Inventory carrying cost definition
/What is Inventory Carrying Cost?
Inventory carrying cost is the expense associated with keeping goods in stock. This expense is comprised of the costs of inventory shrinkage, obsolescence, insurance, interest, taxes, and depreciation on warehouse and rack space, as well as the compensation costs for the materials handling staff. Perishable goods have a higher carrying cost, since they must be written off after they reach a certain age. It is common for a business to experience an inventory carrying cost of about 20% of the cost of its inventory.
An additional factor related to inventory carrying cost is the opportunity cost of the invested funds. If the cash had not been used to acquire inventory, it might have been more profitably invested elsewhere, or returned to investors in the form of a dividend or stock buyback.
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Presentation of Inventory Carrying Cost
This expense does not directly appear on a company’s income statement, since the statement is not normally constructed to separately present such information. Instead, inventory carrying cost is contained within a firm’s cost of goods sold line item. When a firm invests in a large amount of inventory, it can elect to present the associated costs of doing so within a separate line item on the income statement.
Retailers are more likely to separately store and present information about their inventory carrying cost, since this can represent a significant part of their cost structure. For them, tight management of carrying costs is an essential technique for earning a profit (or not).
Reasons for High Inventory Carrying Costs
There are several reasons why a business may find itself with an overabundance of inventory, which triggers high carrying costs. They are as follows:
Poor inventory management. When the materials manager does not have a good inventory tracking system or warehouse layout, it is easy for inventory levels to become excessive.
Volume discounts. The purchasing department may be buying in excessive quantities in order to take advantage of volume discounts. In these cases, the unit cost will be low, but the business is investing in too much inventory for a protracted period of time, which drives up its carrying costs.
Forecasts are too high. The sales manager forecasts higher sales than are actually experienced. The result is excess stocks that customers do not want. The same outcome can arise when a customer backs out of a large purchase. In short, poor systems, incorrect purchasing practices, and inaccurate sales forecasts can all result in high inventory carrying costs.
How to Reduce Inventory Carrying Cost
There are several ways to reduce the carrying cost of inventory, involving just-in-time production principles, constant monitoring of inventory levels, and promptly disposing of excess inventory. These concepts are discussed below:
Use just-in-time production. One way to reduce the cost of carrying inventory is to adopt just-in-time production principles, so that suppliers deliver raw materials directly to the company’s production lines, thereby greatly reducing the inventory investment. Depending on the situation, this can mean that suppliers are taking on the cost of carrying the inventory. Goods can also be produced only to match existing customer orders, so that obsolescence costs are eliminated. This means that the amount of finished goods inventory is kept to a minimum. Instead, the production process is geared towards very short production runs, so that it can process individual customer orders as they arrive. Only an extremely well-organized production facility that uses just-in-time manufacturing principles can produce to order.
Monitor inventory levels. Constantly monitor optimal inventory levels and reorder points, to keep from investing too much in inventory. This analysis can result in differing inventory levels throughout the year, as customer order volumes vary; inventory levels are especially likely to change for a seasonal business, where sales may spike for a very short span of months. Reorder points can be influenced by how far suppliers are located from the company’s location, since closer suppliers have shorter delivery times. Thus, changing suppliers can have an impact on reorder points and quantities. A business that wants to reduce its inventory carrying costs could do so by purchasing from a cluster of suppliers that is located nearby.
Sell off goods. A variation on the preceding concept is to sell off goods near the end of a tax reporting period, so that the firm pays fewer taxes on its inventory assets. This is a common approach for car dealerships, or any sellers of expensive consumer goods.
Dispose of excess inventory. A good way to minimize inventory holding costs is to promptly disposition any inventory items that are not selling well. This may involve returning goods to suppliers (perhaps in exchange for a restocking fee), or selling off goods to a third party at a discounted price. For a larger business with many products, that may require the services of an entire group within the purchasing department.
Example of Inventory Carrying Cost
A business that sells dish washers has an on-hand inventory balance of $1 million. Dish washers are bulky, so they require a significant amount of warehouse space - which costs $80,000 per year, plus $10,000 in depreciation on storage racks and fork lifts. The company maintains an insurance policy that will pay it back if the inventory is damaged - which costs $6,000 per year. It also pays materials handlers $60,000 to move and store the inventory, and writes off an average of $4,000 per year due to inventory damage. The firm also pays $10,000 in interest charges on the funds needed to pay for the inventory. These costs add up to $170,000, so the business is incurring a 17% inventory carrying cost.