Business leaders tend to be laser-focused on revenue growth, and understandably so. But thatfixation may mean they overlook less-obvious costs—even as stealthy expenses dentprofitability. Among the priciest under-the-radar outlays are inventory carrying costs, theexpenses that come with holding inventory until it’s sold.
Are you losing money this way? Ask: Do we pay every month to store lots of unsold goods? Arewe sometimes short on working capital? Have we had to mark down items because they sat too long in a warehouse?
If so, you may need to adopt some new strategies to keep stock moving.
What Are Inventory Carrying Costs?
Carrying costs are among the top inventory managementchallenges companies deal with. These expenses arise from keeping products shelvedat a warehouse, distribution center or store and include storage, labor, transportation,handling, insurance, taxes, item replacement, shrinkage and depreciation. Opportunity cost—the investmentpossibilities a company must decline because its resources are tied up in inventory—isalsoa factor.
Typical holding costs, another name for inventory carrying costs, vary by industry andbusiness size and often comprise 20% to 30% of total inventory value, and it increases thelonger you store an item before selling it. The percentage will vary based on the number ofitems a business sells, its inventory turnover ratio, the location of its warehouse or storeand its storage requirements.
Key Takeaways
- Inventory carrying costs—the full amount businesses spend to stock and store itemsbefore they’re sold—can have a significant impact on profitability.
- This expense often totals about one quarter of the inventory’s total value. For amoreprecise calculation, add up your carrying costs and divide that number by the totalinventory value.
- Excessive safety stock, slow-moving inventory, inadequate tools for inventory managementand planning, poor forecasting and flawed inventory/order management processes can allcause holding costs to soar.
- To reduce inventory carrying costs, keep less inventory on hand, purchase a capablewarehouse management system, explore ways to increase inventory turn and evaluate theeffectiveness of your warehouse layouts.
Inventory Carrying Costs Explained
Inventory carrying costs are a crucial metric that helps determine whether you’rerunning anefficient operation. High carrying costs could mean your organization has more inventory onhand than it needs based on demand, that you need to adjust the frequency with which youplace orders with manufacturers or distributors or that you could do better at keeping stockmoving.
Inventory carrying costs can be sorted into four categories: capital costs, storage costs,service costs and inventory risk costs.
Capital expenditures aremonies spent on products and any interest and fees incurred if the company took outa loan to pay for the goods. Storage costs can be fixed, like a mortgage for astore/warehouse, or variable, as are labor, utility and administrative expenses. Taxes,insurance and inventory managementsoftware are all examples of service costs.
Inventory risk includes shrinkage, depreciation and product obsolescence.
Why Is Calculating the Cost of Carrying Inventory Important?
Because holding costs may make up one quarter of all inventory spend, they can affect abusiness’ overall financial health. If an organization can’t quantify the costof keepingstock on hand, such as by employing aninventory or stock control system, it may end up with cash flow problems.
A company could also miss out on a promising investment or growth opportunity because it hastoo much money tied up in inventory—all without leaders even realizing how muchcarryingcosts are holding back the business.
Here are other reasons holding costs matter:
Production planning: Once a company understands how much it spends to storeinventory, it may rethink its production schedule. In particular, if a certain product canbe manufactured quickly, the business may want to keep only a small quantity in stock. Onthe other hand, a certain item may be a big seller and have a low carrying cost, so it makessense to dedicate more warehouse space to it. A material requirements planning (MRP)process can provide insights.
Profitability of existing inventory: By calculating inventory carrying costsand tracking the value of each product, an organization can better estimate how much profitit can expect to earn from existing inventory. Carrying costs are a major inventory expense,so once that’s deducted, it’s easier to measure profit by item.
Inventory accounting: Inventory is one of the biggest expenses for manycompanies, so it’s important to accurately calculate the cost of holding thatinventory, aswell as the value of those products. The accounting team needs this data to produce accuratefinancial statements.
