Carrying Cost

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INVENTORY CARRYING COST – 9 PAINFUL CONTRIBUTORS YOU SHOULD TRACK

Inventory carrying cost describes the cost incurred by a business for holding inventory over a particular period of time. Similarly, inventory carry cost is the sum total of expenses which a company acquires as a result of storage. The costs include taxes, insurance, cost of obsolesce, shrinkage, warehouse, damage and relocation. As long there is a need to store stocks, these costs will directly or indirectly affect profit and loss balancing at the end of a business year. The best a company can do is to have a clear calculation for inventory carrying cost. The contributors are hereby considered below:

Inventory Carrying Cost is Hidden Cost?

Inventory carrying limits the capital expansion of business because the money that could be used to invest in other projects gets tied down. There is a risk because of fluctuations. What happens if the stocks no longer sell at the value for which it was purchased or manufactured? If an equipment manufacturing company stocks part of its products, if the parts were no longer sellable, it could be sold at a worthless price.

During my 14 years of inventory management, I have seen few firesell events for Excess & Obsolete inventory turnaround and for an average return of 20% of original prices. Therefore, it is important to have clear Excess and Obsolete Inventory Policy Guide

Since no real value is likely to be added to the company, it is usually advisable that a company considers the opportunity cost of inventory carrying. If the calculation shows that the company will be losing more at the risk of the cash invested, there is a need to reduce inventory or consider other investment opportunities with the same cash

9 Contributors to Inventory Carrying Cost & Data Sources to Identify Cost

1. INSURANCE.

The costs of insurance do not strictly apply. Hence, companies need to understand insurance policies so as to determine how much profit can be made irrespective of the invention carrying cost. It should be noted however that the insurance paid by a company depends on the level of inventory. Therefore, the higher the inventory carrying cost the higher the insurance premium.

Data Source: For this calculation, standard costs data are from comptroller’s department and freight rate and product specifications are from distribution reports. Average monthly inventory in cases from printout received from sales forecasting was also used.

2. TAXES.

This inventory carrying cost accrues as a result of personal property cost paid on inventory. On the other hand, too, local authorities’ tax a company based on the rate of inventory in the store. Just like insurance, a higher level of inventory will lead to higher taxes paid. Ultimately, the inventory carrying cost will increase.

Source: Through the comptroller’s department.

3. PLANT WAREHOUSE.

Ordinarily, the costs are fixed. Thus, the storage space is not relevant when considering inventory carrying cost. But this does not mean there are no variable costs. By variable, it means that it varies with the amount of stock that moves through the asset. When this occurs, it has to be included in the inventory carrying cost.

Fixed plant warehouse cost can be calculated with the assumption that if a firm rent out the warehouse space or use it for some other productive purpose instead of using it for storing inventory. An estimate of the appropriate opportunity cost would be appropriate.

Source: Through the logistics services providers

4. INVENTORY HANDLING COST.

The cost incurred here is proportional to the level of stock moved in and out of the warehouse (throughput) and the amount of stored inventory. Usually, the assessment is carried out when stock is moved in from one location to another.

I have seen this happening the most when some business put the excess and slow-moving inventory in 3 rd Party warehouse (which is bad idea by the way) and once in a while they need it or out depends on business needs

When relocation occurs as a result of excessive inventory, the relocation cost should be included in inventory carrying. However, the rate of occurrence of relocation will determine which method is appropriate in a particular situation. If the need to relocate hardly happen, the impact on the inventory carrying cost is minimal.

Source: Distribution operations expenses.

5. RENTED or 3PL WAREHOUSE.

This is a storage space which has been contracted for a particular period of time usually as cost/pallet/week. Therefore, cost does not depend on amount of inventory you carry but the amount of pallet space you occupy. Therefore, the expenses may vary from month to month. Similarly, some costs like warehouse labor, equipment operating costs, among others vary with transfer within and without the storage facility depends on your agreement.

I have advised two companies in the last 3-4 years and their practices/arrangement I would recommend you to avoid.

