December 2, 2021

Inventory Costs- Definition, Types, Tracking, And Calculation

If your firm wants to profit, inventory expenses are one of the most crucial factors to examine. That's because inventory costs significantly impact your business and can affect your profitability for the better or worse (depending on how things are managed). Therefore, understanding the complexities of inventory costs and calculating them for your organization will be critical to improving your entire inventory management strategy.

Inventory Costs

Have you visited a Shopper's Club Warehouse before? You understand how great it is to go into a large building filled with all kinds of things if you have one. I enjoy coming to the store and shopping in quantity, and I'm always shocked at how much stock there is on the shelves! I've never given much thought to how much that inventory must cost the business. If they bought it wholesale, the inventory price, in my opinion, is the actual purchase price of the item.

On the other hand, my thinking is erroneous. In reality, inventory expenses include the cost of purchasing an item and the cost of holding and maintaining that thing for as long as it takes to sell. Ordering costs, carrying costs, and shortfall costs are the three categories of inventory expenses. On the financial statements, these are the only costs that will display. The costs listed below are helpful for management, but they are not inventory costs defined by GAAP.

What Are The Types Of Inventory Costs?

The three basic categories of inventory-related costs are ordering, holding, and shortage costs. These categories help to categorize the many various inventory costs that exist, and we'll go through some instances of each type of cost in each area below.

Ordering Costs

Ordering expenses, also known as setup charges, are the costs you experience each time you place an order with your supplier. Here are several examples:

  • Clerical costs associated with preparing purchase orders – clerical prices include invoice processing, accounting, and communication.
  • Costs of locating suppliers and expediting orders are likely to be variable, but they are significant expenses for the company.
  • Transportation costs are the expenses associated with transporting products to a warehouse or store. These expenses vary a lot depending on the industry and the goods.
  • Receiving costs include unloading goods at the warehouse and checking them to ensure that they are correct and defect-free.
  • Price of electronic data interchange (EDI) — These are methods used by large firms, particularly retailers, to minimize the cost of the ordering process.
  • No matter how modest your order is, there will be some ordering fee. The more the number of orders placed, the higher the ordering expenses. If you place a large order and plan to utilize the goods over a lengthy period, the cost of ordering can be spread out. On the other hand, if your company orders raw materials only as needed, it will keep a small stock on hand.

Holding Costs

These are the costs of keeping goods before it is sold, often known as carrying costs.

  • Inventory finance expenses comprise all costs associated with inventory investment, such as interest on working capital. Depending on the business, financing charges can be complicated.
  • The missed alternatives to locking money up in inventory, such as term deposits or mutual funds, are factored into the opportunity cost of the money invested in stock.
  • Storage space costs are costs associated with the location where inventory is kept and will vary by location. The cost of the storage space itself, or lease payments if it is not owned, will be incurred. Then there's the cost of facility upkeep, such as lighting, heating, and ventilation. This also includes depreciation and property taxes.
  • Costs of inventory services – this covers the cost of managing the products physically, and insurance, security, and IT hardware and software, if any, are used. Inventory control and cycle counting expenses are two other examples.
  • Inventory risk costs – one of the highest costs is shrinkage, which refers to the loss of products between the time of purchase from the supplier and the final sale for various causes, including theft, vendor fraud, shipping problems, and damage in transit or storage. Deadstock is another prominent example.

Costs Of A Shortage

These expenditures, also known as stock-out costs, occur when a company's inventory is depleted for any cause.

Production disruption – when a company produces items and sells them, scarcity means the company will have to pay for things like idle labor and factory overhead even if nothing is being made.

Stock-outs may force shops to pay a premium to receive a supply on schedule, or they may have to switch suppliers.

Customer loyalty and reputation – in addition to the loss of business from consumers who move elsewhere to make purchases, the company loses customer loyalty and reputation when customers are upset.

Spoilage Costs

If perishable goods are not sold quickly enough, they can decay or spoil. Hence inventory control is critical to avoid spoilage. In addition, many businesses, including food and beverage, pharmaceutical, healthcare, and cosmetics, are concerned about perishability because their goods' expiration and use-by dates affect them all. Spoilage not only costs money but also implies that you won't get a return on your investment.

Inventory spoiling and waste are no longer isolated incidents of poor inventory management; spoilage has become a global environmental issue when you think that an estimated $200 billion is spent in the United States alone on farming, preparing, shipping, and disposing of food that is never eaten.

Inventory Carrying Costs

This is a facet of inventory cost that is less well-known. To determine the magnitude of this cost's influence on your P&L statement, you'll need to do some math. For example, inventory carrying costs are the amount of interest a company loses on unsold warehouse stock.

When considering the impact of inventory on a business, business owners sometimes overlook the impact of the above aspects. This is because the inventory holding expenses appear on the Profit & Loss statement as part of the rental charge.

While inventory carrying costs are rarely considered when calculating gross profit, we usually only consider the principle cost of warehouse products.

Ways To Cut Your Inventory Costs

Know when to reorder stock

Unless you have a firm grasp on reorder points and safety stock levels, you risk running out of stock (or creating an overstock problem). Those who have dealt with an overstock know how expensive it can be to carry things you don't need. Thankfully, inventory management software like Conveyr can take the guesswork out of restocking by using reliable forecasting to predict likely sales and product demand.

