a burden on their inventories, businesses should negotiate with suppliers to lower or remove MOQs.
- Negotiate long-term contracts with suppliers: Long-term contracts provide businesses with a sustainable source of revenue and help them to allocate a larger portion of inventory costs to customers and suppliers.
- Monitor inventory KPIs: Businesses should track all applicable inventory KPIs (key performance indicators), such as carrying costs, write-offs, write-downs, inventory turnover rate, average days to sell (DSI), etc. By comparing these with industry averages, they can assess their performance and try to reduce costs.
- Try out new inventory management techniques and systems: Real-time, collaborative platforms provide advanced analytics and automation in budgeting, planning, and forecasting. Inventory management/optimization software analyzes inventory cycles, combining data and key insights, to help optimize inventory management.
Carrying costs have a high impact on a business’ ability to streamline processes and maximize profits. Businesses must reduce them to remain competitive and achieve growth.