The True Costs of Carrying Inventory

What Inventory Actually Costs You

Let’s discuss inventory. Whether you’re talking about raw materials or finished products, inventory is both an asset and a liability. “On average, inventory represents approximately 15% of total firm assets for public U.S. firms” (Inventory Write-downs, Sales Growth, and Ordering Policy: An Empirical Investigation.)

Arriving at a liability percentage is much more difficult. If you think your inventory costs are merely the amount you pay for the items, it will not take long for you to discover the real truth. The cost of capital is only the beginning. The most savvy business owners are aware of the hidden inventory costs: warehouse space, handling of the items (over and over again), loss (usually from said handling), insurance costs, etc. On one hand, increased inventory levels tend to appear as an asset on your balance sheet at the end of the year. However, you should keep in mind a carrying cost formula that accounts for the holding costs of all that inventory you’ve acquired. Do you really know the true storage cost of your inventory? There is a substantial carrying/holding cost, and the negative effects of remaining unaware can be both significant and disastrous to your company’s bottom-line when you consider potential inventory write-downs or write-offs. You have the ability to decrease these liability costs and prevent both monetary loss and loss of reputation.

Carrying Costs

The use of this vague term is incredibly deceptive; it gives a false impression that the cost of holding inventory is one big sum and that little can be done about it. When doing any research on this topic, most sources lump all inventory holding costs into a single percentage. “Inventory carrying costs are expressed as a percentage of the average dollar value of inventory over a fixed period, usually a year. As a rule of thumb, inventory carrying cost is 25% of a company’s average inventory investment, but when you tally up all the relevant carrying costs, it can run as high as 40% or more.” (The Real Cost of Carrying Inventory) This statement is understandable, but it perpetuates a false impression that you have little power over the cost of your annual inventory. This notion can be proven to be completely false. Breaking down and identifying each separate cost percentage will allow you the opportunity to rein-in these costs and allow you the opportunity to significantly impact your bottom-line, one single bite at a time.

The information you will want to understand about the cost of carrying inventory will be outlined in this simple and clear breakdown of carrying costs; this knowledge will help you implement change. There are four broad categories of inventory carrying cost: capital cost, inventory service cost, storage cost, and inventory risk cost. Each of these categories will be broken down further into component pieces.

Capital Cost

Inventory expenses usually start here. Your company’s capital cost is what you expend on carrying inventory and includes two factors: inventory financing charges and opportunity losses. Arriving at your total inventory financing charges should be easy and straightforward, this is either the interest lost on the cash used to purchase inventory or the interest paid on a line-of-credit used to purchase the inventory.

Opportunity costs include both the opportunity missed because your money is invested in obsolete or under-performing inventory, and the opportunity missed for ALL money invested in inventory. Depreciation costs or obsolescence costs essentially amount to opportunity costs since those inventory items represent money that could have been invested in a myriad of ways: research and development of new products, additional staff, or monetary investments like mutual funds or money market accounts.

Your capital cost should be the largest portion of your total carrying cost and should typically range between 6-12% (9 Proven Tips to Control Your SMB Inventory).

Inventory Service Cost

Service costs include insurance to cover your inventory and taxes paid to both local and federal government.

Although the idea of purchasing insurance is not sexy, it is a decision that could make or break you. There are expenses along your supply chain that you may not notice until your financial statements come in. You need to evaluate the various available premiums and the value of what you are insuring. Do you want to cover your items at the depreciated value (actual cost value) or do you want to pay a higher premium that would cover full replacement cost? What risks are you taking by purchasing cheaper coverage? You need to again evaluate the possibility of loss to theft or natural causes. If there is a considerable likelihood your inventory is attractive to staff, vendors, and customers with access and opportunity, or if your warehouse is geographically located in an area prone to flooding, tornadoes, earthquakes, etc., then you need to consider that paying the higher premium may actually be your less expensive option in the long run. Find other ways to cut administrative costs.

