Everything you need to know about Inventory Carrying Costs
Most people think that a company’s growth is driven by its sales and the products demand, but after further analysis of any company you will realize that their success goes beyond their sales, and depends in large part to how they carry out their supply chain process’. A key process that often hinders a growth is inventory control. To potentialize a business’ profits, it is vital to plan demand and have clear control over the costs of your inventory.
What are inventory levels?
The ideal inventory level refers to the quantity of products that you should have in a warehouse to meet demand, without incurring in excessive maintenance costs. Having excess products is not profitable, having too little will lead to shortages. Defining your ideal inventory level is a complex task, to be able to do so companies must take to following into consideration:
Fluctuations in demand
What is inventory optimization?
Inventory optimization is the process that evaluates a company’s historical sales and demand forecasts to keep the right quantity of each product in stock. This practice has the purpose of increasing the profitability of a business, since there are no surplus or missing products that cause loss or leakage of resources for the company.
On top of satisfying demand, inventory optimization controls costs resulting from its storage; these costs are known as inventory carrying costs and, depending on the industry and the type of product, they usually represent between 20% and 30% of the annual inventory value. Therefore, to ensure the profitability of the business, it is essential to quantify and closely monitor inventory levels.
What are the costs of carrying inventory?
The costs of carrying inventory are equivalent to the costs of safeguarding the stock during the period of time prior to its sale. Generally, the costs of holding inventory are quantified as a percentage of the total value of the annual inventory. To calculate these costs, all of its components must be considered:
Cost of capital
Inventory service costs
Inventory risk costs
1.Cost of capital
Commonly, the cost of capital represents the largest portion of the total cost of carrying inventory: it considers the amount invested in making or purchasing a product, the amount of any interest incurred to finance the initial acquisition of that product, and the opportunity cost of said investment. Optimizing inventory levels reduces the cost of capital and frees up cash flow that the organization can invest in other projects.
Storage costs represent the resources invested in maintaining inventory in a warehouse or distribution center. Storage costs include fixed costs (such as the rent or mortgage on a property suitable for the type of merchandise stored) and variable costs (such as electricity, water, maintenance, etc.). Having overstock - an excess of products - translates into the need for more storage space, and with it, increased rents and other costs. In addition, there are products that require special care, such as frozen, for example; the care specifications of this merchandise add considerably to storage costs.
3.Inventory service costs
This category includes the costs of the software and hardware used to manage merchandise movements within the warehouse, such as a warehouse management system (WMS), radio frequency terminals, order fulfillment systems, etc. Inventory insurance premiums are also considered service costs. The cost of the insurance policy increases according to the value of the inventory stored. In addition, in some countries there are specific taxes on the storage of products, which fall under the category of service costs.
4.Inventory risk costs
The costs caused by shrinkage, obsolescence, theft and depreciation are considered here. Every time it is no longer viable to sell one of the products, either because it is lost, expired or for any other reason, it must be accounted for as a risk cost. Again, having overstock increases the likelihood of stock going bad, which leads to higher costs of carrying inventory.
How to reduce the costs of carrying inventory?
The line between profit and loss tends to be blurry: closely frequently monitoring these costs will help identify whether or not they represent a wasteful proportion of the annual inventory value. If this is the case, the organization must analyze if it has an excess of safety stock, review the way in which it forecasts its sales, defines its policies and purchase frequencies, or else, verify that its operations are based on the best management practices of warehouses.
How to determine the correct inventory levels
There are various statistical methods and technological solutions available to achieve an effective demand planning. They collect the necessary information to determine the optimal inventory levels. A warehouse management system (WMS) can also be of great help, as it allows for real-time monitoring of stock of each product. When an organization seeks to reduce operational costs and risks, it can use these softwares to process information about changes in demand and movements in warehouses. In this way, a company can dedicate its resources to more productive processes and increase its profitability.
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I have a BSc in Industrial Engineering from Tecnologico de Monterrey and a MSc in Financial Engineering and Risk Management from Imperial College London. I enjoy writing about the issues I’ve helped my clients solve over my almost 20 years’ experience as a supply chain consultant.