By understanding what is inventory cost and by evaluating it on a regular basis you can ensure that your business is on track to succeed. Like cashflow management, inventory management is an important aspect of a small business, it plays a crucial role in the success or failure of your business.
Businesses have always been seeking ways to optimize inventory levels without compromising their profitability. Hence, it's important for you to know all the components and details of what is inventory cost. This article will help you do that!
What Are Inventory Costs?
Inventory costs includes the cost surrounding purchase and storage of inventory, and other inventory management costs. The cost also consists of expenses such as ordering, carrying, shortage, and stockout charges.
In addition, inventory costs include the cost of managing related documentation. Management considers this cost when determining how much inventory to keep in stock. Thus, inventory cost analysis is essential to management of a company's finances and also impacts its overall performance.
Why Are Inventory Costs Important?
Now that you know what is inventory cost, it's time to know why they are important for any business. Inventory is one of the most valuable assets of any organization and therefore, tracking inventory costs is one of the most significant activity for any company or manufacturer. Most importantly, an excessive amount of inventory can negatively affect your business' bottom line.
Thus, by understanding how much you're spending on inventory, you can manage this expense more strategically to reduce your overall costs and increase your profits. It is possible to accomplish this in several ways, including:
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Optimization of inventory levels with proper inventory forecasting.
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Incorporating strategies to reduce storage and warehouse costs (e.g., warehouse slotting).
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To track inventory discrepancies, consistent inventory valuation methods must be applied.
Types of Inventory Costs
There are typically three types of inventory costs that exist: ordering, holding, and shortage costs. Let's understand what they mean in detail:
Ordering Costs
As the name implies, ordering costs refer to the expenses incurred in creating and submitting an order to a vendor. Costs associated with ordering include payroll taxes, benefits, the wages of the procurement department, and labour costs. Hence, as a business places more orders, its inventory ordering costs increase.
Here are some ordering costs:
- Transportation costs
- Receiving costs
- Cost of finding suppliers and expediting orders
- Clerical costs of preparing to receive orders
- Cost related to electronic information interchange
Inventory Holding Cost
Inventory holding cost refers to the total cost of maintaining unsold inventory. As part of a single supply chain, inventory holding cost is included in the total inventory cost. Thus, all expenses that must be considered include warehousing, insurance, labour, transportation, depreciation, inventory shrinkage, damaged or spoilt goods, obsolescence, and opportunity costs. Some inventory holding costs are:
- Inventory services cost
- Opportunity cost - money invested in inventory
- Inventory funding cost
- Storage space costs
- Inventory risk cost
Shortage Costs
As the name implies, shortage costs occur when a company does not have sufficient inventory on hand. In addition to lost revenues from clients who buy elsewhere, there is also the loss of profit margin on incomplete orders and the cost of overnight shipping to obtain goods that are not in stock.
In particular, businesses that compete on customer service must consider this factor when choosing how much inventory to keep on hand. Here are some examples of shortage costs:
- Expenses for emergency shipments
- Costs associated with production disruptions
- Customer loyalty and name
Spoilage Costs
In order to avoid spoilage, inventory control is necessary for perishable goods that need to be sold more quickly. Currently, many sectors are concerned about expired products. Moreover, businesses such as food and beverage, pharmaceutical, healthcare, and cosmetics are affected by their products' expiration dates or use-by dates.
Inventory Carrying Costs
This cost is not as straightforward as other costs when it comes to inventory costs assessment. To estimate its impact on your profit & loss statement, you will need to perform some calculations. Inventory carrying costs may increase when the quantity of unsold stock sitting in your warehouse increases.
Inventory Costs Example
To understand inventory carrying cost better, let's look at an example. Let us consider the case of a company that sells biscuits. They purchase these biscuits from a manufacturer and then sell them to retailers. Currently, a pack of 10 biscuits is considered to be one stock keeping unit (SKU) . In order to prevent the biscuits from breaking or crumbling before they reach their destination, these packages will need to be properly stored.
As a result, carrying costs would apply. It is likely that these biscuits will come with an expiration date. Hence, it is crucial for the company to move the biscuits forward, well in advance of that date. In addition, the cost of ordering these biscuits at the beginning must also be considered. These costs together lead to the total cost of an inventory for a business.
