Inventory carrying cost
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Inventory carrying cost is the total cost associated with having inventory items in stock. This cost is composed of several elements, including:
- Storage Costs: This cost is associated with storing the inventory in the warehouse. It includes the cost of the space, rent, utilities, and insurance.
- Interest Costs: This cost is associated with the money that is invested in the inventory, and includes the cost of borrowing or the opportunity cost of not investing the money elsewhere.
- Obsolescence Costs: This cost is associated with inventory items becoming outdated or obsolete before they are sold. It includes the cost of disposing of inventory or the cost of liquidating it.
- Shrinkage Costs: This cost is associated with inventory shortages due to theft, damage, or other losses.
Formula of Inventory carrying cost
The formula for inventory carrying cost is:
- Carrying Cost = (Average Inventory Value x Carrying Cost Rate) / 12
Where average inventory value is the average value of the inventory over a period of time, and carrying cost rate is the percentage of the inventory’s value that is associated with carrying cost.
When to use Inventory carrying cost
Inventory carrying cost is used to evaluate the cost associated with carrying inventory. It is useful for determining the optimal amount of inventory to keep in stock, and for making decisions about ordering and storing inventory. It can also be used to compare the cost of outsourcing inventory versus keeping it in-house.
Types of Inventory carrying cost
- Ordering Costs: This cost is associated with the cost of placing an order for inventory items. It includes costs such as freight, handling, and administrative costs.
- Carrying Costs: This cost is associated with the cost of carrying inventory in the warehouse. It includes costs such as storage and insurance.
- Stockout Costs: This cost is associated with the cost of not having enough inventory to meet customer demand. It includes costs such as lost sales, customer dissatisfaction, and expedited shipping costs.
Steps of Inventory carrying cost
- Step 1: Calculate the Average Inventory: This is the average amount of inventory held during the period. It is calculated by taking the beginning inventory plus the ending inventory, divided by two.
- Step 2: Determine the Carrying Cost Rate: This is the percentage of the average inventory that is used to calculate the carrying cost. It is typically determined by the industry and can range from 20% to 40%.
- Step 3: Calculate Inventory Carrying Cost: This is the total cost of holding inventory items in stock. It is calculated by multiplying the average inventory by the carrying cost rate.
Advantages of Inventory carrying cost
- Increased Efficiency: Carrying inventory can increase the efficiency of production and sales operations, as it allows companies to quickly access the items they need.
- Reduced Risk: Carrying inventory can reduce the risk of production interruptions due to lack of materials or components.
- Improved Quality: Carrying inventory can help ensure the quality of products and services by having the necessary items on hand.
Limitations of Inventory carrying cost
Inventory carrying cost is not a perfect measure of the cost of keeping inventory. It does not account for all of the costs associated with inventory, and some of the costs it does account for may be difficult to accurately quantify. For example, it does not account for the cost of managing inventory or the cost of ordering inventory. Additionally, the cost of obsolescence and shrinkage can be difficult to estimate.
- Setting minimum and maximum levels of inventory: This approach helps ensure that the required levels of inventory are maintained in order to meet customer demand. This approach also helps reduce the cost of storing and managing inventory.
- Just-in-time (JIT) inventory management: This approach helps reduce the cost of carrying inventory by ensuring that inventory is ordered and received only when needed. This approach also helps reduce the cost of storing and managing inventory.
In summary, other approaches related to inventory carrying cost include setting minimum and maximum levels of inventory and using just-in-time (JIT) inventory management to reduce costs.
Suggested literature
- Susanto, R. (2018, August). Raw material inventory control analysis with economic order quantity method. In IOP Conference Series: Materials Science and Engineering (Vol. 407, No. 1, p. 012070). IOP Publishing.
- La Londe, B. J., & Lambert, D. M. (1975). Inventory carrying costs: Significance, components, means, functions. International Journal of Physical Distribution, 6(1), 51-63.
