Even after you buy inventory for your store, it may continue costing you money. Carrying costs are the expenses you pay to keep inventory on hand for eventual sale. If, say, you rent warehouse space to shelve your stock, the rent payment is one of your inventory carrying cost components. The carrying cost formula tells you how high the costs are compared to the inventory's value.
TL;DR (Too Long; Didn't Read)
To calculate carrying cost for inventory, you add together four inventory carrying cost components: storage space, handling costs, deterioration and the opportunity cost of tying money up in inventory. Dividing this by the value of the inventory gives you carrying cost as a percentage.
Inventory Carrying Cost Components
To calculate carrying cost, you need to know three components or, ideally, four:
- Cost of storage. This includes rent, depreciation, taxes and utilities for the storage space. It's often the biggest component of carrying cost. If you have special requirements such as a refrigerated area or a time-locked steel vault, that's going to add to the cost.
- Handling costs. If you have people shelving or unshelving the goods or warehouse guards watching over them, the employee cost factors into the carrying cost formula.
- Obsolescence and deterioration. This year your inventory is cutting-edge fashion or technology. If you carry the items long enough, they'll lose value because they're suddenly yesterday's news.
- Opportunity cost. If you buy $20,000 worth of inventory, that's $20,000 you can't spend to reduce debt or to invest. This component of the carrying cost formula represents the cost of lost opportunities. Omit this from the formula if you don't have the information to calculate it.
Carrying costs aren't a problem for everyone. If, say, you have excess space in the back of your shop and don't have to pay extra for warehousing, costs of storage are minimal. If you don't have anything better than inventory to spend money on, your opportunity cost may be non-existent.
How to Calculate Carrying Cost
For a carrying cost example, assume your store sells bargain-priced furniture and shelving.
- The average value of this year's inventory is $500,000.
- The annual cost of storage is $100,000.
- Costs to unload and store the furniture and bring it out of the warehouse to the store comes to $5,000.
- The furniture is designed to be affordable and practical, not fashionable, so there's no lost value from obsolescence.
- You passed up an opportunity to invest $20,000 because of the money you had tied up in inventory.
The inventory carrying cost components add up to $125,000. To calculate carrying cost, divide $125,000 by $500,000 and you get a carrying cost of 25%.
Controlling Carrying Costs
For retailers, inventory carrying costs are a major expense. You can lower them by reducing the cost of warehouse labor or finding a cheaper place to store goods. Another solution is to achieve better control of your inventory.
Achieving the ideal level of inventory is a challenge. Too much and your carrying costs go up; too little and you lose sales from not having the items available. You can figure the right amount by using forecasting software or studying past sales records to spot patterns.
- Identify the reorder point. If past years' sales show back-to-school shopping starts in August, there's no point in ordering all your school-related items in May. You'll have to pay to store them for three months.
- If your supplier insists on, say, a minimum $5,000 order, and you don't need that much, try and negotiate. You might be better off paying a premium for a smaller quantity. Alternatively, you could work with other stores to make a joint order that meets the minimum.
- Be careful about bargains. A discount offer for a large order isn't a good deal if the items just sit on your shelves.
- If you have items in storage that just aren't moving, selling them at a big discount or donating them to charity might be a good way to cut your carrying costs.
Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs. His website is frasersherman.com