Taxes = unavoidable. You have the ability to decrease taxes levied upon your business by decreasing your total inventory. “Many local authorities tax the level of inventory in the warehouse, so higher levels of inventory will lead to higher taxes paid” (Inventory Carrying Costs.) Taking the time to effectively manage the stock level will have a definite impact on your tax rate.

Your carrying cost for both insurance and taxes will range between 3-10% (9 Proven Tips to Control Your SMB Inventory.)

Storage Space Cost

Storage costs include all fees associated with renting or purchasing space to store your inventory: rent or mortgage, lighting, heating, air conditioning, janitorial services, equipment upkeep and all of the costs that are included in the handling of your inventory.

Inventory needs a place to sit, and it doesn’t put itself on a shelf. Whether you own the space or rent, you are still paying premiums on a monthly basis to store your product. Your inventory level also determines the space you need and whether you require specialized storage equipment. Not only do you need to think about how your inventory is stored, you need to consider the cost to secure your facility in your warehousing costs. Security systems, low-end or high-end, cost money and many insurance policies require this securing of your inventory.

A considerable portion of your storage space cost also includes labor costs, i.e. paying your employees to handle the movement of your inventory, as well as the time needed to track the product from purchase to sale. “These expenses may be made up primarily of wages and benefits, as well as including the depreciation or expense on hand-held radio frequency (RF) units, and other related equipment, and any miscellaneous expenses directly related to your inventory control team” (The Full Cost of Inventory: Exploring Inventory Carrying Costs.)

Your carrying cost for handling (including clerical tasks and cycle counting) will range between 3-8% and your carrying cost for warehousing and storage will range between 2-5% (9 Proven Tips to Control Your SMB Inventory.)

Inventory Risk Cost

Holding inventory inherently comes with risk, and you need to acknowledge the potential cost. Product you carry, that has not yet been sold, is a gamble. You are betting on customer demand. What's the likelihood someone out there will purchase the product at a later date? If you carry inventory that quickly depreciates in value or quickly becomes obsolete, there is considerably more pressure to turn over stock. If you’ve miscalculated the need for an item, and your turnover is slower than expected, you could be carrying inventory that has lost a large percentage, or worse, all of its value. This inventory mismanagement significantly impacts your risk cost. “A relatively low inventory turnover may be the result of ineffective inventory management (that is, carrying too large an inventory) and poor sales or carrying out-of-date inventory to avoid writing off inventory losses against income. Normally a high number indicates a greater sales efficiency and a lower risk of loss through un-saleable stock. However, too high an inventory turnover that is out of proportion to industry norms may suggest losses due to shortages, and poor customer-service” (Inventory Turnover.) The potential for inventory obsolescence is the greatest portion of your inventory risk cost within a range of 6-12% of your carrying cost (9 Proven Tips to Control Your SMB Inventory.)

Included in your total risk cost is inventory shrinkage and damage. “Inventory shrinkage is the loss of products between the point of manufacture or purchase from a supplier and the point of sale. The term shrink relates to the difference in the amount of margin or profit a retailer can obtain. If the amount of shrink is large, then profits go down” (Shrinkage.)

While most shrinkage is attributed to employee theft (42.7%) or shoplifting (35.6%), other causes of shrinkage include:

• Administrative errors such as shipping errors, warehouse discrepancies, misplaced goods, and paperwork errors (15.4%.)
• Vendor fraud (3.7%.)
• Cashier or price-check errors in the customer’s favor; perishable goods not sold within their shelf life; and damage in transit or in the store (3.9%) (Employee Theft Statistics.)

“The Global Retail Theft Barometer,” published by the Center for Retail Research, estimated annual retail shrinkage in North America at 1.58 percent in 2011, representing a dollar loss of $45 billion” (Typical Annual Inventory Shrinkage.) You have more opportunity to significantly decrease your inventory carrying cost if you can rein-in shrinkage. Tighter security measures, to prevent both employee theft and shoplifting; an inventory management system, to eliminate administrative errors; and staff training, to eliminate cashier errors, are just a few suggested ways to begin decreasing your inventory shrinkage costs.

