Inventory Carrying Costs
The carrying cost of inventory is often described as a percentage of the average annual inventory value. This percentage includes all the associated costs of holding and managing the inventory.
Like the cost of raising a purchase order, the actual cost of holding inventory can vary significantly from business to business. To use a rule of thumb measurement is not appropriate if real and measurable savings are to be made.
While what follows is only a guideline it is important that the total and relevant input values for your organisation are taken into account when you assess your present environment.
To get things moving a good place to start may be with the people in your finance department.
They should be able to provide much of the necessary figures required and you can work with them to attribute appropriate percentage costs where for example specific warehouse/storage figures are not available. For example if the business premise as a whole is leased you can work out the lease cost of the warehouse simple by looking to area size.
Example
Total lease cost per annum = 75,000 euro
Total Premises size = 15,000 square feet
Warehouse Size = 5,000 square feet
The warehouse is 1/3rd the total space leased therefore the cost attributed is (for our purpose) 25,000 euro.
Inventory Carrying Rate
Now before calculating your inventory carrying cost we must first identify your inventory carrying rate. This is calculated by dividing your total average inventory value by total carrying costs.
Calculate average inventory value over the previous 12 months
How to
If you take the month end value for the previous 12 months and divide by 12 you will get the average inventory value for the previous 12 months.
Carrying Costs
While not exhaustive the following are the kind of costs you can include in your calculations.
Guide/Example
35,000 - Staffing Costs - Warehouse personnel and administration
5,000 - Rent/Lease - see above
6,000 - Insurance / Tax
500 - Redundancy
250 - Theft
2,000 - Equipment and Machinery
3,000 - Maintenance
2,500 - IT
750 - Damage
55,000 - Total
So, let us say average monthly inventory is 550,000 euro and attributed total costs are 55,000.
Divide the Inventory Costs by the Average Inventory Value: 55,000 / 550,000 = 10%
Opportunity Cost
This is, how much could you make if the money held as inventory was invested elsewhere or if you finance your inventory purchases, the amount of interest due to the bank. Let us say 5%.
Add your percentages: 10% + 5% = 15%
Your Inventory Carrying rate is 15%
Inventory Carrying Costs
Inventory Carrying Cost = Average Inventory Value
X
Inventory Carrying Rate
In this example your Inventory Carrying cost is 82,500 [ 550,000 X 15% ]
Now you have a real and measurable figure to be used. Organisations that do not look at the true cost of inventory's overhead are at risk of increased inventory levels. A low carrying cost of
inventory sends a message to people within the organization that inventory is cheap which
makes it an easy solution for other problems.
In conclusion it's best to review all cost factors and decide which are relevant for your organisation. The more important it is to reduce inventory, the higher your carrying cost should be. If inventory is cheap, you will have a lot of it.
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