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Understanding Inventory Costs

Inventory Cost CalculatorOne of the critical impacts on profitability often overlooked and misunderstood is the cost of holding inventory. There are some cost drivers in carrying inventory and sometimes, even more, important, the cost of not having enough inventory on hand. Below we have put together the facts around this important business cost calculation. 

Inventory Assumptions
Each company is different but on average your inventory holding cost will be somewhere between 25% and 40% of the inventory value on hand. In this example, we will make the following assumptions.
  • Assuming you have $500,000 of yearly inventory your cost will range from $125,000 - $200,000
  • Most companies are comfortable using a range of 30% - 35% a year
  • Typically companies will apply a standard 3% “monthly” holding cost
Example Inventory Holding Costs
Below is a case of the yearly inventory cost with a starting inventory value of $500,000. In this example, the annual cost of holding inventory comes to $190,000.
 
Remember we are using average costs in our calculations. It is important that you track your actual inventory costs. Monitoring inventory cost is where most companies fail to follow through in calculating their real costs.
 
Tracking actual costs (see below) is time-consuming, requires all levels of a management buy-in and is often not the most glamorous task. However, every company should attempt at completing these costs.
 
We hear feedback from customers on how eye opening the process is because they had no idea they were spending substantial money on a single expense. We suggest you hire an intern and start immediately to document your cost of holding inventory.
 
Actual Inventory Cost Categories
Here is the list of costs that go into figuring out your Inventory Costs.

1. Cost of Capital: 5%
The cost of financing money and your companies cost of money​​​
2. ​​​Destroyed Inventory: 3%
Unsaleable inventory due to damage, poor handling, not packaged securely. Destroyed product is your people causing the damage
 
3. Damaged Inventory: 7%
According to statistics, the more your inventory is handled, the more it is at risk to be damaged. Relocating slow moving inventory to a different part of your warehouse, not having enough staff or the proper forklift to handle your product all adds to damaged goods.
 
4. Obsolete & Outdated Inventory: 3%
The cost of inventory that is outdated, obsolete, expired, the only option is for scrapping or a distress sale for pennies on the dollar.
 
5. Theft: 4%
Depending on your industry, this can be a significant expense. In this cost is the money spent on theft prevention as well – closed caption security cameras, security guards, software and personnel to monitor and maintain these systems. And of course, the actual cost of stolen inventory.
 
6. Electricity Cost: 3%
The electricity heating and cooling needed for this warehouse space
 
7. Lost Customers: 3%
The cost associated with losing a customer due to not having enough on hand inventory. Customer attrition is one of the hardest to put a number, and almost no one tracks this number. You want to see an eye opener at your next quarterly sales meeting, show these costs. Well, worth the time and effort on this one.
 
8. Freight Costs: 7%
Not having inventory on hand you will often “rush” or expedite to get product inventory in to make your product. As well as keeping inventory too low, you will expedite orders to customers to meet their deadlines.
 
9. Overtime: 3%
When you pay your staff overtime to ship and receive the product in or out due to not having the correct levels of inventory. This problem happens when you just get the product in and you need it shipped and packed the next day for a customer, thus having to pay overtime to have a warehouse person stay late so the order can be ready for a 7:00 AM pickup.
 
Monthly Value of Inventory $500,000.00
Inventory Holding Costs % Cost Total
Cost of Capital 5% $25,000
Destroyed Inventory 3% $15,000
Damaged Inventory 7% $35,000
Obsolete & Outdated Inventory 3% $15,000
Theft 4% $20,000
Electricity Cost 3% $15,000
Lost Customers 3% $15,000
Freight Costs 7% $35,000
Overtime 3% $15,000
Total Yearly Inventory Holding Costs 38% $190,000

 
This example will be different for your company no doubt. The point is we want to help you to start thinking about these real costs. The benefit of investing in this exercise can be significant cost savings that will drop to your bottom line. Everyone has a cost of inventory – do you know what yours is?
 
Also, see more on the benefits of the Cheever Customer Hold Inventory Program.

 

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