The Hidden Costs of Inventory

by Eric Carter

5 min read

    You’ve decided it’s time to invest in new inventory. Your customers demand your product, and you want to deliver promptly and accurately. You have considered the obvious costs of your inventory (e.g. storage and maintenance). But, have you considered all of your holding costs?

    Broadly defined, holding costs are all costs associated with inventory, less the cost of the goods being inventoried. If you dig into your true holding costs, you will find some hidden costs that could hamper your profitability if not addressed.

    The Cost-Per-Touch

    Handling costs are the costs of of holding goods in stock. They are typically expressed as a percentage of your inventory value. While technically handling costs include everything from insurance and storage to taxation and obsolescence, a more obscure handling cost you should be aware of was made famous by furniture maker IKEA: cost-per-touch. IKEA implemented a cost-per-touch inventory strategy after understanding that every time a product is touched (whether by human or machine), that touch costs money.

    IKEA minimizes touches per product throughout its supply chain. For starters, most of its furniture comes in flat packaging. For the customer, it makes transferring the furniture home easy. For IKEA, it means that products can be easily stacked and moved by machines for fewer touches. Next, IKEA’s warehousing operations share the same space as IKEA retail stores. The result? Customers pick up their own products, eliminating further touches for home delivery. Customers generally see these two IKEA concepts as perks to the consumer. But for IKEA, both strategies greatly reduce the number of touch points from production to end user delivery.

    Cost-per-touch is now a commonly tracked metric. As a rule of thumb, you can estimate $1-2 per touch for a product and $3-4 per touch of a pallet. Those costs apply to both inbound and outbound deliveries, as well as movement around a warehouse. Obviously, actual numbers will vary per product, per industry, and per company. To give a ballpark range across industries, the cost-per-touch for a product is 2-5% of the inventory value.

    The Cost of Unavailable Capital

    As mentioned in our post How to Optimize Inventory to Maximize Profitability, inventory shows up on the asset side of your balance sheet. But, until you sell your inventory, that inventory costs you money. First, you either paid for the raw materials to build your inventory, or for the finished product itself. The cash you used to purchase that inventory cannot be used towards other business investments (e.g. marketing, new hires, product development, etc.). The capital allocated to purchase inventory comes at the opportunity cost of cash for alternative investments and expenses.

    Second, if you purchased your inventory on credit, you are most likely paying interest on that inventory until you are able to sell it to pay down the debt. In this scenario, your actual cost of inventory will always be greater than the actual value you were initially charged for the inventory. Further, as long as you hold on to the inventory without paying down the debt, the more expensive the inventory becomes.

    Finally, it often makes sense to insure your inventory. Insurance premiums are typically calculated based on your average inventory on-hand. A typical insurance rate is .5% of average inventory. For example, if your average inventory is $100,000, your premium is $500 per month.

    The Cost of Slow Turnover

    To calculate your inventory turns, divide your cost of goods sold by your average inventory value. Now, how does inventory turns translate into a hidden cost of inventory?

    Consider an enlightening balance sheet comparison between McDonald’s and Wendy’s. In the same time period, McDonald’s turned its inventory every 3.79 days, while Wendy’s only turned its inventory every 9.10 days. What does this mean to the bottom line? As we discussed in the last section, you have significant costs of capital associated with your inventory. The superior inventory turn by McDonald’s over Wendy’s allowed McDonald’s to free up cash almost three times as fast as Wendy’s. McDonald’s was able to spend money elsewhere (e.g. marketing, real estate, share buybacks, etc.).

    The McDonald’s/Wendy’s example brings about another important point about the cost of inventory: it’s not the amount of inventory that drives up costs, but how that inventory is managed.

    Notice, in the same time period, McDonald’s held over twice as much inventory as Wendy’s. But, McDonald’s utilization of that inventory, as measured through inventory turns, was far superior. Even though McDonald’s invested in much more inventory, and its costs associated with that inventory were higher, the effect of McDonald’s inventory what much less than Wendy’s cheaper inventory.

    The Administrative Costs

    If you manage your inventory, or you hire someone else to manage your inventory, you will have administrative costs associated with your inventory. This holds true across the spectrum from enterprise-grade IKEA warehousing strategies to the solo entrepreneur who dropships every product sold.

    On the enterprise side of the spectrum, warehousing operations require resources. At the entry level, you need people to manage and operate the warehouse. As the warehouse operation grows, you will want to invest in software systems and machinery to increase efficiency and lower costs. Whether you have two employees personally moving boxes on and off trucks and to and from shelves, or you have a next generation, fully-automated, robot-operated warehouse, you will always have administrative costs associated with your inventory.

    Outsourcing inventory management to a third party logistics provider (3PL) also comes at a cost. The largest 3PLs in the world (e.g. DHL, Ceva, etc.) make the bulk of their money on managing your inventory. However, small business alternatives (e.g. Fulfillment by Amazon) are money makers as well. A brief look at Amazon’s fulfillment site plainly shows that while Amazon offers the small business owner benefits that were previously limited to larger companies, the services are fee-based. The money might be well worth it, but it must be accounted for.

    Inventory is an asset, and if managed correctly, a powerful one. However, inventory comes with hidden costs that can sneak up on the inattentive business owner. Once you pick an inventory strategy, you must track all of your holding costs to ensure your inventory remains a valuable asset, not a burdensome liability.

    Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.

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