Carrying Cost Formula: Mastery to Win the Inventory Game
January 12, 2024
Trimming down expenses is a smart move to boost profits, and luckily, reducing the costs of keeping inventory can be a pretty straightforward place to start. When it comes to all the expenses you’re juggling, shaving off a bit from what you spend on inventory tends to be both simple and safe. But first, you need to get what those costs are all about. There’s definitely a lot more to inventory than it appears. Whether you’re selling stuff online or managing a warehouse, getting the hang of inventory is key.
So, what’s this thing called inventory carrying cost? Why is it such an important number to track in your inventory game? And how come it’s a golden chance for nearly every business out there? Remember, when you’re drafting up a business plan, factoring in the cost of handling inventory is a must.
Inventory Carrying Cost Formula
At the outset, the inventory annual carrying cost formula, calculated as a percentage is:
Inventory Carrying Cost = (Inventory Holding Cost / Total Value Of Inventory) X 100
The inventory holding cost includes four main expenses:
- The money required to borrow or procure inventory (Capital Costs).
- Expenses for keeping everything running smoothly (Service Costs).
- Costs for any potential losses or damages (risk costs).
- Cost to pay for the place where you store your goods (space costs).
Inventory Holding Cost = Capital Costs + Service Costs + Risk Costs + Space Costs
To find out the total worth of your inventory, multiply the costs that go into each item by how many you have in stock. Remember that we’re talking about the value for figuring out your costs, not what it would sell for on the market.
Now take the total amount of money you spend just to have inventory (Inventory holding cost) and divide it by how much your inventory is worth in total. Then, multiply that by 100.
You can use the total carrying cost formula to estimate costs for any period of time including annual, quarter, or any time frame that suits your business. Generally, it’s recommended to work out your annual costs and also check them regularly, maybe as often as you make sales.
Related read: Inventory to Sales Ratio
Applying Inventory Carrying Cost Formula
Let’s picture BlueCafe Coffee Company, who roast and sell coffee beans wholesale. I’ll guide you through how to calculate the cost of keeping inventory with Carrying Cost Formula, see an example.
First up, we gather the costs from the company’s books:
- Average yearly cost of inventory: $1.5 million
- Money tied up in inventory (capital): $22,500
- Storage costs: $1,50,000
- Other inventory-related expenses: $1,00,000
- Money we could’ve made elsewhere (opportunity cost): $30,000
Next, we sum up these costs:
Total storage costs = Capital + Warehouse + Inventory expenses + Missed opportunities
Total = $22,500 + $1,50,000 + $1,00,000 + $30,000
Total = $302,500
Now, let’s figure out the percentage this cost is of the total inventory:
Cost Percentage = (Total storage costs / Total inventory cost) x 100
- Cost Percentage = ($302,500 / $1,500,000) x 100
- Cost Percentage = 20.16%
So, for BlueCafe Coffee, the cost to keep their inventory is 20.16% of the entire value of the goods. That’s pretty decent! If it wasn’t, they’d need to look at ways to lower these costs.
Inventory Carrying Cost per Unit Formula
Sometimes, calculating carrying cost per unit reveals more insights into the scale of costs. In fact, by figuring out the cost of holding each item in stock, you can spot how your inventory affects both your business’s cash flow and earnings.
Inventory carrying cost per unit per year formula includes what you pay for storage, upkeep, insurance, taxes, falling value, and outdated items. And comparing this with your sale price and profit to see if you’ve got just the right amount of stock or if it’s time for a change.
The formula for Inventory carrying cost per unit is:
Inventory carrying cost per unit = (Total inventory carrying cost / Average inventory level) / Number of units
While the total inventory holding cost remains the same, average inventory is the typical amount of material kept in stock over a year. The number of units is how many items were bought or used in that same year.
Analysing Inventory Carrying Costs
Capital costs
Out of all the types of carrying costs, the biggest chunk comes from capital costs – the money spent on buying materials and inventory plus any added finance charges and interest. This is basically the extra money paid for interest and the actual cash tied up in the stock.
So, when a business says, “Hey, our capital cost takes up 30% of what we spend on our inventory,” and that inventory is worth about $8,000, it means they’re shelling out a cool $2,400 just for that part.
Inventory Service Costs
Holding onto stock at a storage place costs money, even if it’s not about the products themselves. We’re talking about paying for insurance, dealing with taxes, buying equipment, and covering software for keeping track of all those items. If you’ve got more goods, you might pay more for insurance and taxes, but you need enough to make sure customers get what they want.
Even though you’ve got to pay regularly for inventory software, it helps you watch your stock closely and cut out any wasted steps. And let’s not forget, checking what you have on hand, with full stock takes or regular mini checks, is part of these costs, too.
