What are inventory carrying costs and how can you limit them?

For businesses that sell physical products, inventory represents a non-liquid asset that must be converted into cash through sales. How efficiently a business manages this process will determine its profitability.

With inventory carrying costs generally accounting for 15-30% of a business’s total inventory value, carrying cost is an important metric to keep an eye on.

The definition of inventory carrying cost is simply the expenses a company incurs to hold inventory items over a period of time before they are used to fill orders.

With efficient inventory management processes, a business can keep carrying costs closer to 15% of total inventory and maximise profits. With poor inventory control, carrying costs can reach or exceed 30% of total inventory and eat into profitability.

To achieve the former, it’s important to understand and measure your business’s carrying costs and implement best inventory control practices.

What is inventory carrying cost?

Inventory carrying costs are the expenses associated with holding items for a period of time before they are converted into liquid capital. Carrying costs are typically expressed as a percentage of the total value of inventory.

Carrying costs vary by product and industry, but always include the following costs:

• Warehousing
• Equipment
• Employee salaries
• Insurance
• Damage
• Other inventory-related expenses

Costs like rent for storage space are readily quantifiable, while others like opportunity costs are not, but are no less important to consider.

Four components of inventory carrying costs

Carrying costs include a number of expenses involved in holding unsold inventory. The four main components that make up inventory carrying costs are capital costs, inventory service costs, inventory risk costs, and storage space costs.

1. Capital costs

Of the four categories, capital costs account for the highest percentage of carrying costs. Capital costs are those required to purchase raw material or inventory items along with any related financing fees, loan maintenance fees, and interest.

2. Inventory service costs

Inventory service costs are not directly related to stock items but are necessary to hold them at a depot or warehouse. These costs include insurance premiums, taxes, hardware investments, and inventory management software fees.

Higher inventory levels may result in higher insurance premiums and tax rates but may also be necessary to keep products flowing to buyers. Likewise, inventory management software represents an ongoing cost but comes with the opportunity to more closely monitor inventory operations and eliminate inefficiencies. Other inventory management processes such as conducting physical counts and cycle counts fall under this category.

3. Inventory risk costs

Inventory risk is the chance that items in storage can become unsaleable before they can be sold and converted into liquid assets. This risk generally comes from shrinkage and obsolescence. Shrinkage is the loss of saleable product due to damage, theft, or errors in record keeping. Obsolescence is the loss of saleable products due to product expiration or retirement and is an issue for retailers carrying products with a short shelf life. Obsolescence goes down as a write-down or write-off and eats directly into a business’s bottom line.

4. Inventory storage space costs

Storage costs are the expenses required to manage a warehouse. This includes renting or purchasing warehouse space, the cost of climate control and utilities, physical security, and the handling costs of moving items in and out of storage. When a company owns its own warehouse, these costs are fixed and predictable. If a company uses a third-party logistics provider (3PL) to outsource its warehousing and fulfilment logistics, prices may fluctuate based on usage and volume of goods.

In addition to the assigned costs in each of these four categories, holding inventory also comes with an undefined opportunity cost. Opportunity costs are improvements or investments a business owner is not able to make because assets are tied up in inventory that has not yet been mobilised.

So why should your business track carrying costs?

Carrying costs inform business decisions

Inventory carrying costs account for a significant supply chain expenditure and impact the cost of goods sold, thereby directly impacting profitability.

With a more accurate picture of the cost of standing inventory, business leaders can make more informed decisions on optimal stock levels, reorder points, and when to fill vs. backorder shipments.

By monitoring carrying costs over time, organisations can also gain insights for long-term inventory planning. For example, can carrying costs be reduced by using 3PL? Do sales volumes justify carrying certain short-lifecycle products? When does it make sense to offer a promotion to avoid inventory write-offs?

With an accurate understanding of how much it is costing your business to hold inventory items, you can answer these questions and make any necessary adjustments.

Now, let’s see how to put this into action with the inventory carrying cost formula.

What is the inventory carrying cost formula?

To calculate inventory carrying cost, divide your inventory holding sum by the total value of inventory, and multiply by 100 to get a percentage of total inventory value.