10 Components of Inventory Carrying Cost and How to Reduce Them
Many expenses factor into the inventory carrying costs equation—and together they addup to avery common way that businesses waste money.
Let’s break down each component:
1. Cost of Capital
Cost of capital, usually the biggest portion of inventory carrying costs, includes thepurchase price of the products plus any interest and other fees if the business took on debtto pay for that inventory. Tying money up in products could affect cash flow and,consequently, increase the need for and cost of additional capital.
To reduce the cost of capital, invest in forecasting that leads to smaller or more strategicpurchases. You could also negotiate a lower purchase price with suppliers.
2. Cost of Storing Inventory
The real estate items take up in a warehouse or store is valuable: Warehouse space costs anaverage of $6.53 per square foot, soeach shelf, bin and box counts. If you use a third-party logistics (3PL) provider,it’seasier to figure out this cost, because that partner may charge by the shelf, pallet oritem. A company can often re-imagine its warehouse layout or how it stores products ofdifferent shapes/sizes to reduce storage costs. Paring down inventory may even allow acompany to move to a smaller warehouse, another way to trim storage costs.
3. Employee Cost
This is simply the cost of labor associated with receiving and putting away products,fulfilling orders and other touchpoints. Businesses can often rearrange their warehouses toincrease employee productivity by, for example, storing the most popular items near packingstations or supplementing human workers with automation. Experimenting with differentpicking methods and using software that maps the most efficient pick paths for employees areworth considering if labor costs are rising.
4. Opportunity Cost
If you overspend on inventory, that ties up money you could have used for marketing, newhires, real estate and countless other investments—many of them more valuable to theorganization than items sitting on a shelf.
5. Obsolescence
Obsoleteinventory—stockthat can no longer be sold because it’s reached the end of its lifecycle—canlead to a spikein inventory carrying costs. Products become obsolete after they depreciate to the point ofhaving no value and must be written-off. Organizations can minimize obsolete inventory byfinding ways to offload stock while it still has some value, perhaps through deepdiscounting, donating it or by selling it to a liquidator. Otherwise, you’ll likelypay todispose of it.
Without performing regular checks, companies may be holding obsolete inventory in thewarehouse that incurs added costs and ties up space in the warehouse; so, it’simportantthat items are disposed of promptly before they become obsolete.
6. Insurance/Taxes
Many companies invest in an insurance policy to protect one of their most valuable assets:inventory. Then if a flood or fire destroys a store or warehouse, all is not lost. But themore product in the warehouse, the more that insurance policy will cost.
Similarly, the more inventory you hold, the higher your taxes. An organization can pare downboth insurance and tax expenses by keeping fewer products or only its highest-performinggoods in the warehouse.
7. Administrative Costs
Administrative costs encompass a wide variety of expenses, including property taxes, facilitymaintenance and cleaning, transportation and equipment depreciation. Generally, if a companyholds more inventory, it has higher administrative costs, in part because it needs a largerfacility.
8. Material Handling
Labor and the number of “touches” a product requires—from putting it in awarehouse bin toprinting a shipping label—is a big part of the money spent on material handling. Butmachinery, equipment and damage to products after you take possession are also part of thisexpense category. A company may not need as much machinery or equipment, or it may use themless frequently and reduce the need for maintenance and repair, if it stores fewer items inits facility.
9. Shrinkage
When inventory is lost after your company purchased it but before it’s sold to acustomer,that’s shrinkage. Sources of inventory shrinkage includetheft, fraud, damage in transit or record-keeping mistakes. As with other inventory carryingcosts, the more stock a business holds, the more money it will commonly lose to shrinkage.
An organization could identify and terminate employees who are stealing, talk to vendorsabout common causes of damaged goods and perform more frequent physical inventorycounts to reduce shrinkage.
10. Delayed Innovation
If a company is constantly focused on moving excess stock, it’s likely not innovatingandbrainstorming ways to, for example, add a feature or new product requested by customers.Businesses can find themselves stuck in this loop if they’re consistently carrying toomuchinventory. Optimizing stock levels will free up resources for research and development.
