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What is the total inventory cost? The inventory cost formula

As an eCommerce retailer or wholesaler, inventory is one of your biggest, most important assets. Apart from the simple cost of buying the inventory from your wholesaler, manufacturer, or distributor, other factors affect your total inventory cost. Read on for details on what this important sum usually includes and tips on how to minimize overall costs.

Off the top of your head, you would say your inventory costs...a lot. But how much is that exactly, and why is that important to know? If you know exactly how much money is going into maintaining this super-important asset, you can make smarter business decisions. Not only will you be able to smartly analyze where to cut costs, but also make your overall inventory management more effective.

From an accounting perspective, this cost can help you determine how much profit this inventory can bring you, along with how much of your businesses’ capital will be tied up in the inventory and for how long. To get the right values for all this analysis, you need to know your Total Inventory Cost.

Inventory cost calculator

We have built an inventory cost calculator just for you:

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.

Order Costs:

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 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.

Now, to the good stuff: carrying costs

On to one of the biggest parts of total inventory cost - carrying costs or holding costs. The carrying cost is a way to measure the cost of holding your inventory in a year versus the value of the inventory itself. Carrying costs should ideally be between 20-30% of your inventory value, no more. It’s a pretty large percentage, all things considered, so this is an especially important cost to account for.

The importance of carrying costs, in contrast with order costs, does actually change with order quantity. When you’re making Economic Order Quantity or Production Quantity calculations, include any costs that change with the quantity ordered in your carrying costs.

Carrying costs can be further broken down into several categories:

  • Capital costs
  • Non-capital costs
  • Inventory risk costs

Capital costs

Capital costs include all the capital (investments, interest, opportunity cost of investing in inventory) that’s tied up in that inventory. You can use the Weighted Average Cost of Capital (WACC) calculation to help figure out what this number is and how it can be adjusted.

Non-capital costs

Non-capital costs include storage costs and other inventory service costs. For example, storage costs include warehouse space, rent, utilities, security details, inventory equipment and labor. Inventory Services are other non-capital costs that have to do with keeping your inventory going. These include insurance, software and taxes. Using a 3PL? Those are also included in carrying costs.

Inventory risk includes anything that is a negative blow to your inventory. This includes inventory theft, inventory deterioration, or obsolescence (like when that new technology is introduced and suddenly demand for you current product goes way down).

How to reduce carrying costs?

If you make your calculations and find that some of your inventory has a large associated carrying cost - don’t freak out, it doesn’t mean that it’s not worth it! Carrying costs can vary greatly even between products that have similar backgrounds and types, and if demand is high and profit is good, they can make up for that high cost. That said, it doesn’t hurt to look for ways to reduce this cost.

This can include looking at different ways to store your inventory, changing your service providers, or switching to a technique like dropshipping, or perhaps using backordering, for some of your products.

How to minimize them all?

How to minimize your inventory cost on a macro level? Your inventory costs are somewhat balanced out, (or at least justified) by the demand for each of your products. You can use calculations such as Total Inventory Cost and Economic Order Quantity formulas to identify the ideal demand and quantity to order, to make these costs worthwhile.

In conclusion

Keep in mind that there are tons of variables in these cost calculations, depending on your business and its products. Take a minute to re-evaluate how you’re calculating the true cost of your inventory, where you can make adjustments and where you can find a bit more profit or efficiency. As one of your biggest and most important assets, you want to make sure your inventory is really worth investing in.

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