Do You Know the Real Cost of Carrying Inventory?
 By Dennis Lord - Inventory Guru

A client asked me just how much it was costing to carry inventory.  I am asked this question frequently, and my answer is always the same, a company’s inventory carrying cost is, on average, 25% of its average annual inventory investment.

My client – a seasoned inventory control manager – seemed disappointed to hear that carrying inventory in the warehouse and storeroom was not free.  But he’s not alone! 

What are Inventory Carrying Costs?
Inventory carrying costs represent a large chunk of an organizations total logistics systems costs.  Inventory carrying costs are expressed as a percentage of the average dollar value of inventory over a fixed period – usually a year.   As a rule of thumb, inventory carrying cost is approximately 25% of a company’s average annual inventory investment, but when you tally up all the relevant carrying costs, it can run as high as 40% or more. 

Capital vs. Non-Capital Costs
An organization’s inventory investment represents both capital and non-capital costs.  The actual investment in your inventory itself is regarded as a capital cost, but there’s also the non-capital cost of carrying the inventory. 

Determining your capital costs is as straightforward as checking your financial reports.  Estimating your non-capital costs takes more work.  They’re not readily apparent from your accounting records since most book keeping systems do not capture all the information you need to calculate those costs.

Non-capital costs are considered by most managers to be a cost of doing business, and they’re content to use ball-park estimates or traditional industry benchmarks.  Yet few companies know what their true costs really are.

Capital Costs for Inventory Investment
Your inventory ties up money that could be used elsewhere, so it’s no wonder that capital costs are the biggest factor in determining your carrying costs.

Capital costs can include the interest on the money you invested in your inventory.  There’s also opportunity cost, which is the return you could reasonably expect if you invested your money in something other than inventory.

Non-Capital Costs For Inventory Investment
These costs may vary according to the company, its product, and location but they typically include risk costs, storage space costs, and service costs.

Inventory Risk costs generally include obsolescence, damages, and pilferage.  They are the largest component of non-capital costs.

Storage space costs include warehouse or factory space, workers, and material handling equipment.  These are variable costs, and they rise as inventory increases.  It takes careful analysis to determine how much of this cost is actually driven by inventory levels.

Inventory Service costs include expenses such as insuring your inventory, or even taxes.  They’re calculated as a percentage of the average annual inventory value.

Applying Inventory Carrying Costs
From a financial point of view, understanding and managing inventory carrying costs will have an impact on your company’s operating income.  It will also help you balance your operating expense with inventory levels. 

In operations, when your planners replenish an item, they ask themselves two basic questions: how much should we order, and when?
  These aren’t trivial questions.  Order more frequently, and your order cost increases while carrying costs decrease; order less frequently, and you trade off lower order costs with a larger average inventory.

The most efficient way to figure out “how much” is to use the economic order quantity model.
  This model minimizes the total variable costs required to order and hold inventory.  Inventory ordering cost, also known as purchasing cost or set-up cost, includes the clerical work required to prepare, release, monitor, and receive orders.  In manufacturing, inventory ordering cost includes production scheduling time, machine set-up time, and inspection.

Why all the fuss?
Knowing your inventory carrying costs is a vital part of managing inventory.  Without that knowledge, you can't properly optimize your inventory management system, which means you can’t make informed decisions about establishing the right inventory levels.  And as we all know, that leads to poor customer service, excessive inventory and lower profits.

Any inventory manager will tell you that you need to balance inventory investment, cost, and customer service when managing inventory.
  Yet too many small and mid-size companies make little effort to properly calculate and apply their inventory carrying costs when planning inventory levels.  The results are inevitable: too much inventory, poor delivery service, and shrinking profit margins.

Not long ago, I chatted with my inventory manager client.
  I was pleased to hear that he had a better handle on inventory carrying cost and the impact it has on finance and operations.

Like anyone else, he’s under a lot of pressure to minimize costs and improve service.
  Now that he understands the value of knowing and using his inventory carrying costs, he’s seen the light. Through better inventory management, he’s maximizing his company’s profits by planning inventory more effectively.

Dennis Lord
CPIM 
is Executive Director of IMS Business Academy - IMS Consulting
                                           Principal Inventory Management Solutions. 
He can be reached at 416.477-2467, dennis@imsconsulting.ca  www.lean-inventory.com