Inventory CostWhat are the costs of having inventory?

If you run a business that deals with goods, chances are, you’re already familiar with the term “inventory”.

Inventory can refer to the goods that a business sells.

For example, a car dealership’s inventory will primarily consist of the cars that it sells.

A business that exclusively sells shoes will probably have an inventory of shoes.

Whatever goods a business sells, any unsold goods will be its inventory.

That said, inventory can also refer to the materials a business uses for the production of its products.

For example, a bakery will have an inventory of flour, eggs, yeast, and any other materials needed for the creation of bread.

A car manufacturer will have an inventory of the materials needed to produce a car.

We refer to this inventory as the raw materials inventory.

Inventory management is one of the crucial processes of any business that has inventory.

A lack of a proper inventory management system can result in great losses for the business.

That’s why it’s important for you to find ways to optimize inventory management without negatively affecting profits.

And one way to do that is to manage inventory costs.

The very act of ordering inventory already entails costs.

And these costs are separate from the acquisition cost of inventory (cost of goods).

Not only that, holding inventory entails costs too.

And then there’s the administration cost of maintaining inventory.

You would want to optimize inventory levels to make the most out of these costs.

Having a proper understanding of these costs can lead to better inventory management.

What are inventory costs?

Inventory costs refer to costs directly associated with the procurement, storage, and management of inventory.

When you order goods, you incur costs even before you receive your goods.

Costs such as shipping fees or freight.

These are inventory costs.

Specifically ordering cost.

Inventory cost also includes carrying costs.

Whether you own or rent the storage or warehouse for your inventory, you’d still be incurring costs just for holding inventory.

And then we have other costs such as shortage and spoilage costs.

Collectively, all these costs will constitute your inventory costs.

As inventory is an important asset for any business that has it, handling its costs is crucial if the business wants to generate profits.

Inventory costs have a substantial effect on a business’s bottom line.

Understanding these costs will have a positive effect on your business’s profitability and sustainability.

Finding the right balance to these costs will greatly help your business.

For example, you want to minimize ordering costs.

To do so, you order a larger volume of goods to reduce the number of times you need to reorder.

But this can compromise your carrying costs.

If your current storage or warehouse cannot accommodate all the goods you’ve ordered, you’d have to find another way to store the excess inventory.

This is an additional cost that could outweigh the benefits of cutting ordering costs.

Even more so if the goods are perishable, as spoilage costs come into play too.

If you’re unable to sell all of your inventory before its expiration, that is an additional cost for your business.

Still, you don’t want to understock, as that too comes with another cost – shortage costs specifically.

You want to order just the right quantity of goods without having to compromise carrying costs.

You also need to consider shortage and spoilage costs.

The types of inventory cost

Inventory costs can be split into four main categories:

• Ordering costs
• Holding or carrying costs
• Shortage costs
• Spoilage costs

Ordering Costs

Ordering costs refer to costs that are necessary for the procurement of goods and/or materials.

Take note that you do not include the actual cost of the goods.

Just the costs that you incur to have the goods reach your storage or warehouse.

Ordering costs also include the salaries, wages, and benefits of your business’s procurement department.

If your business employs specialized personnel to handle the receiving of goods, you consider their pay as an ordering cost too.

These costs are typically included in your business’s overhead costs.

Ordering costs are typically incurred every time you place an order from your supplier.

Examples of these costs are:

• Transportation costs – this refers to costs that you incur to move goods or materials from your supplier to your storage, warehouse, or store. Examples include shipping fees and freight (if shouldered by the business)
• Receiving costs – this refers to costs associated with the unloading of goods, as well as inspecting them to ensure that the goods received are correct and of good quality
• Clerical cost of preparing purchase orders – when processing an order, you’ll need at least one employee each to request, prepare, and record purchase orders. Essentially, any cost that you incur in the processing of a purchase order is a clerical cost
• Cost of finding suppliers and expediting orders – while it may be the case that there are many suppliers of certain goods or materials, finding a supplier that best suits your needs and preferences is ideal. However, finding such a supplier will cost you (but it should be worth it). You’d also want to find a supplier that can help expedite the ordering process
• Cost of electronic data interchange – this refers to the cost of using an electronic system to process orders. Most retailers use a system of this kind.

