It’s time to address a subject that a lot of companies fail to notice or incorporate into their business planning – the costs of carrying inventory. Inventory costs money to purchase, this much is a given; however the cost of the inventory goes far beyond that. Typically, (if accurate values are not calculated on a case-by-case basis) the total carrying costs of a product are 25% of its value and composed of capital costs (15%), storage costs (2%), servicing and handling costs (2%) and the cost of risk (6%). Let us look at these different components of inventory carrying costs more closely.
The capital cost is basically the monetary figure the capital could return if it was put into another investment that had a similar associated risk to it. By ascertaining this figure, the minimum required return on investment of the capital can be deduced. There is an equation to work a weighted-average cost of capital that makes life a bit easier. To use this equation, the cost of debt and cost of equity need to be known. The Weighted-Average Cost of Capital (WACC) equation is as follows:
(Debt Weighting x Cost of Debt) x Marginal Tax Rate + (Equity Weighting x Cost of Equity)
Essentially, owning inventory means there is capital or cash flow tied up in the value of the inventory. As long as the inventory is being housed in the warehouse and not turned into sales, this is lost cash flow that means the company lacks this money to invest elsewhere and reap a return on investment. This lost opportunity has to be costed and is what is represented by capital costs. Typically, capital costs make up the majority of carrying costs (approximately 15% of the inventory value).
As long as inventory is being stored, there are costs associated. These storage costs are composed of things such as rent or lease expenses, electricity, insurance of the goods, any payable taxes and depreciation of the goods over time. Storage costs are time sensitive whereby the less time inventory is stored, the less it costs the company and the chances of selling inventory are increased, thereby increasing cash-flow and reducing the amount of money tied up in capital.
Service and Handling Costs
Inventory requires insurance and often the greater the amount of inventory, the greater the premium for insurance. This can certainly drive the cost of the inventory up. The inventory stored also needs to be ‘handled’. That is, the inventory needs to be organized, managed, moved and packed – all of which require someone to do it and someone that needs to be compensated for their time. This is an added cost, and should the inventory spend a long time in the warehouse, this cost may increase as constant organizing and relocating when more stock arrives becomes necessary.
Cost of Risks
Inventory being stored in a warehouse is inevitably at risk and this is a cost that is built into the carrying costs of a product. The risks the inventory is subjected to include things such as becoming obsolete (particularly in the electronic and tech industries), expiring before it is able to be sold (such as food and consumables), damage from water or fire and being stolen. These risks are all very real and can easily occur – therefore it is essential to incorporate the cost of them occurring into the carrying costs of the inventory.
It is all too common that the carrying costs are not properly taken into account resulting in an underrepresentation, ultimately causing the company to crumble when it can no longer simply absorb these costs. Therefore, it is essential to build some of these costs into the sale price of the inventory to ensure as far as possible, the company is not exposed to undue risk and the bottom line is preserved.