Your inventory holding cost is the sum of the four components we described in the previous section:

The total value of your inventory is the costs of inventory multiplied by the available stock.

Note, the total inventory value we are discussing here is only for calculating internal costs and does not represent the market value of inventory.

Here’s how it all comes together to calculate your inventory carrying costs as a percentage of total inventory value.

The carrying cost formula can be used to calculate annual carrying costs, quarterly carrying costs, or a smaller increment of your choosing. It’s best to do an annual inventory carrying cost calculation, as well as an incremental calculation at an interval that coincides with your sales cycle.

The inventory carrying cost formula in action

To see how it looks in practice, consider this example of an ice cream supplier:

Ice cream inventory holding costs:

Capital costs: $10,000 for dairy raw materials and associated costs

Inventory service costs: $3,000 for insurance on refrigeration equipment, financing fees, and inventory management software expenses

Inventory risk costs: $1,000 for the risk of ice cream spoiling or melting

Inventory storage costs: $4,000 to rent space and keep the ice cream frozen

That’s $18,000 worth of holding costs. Now, let’s assume the total inventory value of the ice cream on hand is $120,000.

Based on this calculation, we can see that the ice cream supplier has an exceptional carrying cost of 15% of inventory value.

To achieve such a low carrying cost, the ice cream supplier must have reasonable inventory management control with minimal depreciation and product write-off.

Let’s look at some best practices your business can use to pursue a similar result.

Three reasons for high inventory carrying costs

If left unchecked, a business can end up with overly high inventory costs that tie up its cash flow.

While it’s important to have enough inventory to meet market demand, the following reasons can lead to excessive inventory carrying costs:

• Improper inventory management: This can include failure to organise and optimise inventory stock levels or bad warehouse design, which leads to misplaced and damaged items or wasted space.
• Carrying too much stock: It’s good practice to have extra inventory to protect against unforeseen circumstances, but this should only be enough for a short period. Too much safety stock will naturally increase total holding costs.
• Inaccurate sales projection: Sales projections aren’t always 100% accurate. But if a business gets them wrong too often, it results in high levels of unrealised revenue and increased carrying costs. Overestimating sales can lead to renting a large storage space or placing large orders that are difficult to sell.

The four best ways to reduce inventory carrying costs

To bring down inventory carrying costs, your business needs to reassess its processes and eliminate any inefficiencies. This can be done by using any of the following tips:

1. Improve your warehouse layout

As inventory increases and sales ramp up, a company may not pay much attention to reorganising its warehouse operations. But with warehouses serving as the hub of all inventory, taking the time to improve its layout and workflow can provide a great opportunity to reduce costs and increase overall efficiency.

2. Determine your optimal inventory levels and reorder points

Purchasing large quantities of inventory may save on the initial per unit cost, but end up incurring more expenses in the long run if it ends up sitting in storage.

Instead, look at historical data and calculate optimal inventory levels and reorder points. This information will allow you to still fulfil sales and customer demand, without overstocking more inventory than you need.

3. Accelerate inventory turnover

Carrying costs can quickly increase when any inventory remains unsold and can no longer generate profit. The best guard against this is to reduce the time your inventory stays in storage. This includes only holding the inventory you need for the sales period, negotiating with suppliers for favourable lead times or MOQs, and getting rid of dead stock or excess inventory.

By increasing inventory turnover, a company can decrease its holding costs and sell items at their highest value.

4. Use inventory management software

Instead of tracking inventory by hand and conducting manual cycle counts, consider the benefits of inventory management software. With a digital inventory management system, you can extend visibility across your supply chain to see what’s in stock, what’s on order, and where items are located at all times.

With an inventory management system that integrates data from purchase orders, sales fulfilment, and demand forecasting, you can leverage customised reports to optimise stock levels, fine-tune pricing strategies, and determine the best warehousing strategy to reduce holding costs.

Leaner carrying costs bring benefits to you and your customers

When it comes to the cost of holding inventory, don’t leave your business in the dark. By regularly calculating carrying costs, you can identify and eliminate inventory inefficiencies and establish benchmarks to guide future business decisions. Leaner carrying costs contribute to more favourable profit margins and improved cash flow. This can then be reinvested in your business for continued growth and the benefits passed on to your customers.