Get rid of the dead stock

Deadstock refers to things that aren't selling and are therefore taking up precious warehouse space. Stagnant inventory levels can be quite harmful because they significantly increase your carrying expenses. In addition, it costs money to keep any item in your inventory. Therefore it's usually preferable to give up and get rid of your lingering dead stock. Selling a bundle, returning the goods to your supplier, or finding a place to donate them are all options.

When you find a reasonable offer, don't overstock

You can come across a 'buy one, get one free' offer while shopping for products from a provider. While this agreement benefits the supplier by allowing them to get rid of excess inventory, it can soon result in an overstock on your end if you opt to participate. Also, remember that the more you order, the higher your shipping fees will be. That's why, if you're tempted by a price that seems too good to be true, you should stick to your inventory management approach.

Know what you have and where it is kept

How many widgets do you have on hand, what varieties/sizes do you have, and where can I obtain them? A well-managed warehouse or storage system should make it simple for employees to keep track of stock levels, identify goods quickly, and adequately document stock movements.

Using mobile technology in the warehouse is one method to accomplish this. This allows warehouse personnel to update inventory and logistics information as goods continuously are received and delivered, while providing sales staff with a mobile device and internet connectivity will enable them to enter orders faster, avoiding stock-outs and shortening lead times. For example, unleashed software is a mobile sales app that allows your sales force to see inventory and make sales while on the go.

Keep track of lead times

The delivery time it takes for a product to travel from the order placing to manufacture to final delivery to your warehouse or facility is known as lead-time. Varying suppliers have different lead times, so it's good to do some research and ask around to see their lead times before deciding on the best one for your company.

In general, the shorter the lead-time, the better for your business; but, if the quality is noticeably increased, it may be worthwhile to wait a little longer from a supplier. Knowing your suppliers' lead times makes the job of your buying managers a lot easier.

Use cloud-based technology to your advantage

Many small firms are hesitant to invest in a complex software solution to manage their inventory control requirements. What they don't account for is their company's ability to scale as it expands. In addition, today's cloud-based inventory management software service providers are inexpensive for organizations of all shapes and sizes. In contrast, top-of-the-line inventory management software used to need a significant upfront financial commitment.

This is because the focus has switched from providing on-site inventory software that requires a significant capital investment to selling inventory software as a service. As a result, small business owners may now seamlessly combine their operations with a sophisticated, continually improving inventory management software solution to manage their inventory with pinpoint accuracy and complete functionality.

When It Comes To Inventory Management, These Are The Pitfalls To Avoid

Inventory management is undervalued

If you've ever heard someone say that inventory management is simple, that individual was probably not speaking from experience. In actuality, managing many sites, reordering new products, screening personnel applicants, and researching new technology to apply are not trivial tasks. That's not to mention the complexities of compiling reports, detecting fraud, and determining when things have gone missing.

Inventory management is complex, even with the aid of capable, straightforward software; it's never been easy, and it never will be. However, given how vital inventory management is to a company's success, there's no reason to believe this fallacy.

Launching a product, then managing inventory

Another widespread fallacy is that once your firm is up and running, you can manage your inventory. For example, let's say your company launches and then wishes to implement an inventory management platform. The problem is that your stock has already had a chance to become disorderly, potentially harming your bottom line. Whether you like it or not, structuring your inventory well ahead of your first sale is in your best interests. Otherwise, you'll inevitably run into inventory problems (and associated costs) that could have been avoided.

Thinking that change is complex and time-consuming

Change and innovation are the heart of any successful firm. If a firm does not embrace change willingly, it will only be a matter of time before changing its thinking to expand and keep up with its competition. Some eCommerce retailers believe it is a waste of time, money, and energy to modify their current systems. Even if it takes several months or weeks to deploy an inventory management system, it is still the best approach to increase efficiency and sales for any firm.

How Can You Figure Out How Much Inventory Costs?

Inventory expenses are an important (ongoing) habit because they directly impact your profitability and profit margins. While you can compute these prices for yourself using a simple method, you may also use a cost calculator to expedite the process.

Use the formula for calculating inventory costs

The inventory cost formula includes beginning inventory value, ending inventory value, and purchasing expenses over a specified period. Inventory cost = [starting inventory + inventory purchases] - ending inventory, to put it another way. Let's imagine your company's inventory is valued at $100,000 at the start of the year, and you plan to buy $25,000 worth of inventory during the next 12 months. If your inventory is valued at $50,000 by the end of December, your inventory costs will be: [$100,000 + $25,000] - $50,000 = $75,000.

Wrapping Up

Every business, no matter how small or large, has to deal with inventory management. It can make or break your firm and is often a big factor in deciding what will work for you as an entrepreneur. When it comes down to the basics of how much money you need on hand at any given time, there are many things that go into consideration like cash flow and expenses (rent etc). But one thing we know about inventory costs is they include all of those pesky little details like ordering and holding goods along with the associated documentation which must be tracked through accounting records. This cost gets included in your overall inventory cost because it's considered by management when determining how much should be maintained on our hand right now.

It’s time to regain your inventory confidence. Partner with Conveyrs software and get back on the right track today!

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