The cost of goods is a common concept already familiar to all of us. We have all been there, looking for the best-priced item among a list of purchasers that we trust using our inventory management software. And besides that, we try to factor in the shipping cost which could become really fickle depending on the kind of season the business is having. You know you have to shell out some cash for it though since bringing the asset from the purchasers to your warehouse is an acceptable expense.
What inventory managers fail to realize however is that inventory generates expenses even just by sitting there in your warehouse without a single peep. This is what inventory managers call the inventory carrying cost because there is a price to pay for holding an asset in stock for a longer time than what is necessary. What usually happens is while we are off to find the lowest prices in the market, we often neglect the cost of having too much inventory without regard for how the item depreciates over time and how it could fill out the warehouse for no reason.
In this article, we will try to look at the consequences of inventory costs while highlighting some cases. We will also try to understand why it is vital for your business to always be monitoring the inventory carrying costs that your business is spending on. And finally we will cover the reasons why sometimes this is a necessary expense and how best you can avoid or at the very least reduce them.
Table of Contents
Inventory Carrying Cost – What is it?
If you have been in inventory management for a long time then you might have heard of inventory carrying cost or some of its other designations like holding a cost or simply carrying a cost. These are keywords that probably pop up as an option to classify costs on your inventory management software. Plainly speaking, this is the cost of having to keep your items in inventory for a specified time. Some of the costs that some of this value includes the cost of warehousing the items which could include rent, utilities, and even the salaries of the personnel tasked to track inventory. Other costs not quite obvious are the opportunity cost and economic costs which will be discussed later. Finally, a few more costs that also belong to this category are shrinkage, expiry, and insurance.
Opportunity cost, in terms of inventory management, means the value that you lose when unnecessarily stacking your stockroom full of items that you could have instead used for something else. For instance, if you have an inventory item A ready to be sold from your stockroom and decided not to buy item B because item A already filled the room. In this instance, any customer deciding to buy item B can be cashed out as an opportunity cost that could have been avoided if item A did not fill up the stock. This also includes losses incurred from losing purchasing power to diversify the items in stock.
One might ask if there is truly a legitimate reason to be worried about inventory carrying costs when we already have trouble selling out all the items that we do have in stock. The answer to this question is to simply define inventory carrying cost by the money that you lose. That is inventory carrying cost is the measure of how long you could keep the inventory in your stock before making losses. Based on several studies in warehousing, carrying costs typically makeup to a quarter of the value of the stock. Such a huge percentage is too much to simply be cast aside without worry.
Can we avoid Inventory Carrying Costs
If you own a business and just now realizing the impact of inventory management costs, you may be wondering if you have the luxury or the capability to carry this cost at all. You could think of optimizing supply and demand to minimize the cost by utilizing just-in-time systems. However, there are many reasons why a business will hold on to stocks for longer periods. And while just-in-time systems are quite attractive, it is far from possible to implement for most business cases.
It does not matter how we view inventory carrying costs. It is a necessary aspect in business and all we can do about it is to reduce its impact.
Safety Stock
One of the reasons why we need to expend for inventory carrying costs is to maintain a safety stock. These stocks are simply supplied that businesses keep in order to hold against unexpected spikes in demands to avoid understocking. Today’s market is especially volatile meaning demand for a particular product can peak at any time. There are plenty of reasons for suppliers to not be able to soundly meet the demand of their clients and thus it might be wise to keep a buffer for when spikes in customer demand do happen.
Inventory carrying cost is directly impacted by the level of safety stocks that a business keeps. Since having safety stocks means typically not having to use them in most cases, they almost certainly incur carry costs. Because of this, there is a real danger of losing the values of these stocks to spoiling, expiration, damages, and even theft. These all may happen simply because you kept the product too long in your inventory.
On the other hand, holding a thin safety stock barrier or not having one at all leaves you at risk of losing mileage to your competitors. When the demand spikes and you have no inventory ready to be sold then you could risk missing out.
Summary
While it is definitely necessary to keep inventory carrying stock as low as possible, it is also valid to feel that this is something that a business may not be able to avoid thoroughly. Luckily, many solutions are available such as keeping a record of supply and demand for each item and forecasting the necessary safety stock amount. This process can be simplified further using inventory management software.
