Inventory Carrying Costs

Carrying Costs

There is always a cost associated with inventory. Inventory carrying cost is one of the major components in any inventory optimization project. If the carrying cost is inaccurate or incorrect, then the calculation will produce sub-optimal and sometimes misleading results. In some cases, an exact carrying cost can be the difference between a highly profitable inventory optimization project and one that costs you dearly.

Facts About Inventory Carrying Costs

Inventory carrying cost influences many decisions in the strategic, analytic, and operations levels of a business.

Definitions:

Strategic Decisions: Adjusted Profit Margin, Sourcing Strategy, Make or Buy, etc.

Analytical Decisions: Total Landed Cost, Acquisition Cost, Make-To-Stock or Make-To-Order, Inventory Positioning, etc.

Operational Decisions: Economic order quantity (EOQ), Economic Production Quantity (EPQ), Break-Even Analysis, etc.

While decisions are made every day using inventory carrying cost, most companies do not calculate the actual inventory carrying cost and instead use the hurdle rate, the minimal acceptable rate of return, as a substitute for the inventory carrying cost. This practice dramatically understates the cost of owning inventory and may affect the bottom line of an important business decision.

Click here to view a video on how to calculate inventory carrying costs.

Inventory carrying cost is a ratio which describes the relationship between the cost-of-owning-inventory-per-year and the inventory value. For example, if your inventory carrying cost is 25% and your annual average inventory is R 1 000 000, then your annual cost of owning inventory is R 250 000.

The rule of thumb for inventory carrying costs is between 20% and 30%.

Inventory carrying cost is different for every business. It is not wise to use the industry average as your inventory carrying cost. Inventory carrying cost (E.g. 1) should be calculated for each business.

E.g. 1: Inventory Carrying Cost (%)

(Cost of Owning Inventory Per Year (R))/(Inventory Value (R))

To compute the inventory carrying cost, we must break down the numerator in the above equation. The cost-of-owning-inventory-per-year (E.g. 2) includes four cost categories: Inventory Capital Cost, Inventory Service Cost, Inventory Storage Cost, and Inventory Risk Cost.

E.g. 2: Cost of Inventory Per Year (R)

= Inventory Capital Cost + Inventory Service Cost + Inventory Storage Cost + Inventory Risk Cost

Inventory Capital Cost

Inventory Capital Cost is the expected financial return that capital could be expected to earn in an alternative investment of equivalent risk. In other words, it is the minimum financial return necessary to make a project worthwhile. The Weighted-Average Cost of Capital (WACC) equation (E.g. 3) is commonly used to calculate the capital cost once the cost of debt and the cost of equity have been determined.

E.g. 3: WACC = Weight for Debt * Cost of Debt * (1- Marginal Tax Rate of the Firm) + Weight of Equity * Cost of Equity

In the case of an inventory project, the most commonly-accepted practice is to use the annual interest rate paid on debt as the cost of debt and the capital asset pricing model (CAPM) (E.g. 4) as the cost of equity.

E.g. 4: CAPM = Risk-Free Rate + B (Expected Market Rate – Risk-Free Rate)

Inventory Service Cost

The inventory service cost includes the annualized insurance cost, physical handling cost, and taxes as the result of the inventory (E.g. 5).

E.g. 5: Inventory Service Cost = Insurance Cost + Physical Handling Cost + Taxes

Inventory Storage Cost

Space costs money. Inventory storage cost will capture the cost of space, which includes the cost to rent, lease, or finance the storage facility that is used to store inventory. The inventory storage cost may also include extra costs to handle, store, and maintain hazardous, perishable, or sensitive inventories.

Inventory Risk Cost

Inventory risk costs consist of costs due to obsolescence, damage, shrink, deterioration, and relocation (E.g. 6).

E.g. 6: Inventory Risk Cost = Obsolescence + Damage + Shrink + Deterioration = Relocation