Definition of the inventory costs - Inventory Optimization Software

Inventory costs (ordering costs, carrying costs). Definition and formula.


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By Estelle Vermorel, last revised September 2013

Inventory costs are the costs related to storing and maintaining its inventory over a certain period of time. Typically, inventory costs are described as a percentage of the inventory value (annual average inventory, i.e. for a retailer the average of the goods bought to its suppliers during a year) on an annualized basis. They vary strongly depending on the business field, but they are always quite high. It is commonly accepted that the carrying costs alone represent generally 25% of inventory value on hand.

That being said, it is not easy to establish a clean definition. Inventory cost, total inventory cost (TIC), total cost of inventory ownership, …: the nomenclature surrounding the terms of “inventory costs” can be in itself somewhat tricky, and what it covers tends to vary slightly depending on the sources and the business fields concerned. In this article, we focus on the vision of the costs of a “static” inventory, rather than the costs caused by inventory movements. To be more precise, we put aside the aspects related to the flow of goods to focus solely on the costs of actually owning a certain amount of inventory. We also adopt a perspective on the matter most suited for commerce.

For retailers or wholesalers, as well as for most eCommerces, inventory is usually the largest asset, as well as the largest expense item. Assessing inventory costs is therefore essential and has repercussions on the finances of the company as well as on its management. It helps companies determine how much profit can be made on the inventory, how costs can be reduced, where changes can be made, which suppliers or items must be chosen, how capital must be allocated, etc.



Difficulties of properly assessing inventory costs

We routinely observe that a lot of companies don’t know exactly the full costs tied to their inventory. Worse, many companies rely on the false premise that regular accounting gives a reasonable estimate of the costs of their inventory.

First, inventory cost measurement, in itself, is a tough problem. There are a number of alternative cost accounting systems that can be relevant for some purposes while being inadequate or dangerous for others (cf. Edward A. Silver, David F. Pyke and Rein Peterson, see below References n°4). Then, it is neither always possible nor economical to keep track of all costs, or to split them and allocate them properly. To start assessing inventory costs, one has to understand that the relevant numbers won’t always appear in conventional accounting records, and when it seems that they do, one still has to be careful about the set of rules and assumptions used to produce those numbers. For instance, at the time of combining the different costs, one needs to make sure that the elements are consistently expressed either as before-tax figures or after-tax and not a mix of the two.

Second, the true cost of inventory simply entails many elements and goes far beyond the cost of goods sold or raw materials. Managing and maintenance expenses immediately come to mind, but it doesn't stop here. Add to this insurances, interests, shrinkage, etc. The list is actually long. In this article we endeavor to produce a clear typology of these costs to help managers get a better understanding of where they should start looking for when determining their inventory costs.

While we might try to give rule of thumb estimates for some of these, the reader has to keep in mind that each of these costs is extremely business specific and depends on policies and management decisions (ex: the decision to use third party services providers, or to apply a just-in-time inventory policy, etc.).

Categorizing inventory costs

Again, while there are a lot of common grounds in the literature, the categories and subcategories of inventory costs fluctuate and overlap, or are designated under different names. We don’t pretend to expose below the “right” typology, but simply one that hopefully can make sense (again focusing on commerce) and be useful for manager to get a full picture on inventory costs.

Inventory costs fall into 3 main categories:
  • Ordering costs (also called Setup costs)
  • Carrying costs (also called Holding costs)
  • Stock-out costs (also called Shortage costs).

We briefly define these notions, but among those three categories, the carrying costs retain the bulk of our attention.

Going further: Other typologies exist, some of them more relevant for producers. For instance, Mary Lu Harding (see below References, n°1) adopts a different perspective, with categories such as cost of non-delivery, cost of non-quality, use-related costs, etc., most suited for businesses processing raw materials, and useful to determine how to select raw materials suppliers.

Ordering costs

The ordering cost (also called setup costs, especially when producers are concerned), or cost of replenishing inventory, covers the friction created by orders themselves, that is, the costs incurred every time you place an order. These costs can be split in two parts:
  • The cost of the ordering process itself: it can be considered as a fixed cost, independent of the number of units ordered. It typically includes fees for placing the order, and all kinds of clerical costs related to invoice processing, accounting, or communication. For large businesses, particularly for retailers, this might mainly boil down to the amortized cost of the EDI (electronic data interchange) system which allows the ordering process costs to be significantly reduced (sometimes by several orders of magnitude).
  • The inbound logistics costs, related to transportation and reception (unloading and inspecting). Those costs are variable. Then, the supplier’s shipping cost is dependent on the total volume ordered, thus producing sometimes strong variations on the cost per unit of order.