  • One of them has a minimum rental space agreement. Meaning, they were paying for a minimum of 200 pallets every month, despite they only have 154 pallets in stock, this is a bad idea! Never sign a minimum rental space agreement, always go for charge/pallet/week. This is clear and variable.
  • The other company was hiding their excess and obsolete inventory far away in 3PL warehouse and as a result, everyone forgets about that! Again, not a good idea, I would recommend to have this excess and obsolete inventory visible so you don’t forget about it and try to result as much as possible and as quick as possible using as many Inventory Reduction Strategies I have mentioned in this blog.

Learn More About Supply Chain Operations

Source: Distribution operations expenses.

6. COST OF OBSOLESCENCE.

Cost of obsolesce is the difference between the original purchase price of each unit of product and the reduced selling price. Usually, reducing the selling price of a product against the original price may be needed in order to move the product or firesale. As a form of sales forecast, costs of obsolesce are included in the costs of manufactured goods account or cost of goods sold. However, it is relevant to inventory carrying cost as long as products go through depreciation when held beyond their useful life.

Source: Inventory Records from the finance function

7. DAMAGE COSTS.

Irrespective of the inventory level, damage costs cannot be avoided. Also, it is an inventory cost related to perishable products. Damage could occur during shipping, transportation and even while being handled in the warehouse. Since they will continue irrespective of the inventory level, it should be taken as a throughput cost.

It should, however, be noted that only the part attributable to inventory carrying needs to be included. There are instances when damage costs are not included in the inventory carrying cost. If the damage is as a result of your own warehousing operator’s or 3PL negligence and it is at the same time above an amount specified in the contract, it is taken from the fee payable. Damage cost is the net value after claims have been settled to be included in inventory carrying cost.

Source: Distribution operations expenses.

8. SHRINKAGE COSTS.

Shrinkage is becoming an observable occurrence with today’s businesses. It is a loss of merchandise which mostly occurs through theft and embezzlement. Occasionally, it occurs as a result of poor record keeping, shipping wrong products or incorrect quantities to customers. On the other hand, some edible and liquid products may undergo shrinking and spillage while being transferred from one point to the other.

However, theft is a seriously common situation when it comes to expenses and easily sellable products, it could be hard to manage effectively without resulting to dismissal. The success of shrinkage as a result of theft and misappropriation could be blamed on the poor security measures put in place by the business. Not all can be attributed to inventory carrying cost even though the level of shrinkage varies with the number of warehouse centers. While some of them are at best charged to the warehouse than the cost of inventory, the ones attributable to inventory carrying should be included.

Source: Distribution operations expenses.

9. CAPITAL COST

This is generally applied by financial controllers, but probably the most strange one for me. They mostly calculate as if the amount of $ value invested in inventory if invested with a bank or any other investment opportunity to earn a return, then the return should be comparable to this investment. If it is not then this is the cost of carrying inventory.

This is a strange one for me as it changes very abruptly from country to country and from situation to situation so I never really able to make the full sense to this. But one thing is super clear this should be part of inventory carrying cost calculation, somehow!

The other contributors which are important to consider but difficult to calculate to include in inventory carrying cost are:

  • Extra Time and Cost of Stocktaking or Annual Stock Count
  • Extra Time and Cost of Cycle Counting
  • Extra Time and Effort by planning team to classify the in ABC-XYZ analysis.

Source: Financial Controller!

CONCLUSION

Inventory carrying cost depends on how you want to manage your logistics cost overall and it varies from business to business. However, it is good if managements attempt to put in place appropriate logistics cost management structure to have a full view of logistics cost.

For example, if there is just one product line then inventory carrying cost may not be hard to calculate against the financial performance of the business. That is, costs like transportation and storage are included based on average occurrence. If the case is otherwise, let’s say diverse product lines, inventory carrying cost has to be calculated for each product line. That means, costs like transportation and storage would be added on a particular product. Generally, this is hard work!

