Types of costs associated with inventory

What are the types of costs associated with inventory?

  Touseef Riaz

Posted on: 14 Feb 2022

Types of costs associated with inventory

What are the types of costs associated with inventory?

There is a constant need by business owners to optimize inventory levels without sacrificing profits. Maintaining a regular assessment of your business is essential to ensuring success. Because of that, we will be focusing on inventory cost management in this article.

Let's learn What are the types of costs associated with inventory?

What are the types of costs associated with inventory?

There are three main types of costs associated with inventory: ordering, holding, and shortages. The various types of inventory costs can be divided into these three broad categories, and we now will examine some examples of each type of cost within each category.

  • Ordering costs

You pay your supplier a set fee every time you place an order, known as an order cost or setup cost. Some examples include:
 

  • Preparation of purchase orders involves clerical costs. Costs associated with clerical tasks, such as invoicing, bookkeeping, and communication, are numerous
  • Locating and expediting suppliers costs money. There will likely be variations in costs, but they will be important expenditures for your business
  • Costs of transportation. Charges are associated with moving goods from one warehouse to another. The cost varies widely depending on which items and industries are involved.
  • Costs of receiving. The costs include unloading the goods at the warehouse and checking them for defects.
  • Costs associated with electronic data interchange (EDI). Businesses, especially retailers, can significantly reduce ordering costs with these systems.

It doesn't matter how small your order is, and there will be an ordering fee. Generally, a larger order means a higher fee. If you purchase goods in bulk, this cost can be spread out over a number of months. In contrast, if your business orders raw materials only as necessary and do not accumulate stock, you may be able to tolerate higher-order costs because they are offset by a lower holding cost as a whole.
 

  • Costs of holding

They are associated with the cost of storing inventory before it is sold and are also called carrying costs.

The cost of financing inventory includes interest on working capital, as well as everything related to the purchase of inventory. There are different ways for businesses to finance inventory purchases.
 

  • Money invested in inventory has an opportunity cost. When alternative investments, such as term deposits and mutual funds, are factored in, the apparently lost value of tying up money in inventory is discovered.
  • Costs associated with storage space. These are storage costs that will vary depending on the location where the inventory is kept. Storage facilities cost money, and if they are not owned, there will be lease payments. Lighting, heating, and ventilation are also included in the cost of facility maintenance. The cost also includes depreciation and property taxes.
  • Costs associated with inventory services. This includes the costs for the physical delivery, insurance, and security as well as the cost for IT hardware, and if any, applications. Additionally, inventory control and cycle counting costs should be considered.
  • Costs associated with inventory risk. A significant cost can be identified as shrinkage, which is the loss of items between the time the supplier purchases the product and the time the final sale is made. The reasons for shrinkage include theft, fraud, shipping errors, and damage during transit. The other major reason for shrinkage is dead stock.

 

  • Shortage costs

Whenever businesses run out of stock for whatever reason, they incur these costs, also known as stock-out costs.

  1. Production was disrupted. In a business that involves producing and selling goods, there may be a problem that disrupts the process. Even if no product is being produced, businesses must pay for idle workers and factory overheads.
  2. Sending urgent shipments. Retailers may have to pay extra to get a shipment on time or may have to change suppliers because of stock-outs.
  3. Reputation and loyalty to customers. Customer dissatisfaction and anger result in lost business from customers who go elsewhere to buy and affect the company's reputation and customer loyalty.

 

  • Spoilage costs

Perishable inventory stock can rot or spoil if not sold in time, so controlling inventory to prevent spoilage is essential. 

Products expire and must be used before they go bad for many industries, including food and beverage, pharmaceutical, healthcare and cosmetics. In addition to costing money, spoliation means that you will not realize a return on your investment.

There is no such thing as a single case of poor inventory control causing spoilage and waste in inventory. Today, spoilage and waste are major environmental concerns. Consider that food grown, processed, transported and disposed of in the United States alone cost about $200 billion.

Preventing spoilage and waste begins with a strong inventory control system. With the right inventory system, you can improve forecasting, boost efficiency, access real-time inventory data and up-to-date information on the lifecycle of your stock, enabling staff to rotate and manage stock to ensure older products get sold first. This approach is used in the grocery and FMCG sectors, where products with shorter expiry dates are rotated to the front of the shelf. Items that are due to expire are often heavily discounted to clear the inventory stock.

What Are Inventory Carrying Costs?

Inventory management companies face many challenges related to carrying costs. Stored products incur expenses such as storage, labor, transportation, handling, insurance, taxes, item replacement, shrinkage, and depreciation. Investment potential is also reduced when a company is tied up in inventory, decreasing the likelihood of making investments.