It is not easy to produce even a rough estimate of the ordering cost, since it includes elements that are very business specific and even item specific: suppliers can be local or overseas, they can adopt rules to deliver only per palette instead of per unit, or only when a certain number of items is ordered; then of course, suppliers can provide volume discounts, etc.

There are ways to try to minimize those costs, more precisely to determine the right trade-off of carrying costs vs. volume discounts, thus essentially balancing the cost of ordering too much and the cost of ordering too less (basically, a smaller inventory typically leads to more orders, which means higher ordering costs, but is also implies lower carrying costs). This is usually achieved through the calculation of the Economic Order Quantity (EOQ). Without going into details here, let’s just add the following reminder: though a classical way often appears in the literature to compute the EOQ with the Wilson formula, this particular formula - going back to 1913 - is a poor fit for retailers, mainly because it assumes that the ordering cost is a flat. Nevertheless, it is possible to determine optimal order quantities by devising a cost function taking into account volume discounts, as detailed in our article.

Carrying costs

Carrying costs are central for a “static” viewpoint on inventory, that is, when focusing on the impact of having more or less inventory, independently of the inventory flow.

Again the typology varies in the literature; the categorization we propose is the following:

  • Capital costs (or financing charges)
  • Storage space costs
  • Inventory services costs
  • Inventory risk costs

Capital costs

It is the largest component among the carrying inventory costs. It includes everything related to the investment, the interests on working capital and the opportunity cost of the money invested in the inventory (instead of in treasuries, mutual funds …). Determining capital costs can be more or less complicated depending on the businesses. Some basic rules can be given: it is important to understand is the part financed externally versus the part financed through internal cash flow, and it is likewise important to assess the risk of inventory in one’s business.

A classical way to determine the capital costs is to use a WACC (weighted average cost of capital), that is, the rate a company is expected to pay on average to all its security holders to finance its asset. See the Wikipedia article for the formula. Stephen G. Timme and Christine Williams-Timme (see below References n°5) also propose to express the WACC as the cost of equity and the after-tax cost of debt.

Typically, capital costs tend to be vastly underestimated. The common mistake is to reduce them to short-term borrowing rates. According again to S. G.Timme and C. Williams-Timme, among others, for the great majority of companies, the capital costs reach 15%, while many companies tend to simply apply a rate of 5%.

What companies also forget to measure and take into account is the risk attached to their inventory, which sometimes can be quite high (fresh products can lose their entire value in a matter of days if not sold, consumer electronics have a high risk of obsolescence, …). If the company had decided to put its money in a similarly risky investment rather than on the inventory, what would have been the return on investment?

Going further: The discussion about the use of the WACC as a proper way to measure capital costs goes far beyond the scope of this article. For a different point of view see the article of Christopher S. Jones and Selale Tuzel (see below References n°2). This article also includes a comparison between fixed capital depreciation rates vs depreciation rates of inventories.

Storage space costs

They include the cost of building and facility maintenance (lighting, air conditioning, heating, etc.), the cost of purchase, depreciation, or the lease, and the property taxes.

These costs are obviously vastly dependent on the kind of storage chosen, whether the warehouses are company owned or rented, for instance. For smaller businesses, when the same building is used for different purposes, the portion of the building associated with receiving and storing inventory must be determined.

In this category, we should also make note of a problematic phenomenon: the saturation of the storage space. It can cause the costs to increase in an absolutely non-linear way by creating all kind of extra costs. For instance, when a warehouse reaches the point of saturation, it becomes hardly possible to move within the warehouse; the flows stop, sometimes entirely, and it is very difficult to remedy quickly to this situation by finding in an emergency extra storage capacity. For companies subject to this kind of problems, the time and money necessary to clean the mess and restart the flows are considerable. We observed that in some instances, 3 or 4 occurrences of such events per year were enough to keep the supply chain teams busy for more than half of their time during the year.

Inventory services costs

They include insurance, IT hardware and applications (for some businesses, RFID equipment and such), but also physical handling with the corresponding human resources, management, etc. We can also put in this category the expenses related to inventory control and cycle counting. Finally, although they are kind of a category on their own, taxes can also be added here.