Inventory Carrying Cost Formula and Calculation
Companies need to regularly measure their inventorycarrying costs to find out if holding costs represent a disproportionate amount ofinventory value. This calculation will help businesses determine when they need toreevaluate their processes and practices.
To determine inventory carrying costs, first add up the expenses outlinedabove—capital,storage, labor, transportation, insurance, taxes, administrative, depreciation,obsolescence, shrinkage—over one year. Then divide those carrying costs by totalinventoryvalue and multiply the number by 100 for a percentage.
Inventory Carrying Costs = Cost of Storage/ Total Annual Inventory Value x 100
For a quick, rough estimate of carrying costs, divide your total annual inventory value byfour.
Carrying Cost Example
As fall winds down, retailer Seasonal Inspirations’ two warehouses are still full ofwinterclothing. It wants to better understand the price of having so much inventory on its shelvesas it tries to make room for spring apparel.
The retailer calculates storage costs of $10,000, labor expenses of $2,000, $3,000 forshipping, $2,000 for insurance and $1,000 for shrinkage and depreciation. That puts totalinventory carrying costs at $18,000, and that inventory has a cost of goods of $75,000.
$18,000 /75,000 x 100 = 24%
Per that calculation, Seasonal Inspirations has inventory carrying costs of 24%.
5 Reasons a Company Holds Inventory
Striking an ideal inventory balance is no simple task. Many companies think it’s bettertohave too many items than run out and lose a sale and potentially damage a customerrelationship. Here are a few other reasons organizations hold onto too much stock, pushingup their carrying costs:
1. Safety Stock
Stocking just enough product to cover expected need can be a risky proposition.That’s why most companies carry some safety stock, or extra inventory to coverunpredictableevents like a surge in demand, an unexpected supplier delay or a damaged shipment.It’sgenerally a good idea to have safety stock for popular items, but be judicious becauseexcess safety stock will lead to unnecessarily high holding costs.
2. Cyclical or Seasonal Demands
Certain businesses—retailers in particular—earn most of their annual revenue injust a fewmonths, making retail inventorymanagement particularly important. An electronics retailer may see a surge in ordervolume in the months leading up to the winter holidays, while a manufacturer of inflatablepool toys may do most of its business in the spring and early summer. In an effortto be ready for that crucial stretch, these companies may build up large inventory reservesbefore the busy season starts.
3.Cycle Inventory
After creating sales forecasts, a company purchases cycle inventory. This is the stockrequired to fulfill anticipated demand for various products; it’s not meant to covertheunexpected, like safety stock. Every products-based business must have cycle inventory, orworking stock, to keep up with customer demand and generate sales. Accurate forecasts and cycle counting are crucialto stocking the right amount of cycle inventory.
4. In-transit Inventory
In-transit inventory refers to products a company has purchased but not yet received.Depending on where a supplier is located and the type of product, lead times can be severalmonths, so inventory could be in transit for a long time. Businesses need to account forthese goods in transit as they plan future purchasing—yet they can be easy to overlookbecause they’re not yet in the warehouse. This is especially true if you don’tuse an inventory management systemthat shows the status of all purchase orders.
5. Dead Inventory
“Dead inventory” is another term for obsolete inventory. These are goods acompany no longerbelieves it can sell and that are often written-off as a loss. Dead inventory may linger ina distribution center or the back room, quietly and continually raising inventory carryingcosts without leaders even realizing it.
5 Ways Companies Fail to Reduce Carrying Costs
There are a few common causes of unnecessarily high holding costs; any of them can make itdifficult for businesses to lower this expense. If your inventory costs seem excessive andyou’re not sure why, look into these potential issues:
1. Using Excel and Obsolete Methods
Businesses outgrow spreadsheets quickly because of their limited functionality and lack ofautomation. With Excel spreadsheets, paper records or other legacy tracking methods, acompany’s inventory reports are often inaccurate and can’t update in real time.
