Why is it important for you to have an accurate view of your carrying costs at all times?
1. It is critical in figuring out how much profit you can make on current inventory.
2. It can help you determine if production should be increased or decreased, in order to maintain the current or desired balance between income and expenses.
3. Carrying costs are typically 20 - 30 percent of your inventory value. This is a significant percentage, making it an essential cost factor to account for.
(C + T + I + W + (S - R1) + (O - R2))/ Average annual inventory costs
where the individual components are:
C = Capital
T = Taxes
I = Insurance
W = Warehouse costs
S = Scrap
O = Obsolescence costs
R = Recovery costs
We have built an inventory holding cost calculator to save you time:
Don’t be intimidated by this seemingly complicated formula! We’ve broken down the formula, and there are just four important cost components you need to understand:
Capital costs refer to the costs incurred for carrying inventory. Examples include money spent on acquiring goods, interest paid on a purchase, interest lost when cash turns into inventory, as well as the opportunity cost of purchasing inventory. Capital cost usually makes up the largest portion of the total carrying cost.
Storage costs are expenses incurred to help keep your inventory safely organized in a particular place like your warehouse. It can be separated into two components: fixed costs and variable costs.
Fixed costs include rent or mortgage costs of the storage space, while variable costs are manpower costs, costs of handling materials and utilities expenses associated with the space.
Service costs are incurred to protect your inventory from issues such as theft or workplace accidents, to ensure that government regulations are met and to keep your inventory well managed. Examples include insurance payments, taxes on inventory, as well as the costs of using an inventory management software system to keep track of inventory levels.
Carrying inventory presents a certain level of risk, and this risk translates into a cost component. This cost component is made up of a few factors. The first factor is the risk of shrinkage, which refers to any inventory loss that occurs after a good is purchased, and before it is sold to your customer. Shrinkage may occur to due to damages in transit, administrative errors or theft by employees.
The second risk is the fall of the real value of your inventory while it is being stored to be sold. Possible causes for this include the launch of new products or models. Thirdly, there is the risk of obsolescence, whereby goods held have run past their expiration or sell-by dates.
Now that you’ve a better understanding of inventory holding costs, the next question you’re likely to raise is: “How do I lower these costs?”
You could work on...
Start by making improvements to the design of your storage space. Do not underestimate the value that good design brings — a design modification of your storage area can be a highly effective measure in creating additional space to reduce carrying costs. Consider making changes such as narrowing the aisle used for equipment handling, installing a mezzanine floor, altering the layout of your storage space or making a switch to adopt more appropriate storage modes.
Having long-term contracts in place does not only mean that you’ve secured a sustainable source of revenue; it could also mean that you’re in a better position to allocate a larger portion of your inventory costs to your customers. Negotiate these contracts to ensure that they cover a portion of your inventory carrying costs. You could lay down terms that specify the duration that inventory remains in your storage complex, or impose carrying charges for storing inventory for extended periods of time.
Negotiation does not end with customer contracts — you should also review and discuss the terms in vendor agreements. When vendors hold on to your inventory, costs associated with damage, theft and handling are borne by them. Avoid stipulating unfair terms that make the contract a one-sided agreement. Instead, adopt a balanced approach by splitting carrying costs between you and your vendors.
Consider adopting online inventory management techniques that minimize carrying costs, such as selling on consignment, drop shipping or backordering for some of your products. Rather than rely on excel spreadsheets (manually tracking each and every transaction will quickly turn into a nightmare), utilize inventory control software that will provide valuable information, such as accurate demand forecasts and reorder points, to help reduce your carrying costs.
Read next - What is dead stock and 3 tips to fix it!
QuickBooks Commerce gives you the power of inventory management software without all the time-consuming data entry or human errors.
Inventory Turnover is a measure of the number of times inventory is sold and replaced in a time period. This ratio is calculated by dividing Sales by Inventory. The time period is typically a year but can be shorter.
Analyzing inventory churn helps a business to plan at all levels of its income statement. It allows one to better forecast the cash likely to be required to reinvest in inventory in the coming months based on past performance.
It allows one to identify underperforming sales lines and products so that those products can be moved more quickly, either via specials or a focus on those products which may have previously been neglected.