Carrying cost components

Carrying costs are comprised of four main components:

1. Capital cost

2. Inventory service cost

3. Inventory risk cost

4. Storage space cost

 

  • Capital cost

Businesses incur the greatest amount of carrying costs due to capital expenditures. Capital expenditures include interest and investment costs. Typically, the capital cost is calculated as a percentage of inventory value. 
 

  • The cost of inventory service

Hardware and software costs are included in inventory service costs, as well as tax and insurance. It depends on the type and amount of inventory the company has in its warehouse how much insurance costs it. Keeping a high level of inventory helps you meet customer demand since it helps the company fulfill orders more easily. Insurance premiums and taxes are higher when the inventory level is high, increasing the total inventory service cost.

 

  • Cost of inventory risk

There is a risk associated with carrying inventory. A company's inventory risk costs can be a result of shrinkage (loss of stock), theft, and administrative errors such as lost goods and misplaced shipments. Likewise, product value depletion can decrease the value of items that are stored in inventory for too long.
 

  • Cost of storage space

In addition to the rent you pay for warehouse space, you must pay for utilities, air conditioning and heating, lighting, and transportation. Some of these costs are fixed and some are variable. A fixed cost such is rent, but material handling costs will continually change with demand and stock levels.

So next time when you ask yourself what are the types of costs associated with inventory, these 4 will be your answer.

How to calculate inventory costs?

In order to calculate your inventory profit, you should calculate your inventory carrying cost percentage. In inventory carrying costs, the percentage of the inventory value is always expressed. Generally, inventory carrying costs are expressed as a percentage of the inventory value. They are calculated by dividing the total inventory management or holding sum by the total inventory value and then multiplying it by 100 to get %. 

Carrying cost (%) = Inventory management sum / Total value of inventory x 100

You can calculate inventory management costs by adding all components of carrying costs. 

Inventory management cost = Inventory service cost + Inventory risk cost + Capital cost + Storage cost

 

To calculate your carrying cost:

  • Calculate the value of each of your four inventory cost components mentioned above
  • Calculate the inventory management sum by adding the inventory cost components.
  • Calculate how much inventory you have. To calculate inventory value, use the cost of inventory formula, which is 
     

Divide the inventory holding sum by the total inventory value, then multiply by 100

An example of inventory carrying costs

Consider the example of an importer of goods to understand better inventory carrying costs. First, he must receive the goods at the dock when he imports them into his country. To transport the goods to the warehouse, customs departments must clear them repeatedly. Suppose, for example, that the goods were held up in the customs clearance department due to some discrepancy in the documentation.

Additional costs associated with goods stored in a dock depend on their value and the space needed to store them. Customs impose charges for holding these goods until they have been cleared, and these charges go up steadily. We can compare the interest charges a business owner bears on items with the additional charges that he has to pay on goods, such as the interest charges a business owner has to pay on items. This is a normal scenario that is not readily visible to ordinary people.

Docks serve as warehouses; while customs department fees can be compared to the interest income, the business misses out on the principle value of the merchandise. In spite of these penalties, the only change is that a business doesn't accrue any interest on the stock the company loses.

Four tips to reduce carrying costs associated with inventory

When you question What are the types of costs associated with inventory, you should also know how to reduce them. You must reassess your business's processes and eliminate any inefficiencies if you intend to reduce inventory carrying costs. You can do this by using the following tips:

  • Make your warehouse layout more efficient

Reorganizing warehouse operations becomes less important as inventory and sales rise. The warehouse is the hub of all inventory, so improving its layout and workflow is an effective way to reduce costs and become more efficient.

  • Calculate the optimal level and time for reordering

The initial unit cost of purchasing a large amount of inventory can be lowered, but you might incur more expenses if the inventory sits in storage for too long. Rather than guessing or deciding based on historical data, figure out the optimal inventory levels. By knowing this information, you can meet sales and customer needs without overstocking your inventory.

  • Increase inventory turnover

Inventory that remains unsold and doesn't generate profit will result in higher carrying costs. Reducing the amount of time your inventory spends in storage is the best way to avoid this. In addition, only maintain inventory needed for the sales period. Negotiate with suppliers for favorable lead times and minimum order quantities (MOQs). Also, dispose of dead stock or excess inventory that might be in your warehouse. 

In order to decrease costs, a company can increase inventory turnover while selling items at top dollar.

  • Manage inventory with inventory management software

Think about the benefits of software instead of manual inventory tracking and cycle counting. Using a digital inventory management system, you can keep track of your stock and your order status and know where your items are at any time.