Methods to Track Inventory Cost
Business owners can use various strategies to track their inventory, depending on the kind of inventory and how it moves. The total Inventory cost can be tracked using the following methods:
Manual inventory tracking
The manual card system is a traditional method of managing inventory. In this method, products are classified according to their types and cards are assigned to each group. Using these cards, you can keep track of your inventory and receive notifications when it is time to stock up. Most importantly, a store representative must enter the required facts, including the date, time, and location of the inventory tracking event.
Inventory management systems
It is possible for businesses to combine accounting and payment procedures by using dedicated inventory tracking and management software. They are used to manage inventory, forecast demand, and generate reports.
Furthermore, businesses are able to purchase inventory management systems online and customize them according to their specific requirements. Additionally, cloud-based solutions and offline software are viable options.
Spreadsheets
As with the manual inventory card method, the spreadsheet method also involves manual entry of data into spreadsheet tools. Due to the possibility of errors and omissions, this method should be undertaken with caution.
Third-party providers
Outsourcing inventory management can be accomplished alongside third-party companies. A variety of functions are included in inventory management, including receiving, storing, shipping, and tracking merchandise. Consequently, organizations will be able to save money on storage and have more time to devote to other activities. Nevertheless, inventory management and communication problems may occur.
Stock Categorization in Inventory Cost
It is important to classify all stock items according to the four brackets listed below to ensure seamless inventory cost assessment:
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High Worth - Fast Moving
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High Worth - Slow Moving
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Low Worth - Fast Moving
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Low Worth - Slow Moving
High Worth - Fast Moving
Identify the daily sales trends for these items and determine how much they sell. The warehouse should have stock that corresponds to the lead time on the basis of this criterion.
High Worth - Slow Moving
Due to the high value of such items, the inventory team must only order them when consumer orders are received. Furthermore, it is important to examine the ordering patterns of these types of products among customers.
Low Worth - Fast Moving
Since these stocks have minimal value, keeping them in stock will not increase costs in a noticeable way. However, a smart strategy would be to anticipate their lead times and per-day sales and maintain at least as much stock as is required until the lead time has passed.
Low Worth - Slow Moving
In this category, the business suffers the least damage. While this may not be the most important aspect of your company, it may still be important since it may include spare parts that may be difficult to obtain from any dealer.
How to Calculate Inventory Cost?
The costs of inventory directly impact your profit. To keep track of how much you are spending on inventory, it is imperative to calculate your inventory costs accurately. The following is an overview of how inventory costs are calculated at a high level with the inventory cost formula.
Inventory cost formula (with example)
Below is a inventory cost formula that can be used to determine your inventory cost:
Inventory Cost = (Beginning Inventory + Inventory Purchases) - Ending Inventory
Use online inventory cost calculators
Online inventory cost calculators are available to simplify the process of finding the total inventory cost. As a result, you will be able to save time and improve inventory accuracy. Simply enter the necessary information regarding what is in your beginning inventory, ending inventory, and what you have purchased throughout the year. It will then automatically do the calculation for you and save you a lot of time.
Manage the Inventory Costs of Your Business With TranZact
The cost of inventory is often a significant factor in the price of your product. Hence, it is necessary to consider all variables when determining the economic order quantity for your business. TranZact provides you with inventory costing techniques such as first-in first-out (FIFO), average pricing in an automated manner. This helps you to calculate inventory costs easily with minimal effort, and also streamline your inventory strategies profitably!
FAQs on Inventory Cost
1. Why do we need inventory, and what are its costs?
Inventory is the most important aspect of a business as it helps the business to manage its raw material purchases, finished goods and order deliveries. Inventory costs are directly linked to the space required for storing inventory, the cost of acquiring inventory, and the risk associated with obsolescence-related loss of inventory. Most of these costs are grouped into an overhead cost category and are based on the number of units produced each month.
2. What are some examples of inventory costs?
There are three main categories of inventory costs including inventory ordering cost, carrying costs, and shortage costs, also known as stockout costs.
3. What is not regarded as part of inventory costs?
Every business is unique when it comes to categorization of costs, but in many cases, the costs associated with production labour, sales, and distribution are excluded from the calculation of inventory costs.