Inventory shrinkage and damage account for 2-4% of your carrying cost (9 Proven Tips to Control Your SMB Inventory.)

To round out this information on carrying cost, it is incumbent upon you to determine exactly what you are paying to carry your inventory and to fully evaluate the financial impact to your business. Remember, “Inventory typically loses roughly 1%-2% of its value per week under normal conditions, but can depreciate faster when times are tough” (Apple Lesson of the Day: Inventory Is Evil.)

In the calculation examples, based off a $500,000 investment in inventory, thinking the average carrying cost of 25% is appropriate is clearly inaccurate. If an assumption is made that your carrying cost will fall within that 25% because it happens to be the average, it is just that, an assumption. Middle of the line percentages are selected here for each cost category in the scenario. The accurate carrying cost percentage was 37% instead of the average 25%.

What could possibly happen if you choose a more laissez faire attitude about inventory management? Are the negative impacts really that large or significant?

“The costs of shrink, damage, and obsolescence are the value of the write- offs taken, or stated in percentage terms, the value of those write-offs over a given period of time divided by the average inventory during that period. This assumes, however, that all write-offs were taken on a timely basis throughout the year” (The Full Cost of Inventory: Exploring Inventory Carrying Costs.)

Inventory mismanagement leads to inventory write-downs and ultimately to inventory write-offs, both negatively impact your reputation and your bottom-line.

Write-Downs

As mentioned above, inventory depreciation and obsolescence is a risk of carrying inventory. Holding stock for too long increases your chance the market price for the item will fall below what you actually paid.

The item itself isn’t without value. However, if customer desire has waned, you may be forced to write-down the price of the item below its actual purchase cost. “Any inventory write-down must be reflected as an expense (part of cost of goods sold) on the income statement. Thus, if the value of inventory declines, a company incurs a financial loss” (Inventory Write-downs, Sales Growth, and Ordering Policy: An Empirical Investigation.)

Write-Offs

Although you’ll take a hit when you write-down inventory, write-downs are preferable to write-offs. A write-off is, “An accounting term for the formal recognition that a portion of a company’s inventory no longer has value” (Inventory Write-Off.) Most companies prepare in advance for inventory losses due to write-downs and write-offs by creating an Inventory Reserve.

The recommended reserve is projected from the calculation of historical selling data and current market conditions. To continue the calculation scenario and using the $500,000 inventory total, estimating 1% of inventory will never be sold, requires $5,000 be placed in the inventory reserve. This inventory reserve is accounted for as an expense on your company’s income statement. It needs to be emphasized that the inventory reserve is an allowance, an amount designated and set aside in advance of your inventory actually losing value.

When an item you are holding loses value, the “write-off” amount is deducted from your reserve. The potential problem is not allocating enough funds to the reserve. 1% of your total inventory is a fairly conservative amount to project, and it requires you to be vigilant in managing your inventory and deducting losses in a timely manner. “Companies with efficient inventory management create two task forces with linked action plans. The first task force identifies the root causes and determines ways to reduce the creation of new excess and obsolete stock. The second focuses on ways to sell off the stock more effectively. It provides the sales team with a list of top excess or obsolete products to push to ensure that they’re discounting specified excess products” (Inventory management: 10 questions to diagnose your inventory health.)

Let’s talk numbers; let’s talk reality. If you’ve been paying attention to some big-market players, inventory writes-offs don’t cost mere pennies. Research In Motion, AMD, and Caterpillar have all recently felt the burn of ineffective inventory management to the tune of millions of lost dollars.

