How to manage and reduce inventory costs
Updated 04 July 2022 • 9 min read
Managing a profitable business often requires operators to watch their costs, and if you’re selling physical goods, inventory costs can be a major part of that process.
Understanding the nuances around calculating inventory costs is crucial to your inventory management approach and business success.
In this guide, we’ll cover how to calculate average inventory cost, how to calculate the cost of inventory, and share some tips on how to manage your inventory more efficiently.
What is inventory costing?
Inventory costing refers to the price of ordering and holding inventory, and the work required to process the necessary paperwork to keep your stock organised.
Evaluating the cost of inventory is needed to determine how much stock to keep on hand to fulfil orders for customers on time.
There are various types of inventory costs, like ordering costs and spoilage costs, to name a few. Sorting costs into categories can help businesses identify where they’re losing money and how to mitigate those losses for greater financial success.
What are the different types of inventory costs?
1. Ordering costs
Ordering costs refer to what it costs to order goods, including labour, payroll taxes and benefits. Costs are often included in an overall allocated amount to cover these expenses.
Ordering costs can also include transport fees, receiving costs, expedition charges, clerical costs or the cost of EDI (electronic data interchange). EDI systems allow your business's ordering costs to be processed at a reduced price.
2. Holding/carrying costs
Holding costs (also known as inventory carrying costs) refer to the expenses incurred when storing inventory before sales.
Inventory holding costs can include what it costs to finance inventory, which can be complex depending on the type of business.
Storage costs can be high depending on how much a company pays to lease a property, and interest on working capital can be significant as well.
There are also risks associated with inventory, as holding inventory creates the potential for loss caused by damage, theft or other issues.
3. Shortage costs
When businesses run out of stock, they lose out on the opportunity for sales. Stock shortages could occur for numerous reasons, like delayed deliveries or disrupted production.
When a business's product is out of stock, customers may simply choose to purchase a similar product from a competitor. Plus, the company’s reputation is on the line, as it may appear unprepared or unprofessional to run out of stock.
4. Spoilage costs
Perishable items can spoil if they’re not sold quickly, so controlling the environment in which they’re held is imperative to success.
The food and beverage, pharmaceutical, cosmetic, and healthcare industries all must abide by the expiration dates of their products.
What are the different types of inventory costing methods?
The need for different inventory costing methods results from differences between business types, sizes and complexity. As a result, you’ll want to adopt an approach that meets your operation’s specific needs.
Here are some of the most common types of inventory costing methods and how they’re used.
First In, first out (FIFO)
This means the first inventory purchased is the first inventory sold.
When to use:
FIFO is beneficial when inventory spoilage is a risk.
How it affects financial statements:
This method provides a clearer representation of your inventory, which is beneficial if you buy items at varying prices with market fluctuation. The downside is this method is often more laborious as it required you to keep track of varying costs very regularly.
Weighted average cost (WAC)
The weighted average cost (WAC) inventory method may also be called the average cost inventory method.
The WAC method gives you the average cost of inventory per unit, based on the weighted average of the price of inventory and goods sold.
To calculate the WAC, divide the total price of available goods for sale by the available units for each inventory item.
When to use:
The weighted average cost method is useful when a business is buying inventory regularly and when inventory has a fast turnover rate. Also, when items are nearly identical to one another, it’s often not necessary to assign specific costs to single units of inventory.
How it affects financial statements:
When there are significant lapses in inventory purchases, the WAC could change considerably, depending on the market.
This method is used when each item is uniquely identified.
When to use:
The specific identification method isn't often needed in everyday sales. However, it’s useful when selling expensive items like rare vehicles, collectibles or art pieces.
How it affects financial statements:
When figuring your cost of inventory using the specific identification method, you add the cost of each inventory item after the end of a financial period.
What is standard cost inventory?
To help when planning budgets, companies may use standard cost inventory methods, which is when an expected or standard cost of labour or material — instead of the actual cost — is assigned to a good.
Examining historical data and operations under normal circumstances determine the standard cost amount. When significant variances occur, leaders will need to identify the cause and adjust accordingly.
What is the cost of ending inventory?
The cost of your ending inventory is the value of stock still available for sale at the end of a given period of time. It’s generally used for accounting purposes as part of a stocktake activity.