More importantly, attention should be paid to inventory turnover. This is because there is a relationship between inventory carrying cost and inventory turnover. For inventory turns to improve annually there must be a logistic cost system for inventory carrying costs. In the absence of no effective logistic cost structure, improved turnover will only endanger the financial performance of the business. If for example, there is a desire to increase inventory turnover from 25% to 30%, the management must put in place appropriate logistics cost structure to ensure that handling cost, taxes, insurance, relocation costs, warehousing, among others reduces with the same proportion.

So, are you going to continue to focus on Inventory Carrying Cost

Carrying Cost and Holding Cost
Explaining Carrying Charges in Inventory Management, Lending, and Investing

Business Encyclopedia ISBN 978-1929500109 © 2020 Solution Matrix Ltd All Rights Reserved

For businesses that sell or manufacture goods, the carrying costs for storing and handling inventory can be substantial. Successful inventory management is the art of making goods available to customers when they want them while keeping inventory carrying costs low.

Carrying Costs Usually Pass on to Customers—in One Way or Another

What is a Carrying Cost? What are the Different Kinds of Carrying Costs?

In business, carrying cost (or carrying charge, or cost of carry, or holding cost) has several different meanings:

1. The primary definition of carrying cost refers to one of the significant cost categories in inventory management. Inventory carrying costs in this sense can include the costs of insuring, financing, storing, and handling inventory.

2. Carrying cost also refers to charges that lenders passed on from lenders to borrowers for maintaining an open balance due. Monthly charges for a credit card account that has nonzero balance at the end of the month, for instance, are carrying charges.

3. For investors, carrying costs or carrying charges refers to margin account charges with a broker. These are essentially interest charges on loans to purchase investment bonds or stock shares. Tax authorities sometimes allow investors to claim these carrying charges as income deductions.

Carrying Cost Charges Appear But Under Different Names

In all three cases, the terms carrying cost or carrying charge refer to a cost category, almost never the name of a specific cost item.

  • “Carrying cost” very rarely appears as a line item or expense account name in on the Income statement. Instead, carrying cost expenses appear on the Income statement under several named accounts, such as “Warehouse insurance expense.”
  • Borrowers and investors very rarely, if ever, receive a bill with a line item called “Carrying Cost.” Instead, for instance, a monthly statement (bill) from the credit card issuer can include a charge for “interest.”

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Carrying Costs in Inventory Management

For companies that sell goods, inventory refers to as goods or materials the firm owns and holds ultimately for sale. Retail businesses typically call their inventory merchandise inventory. Firms that manufacture and sell goods hold manufacturing inventory, which they further classify either raw materials, work in process, or finished goods. In either case—merchandise or manufacturing inventory—the cost consequences of inventory ownership can be large

In most cases, carrying costs are one of three primary inventory cost categories:

  1. Total stocking costs.
    These costs include all the costs of procurement and order, as well as inbound logistics costs (e.g., shipping costs).
  2. Loss or devaluation costs.
    These costs include the expense of writing down inventory value due to obsolescence or spoilage, for instance, as well as loss costs from theft, or damage in storage.
  3. Carrying costs.
    These costs are the expenses of insuring, financing, storing, and handling inventory. Inventory carrying costs may include;
    • Storage costs. Inventory storage can bring costs for:
      • Building or leasing storage warehousing.
      • Warehouse building operations and maintenance (e.g., for utilities).
      • Inventory handling infrastructure, such as materials movement belts and forklift tractors.
      • Software and hardware IT systems for inventory tracking and inventory management.
      • Employee wages and salaries for managing stock and inventory administration.
      • Installing, operating, and maintaining security systems, as well as wages and salaries for security guards.
    • Cost of Capital: Costs of financing purchases, costs of insurance, costs resulting from legal liabilities.

Note that some business people prefer to consider “loss and devaluation” costs as “carrying costs, ” as well. For accounting purposes, however, it does not matter whether loss and devaluation costs are called “carrying costs” because “carrying cost” that term neither an account nor a budgeting category. The many cost items listed above appear in financial reports and budgets under those names.

For more on managing inventory costs, see Inventory.

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How to Calculate Carrying Costs

How to Calculate Holding Costs

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.
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