Every business deals with some kind of product. This requires storing these products to meet customer demand within a certain timeframe of 3 to 5 days. But where do you store these goods? Probably in warehouses. However, storing items in a warehouse does not come free of cost. Carrying inventory accounts for 15% to 35% of total inventory value in the manufacturing industry, and this percentage varies depending on the industry. You may bear higher inventory costs if you handle bulky, perishable, or high-value products that require maximum maintenance.
Let’s break down the components and factors that directly impact or contribute to your inventory carrying cost and how you can calculate, reduce, and control them for better cash flow and informed decisions that directly impact your bottom line.
What is inventory carrying cost?
Inventory carrying cost or holding cost, is the cost of unsold goods stored in your warehouse. This cost is directly added to your total inventory value, which means that every single item has a percentage of carrying cost.
The total carrying cost is the sum of costs related to warehousing, insurance, depreciation, and the opportunity cost of capital held in stock.
What are the components of inventory carrying cost?
The total inventory carrying cost has four major components. Understanding and managing these components can help you control and reduce carrying costs.
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Capital Costs
Capital costs represent the total cost tied up in your inventory sitting in your warehouse, which can be invested elsewhere where it could generate better returns.
Most businesses don’t think long-term when it comes to inventory. They calculate profits based on inventory value, but once they add inventory holding costs or overhead charges, which they consider insignificant, most of the business becomes unprofitable. Largely, these are products with small profit margins. The most successful businesses use a method called EOQ, or Economic Order Quantity, in which businesses determine how much product they should add to their inventory with each batch order, preventing them from stockouts and overstocking while maintaining a balance between inventory holding costs and inventory setup costs. And that is how they remain profitable while investing the saved dollars in other areas like marketing, product development, etc.
Capital cost includes;
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Opportunity costs:
It means the cost is stuck in inventory for managed prosperity and uses elsewhere compared to how much potential returns a business could get.
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Interest on inventory-related loans
This is the cost associated with borrowing money to purchase inventory. When a business takes out a loan to buy inventory, it must pay interest. For instance, if a business has an average inventory worth $100,000 and the interest rate on the loan is 10%, it would incur an annual cost of $10,000 in interest. This is important to consider because this $10,000 could have otherwise been used for other investments in the business that might generate profits.
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Cost of capital used to purchase inventory
This includes the cost that businesses use to purchase inventory. If not backed by data, businesses might face overstocking or understocking. In overstocking, a large portion of cash is stuck in sitting inventory. Now, businesses have to pay the inventory cost every month without getting any return because the order flow is slow.
And if you stock too many seasonal products that become outdated and out of trend after the season, that sitting inventory will cost you money that you could be using elsewhere.
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Storage Costs
This is the cost associated with storing the goods in the warehouse, including warehouse rent or mortgage, utilities (electricity, heating, cooling), equipment cost, facility maintenance, security systems and personnel, and warehouse management labor costs. The rent remains fixed, but the cost related to utilities and labour might vary.
For example, the average rent in the US is $6.53/sq ft. A 5,000 sq ft warehouse costs $32,650/year in rent alone.
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Service Costs
Service costs include insurance (up to 2–3% of inventory value), taxes, software subscriptions, Administrative personnel expenses, and Inventory planning and forecasting costs.
Insurance premiums directly depend on your inventory level. A higher inventory level means high insurance value and taxes. Therefore, maintaining an optimal stock level is important to run a successful and profitable business.
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Risk Costs
This is the cost related to risks that a business might face while its goods are stored in a warehouse. These include obsolescence and depreciation, damage and deterioration of any product, theft and shrinkage, and expired or outdated products. According to retail dive, the average shrinkage cost that businesses bear is around 1.4% to 1.6% due to theft or damage annually.
Netsuite also stated that about 30% of retail inventory becomes dead or outdated within 6 months. Therefore, it is important to control the cost of carrying inventory, which is only eating into your profit margins, to reduce overhead costs. Managing stock levels while keeping a safety stock at a maximum is recommended to prevent tying up cash in dead stocks.
How do you calculate inventory carrying cost for a specific product?
Formula 1: Quick Estimate
Carrying Cost ≈ Total Annual Inventory Value / 4
A 200k inventory = 50k/year in carrying costs
Formula 2: Detailed Calculation
(Capital + Storage + Service + Risk Costs) / Total Inventory Value x 100
Example:
Let’s take this example of a T-shirt retailer.
Inventory Value: $50,000
Cost Breakdown:
- Capital: $7,500 (15% interest)
- Storage: $4,000
- Service: $1,200
- Risk: $2,300 (shrinkage + obsolescence)
Total Carrying Cost: $15,000 (30% of inventory value)
Step-by-step calculation process
If you want to calculate your year-long inventory carrying cost, then this is how you can do it.
- Identify and total all capital costs for one year
- Calculate all annual storage costs
- Sum all service costs for the year
- Estimate risk costs based on historical data
- Add all four categories to get your Total Inventory Carrying Cost
- Divide by your Total Inventory Value
- Multiply by 100 to get a percentage
For example
Take this retail clothing business:
- Capital costs: $10,000
- Storage costs: $20,000
- Service costs: $5,000
- Risk costs: $3,000
- Total inventory value: $100,000
Total Carrying Cost = $10,000 + $20,000 + $5,000 + $3,000 = $38,000
Carrying Cost Percentage = ($38,000 / $100,000) × 100 = 38%
This retailer’s carrying cost is 38%, much higher than the industry average of 20-30%. This suggests there may be loopholes that need to be fixed.
