Inventory carrying costs: slicing the excess waste
Are you storing more than you need? Explore the hidden costs of inventory — carrying costs. You might be surprised by how much more you can do with less.
Last updated: 20.07.2022
Congrats — you’ve turned your passion into your next adventure in the world of manufacturing.
But, as a hobby grows into a viable business, scalability presents its own problems. Fluctuations in sales can leave you struggling to find a solution for optimizing inventory levels and fulfilling orders. In a situation like this, you might approach your warehouse management with a very simple strategy — keep your shelves full.
But this tactic is counterintuitive and will force you to miss out on opportunity costs in the long run.
Why? Because of inventory carrying costs.
We understand your frustration. You started your manufacturing business to free yourself from sitting behind a desk. Now you must get back into the nitty-gritty of calculating the costs of inventory.
Thankfully there are tools to help you keep costs to a minimum so you can get back to what you do best.
Calculate costs with an inventory management system
Inventory systems like Katana automatically calculate the manufacturing costs and the profit margins of held inventory. Try it out for free.
Inventory carrying costs is the total cost of holding inventory for your business, also known as the carrying cost of inventory or holding cost.
Some examples of inventory carrying costs include:
Warehouse space and storage rent
Work hours spent handling inventory
Security costs, including systems and personnel
To some, these carrying cost examples may seem like hidden costs.
You know the cost of buying raw materials, but you might not have known you are also paying to store and carry them. So, holding inventory that you intend to sell, but have not yet done so, increases your carrying costs. Every business that sells a physical product is subject to these costs.
Every second you have items sitting in your different types of inventory, money continues to leak from your profits and stunt your business’s growth.
Something to note
The costs of carrying inventory do not include the cost of producing your finished goods. While your business retains its inventory during production, you shouldn’t conflate these expenses. To track manufacturing costs, be sure to look into the costs of goods manufactured.
What you shouldn’t include when calculating inventory carrying costs
The list of expenses you should leave out from your total carrying costs includes:
You might mistakenly report higher expenses than you have and artificially reduce your taxes. Another reason is that your prices will go up. If you over-report your expenses, you might put up your prices to make up for this — which might put off customers.
You can’t afford to misunderstand every cost that your business incurs.
Learning to differentiate carrying costs from manufacturing costs is one of the tricks of the trade. It might be a good idea to keep just the right amount of stock ready to be sold as soon as possible. If you go down this route, be ready for supply shortages or spikes in demand at different periods.
Don’t forget the less obvious costs to hold inventory.
For example, the reduction in bank interest as you convert cash into stock. Another often overlooked cost is the opportunity cost of keeping excess inventory — could the cash be better spent elsewhere?
After all that, you might already be asking: how can I reduce this money drain in my business?
How do you start to calculate inventory carrying costs?
Here are the components of inventory carrying cost for calculating expenses:
Utilities — electricity etc.
Obsolescence and dead stock
*To do with handling and other inventory issues — not labor related to production.
Once you have the expenses on hand, you can start going through the following inventory carrying cost formula and calculation to better understand just how much holding inventory is costing you.
So, before you can start calculating your inventory carrying cost, you’re going to need to understand your inventory holding cost:
Inventory holding cost = capital costs + service costs + risk costs + space costs
Next, you can work out your total inventory value by following this inventory carrying cost calculation:
The total inventory value = sum of inventory costs x stock of available items
Once you have the answers to the inventory carrying cost formulas, you can go ahead and finally work out your inventory carrying costs:
Inventory carrying cost = inventory holding cost / total value of inventory x 100
NOTE: multiplying by 100 will give you a percentage.
What are examples of inventory carrying costs?
Using the inventory carrying cost calculation for a factory with an inventory value of $85,000 over the past year:
Cost of capital — $18,000
Service cost — $4,500
Inventory risk cost — $4000
Storage cost — $3,000
$18,000 + $4,500 + $4000 + $3,000 = $29,500
Now you have the inventory holding cost. You can divide it by the annual inventory value and multiply it to calculate the percentage of your inventory carrying cost:
With this example, we can see that the inventory carrying cost calculation shows that 35% of the total inventory costs is from keeping items stocked.
But is this a good or bad thing?
How much of my total inventory costs should be from carrying costs?
In the above example, the percentage of total inventory cost was 35% — this is way too much.
The average carrying costs for most manufacturers is between 20% to 30%, though going below 20% means lower expenses for you. Using the inventory carrying cost formula, you can help you determine your percentage, and if it’s above average, you can start taking action to reduce this figure.
A simpler inventory calculation costs formula
Calculating the cost per square foot of storage is an excellent way to make your total carrying cost more understandable.
To calculate square footage for a rectangular space, simply multiply the length of the area by its depth. If it is an irregular shape, you need to work out the area of the additional or missing parts and add or subtract them from the total.
Then follow this simple calculation:
Carrying costs per square foot = total carrying cost / total square feet
Are you using your space wisely?
Remember, these costs apply if your excess stock sticks around.
This is also useful for working out your inventory turnover ratio as you can do this calculation for different areas of your warehouse. You can find out which products are selling faster than others, which you can use to inform your purchase decisions better.
It could be that you are paying for your stock many times over. The stock you brought in to get you out of a tight spot could slow your business down. Do the benefits of having lots of spare stock outweigh the ever-increasing costs of housing it?
You don’t need to copy the large manufacturer’s mantra of “more is more”, when your business can thrive on “less is more.”
5 reasons manufacturers hold inventory
Here are some examples of costs that all product-based businesses must deal with.
As a business grows, its holding costs can spiral out of control due to the increased management requirements. That’s why it is important to start thinking about these costs early before they slow your business down to a halt.