To calculate your ending inventory, add the beginning inventory value to any additional purchase costs incurred over a given period of time, less the cost of goods for the same timeframe.
As an example, if you had inventory valued at $100,000 at the beginning of the quarter, bought $50,000 worth of inventory throughout the quarter and finished up with $80,000 in COGS, the value of your ending inventory should be $70,000. This can be verified with a stocktake to look for errors and discrepancies.
Ending inventory = (beginning inventory + purchase costs) - cost of goods sold
How do you track inventory costs?
Knowing how to calculate inventory costs is crucial for accurate insight into the financial health of your business.
Using a smart inventory management system can help you do this with efficiency and less stress, letting you see all your stock items in real time.
How do you reduce inventory costs?
When learning how to calculate inventory costs, multiple methods can be used. Below we've presented a few that are tried and tested.
Use an inventory management system
Inventory management software provides in-depth information and analysis and offers insights when navigating purchasing decisions.
Smart software can help you plan for the future of your business, let you foresee upcoming challenges and save you time.
Order in bulk to access discounts
Typically, ordering in bulk will save you money. Manufacturers also might be willing to strike a deal with your business to help with your larger purchases.
Get rid of dead stock
Keeping stock you don’t need means you’re wasting time and money. If you have more stock than you need or can sell, clearance sales can help you move products quickly. However, if you can’t sell it all, find a way to get rid of it. You may even be able to donate goods for tax write-offs.
Use safety stock
Safety stock — additional products outside of your regular inventory — can help you fulfil orders quickly when your regular inventory is depleted.
Negotiate carrying costs with customers
Negotiating carrying costs and implementing long-term contracts with customers can help you secure a sustainable revenue source. Long-term contracts can put you in a stronger financial position because you’re likely to get better rates on goods.
Use storage space efficiently
Knowing how much inventory you have and optimising your space can help you keep your costs down.
Keeping perishable and high-turnover goods in easily accessible places is important for inward/outward inventory flow. Furthermore, keeping goods in clearly marked spaces makes stock-keeping easier for warehouse workers.
Set minimum on-hand inventory thresholds
Setting minimum inventory quantities can help you keep the right stock on hand to meet customer demand and avoid overstocking risks.
Also, minimum inventory levels help you know when to order more stock. Management must analyse how quickly certain items sell and set minimums accordingly.
Align your product and inventory costing methods
Inventory stock levels need to be set with the nature of the inventory and supply chain in mind.
For example, some goods may be perishable, while others have high turnover rates, and some may have significantly longer fulfilment times. Sometimes adopting a FIFO policy will yield better results.
Inventory management systems can help with more complex inventory items, such as items needing assembly. Labelling, itemising, and storing goods appropriately and efficiently will help your business manage complex inventory challenges.
Watch lead times closely
Knowing your lead times and how long it takes to move products from the order placement stage to warehouse inventory to final delivery can be crucial for keeping the right amount of stock on hand.
Generally, while shorter lead times are often preferred, suppliers who provide better customer service and reliability may be better for your business in the long run.
Inventory management software can help alert managers to low inventory levels, supplier availability, and lead times and remind them to reorder.
Include inventory management in forecasting calculations
Previous data can’t always predict future sales, but using an advanced inventory management system can help.
Brands can improve forecasting, KPIs and sales with these efficient tools. Inventory management software can provide businesses detailed insight into warehouse stock, lead times, restocking issues, and product sales, letting you have a better grasp of your company’s health.
Calculate your reorder points
Setting reorder points can provide you with clear safety stock levels and avoid stockouts or overstocking.
Avoid understocking to save money
Understocking may sound like a good idea, especially when you’re just starting out.
However, reordering from suppliers and adding express delivery fees will only cost you more money. Furthermore, you run the risk of stockouts by understocking, thus, potentially losing customers.
Automate inventory cost calculations and tracking
Automating your inventory calculations and tracking your needs with an inventory management platform can help you take the guesswork out of inventory planning, and save you time and money.
With inventory management software, you can automate inventory tracking, set reorder points, and analyse data on your stock levels.
Inventory management: a beginner’s guide
An inventory manager’s guide to stock control
Getting to know order management systems (OMS)