When using Third Party Logistics (3PL) Providers, those costs might come as a package with the storage space costs and can be quite straightforward to determine.

Inventory risk costs

They cover essentially the risk that the items might fall in value over the period they are stored. This is especially relevant in the retail industry and with perishable goods.

Risks first include shrinkage, which is basically the loss of products between the purchase from the suppliers (i.e. recorded inventory) and the point of sale (i.e. actual inventory), caused by administrative errors (shipping errors, misplaced goods, …), vendor fraud, pilferage and theft (including employee theft), damage in transit or during the period of storage (because of incorrect storage, water or heat damage, …).

In retail, shrinkage is mainly caused at the point of sale level. The following estimates can be found:
  • In the United States, a National Retail Security Survey is conducted annually by the University of Florida on 100 retailers. According to this study, in the United States in 2009 shrinkage represented 1.44% of retail sales - 43% of it due to employee theft.
  • According to the same survey, in 2011 (survey published in 2012), shrinkage represented 1.41%.
  • Another study from the Centre for Retail Research, which publishes the Global Retail Theft Barometer (a study on 43 countries), places it at 1.45% of retail sales for 2011.

The highest rates are found for grocery on fresh meat and cheese, for health and beauty on shaving products and perfumes and for apparel product lines on accessories and outerwear.

Inventory risk costs also take into account the obsolescence, that is, the costs lead by items going past their use-by dates, or by items becoming obsolete (especially true for consumer electronics, but also sometimes for items benefiting from a new package, …).

Determining the value of the inventory risk costs is not always as straightforward as it can appear. For instance, we need to consider the value of the write-offs over a given period of time (divided by the average inventory during the same period). However, write-offs are not always taken into account correctly, cycle counts are not always regular, and so on. In some companies, items that should be write-offs are still kept for years.

Finally, it should be noted that what we have chosen to put here under the two labels of storage space costs and inventory risk costs are sometimes put together and simply labeled as noncapital carrying costs, which emphasizes the fact that the capital costs form indeed the largest bulk of the inventory costs. While the capital costs alone can be evaluated at approximately 15%, all the other costs put together reach more or less this same percentage (10% according to S.G. Timme and C.Williams-Timme, 19% according to the Annual State of Logistics Report by Robert V. Delaney of Cass Information Systems). The key factor of the fluctuation of this value is the risk of obsolescence.

A first approach to the carrying costs: quick estimates and formula

While we have emphasized the difficulty of precisely assessing the carrying costs with all of their multiple components and the fact that these costs are always very business specific, some rough estimates can nevertheless be given.

Most companies tend to underestimate the total carrying costs (or total cost of holding inventory). For most retail and manufacturing businesses, experts’ evaluations of the cost of carrying inventory range from 18% per year to 75% (or, according to Helen Richardson, see below References n°3, between 25-55%). As previously mentioned, the leading factor to determine this percentage are the capital costs (including the investment in inventory) and the type of products (intuitively, the more perishable the products, the higher the costs).

The standard rule of thumb puts the carrying costs at 25% of inventory value on hand (cf. James R. Stock and Douglas M. Lambert, Strategic Logistics Management, 2nd Edition, Irwin Professional Publishing, 1987).

Another quick method of calculating the cost of carrying inventory consists in adding 20% to the current prime rate for borrowing money. For instance, if the prime rate is 10%, the carrying costs would be 10+20=30%.

For the reasons mentioned previously, it is hard to give more precise estimates. Let’s simply say that for the categories mentioned above, the following estimates can be found in the literature:
  • Capital costs : 15%
  • Storage space costs : 2%
  • Inventory service costs : 2%
  • Inventory risks costs : 6%

One notable reference is the study of Helen Richardson (References n°3) from 1995. According to H. Richardson, total inventory costs could be placed between 25-55% with the following distribution:

  • Cost of Money 6% - 12%
  • Taxes 2% - 6%
  • Insurance 1% - 3%
  • Warehouse Expenses 2% - 5%
  • Physical Handling 2% - 5%
  • Clerical & Inventory Control 3% - 6%
  • Obsolescence 6% - 12%
  • Deterioration & Pilferage 3% - 6%

It means that, on average, over a year, in the most favorable case (25%), a distributor spends $250 for every $1000 carried in inventory.