1. Safety stock
Also known as buffer stock or strategic inventory. The idea is that it safeguards against a sudden requirement for more stock. This could be a substantial order or make up for temporary supply or supply chain problems.
2. Cyclical or seasonal Demand
Businesses make stock more when they know there will be high demand, such as during the holiday season. This helps a business keep running without burning out at a very profitable time. Extra carrying costs are offset by higher sales, while excess stock can be removed with a post-season sale after cycle counting.
3. Cycle stock inventory
This is the stock you have available anytime to fulfill your usual demand forecasting. If you have a physical store, this includes “shelf-stock” that customers view and purchase. This stock should allow you to fulfill the majority of purchases. If you are in a low-volume industry, like many scaling manufacturers, this can be kept to a minimum.
4. Inventory in transit
This is the inventory you have ordered from a supplier and has not yet reached your factory. Large time gaps from the point of order to the completed delivery bring down the fluidity of your production process.
5. Dead stock
Unsold stock due to obsolescence, canceled sales orders, and other stock that cannot be sold.
Is it possible to eliminate carrying costs?
Well, you can try.
But no matter how much you sell, you will probably want to keep some stock around for urgent deadlines or samples.
It might be tempting to view all carrying costs as waste. Lean manufacturing does not mean stripping your business down to its bare bones. It’s all about finding what is optimal for your business:
If you run an online business, perhaps you don’t need demo stock, but what about safety stock?
Is your business prepared for eventualities like your machinery or supply chain breaking down?
Can you keep spare machines on hand, or will you need to rent more?
Keep extra stock for emergencies or a second sewing machine?
Sometimes incurring carrying costs could be the cheaper alternative. Every bit of efficiency in manufacturing is gained from some kind of trade-off. This trade-off can come from an upfront cost, which pays off afterward.
How do the masters deal with this?
Avoiding waste is a modern manufacturing principle, coming from the “Kaizen” philosophy which originated in Japan. This was the origin of lean manufacturing, which propelled brands like Toyota to global success.
This has evolved into the Agile Scrum Methodology. This is suited to scaling manufacturing businesses as change can be very fluid. Depending on the day’s task, you can pull stuff from one workstation and post it on others.
Because you are running a lean manufacturing business, you can have “sprint” periods of times for far greater productivity than your normal output.
One downside of this is that it takes time to train staff in these new practices. Again, maybe an investment in the here and now will pay off down the road. Having an agile workshop brings Samurai-like effectiveness to your production lines.
Once things get complicated, you can begin integrating an ERP system into your lean manufacturing process. An ERP system can help eliminate waste, improve quality control, and boost efficiency throughout your organization by automating key manufacturing and business processes.
It’s how scaling manufacturers can get one up on large enterprises.
But before you reduce carrying costs, you first need a plan.
5 tips to reduce carrying cost of inventory
No one likes losing money to avoidable costs.
While you may be unable to cut your inventory holding costs down to zero, you can still save cash with these handy tips.
This inventory management software lets you know exactly how much of everything you have in stock. The more accurate your information, the less time needs to be spent preparing for “what-if” scenarios. Knowing this information takes all the guesswork out of supply orders.
Track your sales data to see which product variations are sold as a ratio of how much each is produced.
It could be the case that some of your products sell like hot cakes, and some leave your shop floor rather sluggishly. Once you identify the slow-moving stock, you can focus less on that and more on what is selling. The key is to measure your data effectively with manufacturing ERP software.
Your EOQ is the optimum stock your business should purchase to reduce annual holding costs as much as possible. However, some of the assumptions it makes are unsuitable for businesses. A better compromise is to adopt a just-in-time inventory approach to making orders.
They could be physical or procedural. Maybe distance could halt your productivity.
Are you buying materials that take weeks to come into your workshop? Do your staff have to spend valuable minutes locating and retrieving materials? Sometimes shaking up things in your factory can pay off.
5. Adopt the Kaizen philosophy
Make striving for improvement an integral part of your company’s culture:
How can costs be cut?
Can something be done quicker?
Why are my raw materials going on an epic journey rather than coming straight to me?
These are just some of the questions you can ask yourself when evaluating the efficiency of your production line.
You might now be thinking all of this is easier said than done.
Well, it might be easier than you expect.
Carving out a bigger piece of the pie with ERP
Katana manufacturing ERP software automatically calculates manufacturing costs and continuously valuates your inventory, so you can get a real-time breakdown of your expenses.
Speaking of waste, it seems like an awful amount of paper and time to keep track of all this, doesn’t it?
There is enough to make anyone’s head spin.
Thankfully, technology is there to make your life easier — combining the vision of the old Japanese masters with cutting-edge 21st-century tech. Katana manufacturing ERP software helps streamline order fulfillment and other operations, reducing the need for manual intervention and increasing efficiency. All of these factors can contribute to reduced carrying costs over time.
ERP software can be a valuable tool for reducing carrying costs but selecting the right system for your organization is important. Not all ERP systems are created equal, and some may not be well suited to your specific needs. Be sure to do your research and consult with an experienced ERP consultant before making a decision.
In short, you can use inventory management software features included in ERP systems to reduce your carrying costs:
Spend fewer man-hours counting and finding stock
Sell stock before it becomes obsolete
Get finished products shipped before it becomes a loss for your business
Get inspired by Samurai discipline and cut costs with Katana — try it for free with a 14-day trial.
Katana gives thousands of manufacturers a live look at their business. Manage all the moving parts of your business and unite the apps and services you use in one visual platform.
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Each business is different, and each business has different requirements when it comes to handling stock. In this article, you’ll learn how to improve inventory turnover in your manufacturing business to reduce carrying costs and increase sales.