What is Inventory Carrying Cost?
We’re all familiar with the cost of goods. We spend hours researching and comparing the lowest possible prices for goods. And we pick the most cost effective means of shipping. After all, this is a business expense that you need to pay upfront in order to bring goods to your warehouse and stock them up.
But while the newly arrived goods sit in your warehouse, did you know that there are also costs associated with keeping inventory? They are collectively called inventory carrying costs because they need to be paid to hold inventory. Often, we are so preoccupied with the purchase price of goods that we forget their holding costs as well.
Here, we’ll explore what is meant by inventory carrying costs and their examples. Most importantly, we’ll also cover why you should keep an eye on carrying costs. Next, we discuss why businesses carry inventory at all and look at some ways to reduce their holding costs.
What is Inventory Carrying Cost?
Inventory carrying costs are also known as carrying costs or holding costs. They are the total cost of holding inventory by your business. These costs include the cost of warehousing the inventory such as rent, utilities and warehouse staff salaries. Carrying costs also include economic costs such as opportunity cost. And inventory costs such as shrinkage, expiry, and insurance.
An opportunity cost means something that is given up in exchange for holding inventory. So by purchasing and stocking up on certain products, you face an opportunity cost of selling another product if consumer tastes shift. Your business purchasing power and warehouse space are already taken up by a product and thus it would not be easy or feasible to purchase other stock.
Why should businesses be worried about carrying costs when there are already challenges in selling the stock? Simply put, inventory carrying cost is a measure of how long inventory can be held before you make a loss. And carrying costs typically make up 20-30% of the inventory’s value. This is a sizeable figure that cannot be ignored.
Why Do Businesses Carry Inventory?
If inventory holding costs make up about one-fifth to one-third of an inventory’s value, why do businesses carry inventory at all? Why not simply reduce the amount of inventory carried or move towards a Just-in-Time system? Businesses have various reasons to hold stock. And JIT requires a finely-tuned supply chain that may not suit some products and markets.
Whether they like it or not, businesses carry stock for various reasons.
1. Safety Stock
Safety stock is stock that is held as a buffer against unexpected swings in demand and supply, and thus avoid stockouts. Consumer demand for a particular product may spike unexpectedly due to a viral fad or event. Suppliers may not be able to produce more products than their production schedules allow because of limited raw materials.
The level of safety stock has a direct impact on inventory carrying costs. High levels of safety stock mean higher holding costs. Also, the risk of spoilage, expiry, theft or damage rises if goods are held for too long. Conversely, too little safety stock means lost sales because of stockouts. Customers will move their purchases to your competitors.
2. Cycle Stock
Cycle stock is the on-hand inventory held to satisfy regular demand. Over time cycle stock turns over and refreshes itself. New items replace the older ones that are sold. When demand is constant the purchase cost and the carrying cost are equal to each other. Thus, cycle stock also acts as a buffer and allows a business to minimize costs and time their purchases.
Some products that are cycle stocks are typically necessities and household staples. For example, rice is widely eaten in Asia and the demand is very constant as it is a dietary staple for meals. Another example is toilet paper. Regardless of the season or economic cycle, consumers still need to buy toilet paper. There are no substitutes and forgoing it is not an option.
3. Seasonal and Cyclical Stock
The four seasons sharply dictate what retailers and consumers buy. The arrival of spring and summer sees a sharp drop off in cold clothing wear and hearty food. Post-Christmas fruit cake, mulled wine and mince pies are discounted. Likewise, autumn and winter see a sharp spike in demand for non-slip boots and just about anything with pumpkin in it.
Cyclical stocks are those goods that rise and fall with the economy. So in good times luxury brands and fancy cars enjoy an uptick in sales. On the other hand, in bad times consumers frequent discount stores, and supermarket sales spike because more people are cooking and eating at home.
Thus businesses are left holding seasonal and cyclical stocks because they stock up in anticipation of sales. And they cannot sell all of the stock in time when the season ends or when the economic cycle turns. Sometimes an unexpected sharp turn in seasons or the economy may leave businesses holding stock as well.
4. In-transit Stock
When shipping finished goods or raw materials between two countries, the savings on bulk purchases can help offset the shipping costs and the time taken to reach the destination market. Thus businesses plan and make purchases in advance to allow for the shipping time. In-transit stock is part of the inventory and thus their value is included.