Case Studies on Write-Offs

Research in Motion

Research In Motion, the manufacturer of the struggling BlackBerry phones and PlayBook tablets, is writing off much of its unsold inventory to help fight a slipping profit margin. The inherent cost of this motion is not chump change, either. RIM said earlier this month that it’s taking a pre-tax charge of $485 million off of its taxes to account for the slipping value of its PlayBook tablets, which recently saw its price drop from $500 to $200. That price drop was necessitated by an inventory overload that has ballooned to $1.4 billion as of late August. Selling the PlayBook has been a huge problem for RIM, which has struggled to compete with Apple in the tablet computer market (RIM writes off $485M worth of overstocked inventory.)

The impact on RIM’s cash position has been dire. Its second-quarter results (to the end of August) show that its cash on hand dropped from $1.99bn at the end of May to $851m at the end of August. That’s $1.14bn spent on something; most likely the PlayBook (PlayBook writeoff means RIM’s tablet has been a $1.5bn mistake.)

AMD

AMD said it was also affected by lower selling prices for its chips and poor utilization of its manufacturing facilities. It will take a US$100 million inventory charge for unsold products. The write-off could be tied to its “Llano” Fusion Chips, which started appearing in PCs in the middle of last year (AMD cuts sales, forecast, blames weak economy.)

In the third quarter, AMD now projects a roughly 10% sequential sales decline, which would deliver about $1.27 billion of revenue. The company’s already pessimistic July guidance called for about $1.36 billion to $1.44 billion of sales (AMD Cuts Revenue Outlook.)

As a result their margin dropped down to 31%, down from the previously expected 44%. This was primarily caused by a $100 million inventory write-off due to lower anticipated future demand for certain products. Piled-up Llano inventory is a possible explanation for the delayed launch of Trinity for the desktop aside from OEMs. Now it appears AMD had to write-off these chips, as they won’t be able to sell them at their projected value (AMD Cuts Revenue Forecast, Had to Write Off $100 Million.)

Caterpillar

The world’s largest maker of construction and mining equipment disclosed late June that it would write down the value of a Chinese mining-equipment subsidiary, ERA Mining Machinery Ltd., by $580 million (Caterpillar digs into deeper trouble in China.)

The $580m writedown, which was double the asset value of the company at the time it was purchased, caught those involved in the deal by surprise. “When you lay the accounting systems of someone like Caterpillar over a small, growing Chinese company there are always going to be discrepancies, but $580m worth?” (Caterpillar digs into trouble in China.)

How to Avoid Inventory Downfall

The various types of inventory costs can threaten your business’s financial health. Meanwhile, there are many factors to consider when making informed decisions about your inventory. It’s too easy to make a mistake and face dead stock or excess inventory (or both.)

Stocking items customers don’t want, or having a shortage of the items they do want, all lead to an inability for your company to provide prompt, quality customer service.

Answering the following questions honestly will get you started:

• What are you promising that you can’t deliver?
• Has your reputation taken a hit because you’ve been forced to write-down or write-off product?
• Are you tracking your inventory efficiently?
• Can you find what you need when you need it?
• Do you know what you have in stock?
• Do you know current stock levels?
• Do you know the items (and quantities) customers have purchased from you in the last year?
• Can you forecast product levels?
• Is your method of recording all this information easy, streamlined, and cost-effective?

Why worry about inventory management at all? The subtext of this entire article and the reason an emphasis has been placed on educating you about the costs of carrying and mismanaging your inventory, is due to the negative impact on, not just you, but your customers if you don’t take the issue of controlling inventory seriously.

The Benefits of an Inventory Management System

Using inventory management software, like those provided by Wasp, will assist you in reducing your annual carrying cost. In addition to reducing the annual carrying cost, an inventory management solution may also help your business reduce write-offs to 1%, provide detailed analytics to determine slow moving and obsolete inventory, and gain your return on investment in weeks or months, instead of years. Both large and small businesses benefit from an inventory management system. Amarillo National Bank saved $12,000 per year by implementing a barcode based system, while Racesource saved over $8,000 annually in parts lost alone. Process Control saved over $35,000 annually, and Ace A/C saves over $800 per week by using their inventory management system.