And when a business doesn’t know what it already has, it’s much more likely toover-purchaseor buy the wrong items. Decisions are guided by feel or best guesses rather than strategyand data.
2. Flawed Demand Forecasting
Poor inventory demand forecastingis a common driver of high holding costs. If a company uses flawed data to create forecasts,it may expect a spike in demand for a certain SKU and load up on inventory, only to seesales fall far short. Or it may falsely assume that because a specific product was a topseller last quarter, that item will continue to fly off the shelves for the next twoquarters. In either situation, the company ends up with a lot of excess inventorythat’sconsuming valuable space and tying up cash that would’ve been better spent elsewhere.See:opportunity cost.
3. Failure to Understand Trends
Accurate inventory and production planning is built on not only accurate data, but people whocan effectively analyze andinterpret that data. Employees must be able to spot trends in the numbers andinterpret the impact. If a purchasing manager fails to realize that sales for severalproducts tapered off for the last month of the third quarter, for example, he might place abig order for the fourth quarter that creates obsolete inventory. Leaders must also accountfor how industry trends or broader economic shifts could affect demand for its items.
4. Overstuffing and Low Inventory Turnover Ratio
Inventory turnover ratio is a critical metric that shows how often certain products are soldand restocked over one year. This ratio informs purchasing decisions. A low turnover ratiofor too many products leaves an organization with high inventory carrying costs and,eventually, obsolete inventory. That creates an overstuffed warehouse packed to the brimwith stock that is neither moving quickly nor as valuable as it once was.
5. Flawed Inventory Management/Order Fulfillment Processes
Much like organizations that use Excel or other legacy methods, those without a detailedinventory management strategy will over-order to protect themselves. It’s unavoidablewithout a solution that lists reorder points based on lead times and current demand andprovides real-time visibility down to the SKU level.
Similarly, inefficient fulfillment methods can increase labor costs, while poor warehousedesign or storage techniques can raise storage costs and make it easier to overlook existinginventory. That leads to obsolete inventory, depreciation and higher insurance, tax andadministration costs.
5 Ways to Reduce Inventory Carrying Costs
There are a number of ways companies can cut inventory carrying costs, and some requireminimal time and effort. Smart strategies to spend less money keeping items in stockinclude:
1. Minimize Inventory On Hand
Although the coronavirus pandemic has laid bare the risks of a just-in-time inventorystrategy, companies still often hold too much stock or the wrong products. Start by tracking a slate of inventory keyperformance indicators (KPIs) that will help you evaluate each SKU to determine ifit deserves a place in the store or warehouse, and then help decide the appropriate quantityto keep on hand.
While accurate forecasting is critical, so is software that alerts purchasers when it’stimeto reorder and suggests how much to buy. It will take time and experimentation to strike theright balance, but it’s worth it—optimized inventory levels save a lot of money.
2. Speed Up Inventory Turnover Times
Increasing your sell-through rate isanother powerful way to lower inventory holding costs, because it means items spend lesstime on your shelves. Calculate your sell-through rate using this formula:
Sell-through rate = (# of units sold duringperiod / # of units received at start ofperiod) x 100
Review the performance of all products every month to see if they’re selling at theexpectedrate. If turnover is higher or lower than expected, adjust accordingly. Once again, accurateforecasts will minimize excess inventory that sits around and loses value.
An ability to interpret business- and market-specific trends will also improve your inventoryturnover ratio. When companies do find themselves moving through inventory too slowly,promotions and bundling may help clear it out.
3. Redesign Your Warehouse
Businesses often don’t make the most of the space they have. You may be surprised byhowdramatically physical changes to a warehouse or store can reduce holding costs. Tweaks couldinclude using containers for more efficient storage, adding shelving to increase verticalspace or putting popular items in a central location. All of these methods can drive downlabor and storage costs.
