Small business owners may think that accounting for inventory ends upon its purchase. The real cost of carrying inventory involves much more. Considering the fine line that half of all small businesses walk between success and failure within their first 5 years, understanding the real cost is crucial to survival.
The carrying costs of inventory (which represent as much as 25% of inventory value on hand) contain few hidden fees. They refer to aspects of business that are often overlooked by new companies, such as the total cost of purchasing items, housing, handling, and accounting for depreciation if those items don’t fly off the shelves. Often the costs are computed for a year and then expressed as a percentage of the cost of the inventory items. For example, a company might express the holding costs as 20%. If the company has $300,000 of inventory cost, its cost of carrying or holding the inventory is estimated to be $60,000 per year. Neglecting to account for any of these steps can lead to excess, wasted, lost or damaged inventory, and turn into a loss through a write-down or write-off for your business.
Related Article: Reducing Inventory Cost
A write-down happens when stock has not sold and its market price has fallen below what it was purchased for. The item itself isn’t worthless; it just isn’t valued at its original purchased price. The difference between the purchase price and the current, lower, price is the write-down amount. Any inventory write-down must be reflected as an expense on an income statement.
An example of poor inventory analysis and management is J.C. Penney’s recent rebranding flop. The company lost $1 billion dollars that has caused a long term negative effect throughout the company. This caused inventory liquidation and significant write downs even as low as 95% off on some clothing items.
Write-Offs are the formal recognition that a portion of a company’s inventory no longer has value. This is far more damaging to a company’s bottom line than a Write-Down. Many businesses will complete a manual inventory assessment only to realize that a large portion of their inventory is missing. These missing products have no value and the company must write them off.
Amarillo National Bank, headquartered in Amarillo, TX, were still manually tracking inventory. The bank had trouble accounting for their entire inventory which resulted in needless purchases and inaccurate billing because their actual inventory does not match the numbers in the books. Amarillo National Bank realized that they needed a dedicated inventory management system and implemented Wasp’s Inventory Control. This reduced their inventory write-offs from tens of thousands of dollars annually to just a few hundred dollars each year.
It’s helpful to break the steps down into the simple but interconnected costs that, when reduced, can make a huge impact on your bottom line. The cost of carrying inventory certainly does not end after the initial purchase.
Inventory Write-Offs and Write-Downs
As a business owner, you take on an inherent risk when you buy large amounts of inventory with the goal of selling it for a profit. If your items don’t sell as quickly as you anticipated, you may find that they will lose value or become obsolete altogether. The rule of thumb for inventory carrying cost is between 20% and 30%. You may think that only products like milk can go bad after a period of time set on the shelf, but everything from consumer electronics to apparel run the risk of losing value over time. Another risk cost is shrinkage, or the loss of inventory between purchase from suppliers and purchase by consumers. Shrinkage usually happens due to employee theft, but it can also be caused by administrative error or damage in transit.
“You may think that only products like milk can go bad after a period of time set on the shelf, but everything from consumer electronics to apparel run the risk of losing value over time.”
Inventory capital cost
When you purchase inventory, liquid cash become tied up until you recoup your money by selling the item, a process that takes vital capital out of your business operations. The cost of capital, which is typically the largest portion of your total carrying cost, refers to both financing charges (including the money spent, the interest paid on a purchase and even the interest lost when that cash becomes inventory) and opportunity cost of the money spent (specifically the fact that your money is invested in unsold inventory rather than in other aspects of your business).
Storage space cost
Your inventory will disappear fast, and not into the hands of customers, if you don’t have a place to store it. This cost covers everything associated with keeping your inventory organized in one place, as well as secure, safe and in good condition. Storage costs include rent, utilities like lighting and heating, security and upkeep. These costs are primarily seen in the form of wages for janitorial or security workers, as well as securing the physical space for your products.
Inventory service cost
The cost of servicing your inventory means protecting it from issues such as theft or workplace accidents, or keeping it on the right side of the law. Depending on the type of coverage, insurance will cover your inventory in the event of natural disasters, theft or accidents. Taxes must be paid on the levels of inventory kept on hand, the higher the inventory, the higher the taxes. Finally, if you have large amounts of inventory that need to be tracked, inventory management systems or applications may be needed to ensure no inventory goes missing.
Racesource, part of the team that maintains the monster trucks Grave Digger and El Toro Loco, learned quickly the cost of inventory when they realized they weren’t tracking their inventory reliably. Racesource Vice President Paul Huffaker shared that “Often I would reorder or manufacture parts I already had simply because I didn’t know I had them, which was an unnecessary cost.”
There are also a variety of costs not expressly covered by these broad categories, including stock-out costs (the costs that occur when not enough inventory is on hand to complete an order, such as emergency shipping fees) and strategic planning time (more time spent communicating with suppliers or improving ordering processes means less energy and focus devoted towards other aspects of your business). Carrying inventory can have a ripple effect on almost every aspect of your business. Some of it is easy to quantify, while some must be measured less concretely.
There are tools to help you calculate and reduce the cost of carrying inventory. Many businesses use formulas to find the exact amounts they spend on various inventory costs. One of the most helpful formulas in business management is inventory turnover ratio, which is the cost of goods sold divided by average inventory. If your inventory turnover ratio is too low, you’ll see that your business spends too much on holding costs and is gambling on obsolescence of your products. On the other hand, a high inventory turnover ratio leads to not being able to take advantage of surges in demand due to little on-hand stock.
While inventory costs are different for every business type and model, the purchase of inventory and its subsequent handling are one of the biggest expenditures a small business makes. Considering that growing revenue is a top concern for almost all small business owners, reducing costs whenever possible should be a priority. The first step to reducing the cost of carrying inventory is understanding all the costs associated with that process. A leaner, more organized and efficient business will be able to outmaneuver competitors and succeed in this increasingly global economy.