The annual inventory cost, otherwise known as the carrying cost, is the cumulative annual cost of holding inventory. The cost is normally expressed as a percentage and helps a business understand the true cost structure of its inventory. The annual inventory cost includes the cost of the inventory's storage space, taxes paid, insurance premiums paid, bad inventory, handling and the opportunity cost of the money invested in inventory.
Determine the annual cost of the storage space used to store the inventory. This figure should include all rent and insurance premiums paid on the space where the inventory is stored. For example, if you rent a warehouse to store your inventory at a monthly cost of $2,000, the annual storage space cost is $2,000 x 12 = $24,000.
Determine the annual taxes paid on the inventory held. You can typically get this information from your company's balance sheet or from your company's accountant. For example, assume the annual taxes paid on the inventory are $20,000.
Determine the insurance premiums paid on the inventory. Only consider premiums directly paid to insure the inventory. Assume the annual insurance premium to insure the inventory is $5,000.
Determine the cost of bad inventory. This includes inventory lost or damaged during the course of the year and also includes inventory that you can't sell due to obsolescence. Assume the annual cost of bad inventory is $7,000.
Determine the inventory handling cost. This includes the cost of labor and equipment used to handle, store and distribute the inventory. Assume the annual cost of inventory handing is $15,000.
Calculate the opportunity cost of the money invested in the inventory. Opportunity cost is money invested in inventory that you could have used for something else. Determine the average value of the inventory held. For example, assume the average value of the inventory held is $200,000. Multiply this value by the rate of return you would expect to receive investing this sum in something else. For example, assume you could invest the money in bonds and receive a 5 percent rate of return. The calculation is $200,000 x .05 = $10,000.
Add the figures from Step 1 to Step 6. Continuing the same example, $24,000 + $20,000 + $5,000 + $7,000 + $15,000 + $10,000 = $81,000.
Divide the figure from Step 7 by the average inventory value. Continuing the same example, $81,000 / 200,000 = 40.5 percent. This figure represents the annual inventory cost. In other words, the inventory cost is 40.5 cents for every $1 of inventory held.