The carrying cost of inventory refers to the expenses associated with holding and storing unsold goods. These costs can largely impact your business’s profitability and include storage, labor, insurance, and opportunity costs. Understanding and managing these costs is crucial for maintaining a lean and profitable inventory management process inside your company.

What is the Carrying Cost of Inventory?

Inventory carrying costs (or holding costs) are the costs of holding unsold inventory. These costs include opportunity costs, storage, labor, transportation, handling, insurance, taxes, replacement, shrinkage, and depreciation.

Carrying costs are a big fragment of total expenses for businesses that have physical inventory, usually 20% to 30% of total inventory value. So, inventory carrying cost is a key factor in your overall profitability.

High carrying costs will make you want to start working on optimizing your inventory levels. If you know these costs, you can make informed decisions on inventory management, especially to balance customer demand with the risks and costs of overstocking.

Related: Mastering Inventory Management: Everything You Need to Know

Tangible and Intangible Costs

Your company’s inventory carrying costs can be broken down into physical and non-physical costs. Tangible costs are direct expenses like warehousing and employee salaries; intangible costs are opportunity costs, deterioration, and obsolescence.

• Tangible Costs. Tangible carrying costs include expenses incurred through various operational activities, employee wages, equipment purchases, property taxes, facility costs, maintenance, cleaning, and transportation. Knowing these costs is key to managing inventory and reducing carrying costs.
• Intangible Costs. Intangible inventory carrying costs include opportunity costs, deterioration, and obsolescence. Bad storage techniques can lead to obsolete inventory and depreciation and, therefore, carrying costs. Also, intangible costs can include losses that are hard to measure, like employee morale and brand reputation.

Key Components of Carrying Costs

Inventory carrying costs are made up of many components of inventory carrying that together equal the total cost of holding inventory. These include storage, labor, insurance, taxes, opportunity costs, inventory costs, etc.

Opportunity Costs

Opportunity costs are the price of giving up better uses of the money tied up in inventory. This capital could be invested in other areas of the business that could generate higher returns. Excessive inventory means missed investment opportunities and financial losses.

Storage Costs

Storage costs are a big part of inventory carrying costs and include costs of warehousing such as rent, utilities, and third-party fees.

The main expenses are warehouse space, lighting, electricity, refrigeration, personnel, and administration. Warehouse space costs average around $9.7 per square foot.

These costs can be fixed and variable.

Fixed costs include mortgage payments for owned warehouses, while variable costs change with the volume of inventory stored. Optimizing warehouse layout and reducing inventory volume can reduce storage costs.

Labor Costs

Labor costs of inventory management include costs of receiving, storing, and fulfilling orders. These costs include warehousing employee salaries, transportation, benefits, severance packages, and wages for hourly or contract workers.

Organizing warehouse items efficiently and improving employee productivity can reduce overall labor costs.

Insurance and Taxes

Higher inventory levels mean higher insurance costs as the cost of insuring the company’s inventory increases with the volume of products stored. Property taxes are also considered administrative costs of inventory management.

Both insurance costs and property taxes contribute to overall inventory carrying costs.

Inventory Risk Costs

Inventory risk costs must also be added to inventory holding costs as they take into account the potential financial impact of holding unsold stock. These costs come from various risks of holding inventory, such as replacement, shrinkage, and depreciation.

Replacement Costs

Replacement costs are the costs incurred when inventory items are damaged or lost and must be replaced. This can happen because of mishandling, possible accidents, or natural disasters. You need to account for these costs so you can maintain enough stock without incurring unexpected costs.

Shrinkage Costs

Shrinkage costs, on the other side are expenses related to inventory losses due to theft, fraud, or administrative errors. These losses can be significant and represent unexpected reductions in inventory value. Implementing strong security measures and inventory tracking systems can help you reduce shrinkage costs.

Depreciation Costs

Depreciation costs are the costs when inventory items lose their value over time, often due to obsolescence or deterioration. This is more relevant for perishable goods or technology products that quickly go obsolete. Accurately accounting for depreciation will help you manage your inventory better and minimize potential financial losses from holding old stock.

How to Calculate Carrying Costs?

Calculating holding costs of inventory is really important if you want to ensure effective inventory management and financial decision-making. Awareness of these costs will help you maintain optimal inventory levels and balance customer demand with overstocking risks.

The Formula for Carrying Costs

To calculate the inventory carrying cost, you need to sum all the costs mentioned above and get the value in currency. Usually, we present these costs as a percentage of average inventory value on an annual basis. So, we need to divide the calculated amount in currency by the total inventory value and multiply by 100.

