Inventory costs have the power to make or break a mid-size business. If your inventory costs are too high, you may negatively impact your profit margin or leave yourself with poor cash flow.
Keeping just the right amount of inventory on hand will help you match customer demand without using too much storage space or risking throwing out obsolete inventory.
The key is for business owners and managers to understand their stock type and the different inventory costs their business faces. Ultimately, when you regularly evaluate your inventory costs, you’ll be able to lower them and invest capital where you need it the most.
Learn the 5 different types of inventory costs and how you can track them, along with some best practices for optimizing your inventory costs.
What is the cost of inventory?
Inventory costs are made up of the costs to order and hold inventory, as well as administer paperwork associated with the inventory. Management should always closely monitor inventory cost to determine how much inventory to keep.
Changes in inventory costs may have downstream effects, like changes to the order fulfillment rate for customers and variations to the production process flow.
5 types of inventory costs
From the moment you order your inventory, through to holding it or having to throw it out due to spoilage, inventory has a cost. There are 5 main categories that group together different inventory costs your business may face.
1. Ordering costs
Ordering costs are usually included in the overhead cost pool and are allocated to the number of units produced in each period.
Some examples of ordering costs include:
- Costs of identifying suppliers and making orders
- Admin costs of organizing purchase orders
- Receiving costs
- Electronic data interchange costs
- Transportation costs and labor costs
Ordering costs are those your business incurs to obtain the inventory before it is in stock.
These costs may also include wages of the procurement department, associated payroll taxes, and benefits. Ordering costs are usually included in an overhead cost pool and allocated to the number of units produced in a given time period.
2. Inventory holding costs
Inventory holding costs are the sum of money paid for the storage where a business keeps its inventory. This could be the money a business pays for all of its storage units. Or it could be a percentage of the total rent of an office area used for storing inventory.
Inventory holding costs are also known as the money needed to acquire inventory, as well as the risk of loss of money from expired or obsolete inventory.
Holding costs include:
- Storage space costs: Usually the largest inventory cost, it not only includes rent but also related costs like warehouse depreciation, utilities, insurance, maintenance, warehouse staff, storage equipment, materials handling equipment, and servicing costs.
- Cost of money: There’s an interest cost associated with the funds to pay for inventory. If a business has no debt, the cost represents foregone interest income associated with the allocated funds.
- Cost of obsolescence: Some inventory items may never be used or get damaged in transit or in storage. They must be sold at a reduced price, or not sold at all. This cost largely depends on how perishable the inventory is and how the speed of changing technology impacts the relevance of inventory.
Again, costs are included in an overhead cost pool and allocated to the number of units produced in a given time period.
3. Shortage costs
Also known as stockout costs, shortage costs occur when businesses suddenly have inventory out of stock. They’re associated with the funds needed to quickly restock items or make alternative arrangements.
Some of the costs associated with shortages could be:
- Emergency shipment costs: Shortages may mean a retail business needs to switch suppliers or pay extra to get a shipment out on time.
- Disrupted production costs: When the business produces and also sells goods, a shortage means that the business will have to pay for things like factory overhead costs and workers even if nothing is being produced.
Besides dealing with these quantifiable costs, companies lose business from customers who decide to go elsewhere to make purchases. Companies also take a loss to their reputation and customer loyalty when customers are dissatisfied.
4. Spoilage costs
Perishable inventory stock can expire if not sold in time, leading to spoilage costs.
Products that expire can dramatically increase a business’s costs. Spoilage not only costs your business money but also means you don’t realize a return on your initial investment. For that reason, care has to be taken to limit excess inventory and prevent potential spoilage costs.
Food and beverage, pharmaceutical, cosmetic, and healthcare industries are particularly affected by the expiration and use-by dates of products. Or if your business manufactures goods using perishable raw materials, you might be at risk of throwing out inventory before you manage to manufacture it.
Effective inventory control is your business’s first line of defense for limiting spoilage and waste.
5. Inventory carrying costs
Inventory carrying costs needs some calculation to see the full impact on your business P&L statement. In simple terms, it refers to the interest your business loses on the unsold stock value sitting in warehouses.
Learn more about inventory carrying costs and their impact on mid-size businesses.
How to track inventory costs
Properly monitoring your inventory costs is essential for ensuring they don’t spiral out of control or cause your business to lose money. To track your inventory costs, it’s critical to use an effective inventory management system that is set up for your business’s unique use case and financial statements.
Here are 3 ways to properly track and manage your inventory costs:
1. Stock ageing report
Stock ageing reports show you how long your inventory has been sitting around.
Once you know how long your stock tends to sit idle before being sold, you can make better stock purchasing and holding decisions. These reports can help show you which inventory to keep in warehouses, for how long, and in what quantity.
For example, by analyzing a stock ageing report you might identify that some of your inventory actually sits in a warehouse for six months before being sold. When you know this, you may then decide to order stock according to customer demand, instead of leaving it in your warehouse for long periods of time.
2. Checks and balances on inventory masters
Multiple checks and balances ensure that your inventory costs are always optimized.
Businesses need to run multiple reports to highlight all the costs associated with their inventory to help them better manage it moving forward.
For example, businesses that don’t know their minimum order quantity levels and reorder levels will always end up ordering the wrong quantity of items at the wrong time. These ordering errors add up and ultimately increase inventory costs.