Warning signs of high carrying costs
Here are some signs that your carrying costs may be too high:
- Slow-moving inventory inventory
- Frequent discounts on old stock
- Cash flow issues despite good sales
- Warehouse space is almost full
- Rising insurance and storage costs
- Lots of obsolete or damaged items
If you notice any of these signs, it’s important to examine closely how you manage, control, and reduce your holding inventory costs.
7 ways to reduce inventory carrying costs
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Liquidate Dead Stock
Carrying dead stock means you are paying without expecting any return. And that’s not how a business gets profits and returns. To reduce the holding costs tied up in dead inventory, you can liquidate it. Businesses offer flash sales on their slow-moving products; this way, they are able to sell their dead stock and reduce holding costs. For example, a 40% discount can recover 60% of sunk costs.
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Adopt Just-in-Time (JIT)
Using the JIT model, businesses can reduce holding costs. How? By only getting inventory when needed, they can save on storage costs. This means you don’t have to store too much inventory, like a year’s or six months’ worth, and avoid unnecessary expenses.
Here are some tips for adopotying JIT model:
- Build better relationships with suppliers.
- Negotiate quicker delivery.
- Think about drop-shipping certain products.
- Use automated systems for reordering.
For example:
Businesses that use Just-In-Time (JIT) methods can often reduce their carrying costs by 20-30%. For example, Toyota cut its carrying costs by 25% by using JIT inventory management. JIT works by aligning production with demand, which means keeping inventory low and reducing waste. This strategy, developed by Toyota, has helped them make their production process more efficient.
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Optimize warehouse layout
Even a small step can make a big difference. By grouping high-turnover items near packing stations, businesses can cut labor time by 15%.
For example, in a retail business, having the most in-demand products at a single station can help reduce labor costs, as this way, they don’t have to be present at multiple locations to fulfill orders.
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Negotiate with suppliers
Businesses can reduce holding costs by ordering small batches. Smaller batches + extended payment terms can free up 10–20% of working capital. But the problem is, not all suppliers agree to that. Wholesale businesses work best with bulk orders, where they can share higher profit margins.
But if you have good relations with your supplier and are able to negotiate by maintaining a long-term business relationship and giving them the sense of security that this partnership will go a long way, you can be able to negotiate your demands.
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Use Inventory Management Software
With inventory management software, businesses can see real-time stock levels, safety stock levels, and inventory value in the meantime. This way, they can make informed decisions about how much inventory they need, resulting in minimum inventory carrying costs. According to QBotica, businesses that use inventory management tools can cut carrying costs by 18% with accurate forecasting.
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Audit safety stock
Businesses can reduce excess buffer stock by 30% using historical data. Inventory management software makes this process even easier by minimizing manual work and errors. To lower holding costs, businesses regularly audit their safety stocks to determine the necessary amount for each item. This helps prevent overstocking and reduces carrying costs.
- Schedule quarterly inventory audits
- Implement ABC analysis
- Develop a formal process for liquidating old stock
- Create clear obsolescence policies
7- Track Key Metrics
Tracking Key Performance Indicators (KPIs) is important for managing and reducing your holding inventory costs. How does this work? By setting metrics that identify which items have enough stock for a certain period (like 2 months), which items are not selling (dead stock), and which items need restocking.
You should keep an inventory turnover ratio, which shows how often a product is sold and replaced over time.
In retail, the average inventory turnover ratio is usually between 8 and 12. Check if your inventory turnover is according to your industry benchmark. A high turnover means strong sales, while a low turnover may point to weak sales or excess stock.
Conclusion
By controlling and reducing inventory carrying costs, businesses can save a decent amount of money that they could use in other areas that give them potential returns. Businesses that use inventory management software are more efficient in maintaining the optimal balance of holding stocks than those that rely solely on spreadsheets and manual work.
If you want to move stock quickly without incurring unnecessary costs, then invest in good software that provides real-time data to help you understand how much stock is needed to prevent overstocking.
FAQs
What does inventory carrying cost mean?
Inventory carrying cost or holding cost, is the cost of unsold goods stored in your warehouse. This cost is directly added to your total inventory value, which means that every single item has a percentage of carrying cost.
Q: What’s the difference between carrying cost and holding cost?
A: They are often used interchangeably, both referring to the total cost of holding inventory.
Q: How to handle the carrying cost of perishable goods?
A: Use FIFO (First-In, First-Out) and partner with suppliers for shorter lead times.
Q: Can carrying costs be too low?
A: Yes. If turnover is too high, stockouts can cost mid-sized retailers $1.5M/year.
Q: Is inventory carrying cost an expense in accounting?
A: Yes, it’s considered an operating expense impacting the company’s profitability.
Q: How can I lower inventory cost without risking stockouts?
A: Implement accurate demand forecasting and maintain safety stock levels to balance availability and cost. Try using inventory management software for real-time data.
Q: What’s a typical inventory carrying cost percentage?
A: It varies by industry but generally ranges from 15% to 35% of the inventory value.
Q: Should I include software and admin in the carrying cost?
A: Yes, service costs like software subscriptions and administrative expenses are part of carrying costs.