This formula helps express carrying costs as a percentage of inventory value.

If the total carrying costs are $1.5 million and the average inventory value is $6 million, the carrying cost percentage, expressed as a percentage, would be 25%, clearly illustrating inventory management costs relative to inventory value.

Example Calculation

To illustrate, consider ABC Company with an inventory value of $1 million at a carrying cost rate of 20%. The carrying cost would be $200,000, totaling carrying costs for the company. XYZ Company has an inventory value of $1 million. With a carrying cost rate of 25%, this results in a carrying cost of $250,000.

But this doesn’t say anything about the inventory carrying cost formula. So, let’s go with another example.

For example, a company has an average of $3,000,000.00 worth of products in inventory annually. Opportunity costs amount to 7%, taxes amount to $270,000.00, and insurance amounts to $5,000.00 per year. It allocates $300,000.00 per year for storage space (warehouse).

The documentation’s data analysis shows that 0.8% of the products’ value becomes obsolete annually, 0.6% is shrinkage costs, and 1.3% is depreciated.

From the figure below, you can see that first, we convert these costs where they are not in a percentage amount, then steps 2 to 8 are summed to finally calculate the amount in the currency of the total inventory costs. As you can see, inventory holding costs are $916,000.00.

If you divide this inventory holding sum by the total value of the inventory and multiply by 100, you will get how much these costs are as a percentage of annual inventory value.

This method is a simple way to determine the annual inventory carrying cost. The example shows that these costs account for almost 30% of the value of the stored goods.

These examples show how carrying costs can significantly impact your company’s finances and bottom line.

How Businesses Lower Inventory Carrying Costs?

Cutting inventory costs is key to being profitable and efficient. Strategies are to optimize inventory, improve inventory turnover, and improve supply chain agility.

Optimise Inventory Levels

Improving demand forecasting through historical analysis will reduce overstocking and stockouts. Advanced analytics will allow you to track inventory against operational needs and avoid excess storage costs.

Evaluating each SKU to forecast sales will be a key strategy to determine the right inventory levels. Having the right inventory will save you storage costs and reduce the risk of holding stock that doesn’t sell.

Improve Inventory Turnover Rate

Reviewing product performance regularly will allow you to adjust pricing and inventory for a better turnover rate. Real-time visibility in inventory management will reduce reliance on safety stock by allowing you to anticipate inbound shipment delays.

Supply Chain Agility

Improving your supply chain operations with real-time shipment data will cut inventory service costs and reduce supplier lead times, which will allow you to hold less inventory and cut inventory carrying costs.

How Technology Can Help Lower Inventory Carrying Costs

Modern technology gives you real-time visibility into stock levels and optimizes replenishment.

Better Inventory Management

Better inventory management can help you to optimize inventory levels, save costs and help you make better decisions, and reduce carrying costs. With better inventory visibility you can make better supply chain decisions and timing for new products.

Using spreadsheets for inventory management can mean limited functionality and no real-time updates. Inventory management solutions can give you real-time visibility and intelligent cycle counts and, in such a way, improve accuracy and efficiency.

Real-Time Analytics

Real-time data visibility helps you to reduce safety stock by forecasting shipment delays. Historical inventory movement data helps you make better decisions and optimize the supply chain.

Automation Tools

Automation tools are key to inventory management by simplifying processes and increasing operational efficiency. They will reduce your labor costs by minimizing manual handling and will increase the overall efficiency of your inventory processes.

Inventory Carrying Costs and How They Impact Your Business

As you have seen, inventory carrying costs are complex and can be really overwhelming. So, understanding your inventory holding costs and how they impact your business is critical.

Financial Implications

Carrying costs affect a business’s overall financial health since they can represent one-quarter of all inventory spending.

You can reduce your inventory carrying costs and add to your bottom line if you implement a more effective inventory management system to lower your inventory levels. This, in turn, will not only improve your productivity because you must improve your operations, but it also will directly impact your profitability and the financial health of your company.

Production Scheduling

Inventory carrying costs can help you manage your production scheduling. Scheduling production for your most valuable items is critical to your business’s success. So, finding a balance between customer service levels and managing your inventory is important. You want to make sure you are not overproducing to avoid higher inventory-carrying costs.

Investor Perception of Your Business

Remember that inventory carrying costs affect investor sentiment. High inventory-carrying costs can indicate poor management and potential financial trouble. This is especially true if your costs are very high as a percentage of your inventory value. Reducing carrying costs through effective inventory management can increase the value of your company and make a positive impact on investors.