How to calculate and manage inventory carrying costs
Carrying costs — the expenses that come with holding inventory until you sell it — help a business determine whether it's operating efficiently. Higher carrying costs usually indicate that your business is ordering too much stock or ordering too frequently, which could impact cash flow.
This guide explores inventory carrying costs, how to calculate the total costs, and what you can adjust to reduce these costs, keep stock moving and increase profits.
What are inventory carrying costs?
Inventory carrying costs are expenses related to storing unsold products.
The 5 main types of carrying costs
1. Capital costs
Capital costs make up the most significant proportion of inventory carrying costs. They include the purchase price plus any interest and other fees incurred from buying the stock.
2. Inventory service costs
These costs include inventory management software expenses, taxes and insurance. Insurance costs will depend on the type of goods and how much stock you have on hand. A higher inventory level often means higher insurance premiums and taxes, which can increase inventory service costs.
3. Inventory risk costs
The risks of carrying inventory have a financial impact. Inventory risk costs include:
Shrinkage – the loss of products due to factors other than sale
Theft or damage
Administrative errors – misplaced goods and shipping errors
Product value depletion – a drop in the value of products stored for too long
4. Storage space costs
These are the operational costs of storing inventory in a warehouse or distribution centre, including:
Other facility costs
5. Opportunity costs
An opportunity cost is the investment opportunities you're unable to make because your cash is tied up in inventory. These costs are often intangible but show how high carrying costs can impact your business.
How to calculate inventory carrying costs (with formula)
Carrying costs tell you how much money you've invested in inventory. To calculate inventory carrying costs, use this formula:
Inventory carrying costs (%) = inventory holding sum / total inventory annual value x 100
Here's a step-by-step guide:
1. Add up all carrying costs – capital, inventory service, inventory risk, storage space, and opportunity – for one year to calculate your inventory holding sum.
2. Divide your inventory holding sum by total inventory value.
3. Multiply by 100 for a percentage.
Once you've calculated your inventory carrying costs, you can find ways to maintain optimal inventory levels and increase overall profitability. For example, you might run a product-specific marketing campaign to increase demand and sales, or create product bundles to drive your inventory turnover up.
What are good carrying costs in business?
Typical holding costs vary by industry and business size. But generally, good carrying costs in business are approximately 15%-30% of your total inventory value.
What inventory costs aren't carrying costs?
There are four types of inventory costs that aren’t carrying costs:
Also known as set-up costs, these expenses are what it costs to order goods from your suppliers, including administrative labour, transport fees, receiving costs, and the cost of EDI (electronic data interchange (systems that help reduce ordering costs).
You'll incur these expenses when your business runs out of stock. They include the cost of lost sales, filling backorders and expedited shipping to dissatisfied customers.
Spoilage costs are when perishable items spoil or expire. To keep these costs low, you'll need efficient inventory control to move stock on time.
Costs to reduce inventory
Reducing your inventory can come with costs. For example, you may need to place smaller, more frequent orders, which will increase costs related to ordering.
Impact of carrying costs on economic order quantities (EOQ)
EOQ is the optimal amount of inventory you need to order based on product demand, cost of goods sold and carrying costs. The measurement determines when and how much inventory you need to order to satisfy customer demand, while minimising your cost per order.
If your holding costs are high, the EOQ formula will produce a lower order quantity as the carrying costs will be a larger portion of the total cost. This means you’ll need to order inventory more frequently which can cause cash flow problems.
Ways to reduce inventory carrying costs
To reduce carrying costs, you must optimise inventory levels so you have enough to fulfil orders without accumulating dead stock. By minimising holding costs, you can boost your profitability.
Here are some tips for reducing carrying costs:
Reducing capital cost
To reduce the cost of your inventory, try to negotiate better prices with your suppliers. Consider long-term contracts and ordering in bulk, which will likely get you better rates on goods and save you money over time.
Reducing inventory service cost
Set your re-order point so you have ideal stock levels to meet customer demand without the risk of overstocking. This will also help you control variable service costs like insurance.
Reducing inventory risk costs
Reducing storage costs
Optimising where you hold your inventory is the best way to reduce storage costs. Rearrange your warehouse layout to make perishable and high-turnover goods more accessible. A more efficient use of space makes it easier for staff to find and pack orders and means you could consider moving to a smaller, lower-cost warehouse.
Reducing opportunity cost
Inventory management software can help improve accuracy, visibility and turnover while lowering labour, inventory depreciation and opportunity costs.
Carrying cost FAQs
How does an industry impact carrying costs?
Some industries have lower turnover rates, which can impact carrying costs. These types of businesses are often in niche markets with high profit margins.
How do products impact carrying costs?
The number of products your business sells can also impact inventory carrying costs. A more extensive product range generally requires more storage space and capital investment. Inventory management software is critical to managing these larger inventories.
Are carrying costs fixed or variable?
Some inventory carrying costs are fixed costs like rent and utilities for holding goods in a warehouse. Others are variable costs like insurance, which fluctuate over time and depend on the number of products you sell.
Automate inventory tracking and calculations with MYOB
To operate a profitable business, you must keep a close eye on costs, and if you're selling physical goods, that includes inventory costs. With MYOB's inventory management software, you can automate inventory tracking, set reorder points, and analyse data on your stock levels. Start your free trial today.
Disclaimer: Information provided in this article is of a general nature and does not consider your personal situation. It does not constitute legal, financial, or other professional advice and should not be relied upon as a statement of law, policy or advice. You should consider whether this information is appropriate to your needs and, if necessary, seek independent advice. This information is only accurate at the time of publication. Although every effort has been made to verify the accuracy of the information contained on this webpage, MYOB disclaims, to the extent permitted by law, all liability for the information contained on this webpage or any loss or damage suffered by any person directly or indirectly through relying on this information.