When you calculate what your inventory costs you, it's much more than just the price of buying or making the products. Accountants say when you're holding inventory, or keeping unsold stock on hand, that counts as an added expense. You need to calculate the holding cost, AKA inventory carrying cost, to understand how inventory affects your bottom line.
TL;DR (Too Long; Didn't Read)
Holding inventory on hand generates a holding cost for your company. The simplest way to calculate holding costs is a rule of thumb: the cost is 25 percent of the inventory's annual value.
What is the Holding Cost?
Your company's holding costs have four different elements:
- The cost of the space to store your inventory. Costs include utilities, rent, property taxes and insurance.
- The cost of handling the items. There are the work hours it takes staff to put them in storage and enter them in the computer and any added security to keep them safe.
- The loss to your company if the inventory sits too long. It either deteriorates or becomes obsolescent.
- The capital cost of having money tied up in unsold inventory, unusable for anything else is usually the most significant part of your carrying costs.
Guessing Holding Cost
Some carrying costs vary more than others. If your company has a warehouse, the cost to store, say, 100 cubic feet of inventory is the same whether it's new inventory or old. Above a certain point, though, you run into space issues; if your warehouse staff can barely move around piles of old inventory, that's going to slow them down, decrease efficiency and increase the work-hours it takes to do the job. Other elements are more variable. The cost of insuring the inventory will change as the value goes up.
A further complication is that figuring the individual elements gets subjective. How high is the risk of obsolescence? How do you calculate capital cost? Many companies use short-term borrowing rates to calculate capital cost; if you have $50,000 in inventory for the year, the capital cost is $50,000 times the current short-term rate. This lowballs the figure. A better method is to use the weighted average cost of capital, the average rate your company pays its security holders for financing.
Use a Carrying Cost Formula
The simplest formula skips over the heavy number crunching and goes with a rule of thumb. Calculate the value of your inventory, then divide it by 25 percent to get the carrying cost. If your inventory is worth, say, $650,000 then your inventory holding cost is $162,500. Another rule of thumb is to add 20 percent to the current prime rate. If the prime rate is 7 percent, carrying costs are 27 percent.
If rule of thumb doesn't suit you, you can plug in actual numbers. Add up the money that holding your inventory costs you, from taxes to storage space to capital costs. Divide this by the average annual value of your inventory. If the costs are $300,000 and the value of your inventory is $3 million, your holding costs are 10 percent, for example.
If you're not sure how to calculate some of your costs, inventory experts offer standard estimates you can use for the formula; capital costs 15 percent, storage costs 2 percent. Professionals in your industry may be able to give you averages tailored to your line of work.
Using Holding Costs
Calculating costs won't do you any good if you throw the results in a drawer. Once you have the figures, you can use them in your planning:
- If you buy more inventory, how much will this increase your holding costs?
- Can you afford to store more inventory or will this hurt your bottom line?
- Are the costs significant enough that you need to reduce inventory?
- Are you dealing with obsolete inventory efficiently? Some companies write off old inventory as worthless but keep the physical stock for years.
Whether the inventory carrying cost is a problem depends on your situation. If your company owns lots of empty storage space and your inventory doesn't deteriorate, unsold inventory may not worry you. If paying for storage is an expense, inventory ages or the company has debt it needs to pay off, carrying costs are an issue.
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