As we have said many times: although inventory is costly, it is necessary when running a business. While a lot of the focus of parts inventory control should be given to the money tied up in the inventory itself, the cost of carrying that inventory should also get focus, although it is often given short-shrift in inventory control discussions.
Companies that use a “rule of thumb” – such as counting 25% of the total value of the inventory – to determine the cost of carrying their inventory are making assumptions that could cost them a lot of money – and if you don’t know exactly where your money is, you have a problem.
The rules of thumb are often okay for planning purposes, especially when the exact details of storage are unknown. However, once your inventory is in place, the data required for an exact figure of the cost of carrying your inventory is in your records of bills and wages paid to employees. Instead of relying on the rule of thumb, you should know the exact figure that those records hold. If you don’t know that number, you will never know when you need a smarter, more profitable way to store your inventory.
The inventory carrying cost is usually expressed as a ratio of the cost of carrying the inventory divided by the value of the inventory itself. The value of the inventory is the amount of money spent buying or manufacturing it as a yearly average.
Inventory carrying cost = (yearly cost of carrying inventory) / (average yearly inventory value)
Expressing the carrying cost as a ratio is useful because a quick glance will tell you if the carrying costs are excessive. For example, a ratio of 200% means you are spending twice the value of the inventory itself in order to store it. This immediately tells you that something must be done.
The yearly cost of carrying inventory is the sum of four parts:
This is the “opportunity cost” of your inventory – that is, the amount of money that is tied up in inventory and not being placed in a different investment.
Inventory Service Cost
This is the cost of handling, insuring, and paying taxes on your inventory.
Storage Space Cost
This covers the cost of renting, leasing, or buying a warehouse to store your inventory.
Inventory Risk Cost
The very act of keeping something entails the risk of losing it. Keeping inventory involves the cost of shrinkage, theft, obsolescence, spoilage, deterioration, and/or damage.
Your goal as a business is always going to be lowering costs. Knowing exactly where your money is being used is the first step in reducing them.
So if you aren’t sure what your inventory carrying costs are, or if you have other inventory related questions, please contact Acumen Information Systems for more information today.