Data from buy orders, sales fulfillment, and demand forecasting are integrated into the inventory management system. The custom reports can also be used to optimize stock levels, set pricing strategies as you desire, and determine warehousing strategies to save on holding costs.

How can you track inventory costs effectively?

Small business owners are often faced with the dilemma of how to maintain control of expenses. SMEs are always looking what are the types of costs associated with inventory affecting their net profit. Using an efficient accounting system, understand how to stay in control of these costs. Maintaining the status of your inventory in real-time can be made easier by using an efficient inventory management system.

Inventory masters should have a check and balance system

Keeping your business costs low is crucial as a small business owner. There are multiple steps you have to follow. You cannot include all of this information in one report. The best way to keep inventory costs low is by maintaining a check & balance approach on a daily basis.

A business stock that is held for a long time loses its appeal more quickly. The same is true for companies that fail to maintain reordering and minimum order quantities for their stock items and order them at the wrong time and in the wrong quantities. The costs associated with carrying inventory will be increased.

Report on Stock Aging

Stock aging reports also provide valuable information on which inventory has been sitting in transit for a long time. By analyzing this report regularly, we can determine what stocks to keep in our warehouses and how big they should be.

Mistakes to avoid when managing inventory costs

So that we've seen how important Inventory Control is for managing stock costs (many and varied), let's look at some of the most common pitfalls that businesses fall into.

Managing inventory with Excel

Your small business - or your business after it grew - is likely familiar with Excel if you run one. Adaptable for budgeting, accounting, scheduling, project management, CRM, and more, this software is very versatile.

Excel can be a helpful tool in the early stages of inventory control and management. You can use Excel for small businesses with a small staff, small inventory, as well as a small customer base, whether you operate out of a garage or a small shop.

In the early stages of your business, spending a significant amount of money on software that manages inventory can seem counter-intuitive, and sometimes it can be! Some businesses don't have enough revenue to justify covering that expense, and that's fine. However, the problem with Excel is that if your business starts growing (and that is the ultimate goal), you may realize that it is not scalable and can't keep up. What kind of inventory control issues might Excel present with a growing business? Think about it if you need to invest in management software. 

 

Entering data incorrectly

It's tough enough to keep track of small volumes of inventory. Your inventory will grow as it grows, which increases your probability of data entry errors. Despite this, keeping track of the correct numbers of what comes in and leaves your business becomes more difficult as you deal with larger volumes of products. The number of things sent and the number of things that have yet to arrive make it harder to double-check those numbers and find any errors. This can result in incorrect figures being recorded in your Excel spreadsheet. These incorrect figures may be visible for days, weeks, months, or even years, which can cause problems later on. 

 

An oversupply and a shortage

It is difficult to forecast the amount of stock you need to order accurately and when you need to order it when your inventory software has incorrect figures. You may order excessive amounts of a particular product, forcing you to sell it at a discount in order to reduce your inventory, resulting in reduced profits. There is also the possibility that you order too little of a certain product, causing shortages that force your customers to shop elsewhere.

 

The confusing situation at work

As your business grows, your inventory management data will need to be accessible and modified by more people. Keeping track of this can be tricky, especially if there is no clear chain of command in place for communication or entry of inventory data. If it happens, you might end up using old inventory data to base all of your orders in the future! While most inventory management solutions sync across multiple devices using the cloud, Excel spreadsheets must be saved locally.

 

A lack of communication across offices

If all of these problems were applied to managing inventory across two or more warehouses using one Excel file, the stress would be unbearable!

When a business grows, there will always be a point when Excel becomes unreliable, confusing, and inefficient. After a while, your best bet is to switch to an online inventory management system that works in the cloud. Your employees can stay updated with what's happening with your inventory using these software solutions, which can sync across devices. It ensures accuracy and catches errors more easily. They also often come with a number of perks that simplify your business even further, such as:
 

  • Analyzing your inventory data to generate intelligence reports
  • Business-to-business eCommerce
  • CRM management
  • Syncing across multiple platforms and software solutions

 

Conclusion

Inventory costs provide you with accurate requirements for your business needs. These costs give you a regular assessment of what is in your inventory and what needs to be there in the future. How much will it cost you to buy new supplies for the next or current month? What are the types of costs associated with inventory? And what will it cost to hold these supplies? 

This article provides complete details on inventory costs a seller needs to take care of if they are to succeed in their business. You can't simply continue to run your business if you are at a loss. There are some costs you must cut down to manage your budget fairly