The rise of China as the world’s manufacturing hub, in particular, has seen sea shipping traffic increase between China and the United States. Other major developed markets such as Europe and Australia may have seen longer shipping times as the frequency and load of containers increased. Thus businesses need to factor in these long lead times in reordering stock.
5. Dead Stock
Deadstock describes those products that have not sold in the past 12 months. This can happen for various reasons including obsolescence, poor quality control or expiring products. It can also be due to seasonal and cyclical factors. Deadstock is still considered part of an inventory’s value until it is disposed of or sold at a discount.
Slow-moving stock is an inevitable cost of holding inventory. Not every business can forecast sales with accuracy or make u-turns for sudden changes that affect their product. Sometimes a non-selling product may be due to the manufacturer’s defects or recalls by the supplier. You have no control over this part of the supply chain but it affects you.
How Can We Reduce Carrying Costs?
Now that we know that holding stock comes with carrying costs, how can businesses reduce their dependency on stock?
Here are some ways to keep a trim level of inventory.
1. Know Your Inventory Inside-Out
If you haven’t already done so, implement a perpetual inventory management system so that you have a continuous, real-time insight into your stock levels and movements. This underpins the philosophy behind EMERGE App as you should know the available inventory that you can sell at any point in time.
EMERGE App displays the in-stock quantity in a few ways. The available inventory is the balance inventory after adjusting for committed sales. It considers all purchases and sales that may not be physically in your inventory. This is critical if your business is dealing with plenty of back orders or drop shipping.
Next, physical inventory is what you have in your warehouse. This is also known as stock on hand or physical stocks in your inventory. Holding ready stock is important if your business is a go-to company for immediate stocks. However, physical inventory also attracts carrying costs as we have seen. Thus, it would be prudent to keep this number to a minimum.
2. Reduce Your SKU Dependency
Generating SKUs is fun. Every product that you carry has a barcode with its SKU on it. However, you’re likely to face SKU overload if your products come in multi-matrix product variants, such as color and size. This means carrying stock in every possible color and size so that you don’t miss a sale. But do you really need to do this?
Perhaps it’s time to generate a sales report for the past year. Then see which color and size combinations are really selling and which combinations are not. Only with historical data can you tailor your product mix and reduce your SKUs. Trimming your product variants will also lower your inventory holding costs.
3. Improve Forecast Accuracy
Also, an inventory management system produces historical data. Lots of it. It is said that to forecast the future, you need to understand the past. The same could be said of making sales forecasts and thus your purchasing strategy. From historical sales data, and allowing for seasonality, you can attempt to extrapolate sales and forecast the future.
4. Set Inventory Reorder Points
So, you’ve combed through your past sales reports and you’ve arrived at a safety stock number. Now it’s time to set inventory reorder points. Only your historical data can tell you how low can your inventory go before you issue purchase orders to replenish. You also need to consider the lead time for orders from your supplier.
5. Increase Purchasing Frequency
Going through your historical sales data can also tell you the least amount of stock you can hold to meet your sales. This is your safety stock level. Holding a minimum level of inventory also means increasing your purchasing frequency. You’re buying a lower quantity each time but more frequently. However, check that the MOQ from your supplier allows this.
6. Reduce Supplier Lead Time
While talking to your supplier, you may also want to ask about reducing their lead time to ship orders to you. If you’re setting reorder points for your goods then your supplier needs to consistently deliver on time, every time. Any delays or a long replenishment time means a stockout situation and lost sales.
7. Get Rid of Dead Stock
We left the most painful remedy for last. And that is to get rid of your dead stock. It’s all too easy to forget dead stock if they’re lurking in the deepest recesses of your warehouse on the highest shelves. They’re gathering dust but they’re also taking up space that could be occupied by fast-moving stock or new products.
So, it’s time to swallow your pride and cut your losses. You made a business bet on these products becoming best sellers. It’s time to move on. Some factors may have been out of your control, such as a consumer swing away from overly processed food. Give them away to charities if they’re still useable or edible. Or pay to have them disposed of properly.
If you’re dealing with physical goods, carrying costs are part and parcel of holding inventory. Short of changing your business model, you cannot eliminate holding costs completely. You can, however, take measures to reduce your dependency on carrying stock and thus your holding costs. Keep your holding costs to a minimum and you can stretch your holding period of stock before it turns into a loss.