It is important to know your cost of carrying inventory. It is a critical factor in deciding what products to stock and when to reorder them, as well as the best quantity to order. Too often companies and organizations use an imprecise “rule of thumb” to estimate their cost of carrying inventory. The result: Bad inventory management decisions.
In a previous article, “The Mysterious Cost of Carrying Inventory,” we gave you some direction for calculating an overall cost of carrying inventory for your entire company or an individual warehouse. The calculation considers these expenses and alternative opportunities for revenue:
- Moving material from the receiving dock to the proper bin location and shifting it to other warehouse locations as necessary.
- Rent and utilities for the portion of your warehouse used to store material.
- Inventory shrinkage and obsolescence.
- Physical inventory and cycle counting.
- Insurance and taxes on the inventory.
- Opportunity cost of the money invested in inventory – that is, how much could you make if the money tied up in inventory was invested in a relatively safe, income-producing investment. Or, if you finance your inventory purchases, the amount of interest that you pay the bank.
The sum of these factors is divided by the average inventory value to determine an overall carrying cost percentage – that is, what it costs to maintain a dollar’s worth of inventory in your warehouse for an entire year.
But some companies find that it costs more to stock some items. Maybe they take up more space or are more susceptible to shrinkage and obsolescence. If the carrying cost percentage is used in so many critical inventory-related decisions, doesn’t it make sense to calculate as accurate a carrying cost as possible for each product? If you believe that your cost of carrying inventory may vary for different segments of your inventory, consider calculating a cost of carrying inventory for each item.
Insurance, Taxes, and Opportunity Cost
To determine the specific carrying cost for a product, we first have to determine what factors of the carrying cost will not vary by item. These are the factors that are solely dependent on cost or value of the average on-hand quantity:
- Insurance and taxes
- Opportunity cost of the money invested in inventory
If you take the total amount of these two elements and divide it by the average inventory value, the result is the cost of these elements per dollar of your average inventory investment. We will call it the ITO (Insurance, Taxes, and Opportunity Cost) factor.
Shrinkage and Obsolescence
Shrinkage and obsolescence includes any stock material that is purchased but not sold, used to provide a service, or is part of an assembly or finished good. This includes material that is lost, stolen, broken, scrap, or becomes obsolete in our warehouse. Some products are more susceptible to shrinkage and obsolescence than other items. We need to determine factors for these two important components of the carrying cost.
To calculate a shrinkage factor for a specific item, divide the total amount of adjustments due to shrinkage (material lost, stolen, broken, or considered scrap) recorded in the past 12 months by the total stock receipts for the product during the same time period. Why don’t we use the average inventory value in this calculation? Because all inventory adjustments are already reflected in the average inventory value. We want to determine how much of the total quantity of the inventory that was received could not be sold, used in production, or used to service a customer. Many companies calculate a shrinkage factor for an entire product line, rather than for individual items. This allows a shrinkage factor to be applied to products that have not yet been inventoried for a full 12 months.
To get an accurate obsolescence factor, we usually have to use a longer time period. For example, if you normally consider inventory obsolete after it has been in your warehouse for 12 months, you might want to divide the amount of write-off adjustments made this year by the total amount of stock receipts for the item last year. Why? Because any material written off due to obsolescence this year was probably received last year. Again, it might be more meaningful if you calculate an obsolescence factor for an entire product line rather than an individual product.
If you don’t liquidate obsolete inventory on an ongoing basis, you may also want to vary the time periods you consider in this analysis. For example, one of our customers had a large obsolescence write-off last year that covered material that had been received anywhere from two to five years ago. To calculate their write-off factor, we divided the amount of adjustments due to obsolescence over the past two years by the total amount of stock receipts recorded in that two- to five-year period.
Physical Inventory and Cycle Counting
Most companies count their fast-moving items more often than their slow-moving products. And some products are easier to count than others. As a result, the “cost of counting” can vary from one item to another.
In calculating the counting element of the carrying cost, we usually start by grouping similar stocked items that are stored in similar storage units. We then determine the average number of products in each group that can be counted in one hour as well as the labor cost of performing the count. This cost includes the time spent:
- Performing the actual count
- Entering the count information into the computer system
- Reconciling any discrepancies in the count
The total cost per hour is divided by the number of products that can be counted in that hour. The result is then multiplied by the number of times each product is scheduled to be counted in a year to arrive at the total cost of counting a specific product.
Rent, Utilities, and Moving Material
Some items take up more space, and are harder to handle, than other products. Many companies feel that items that take up more space should absorb more of the total cost of carrying inventory. In order to apportion the cost of space and material movement to individual products or product groups, we must determine how much of the total space used to store products is being used by an individual item.
- Calculate the total cost of rent and utilities for the portion of your facility used to store inventoried products as well as moving material in that area.
- Determine the total cubic volume of space currently used to store stock material. This may not be the total cubic warehouse space. For example, if you just moved into a new warehouse and are using just 25% of the available space, the inventory stored in that area would still need to absorb 100% of the cost of rent, utilities, and moving material, not just 25% of the total cost.
- Divide the total cost by the total cubes used to store material in order to determine the storage cost per cube.
- Determine the total cubic volume assigned to a particular product
- If you are utilizing fixed bins (i.e., a specific space reserved for an specific item), this is the total cubic volume allocated to the product.
- If you are utilizing random bins (i.e., quantities of the product can be stored in any open warehouse location), determine the cubic volume of the average on-hand quantity of the product.
- Some companies store a particular product in both fixed and random bins and have to combine the two factors – that is, they must add the cubic volume of the total fixed bin space allocated to a product to the cubic space necessary to store the average amount of the same product stored in random bins.
- Multiply the cubic space assigned to an item by the cost per cube to determine the utilities rent and material movement expense that should be allocated to the item.
Accumulating the Costs
Now we can calculate the specific cost of carrying a specific product or group of products in inventory by totaling the five components:
- Insurance, Taxes, and Opportunity Cost: Multiply the ITO factor (calculated above) by the average inventory investment of the item or group of items.
- Shrinkage Cost: Multiply the calculated shrinkage factor by the average inventory investment. If history is any indication, this portion of the average inventory value will eventually be lost, stolen, misplaced, or broken.
- Obsolescence Cost: Multiply the calculated obsolescence factor by the average inventory investment. Again, if history is any indication, this portion of the average inventory value will eventually be classified as obsolete inventory.
- Cost of Counting: Add the annual cost of counting the item.
- Cost of Rent, Utilities, and Moving Material: Add the calculated annual cost that was based on the cubic volume of space required to store the item.
Divide the sum by the average inventory investment for the item to determine the product’s specific carrying cost percentage.
Is this a lot of work? Of course. But if significantly different amounts of effort are necessary to maintain individual inventory items in your facility, the exercise may be worthwhile. Remember that the cost of carrying inventory is one of the keys to effective inventory management, and that accurate information usually leads to outstanding results!