Carrying Cost

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Carrying Costs

What Are Carrying Costs?

Carrying costs, also known as holding costs and inventory carrying costs, are the costs a business pays for holding inventory in stock. A business can incur a variety of carrying costs, including taxes, insurance, employee costs, depreciation, the cost of keeping items in storage, the cost of replacing perishable items, and opportunity costs. Even the cost of capital that helps to generate income for the business is a carrying cost.

Although opportunity costs are unseen and intangible, they can have a significant impact on a company’s profitability.

Understanding Carrying Costs

Carrying costs are also sometimes referred to as the carrying costs of inventory. A company pays various costs over time for holding and storing inventory before it is sold and shipped to customers. Businesses calculate these costs to evaluate the level of profit they can reasonably expect on their current inventory. It is also useful in determining whether a company should increase or decrease the production of goods. By knowing its carrying costs, a business can stay on top of expenses and continue to generate a steady income stream.

Opportunity costs are another kind of carrying cost. These costs represent what a business owner sacrifices when choosing one option over another. Although opportunity costs are unseen and intangible, they can have a significant impact on a company’s profitability.

Key Takeaways

  • Carrying costs are the various costs a business pays for holding inventory in stock.
  • Examples of carrying costs include warehouse storage fees, taxes, insurance, employee costs, and opportunity costs.
  • Businesses can reduce their carrying costs by implementing efficient warehouse design and by using computerized inventory management systems to keep track of inventory levels.

Special Considerations

There are options business owners can implement to decrease the amount spent on carrying costs. For example, they can limit the volume of inventory they store. They can also limit the amount of time the inventory spends in storage. For businesses that utilize refrigerated warehouse space, this tactic is of specific importance. Improvement of warehouse or storage space may also be an option when trying to lower carrying costs. Having an efficient and cost-effective warehouse design and utilizing correct storage techniques can help keep carrying costs down.

Inventory tracking is also an option to help businesses cut down on carrying costs. In many cases, computerized inventory management systems are employed to keep track of inventory levels, as well as the business’ supplies and materials. These systems can alert owners or management when more or less inventory is needed.

The advantage of cyber stores over brick-and-mortar stores is the overriding lack of carrying costs. Most online stores stock inventory as it is needed, or simply have it shipped from one centralized location instead of keeping inventory in multiple physical locations.

Example of Carrying Costs

Carrying costs are calculated by dividing the total inventory value by the cost of storing the goods over a given time. It is usually expressed as a percentage.

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For example, a company that sells sporting goods might carry many items in inventory, such as sports equipment, apparel, footwear, and fitness trackers. To figure its inventory carrying costs, the company adds every cost it pays to store these items over one year. Let’s say the total is $150,000. If the company has a total inventory value of $600,000, the company’s inventory carrying cost is 25%. This means the company pays 25 cents per dollar of inventory it holds over the year.

Inventory Carrying Costs – Components and Considerations

Inventory carrying costs need to be understood to determine profitability

The cost of carrying inventory is used to help companies determine how much profit can be made on current inventory.

The cost is what a business will incur over a certain period of time, to hold and store its inventory. The carrying cost of inventory is often described as a percentage of the inventory value.

This percentage can include:

  • Taxes
  • Employee costs
  • Depreciation
  • Insurance
  • The cost of insuring and replacing items

There are four main components to the carrying cost of inventory:

  1. Capital cost
  2. Storage space cost
  3. Inventory service cost
  4. Inventory risk cost

Capital Cost

The capital cost is the cost that a business expands on carrying inventory. It is the largest component of the total costs of carrying inventory.

A company will express the capital cost as a percentage of the dollar value of the total inventory it is holding.

For example, if a company says that the capital cost is 35 percent of its total inventory costs, and the total inventory held is $6000, then the capital cost is $2100.

Although companies will give a percentage of their capital cost, this figure may be an objective figure, derived from a calculation, or a subjective figure, derived from experience or industry standards.

Storage Space Cost

The storage space cost is a combination of the warehouse rent or mortgage, lighting, heating, air conditioning, plus the handling costs of moving the materials in and out of the warehouse.

Some of the costs are fixed, such as rent or mortgage, but there are variable costs, such as the handling of the materials that will vary with the level of inventory.

When a 3PL is used or a private warehouse, all the costs may be included in a monthly cost so the storage space cost is not relevant when determining the cost of carrying inventory.

Inventory Service Cost

The cost of carrying inventory will include inventory service costs. These costs include insurance paid on the inventory and taxes to local government.

The insurance that a company pays is dependent on the type of goods in the warehouse as well as the level of inventory. The higher the level of inventory in the warehouse, the higher the insurance premium will be.

Many local authorities tax the level of inventory in the warehouse, so higher levels of inventory will lead to higher taxes paid and a higher inventory service cost.

Inventory Risk Cost

Carrying inventory comes with a certain degree of risk. This risk is a component of the cost of carrying inventory.

When a company stocks items in the warehouse there is always the risk that the items may fall in real value during the period they are stored.

For example, an item could become obsolete or superseded by a new model or version.