Additionally, redesigning a manufacturing plant or warehouse could make it less likely thatavailable inventory goes unnoticed, lowering capital, depreciation, obsolescence, insuranceand tax costs.
4. Purchase an Inventory/Warehouse Management System
Technology plays a central role in giving supply chain leaders the inventory visibility theyneed to make smart decisions. A perpetual inventorysystem, that is, one that updates in real time, is ideal because it provides a trulyreal-time picture of inventory levels—not what they were last night or four hours ago.Thevisibility an inventory management solution offers makes it a much more realisticproposition to strike an ideal balance with stock because it helps employees better time neworders and track metrics like inventory turn and sales volume.
A warehouse management system (WMS) iscomplementary and can make fulfillment and shipping faster and more cost effective.
5. Renegotiate with Suppliers/Customers
Another method for holding down holding costs is to renegotiate agreements with yoursuppliers and/or customers. Make sure you’re not bearing the bulk of unavoidable risksandcosts before customers buy these items. For example, structure contracts with suppliers sothey are responsible for damage, theft or administrative costs while goods are in theirpossession.
Manufacturers and distributors should explore ways to avoid paying excessive carrying costs.For example, specify a maximum holding time for inventory in the agreement, and tack on feesfor each day beyond that period to recoup some of those carrying costs. Retailers shouldconsider doing the same: There’s no reason to take possession of a shipment ofmeltableHalloween candy in June.
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Reducing Inventory Carrying Costs with Inventory Management Software
One powerful step businesses can take to reduce inventory carrying costs is to invest in aninventory managementsolution. This software offers a multitude of ways to optimize inventory levels,which in turn cuts down on all the expenses outlined above.
The visibility an inventory management system offers is a tremendous asset for any productscompany, because it empowers purchasing, operations andsupply chain professionals to make better decisions. The solution can track not onlycurrent stock levels but the status of all outstanding purchase and customer orders.
No more “forgetting” about stock in a shipping container on its way to yourwarehouse.
This technology will also establish consistent receiving, putaway and fulfillment processesthat ensure each item is traceable from the time it enters your warehouse to when thecustomer receives it. Inventory management software empowers companies to beproactive—theycan adjust purchase orders, sales strategies, warehouse layouts and more to address problemsearly on, before costs pile up.
The reporting tools within an inventory management solution are also invaluable. For example,a business can view its inventory turn or sales numbers for a product category or specificSKU over any period of time. It can monitor the money lost to depreciation or spent on taxesand insurance in a quarter or year.
This data gives decision-makers the insights they need to control inventory carrying costs. Apurchasing manager might check the sell-through rate for the last month and decide to cancelan upcoming order for a few products, reallocating that money toward a rush shipment for anitem that’s seen sales triple in the last two weeks. This information also helpsfinance andoperations managers build more accurate forecasts.
Leaders should be very selective about the products, and the quantities, they keep in theirstores and warehouses. Ultimately, the more strategic an organization can be with theinventory it stores, the lower its holding costs will be.
Bottom line, dodging both out-of-stock and overstock situations is a constant balancing act.
Even with best-in-class forecasting capabilities, it’s almost impossible to getinventoryplanning exactly right. But an inventory management system that’s tied to alarger ERPplatform is a critical step in getting holding costs under control because itenables better forecasting and delivers the real-time visibility every products-basedbusiness needs to make intelligent inventory decisions.
Inventory Carrying Costs FAQs
What are examples of carrying costs?
Numerous expenses contribute to inventory carrying costs: The products themselves (capitalcosts), storage, depreciation, labor, insurance and taxes, obsolete inventory andopportunity cost, along with administrative expenses. That list demonstrates why holdingcosts can dramatically impact a company’s bottom line.
How do you calculate inventory carrying cost?
Inventory carrying cost is a pretty simple calculation once you’ve figured out all theexpenses that go into having these goods on hand. Add all those numbers together for thetotal carrying costs, then divide it by the total value of the inventory and multiply theresult by 100 to get a percentage.