This, in turn, will free up cash flow and shelf space for higher volume or better performing products. It can also improve inventory logistics and supplier relationships. The cost of transportation can be reduced if proper attention is paid to this ratio and, finally, it allows one to consider inventory storage capacity requirements as the business expands.
Andrew Mobbs, Managing Director, The Hatchery Limited
Read how to calculate inventory turnover.
Inventory Write-Off represents inventory that no longer has any value in the business (as opposed to write down, where the inventory value has been reduced). Inventory could be written off due to technological obsolesce, theft or damage. Inventory Write-off is simply the dollar value of the stock to be written off. It can be allocated to the Cost of Goods Sold account, but this will distort the Gross Margin percentage. My preference is to isolate it by allocating it to a Write-Off account.
The Inventory Write-Off value reflects how much writing off inventory is costing the business. If the level is concerning, further investigation into why the write-off is necessary and corrective action may need to be undertaken.
Every growing business should have a process to identify slow-moving or non-saleable products and consider scrapping or writing off some of those items to create room for more profitable products.
Dan Schmidt, founder and CEO, The Emerging Business CFO
It’s important to have a process in place to do this periodically. The last thing you want is to find out, sometime in the future, that your inventory is not the value recorded in the Balance Sheet, meaning you must incur a major write-off in the Profit and Loss Statement. [Tweet this]
There are various types of inventory costs. A few include ordering costs, holding costs and shortage costs. Once you understand where each of these costs is applicable to your business, the next step is to determine the best way to value your inventory. A valuation method is used to determine your business's profit.
So how do you decide which costing method is best suited to your business model? How do you ensure that you are accounting for all inventory costs?
Our Gecko Anika takes us through three different inventory costs and four valuation methods:
Holding Costs (sometimes referred to as carrying costs) are costs incurred in storing and maintaining inventory. They could include insurances, costs associated with the space housing the stock, security, and associated equipment and labor costs.
An example of a holding cost could be a forklift truck required to move stock in the warehouse. Holding costs are simply the cumulative dollar value of these various costs. Typically, they’re accounted for separately but, when reporting, may be grouped together.
The Holding Costs indicate the additional costs involved in managing the businesses inventory. Although they can be easily overlooked, they are an important cost to monitor when making decisions about inventory.
If, for example, inventory levels drop due to seasonal fluctuations, hiring out excess storage space to assist in covering the holding costs may be worth considering.
You can engage a business to manage inventory for you, and understanding your holding costs will assist you in evaluating your options and deciding on a suitable business model for inventory management.
Average Inventory is the median value of inventory, over a defined time period. The Average Inventory ratio evens out seasonal fluctuations, effectively normalizing the data. It is an indicator of how fast inventory is selling, and the average volume kept on hand. A fluctuation may highlight issues with purchasing or sales.
The Average Days to Sell Inventory is a measure of how long it takes a company to buy or create inventory and turn it into a sale. Average Days to Sell Inventory is calculated as (Inventory divided by Cost of Sales) multiplied by the number of days in the year.
The Average Days to Sell Inventory ratio alerts the business owner to how long on average, in days, it takes to sell each item of inventory.
The old adage ‘time is money’ is why the analysis of this report is so important. When businesses tie up capital in holding inventory items, there is an opportunity cost to do so.
Consider the following example... A car dealership purchases a car to be displayed in the yard. The cost of the car is $20,000. The business’s cost of capital is 6%. Therefore, for every month the car sits in the yard, the business has an opportunity cost of 6% × 20,000 ÷ 12 = $100.
If the average time it takes the business to sell each car is 180 days, the business should research to see if the car might sell in a faster amount of time should the retail price be reduced. If the car sold 30 days faster once the price was $100 less, the business would be indifferent, but if the car sold 30 days faster once the price was $90 less, the business would, in fact, be ahead financially by $10. The case is even more compelling when retail price is considered in place of item cost. Tracey Newman, Director, CloudCounting Pty Ltd
Many other ratios and KPIs relate to the movement of inventory, such as order accuracy, fulfillment cycle time, on-time delivery and cost per order. With respect to your business model, embrace the optimal combination of inventory management KPIs to analyze. Work with your accounting and order management system so you can easily extract the key data required to calculate this information.
Monitoring and understanding key inventory ratios can enhance the overall inventory management of the business, and improve performance, cash flow and profitability.