If a company stored parts for their work centers or equipment, but those parts were replaced with a new version, the parts in the warehouse could be worth far less than the price that was originally paid. In the retail industry, the risk is much higher as finished items may be seasonally specific.

If the items remain in the warehouse too long, the value may be a fraction of the original worth.

Other aspects of inventory risk include the possibility that the stored items may expire, especially with items that have a sell-by date or use-by date. If the items expire then they can become worthless and have to be scrapped.

Items in the warehouse can also degrade, by water damage, heat damage, or by incorrect storage.

Pilferage and theft should also be included in the inventory risk cost.

Summary

When companies are looking to reduce costs, a great many times they ignore the inventory sitting in their warehouses and the cost of carrying that inventory. It is important for businesses to carefully examine all the costs of carrying inventory and determine where they can make changes to reduce that cost and help with the company’s bottom line.

In order to optimize a company’s supply chain, a company needs to understand the total cost of its supply chain. Inventory carrying costs are a large part of that total cost.

This Inventory Carrying Costs – Components and Considerations article has been updated by Gary W. Marion, Logistics and Supply Chain Expert for The Balance.

Inventory carrying cost: what it is and how to calculate it

Inventory carrying cost, also known as inventory holding cost, is the cost associated with holding inventory or stock in storage or a warehouse, in order to fulfill sales orders.

Why is it important for you to have an accurate view of your carrying costs at all times?

1. It is critical in figuring out how much profit you can make on current inventory.

2. It can help you determine if production should be increased or decreased, in order to maintain the current or desired balance between income and expenses.

3. Carrying costs are typically 20 – 30 percent of your inventory value. This is a significant percentage, making it an essential cost factor to account for.

Inventory carrying cost formula

(C + T + I + W + (S – R1) + (O – R2))/ Average annual inventory costs

where the individual components are:

C = Capital
T = Taxes
I = Insurance
W = Warehouse costs
S = Scrap
O = Obsolescence costs
R = Recovery costs

Don’t be intimidated by this seemingly complicated formula! We’ve broken down the formula, and there are just four important cost components you need to understand:

1. Capital costs

Capital costs refer to the costs incurred for carrying inventory. Examples include money spent on acquiring goods, interest paid on a purchase, interest lost when cash turns into inventory, as well as the opportunity cost of purchasing inventory. Capital cost usually makes up the largest portion of the total carrying cost.

2. Storage costs

Storage costs are expenses incurred to help keep your inventory safely organized in a particular place like your warehouse. It can be separated into two components: fixed costs and variable costs.

Fixed costs include rent or mortgage costs of the storage space, while variable costs are manpower costs, costs of handling materials and utilities expenses associated with the space.

3. Service costs

Service costs are incurred to protect your inventory from issues such as theft or workplace accidents, to ensure that government regulations are met and to keep your inventory well managed . Examples include insurance payments, taxes on inventory, as well as the costs of using an inventory management software system to keep track of inventory levels.

4. Costs of inventory risk

Carrying inventory presents a certain level of risk, and this risk translates into a cost component. This cost component is made up of a few factors. The first factor is the risk of shrinkage, which refers to any inventory loss that occurs after a good is purchased, and before it is sold to your customer. Shrinkage may occur to due to damages in transit, administrative errors or theft by employees.

The second risk is the fall of the real value of your inventory while it is being stored to be sold. Possible causes for this include the launch of new products or models. Thirdly, there is the risk of obsolescence, whereby goods held have run past their expiration or sell-by dates.

Carrying costs: Bringing ‘em down

Now that you’ve a better understanding of inventory holding costs, the next question you’re likely to raise is: “How do I lower these costs?”

You could work on.

. Tweaking the design of your storage space

Start by making improvements to the design of your storage space. Do not underestimate the value that good design brings — a design modification of your storage area can be a highly effective measure in creating additional space to reduce carrying costs. Consider making changes such as narrowing the aisle used for equipment handling, installing a mezzanine floor, altering the layout of your storage space or making a switch to adopt more appropriate storage modes.

. Negotiating long-term customer contracts

Having long-term contracts in place does not only mean that you’ve secured a sustainable source of revenue; it could also mean that you’re in a better position to allocate a larger portion of your inventory costs to your customers. Negotiate these contracts to ensure that they cover a portion of your inventory carrying costs. You could lay down terms that specify the duration that inventory remains in your storage complex, or impose carrying charges for storing inventory for extended periods of time.

. Negotiating terms in vendor agreements

Negotiation does not end with customer contracts — you should also review and discuss the terms in vendor agreements. When vendors hold on to your inventory, costs associated with damage, theft and handling are borne by them. Avoid stipulating unfair terms that make the contract a one-sided agreement. Instead, adopt a balanced approach by splitting carrying costs between you and your vendors.

. Giving different inventory management techniques and systems a go

Consider adopting online inventory management techniques that minimize carrying costs, such as selling on consignment , drop shipping or backordering for some of your products. Rather than rely on excel spreadsheets (manually tracking each and every transaction will quickly turn into a nightmare), utilize inventory control software that will provide valuable information, such as accurate demand forecasts and reorder point s, to help reduce your carrying costs.

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