Alternatively, instead of running out of inventory, if your business keeps stock for long periods of time, the lost interest on your inventory increases.
Running regular checks and balances reports will help your business pinpoint which stock you need to order when.
3. Using QuickBooks to manage inventory costs
Closely monitoring your total inventory costs is essential for optimizing costs and maintaining your profit margin. But inventory cost tracking can be time-consuming and complicated for mid-size businesses.
By using effective software, you’ll always know what you have and what you need before you run into any inconvenient stockouts or expensive holding costs for stock you don’t need.
QuickBooks can help you better manage your stock in real-time so you’re not second-guessing your stock levels.
Here are some of the ways QuickBooks stock inventory management software can help you optimize your stock levels:
- Receive low stock alerts. Find out when it’s time to reorder inventory with low stock alerts.
- View quantities on hand: As your stock comes in and goes out, QuickBooks automatically updates your inventory. This makes it easy to see what’s selling and what you need to purchase more of.
- Monitor inventory value. While your stock value changes, so does your balance sheet. Values change automatically as your stock shifts.
- Stay on top of orders. Store your supplier contact details in one place and record what you’ve ordered from each supplier to make reordering easier.
7 best practices for improving inventory costs
1. Implement demand forecasts
Knowing when you can expect fluctuations in demand will help you accurately plan how much inventory to order. Maintaining accurate records of your inventory levels and the number of goods sold will help you produce better future demand forecasts.
To produce accurate data-driven demand forecasts:
- Identify what to measure and how to measure it: To properly forecast demand, concentrate on a few relevant data points and metrics. Record stockouts, obsolete stock, shipping, and inventory levels at any given moment.
- Follow repeatable processes: By following a consistent regular process, you can compare previous forecasts with actual real-time demand and results. The data will show you whether your predictions were accurate and what the actual demand was.
Accurate data is vital for fueling your demand forecasts. When you implement accurate demand forecasting, you’ll be able to better identify how much stock you need when.
2. Use your space effectively
How you use your storage space and keep your goods will impact your inventory costs. Properly managed warehousing will help you optimize your inventory costs and bottom line, so pay attention to how you use your space.
For example, if you sell perishable goods like cosmetics, think about whether they’re easy to access. The same goes for high-turnover goods that you sell lots of—are they easy to find within your warehouse?
Use a fixed-location storage system with marked positions for stock-keeping units. That way, you’ll be able to find stock when you need it. Make sure the layout of your store suits the inward and outward flow of your specific inventory.
3. Keep accurate records
Your inventory records need to accurately match the reality of your inventory. You need to know if your stock is in your store, in the warehouse, or in transit. Stock counts, barcodes, information, and stock movements need to be updated accurately and on time.
4. Optimize order cycles and quantities
Streamlining your order cycles will help you order the right quantity of stock for your business and customers. While you might think it saves time to order more products, it can have negative consequences for your inventory costs, since more stock requires more space in your warehouse. Instead, aim to reduce the size of your orders.
More regular and smaller deliveries free up space in your warehouse and lower the risks of potential waste. Lowering the dimensions of orders also has the potential to save on transportation costs too.
5. Track lead times
Lead time is the time it takes for a product to move from order placement through manufacturing to final delivery to your storage facility. Suppliers each have their own lead times, so check out multiple options and see which one suits your business needs the most.
Usually, shorter lead times are best for your business. But sometimes it’s better to wait for longer lead times if the quality or price significantly improves. Knowing your suppliers’ lead times makes it much easier to purchase orders on time and for the right price.
When you know lead times, you’re better placed to reorder goods at the right time to meet regular customer or seasonal spikes in demand.
Pro tip: QuickBooks can show you when inventory is at a high or low level and notify you when it’s time to reorder stock according to supplier lead times.
6. Use the right inventory control system for the type of product
To effectively manage your inventory costs, you need to pick the right type of inventory management system for your stock type.
For example, perishable goods like food and beverages need to turn over at a faster rate than non-perishable goods like stationery. For that reason, you might choose a FIFO (first in, first out) policy for perishable goods to help goods move through the supply chain more quickly without reaching their expiry date.
Alternatively, manufactured goods or products that need subassemblies and multiple components may need more complex inventory management systems. In this case, it’s crucial to label, itemize, and store goods as accurately as possible to reduce errors, overstocking, or stockouts.
Properly controlling your inventory management system according to the product you’re stocking means that every necessary component can be accurately identified and tracked in real-time.
7. Track what you have and know where it is
Lastly, it’s important to know exactly what you have in stock and where it is. How many skincare products do you have in stock and where are they?
An effectively run warehouse and storage system will make it easy for staff to know exact stock quantities to quickly locate items, and accurately track stock movements.
The best way to do this is to implement cloud-based inventory management in your storage systems. That way, your team can consistently update inventory and logistics details when products are received and dispatched.
When teams have access to centralized cloud software, they can log orders more quickly, lower lead times, and prevent stockouts.
Moving forward: How mid-size businesses can optimize inventory costs
As all mid-size and small business managers and owners know, managing inventory costs can be challenging and time-consuming. The key is to understand your inventory type, what inventory costs your business faces, and which tracking system is best for your stock.
Without effective inventory management systems, it’s easy for inventory costs to quickly increase and impact your business’s bottom line. But when you choose a system that’s right for your business, it becomes much easier to optimize your inventory costs.
Start using QuickBooks today and see how you can optimize your inventory costs.