Practical example:

Let’s consider a company with an average inventory value of $10M. In order to compute the carrying costs, we first need to add all the noncapital costs. Let’s assume they go as follows:
  • Storage space costs: 200k
  • Inventory service costs: 800k
    - Physical handling: 200k
    - Insurance: 100k
    - Clerical charges, equipment and control expenses: 300k
    - Taxes: 200k
  • Inventory risk costs: 900k
    - Shrinkage (incl. theft, …): 300k
    - Obsolescence: 600k

This represents a total of 1.9M USD.

To obtain a percentage, we divide this total by the average inventory value: 1.9M USD / 10M USD = 19%.

We finally add the capital costs. Let’s assume they are at 10% in this case, that is to say 1M USD.

In our example, the total inventory carrying costs reaches 2.9M USD for an average inventory value of 10M USD. The inventory carrying rate equals 19%+10%= 29%.

Stock out costs

Finally, to get a complete vision of the inventory costs, we should also add the stock out costs (or shortage costs), that is, the costs incurred when stock outs take place. For retailers, it can include the costs of emergency shipments, change of suppliers with faster deliveries, substitution to less profitable items, etc. While this kind of costs can be determined quite precisely, others are not so easy to pinpoint, such as the cost in terms of customer loss of loyalty or the general reputation of the company.

Modeling the cost of stock outs is in itself a vast topic that goes beyond the scope of this article. Let’s simply mention that basically the cost of inventory is counter-balanced by the opportunity cost of stock-outs. Balancing the cost of inventory with cost of stock-outs is typically achieved through the tuning of service levels.

Direct benefits of reducing inventory

As evidenced above, the costs surrounding inventory are significant. Therefore, initiatives meant to reduce the inventory are very valuable – not only do they have an impact immediately measurable on the inventory itself; they also reduce the capital costs, carrying costs, risks and so on.

One common mistake companies make, according to S. G. Timme and C. Williams-Timme (see References n°5) when assessing the benefits of supply chain initiatives is precisely underestimating their impact on the inventory costs:

“When evaluating supply chain initiatives, companies often discount or even omit the benefits of reducing inventory noncapital carrying costs because they do not possess credible estimates of these costs. Most agree that the benefits exist. But without credible estimates, the benefits typically are excluded from the analysis. This practice is understandable. Nevertheless, if the impact on these costs cannot be reasonably measured, the true value of many supply chain initiatives will be understated”.

That being said, it can be argued that not all expenses are so easily reduced. But while it is true that some expenses (concerning warehousing or equipment for instance) can’t easily be reduced without significant changes in the organization, most of them are directly related to the inventory value, and can be easily quantified as a percentage of average inventory value (taxes or insurance, or obsolescence). Therefore, any reduction of the inventory value carries indeed great benefits.

The benefits carried by any improvement surrounding inventory management are the reason why Lokad specializes in inventory optimization. Lokad offers several webapps to serve that purpose, chief among them, our inventory forecasting webapp dedicated to demand forecasting, that aims to deliver optimized sales forecasts and reorder points to keep just the right amount of inventory.



Going further

Let’s emphasize again that properly measuring the costs mentioned above to gain a full picture of the inventory costs is no easy task, though potentially quite rewarding in terms of financial and decisional impact on the company.

It is possible to go further though, in particular when focusing on the carrying costs. For instance, the items in your inventory probably won’t have the same carrying costs (even within the same warehouse or the same category). Differences appear due to sales volumes, rotations, varying bulkiness of items, etc. Determining more finely the carrying costs of the items within your inventory can help you focus on the most relevant ones, discard the ones giving off less profit and so on. We broach here the subject of inventory categorization, and methods such as the ABC analysis. For more details, see our article.

References

1. Mary Lu Harding, C.P.M., CPIM, CIRM, “Calculating the total cost of ownership for items which are inventoried”, NPMA, volume 14, issue 2, 2002.

2. Christopher S. Jones and Selale Tuzel, “Inventory Investment and the Cost of Capital”, January 2009, available online.   3. Helen Richardson, “Control your costs then cut them”, Transportation & Distribution, December 1995, 94-96.

4. Edward A. Silver, David F. Pyke, Rein Peterson, Inventory Management and Production Planning and Scheduling, 3r edition, John Wiley & Sons, 1998.

5. Stephen G. Timme and Christine Williams-Timme, “The Real Cost of Holding Inventory”, Supply Chain Management Review, 7/1/2003.