Risk Costs
The danger with keeping items in stock is that they might not sell before they’re no good, turning into cash. This problem usually comes from either goods going missing or getting outdated. When stuff goes missing, it’s often because of breaks, theft, or messing up the counts. And when things get outdated, it’s because they’re too old or not cool anymore, especially when they don’t last long on the shelf. This issue hits a store’s profits hard when they have to knock down the value of their stock.
Storage Space Costs
Warehouse expenses involve the costs of running a storage space, such as rent or purchase fees, keeping the goods at the right temperature, paying for electricity, safeguarding the place, and moving items in and out. When a company has its warehouse, these costs stay the same and are easy to predict. But if it hires another company to take care of storing and shipping its products, the costs could change depending on how much stuff they’re dealing with.
Plus, there’s this thing called opportunity cost – which is basically what a business misses out on doing with their money because it’s all wrapped up in stuff they haven’t sold yet.
Three Causes of Steep Storage Costs
1. Inventory Mismanagement:
When you don’t sort out your inventory or plan your warehouse well, things get lost, broken, or take up too much room.
2. Carrying Excell Stock:
Keeping a little extra stock is smart for surprise situations, but don’t overdo it or you’ll pay more for storage.
3. Inaccurate Sales Forecast:
While sales forecasts aren’t foolproof, messing them up regularly could mean missed income and rising expenses. Guessing too high on sales might leave you stuck with too much stock and extra warehouse room.
Keeping Inventory Costs in Check
- Boost your warehouse setup! When stock grows and orders soar, it’s easy to ignore tidying up the warehouse. Yet, sprucing up this critical space can cut expenses and rev up efficiency big time.
- Pin down the perfect amount of stock to keep on hand and nail down when to reorder. Big buys might seem cheaper, but they cost more if they just collect dust. Peek at past sales, find that sweet spot for inventory, and order more only when needed to keep customers happy without drowning in surplus.
- Ditch the old pen and paper stock checks for smart inventory software. See everything in your supply network, track orders, and spot where goods are in a snap. Get the power to adjust stock, set prices right, and cut storage costs—all from clever reports that tie it all together!
You may also like to read: Reorder Quantity Formula and How to Calculate Reorder Level?
Conclusion
Remember that mastery of the Carrying Cost Formula is not a one-off event, but a continuous strategy that demands periodic revisits and revisions. Whether it’s seasonal, quarterly, or in sync with sales, keeping a check on your inventory costs ensures your business remains competitive, and prepared for success.
By effectively managing your carrying costs, you not only save resources but also strengthen your business against the unpredictability of the market. Embrace this carrying cost formula, and you’re not just playing the inventory game, you’re strategically positioning yourself to win it.
FAQs
What is the carrying cost per unit per year formula?
The formula of carrying cost per unit per year is as follows:
Inventory carrying cost per unit = (Total inventory carrying cost / Average inventory level) / Number of units
Calculating the cost to hold each item in stock often offers a clearer picture of how inventory expenses play a role. This cost includes storage, maintenance, taxes, insurance, and losses from items becoming less valuable or obsolete. By measuring it against your sales and profits, you can tell if your stock levels are on point or need adjusting.
What is the total carrying cost formula for inventory?
The carrying cost meaning is all about understanding and managing the ongoing expenses of stocks.
The formula looks like this:
Inventory Cost of Keeping Stock = (Total Cost of Holding Inventory / Total Value of Inventory) x 100.
First step is to add up capital, service, risk, and space costs.
Now figure out the true value of your goods, tally up the cost for each item and multiply by how many you’ve got there on the shelves or in the warehouse. Now apply the formula to get the inventory carrying cost.
What are the components of inventory carrying cost calculation?
There are four components in inventory carrying cost formula:
1. The cash you need to get the stock, which is the capital cost;
2. The charges for maintaining operations, known as service costs;
3. The price for any possible spoils or mishaps, inventory risk costs;
4. The rent for your storage area, or storage costs.
Of all, Capital cost is the major slice of pie. However, the remaining costs are subject to variation without any general order.
How can we reduce inventory carrying costs?
Some of the ways to keep inventory carrying costs in check are
1. Analysing the reason for escalating costs such as extra stocks, dead inventory, in-transit inventory, sudden upsurge of orders, etc.
2. Upgrading your warehouse organisation.
3. Figuring out the ideal stock level and the best time to reorder.
4. Employing inventory management software to view supplies and quick order tracking, managing stocks, setting fair prices, and saving on storage—all thanks to handy, insightful reports.