Holding or Carrying Costs

Holding costs (a.k.a carrying costs) refer to the costs associated with storing or holding unsold inventory.

These include costs to secure a space to house your unsold inventory (e.g. storage, warehouse, store floor, etc.).

Also included are the finance costs of acquiring inventory.

Holding costs also include costs that are not necessarily measurable such as the risk of loss through inventory obsolescence or theft.

You cannot record an inventory loss on your books unless there inventory shrinkage or obsolescence.

There’s also the opportunity cost of holding inventory.

More particularly, holding costs include:

• Cost of space to store inventory – whether you own or rent the space to store your goods or materials, the fact of the matter is that you’d still be incurring costs. If you’re renting the space, you’re paying for rent. If you own the space, you incur depreciation expenses and property taxes. Additionally, you also incur maintenance and utility costs such as lighting and heating.
• Finance costs of acquiring inventory ­– this includes anything related to the money required to acquire inventory
• Inventory services cost – this includes various costs such as the cost of maintaining your inventory system, the cost of insurance and/or security, as well as the cost of the physical handling of goods
• Inventory risk cost – when you hold inventory, you always carry the risk of shrinkage. It is caused by a lot of factors: inventory theft, shipping errors, vendor fraud, damage in storage, etc. If the decrease in inventory isn’t due to a sale or disposal, then there is shrinkage
• Opportunity cost of holding inventory – When you hold inventory, a portion of your working capital becomes inaccessible. Meaning that you can’t use it to pursue other investments. The income that you could have gained from these investments is the opportunity cost of holding inventory.

Shortage Costs

A shortage occurs when a business’s inventory cannot accommodate all of the customers’ demand.

Particularly, if a specific product becomes out of stock even though there is still demand for it, that’s when a shortage occurs.

We refer to the costs associated with shortage as shortage costs.

A shortage can happen for various reasons, some of which are:

• Actual demand exceeds expected demand
• Poor production plan
• Reduction of inventory available for sale due to theft, spoilage, or damage
• Disruption in the supply chain

A shortage is not good for a business as it comes with costs. It could also paint the business as incompetent in handling inventory. Here are some shortage costs:

• Cost of emergency shipments – you probably already experienced purchasing a product and then having it shipped to your door. Did you notice that if you want to have your product to arrive at an earlier date, you need to pay an extra fee? That’s also the case with emergency shipments. If there is a shortage, a business may want to restock as soon as possible. And to do so, the business will have to rely on emergency shipments.
• Disrupted production costs – a business that does the production and sale of goods knows that even a day of disruption is costly. If there is a shortage of raw materials, then the business cannot produce its products. This means that the business will have to pay for idle workers and factory overhead even if no goods are produced (due to the shortage)
• Loss of customer loyalty and reputation – while customer loyalty and reputation cannot be quantified, they’re both important for the sustainability of a business. Losing customers is costly for a business. You wouldn’t want to lose customers due to a shortage that you could have prevented.

Spoilage Costs

Spoilage costs more so apply to perishable products (ones that rot or spoil after a certain amount of time).

If these perishable products are not sold before their expiration date, they become dead stock.

Essentially, they have no value and cannot be sold.

The perishability of products is a concern for many businesses globally.

The food and beverage industry will have to deal with the perishability of food and beverages.

The pharmaceutical, healthcare, and cosmetic industries will have to address the perishability of drugs and cosmetics.

Spoilage is harmful to any business as it not only costs money, it also means that the business won’t be getting a return from its investment (in inventory).

And it’s not like you can always blame it on poor inventory control.

Spoilage is a global phenomenon.

A United Nation released on March 4, 2021, estimates that about 17% of all food produced globally each year go to waste.

That’s an estimated 911 million tons of food spoilage every year.

And that’s just food. There are still other perishable products.

A business that deals with perishable products will need to have solid inventory control.

Having sold inventory control can minimize spoilage costs.