Inventory Carrying Cost: Profit’s Enemy And Friend
If you thought inventory was pricey, it’s about to get a little bit more expensive. There are a number of vital inventory expenses that are crucial to the success of your business. When referencing a company’s total cost of inventory, we call this the inventory carrying cost. This takes all possible factors into consideration and determines the cumulative cost of owning inventory.
While hidden fees seem to pop up all over the place, it’s good to know your inventory carrying cost and how it relates to your total budget, as there are “ideals” that can be achieved for ultimate efficiency. If you’re new to inventory, you’ll want to start off with this introduction to Oracle’s inventory software, R12.
What Is “Inventory Carrying Cost”?
There are several ways to talk about inventory carrying cost. First, let’s just talk about it in a general sense. Company’s who have a lot of experience with inventory know that their inventory carrying cost is a deciding factor when it comes to streamlining their inventory process. As the carrying cost plays such a significant role, then I hardly need to stress the importance of generating an accurate figure. In inaccurate carrying cost will negatively affect every other aspect of the inventory process; in many cases, this is the difference between a favorable margin of profitability and, well, the other margin.
In A Less General Sense
More specifically, inventory carrying cost is expressed as a ratio or percentage. One side of the ratio is the cost of owning inventory (calculated over the period of one year) and the other side is the value of the inventory. As we are about to find out, these numbers are drastically different.
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One of the most common mistakes companies make is substituting the carrying cost number for one generated using the minimum rate of return (“hurdle rate”); if you don’t feel like reading the link, the hurdle rate is the minimum capital return an investor needs in order for an investment to justify the level of risk involved.
You can see why the minimum return rate would be tempting; who cares about inventory carrying cost when I would much rather just know what I need to make in order to justify this investment? The answer is that the hurdle rate tends to much more liberal and, therefore, a drastic underestimation. If you think about it, why would you only want to know the minimum rate of return?
The carrying cost is going to be a much more daunting number, but it will also be more realistic and in the end is a better determiner of business decisions. To learn more about the entire inventory process, take a look at this workshop on order management and pricing.
Components of Inventory Carrying Cost
A number of things factor into the final value of the carrying cost. Here are the factors that most companies have to deal with:
- Space. Inventory must be stored somewhere, and the rent or mortgage on inventory space is one of the largest expenses; additionally, you will need to consider taxes, insurance, utilities, maintenance, improvements, depreciation, etc.
- The capital that is not liquid that is associated with the inventory itself (see: opportunity cost).
- Handling costs (employee wages, accidental damages, etc.).
- Depreciation of inventory value.
Now that we have all that fun stuff out of the way, let’s take a look at some examples.
Examples Of Calculating Carrying Cost
Obviously, the carry cost will be different for every company. A company with a bunch of debt and too much product for the amount of space it has it going to have a carrying cost out the roof. On the other hand, a company with cash to spare, ample space for storage and a consistent rate of return is going to have a low, possibly even too love, carrying cost.
But sometimes the best things in life are free, like this invaluable post on inventory management techniques and why they are so important.
There is a rule of thumb when it comes to the carrying cost ratio. To optimize rate of return, a company should shoot for a carrying cost that is 20-30% of the value of the inventory. So if a company has $100,000 worth of inventory, its carrying cost should be between $20,000 and $30,000 annually. Of course, the wisest businesses will not follow the rule of thumb or even industry averages; find out what works best for your business through analysis first and experimentation second.
Our basic equation for inventory carrying cost is quite simple:
Inventory Carrying Cost = Cost Of Carrying Inventory / Value Of Inventory
The only problem with this is that we can not simply whip out our balance sheets and find the number that corresponds to “Cost Of Carrying Inventory.” As mentioned before, it is a sum of different expenses.
If we look at the four big expenses that I listed above, we have space, not liquid capital, handling costs and depreciation. The problem is that all of these have their own lists of expenses, and so on and so forth. Calculating the carrying cost is not easy, which is why so many company’s forego this procedure.
When Difficulties Arise
Calculating the handling costs and depreciation are relatively easy. Handling is mostly comprised of insurance, physical handling (employees) and taxes; depreciation, or risk, is the sum of deterioration, damages, relocation (when it applies) and, of course, the dreaded obsolescence (when you have products in working order that nobody wants). Avoid obsolescence by streamlining your supply chain; this blog post covers the 6 best and most common supply chain strategies to help dial-in efficiency for any business structure.
Even calculating your space costs is do-able for a non-accountant. You have rent, lease, insurance, utilities, etc.; we already discussed these. Of course, if you’re storing inventory that requires special care or handling, such as frozen goods or valuable art work, you will need to take all of these expenses into account, as well.
The truly difficult thing to calculate is your “not liquid capital” and the aforementioned “hurdle rate.” To do this you will almost have to consult an accountant (which is recommended anyway). You will have to calculate such things as cost of debt, weights of debt, cost of equity, weights of equity, risk rates, market rates, asset return rate, and others. If you’re the kind of person who likes to DIY their accounting (you’d be surprised how many people both do their own accounting and are successful at it), then at least do yourself a favor and check out this in-depth introduction course on bookkeeping and accounting.
The important thing to grasp is the necessity of knowing your inventory carrying cost. Ultimately, it doesn’t matter if you can’t figure it out on your own. Hire an accountant and work together to figure it out; it will be some of the best money you’ve ever spent. You will emerge with a starting point for moving forward; likely it will not be perfect, but it will probably be light-years ahead of your current system. And once you’ve established a base plan, carrying cost will only get easier to manage and your company will only become more efficient.
Once you’ve mastered the fundamentals of Oracle’s incredible inventory software, you’ll want to take your skills – and your business – to the next level. Here is the advanced course on Oracle’s R12 inventory software with expertise in implementing their business suite, even down to streamlining supply chain solutions.
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