What Is Inventory Carrying Cost?
Inventory carrying cost, or holding costs, is an accounting term that identifies all business expenses related to holding and storing unsold goods. The total carrying costs include the related costs of warehousing, salaries, transportation and handling, taxes, and insurance as well as depreciation, shrinkage, and opportunity costs.
- Inventory carrying cost is the total of all expenses related to storing unsold goods.
- The total includes intangibles like depreciation and lost opportunity cost as well as warehousing costs.
- A business' inventory carrying costs will generally total about 20% to 30% of its total inventory value.
Total carrying costs are often shown as a percentage of a business' total inventory in a particular time period. The figure is used by businesses to determine how much income can be earned based on current inventory levels. It also helps a business determine if there is a need to produce more or less to maintain a favorable income stream.
Carrying Cost of Inventory
Understanding Inventory Carrying Cost
Inventory carrying costs are often referred to simply as holding costs. A company's inventory carrying cost can be expressed as a percentage. It is calculated by adding up the total carrying costs and dividing it by the total value of inventory, then multiplying by 100 to get a percentage.
The resulting figure can be used to determine if inventory carrying costs are optimum or whether they can be reduced. Carrying costs generally run between 20 percent and 30 percent of the total cost of inventory, although it varies depending on the industry and the business size.
For retailers in particular, inventory and its associated costs represent a substantial percentage of current assets on the balance sheet. As such, the management of inventory flows can greatly influence the costs of carrying that inventory. Carrying costs also can have a direct impact on the cost of capital and future cash flows generated by the company.
When the company is public, analysts monitor its inventory carrying costs over time for big changes and also compare its inventory carrying costs against those of others in its peer group.
The tangible costs of storing inventory such as storage, handling, and insuring goods are obvious. Less obvious are the intangibles such as the opportunity cost of the money that was used to purchase the inventory, and the cost of deterioration and obsolescence of goods in storage.
Opportunity cost is generally defined as the price of foregoing other, possibly more advantageous uses for money that is being tied up in the stored goods. Opportunity costs should be considered when analyzing your business's inventory carrying costs.
The cost of obsolescence is recorded as a write-off. Perishable or trendy inventory has a higher cost of obsolescence than nonperishable or staple items.
Example of Inventory Carrying Cost
ABC Company has an annual inventory value of $1 million. Its carrying cost is 20% of its annual inventory. The annual inventory carrying cost for ABC would, therefore, be $200,000, or 20% of $1 million.
Like ABC Company, XYZ Company has an annual inventory value of $1 million. But its carrying cost is 25% of its annual inventory. The annual inventory carrying cost for XYZ would, therefore, be $250,000, or 25% of $1 million.
Assuming ABC and XYZ are in the same industry, and they have the same annual inventory value, ABC's carrying costs are lower. An analyst may conclude that ABC is more efficient with their use of inventory.
What Are Examples of Inventory Carrying Costs?
Inventory carrying costs include expenses incurred from storing, transporting, and handling inventory as well as labor costs incurred in those processes. They also include taxes, insurance, item replacement, depreciation, and opportunity costs.
How Do I Calculate Inventory Carrying Cost?
Your inventory carrying cost as a percentage of your total inventory value is an important figure. It tells you what percentage of your total inventory expense was used in storing, transporting, and handling inventory items.
The calculation is:
Total Carrying Costs / Total Inventory Value * 100 = Inventory Carrying Cost %
How Can I Reduce My Inventory Carrying Costs?
You can reduce your carrying costs by minimizing inventory on hand, increasing your inventory turnover, or redesigning your warehouse space.
To minimize your business's inventory on hand, you should take a look at your inventory items and evaluate each SKU to forecast its sales potential. It will allow you to determine the appropriate quantity to have on hand. You may even decide to implement a just-in-time inventory system, which minimizes inventory and increases efficiency.
Promotions or bundles can help to move stale inventory off your shelves. To increase your inventory turnover, use the analysis from your forecasts above to stock your shelves with inventory that has a high turnover rate.
Improving the layout of your physical warehouse location can also have an impact on your carrying costs. Redesigning your warehouse may allow you to see inventory that has gone unnoticed. An optimized layout could also improve the manual processing time and labor costs associated with stored inventory items.
The Bottom Line
Inventory carrying cost is an important metric that a company can use to determine how much income can be earned based on current inventory levels. It includes both tangible and intangible costs, such as opportunity costs. It also helps a business determine if there is a need to ramp up or ratchet down production in order to maintain a favorable income stream.