Total Inventory cost formula
- Calculate costs that come from ordering inventory (Ordering Costs)
- Calculate costs arising out of inventory shortages (Shortage Costs)
- Calculate costs from carrying or holding inventory (Carrying/Holding Costs)
- Add them all together to determine your total inventory cost.
Of the three cost categories, the first two can vary quite a bit depending on your business type and the goods you sell. They also make up the smaller portion of overall cost of inventory, while carrying costs carry the heaviest weight.
This is the cost of getting all that inventory ordered - fixed costs incurred when you make an order. For example: inspections, vendor payments, and landed costs. Order costs are those costs that don’t change much depending on quantity; rather, they change depending on overall orders made.
How can you reduce order costs?
Examine places where aspects such as shipping costs can be reduced. Another place to check out, especially if your inventory comes from an international source is landed costs - are those extra expenses like customs, taxes, duties, and insurance worth the cost, or would it be worth looking into more local sources?
On the other side of the supply chain, you have stock out costs or shortage costs.
Shortage or stock out costs are costs are pretty much what the name suggests - costs that come up from being out of stock of an item. This can include measurable costs such as having to pay for expedited shipping, substituting a higher valued product to make up for it, or buying last minute from another supplier. These also include costs that can’t really be put into an equation: loss of customer confidence, or even harder to recover, loss of customers.
How can you reduce shortage costs?
Stock out costs can be reduced through more efficient inventory management. Check through your inventory management technique and see if it’s the best option for your product type. If you tend to run out of certain products, bulk shipments could be a cost-saving option. Reducing this cost is more preventative in nature - and about eliminating the threat before it happens in the first place.