Inventory Carrying Cost Formula
Where each variable in the calculation is represented by the following:
W= Warehouse costs
O= Obsolescence and Shrinkage Costs
R= Recovery costs
- Capital Costs This is typically the largest cost associated with carrying inventory. It includes the cost of purchasing the goods, interest, and opportunity costs associated with making the purchase.
- Taxes This includes all taxes paid related to carrying the goods.
- Insurance There are many forms of insurance paid, whether it is product insurance, warehouse insurance, or other insurance expenses related to warehousing and inventory.
- Warehouse Costs These costs are related to maintaining the warehouse, whether it be mortgage or leasing for the facility, utilities to run power in the warehouse, and the personnel (labor) for receiving, packing, picking, storing of the goods. Typically these costs are broken into two groups; fixed and variable expenses.
- Scrap, Obsolescence, and Shrinkage These are the result of product that may break as a result of movement throughout the warehouse (scrap). Obsolescence occurs when demand for a product isn't enough to deplete the stock; this can be a result of expired goods (such as produce) or making a large purchase on a good where high sales are anticipated but they fall flat. Shrinkage is the result of lost or stolen merchandise.
- Recovery Costs This is primarily the cost of customer service, processing returns, or other guarantees you may offer as a service to your customers.
Carrying Cost Example
Based on the formula, we may determine that the company has an average carrying cost of 10%. If the business maintains an average inventory that has a value of $200,000, then the annual carrying cost for the inventory is about $20,000 ($200,000 * 10%). It is important to note that carrying costs vary by business and industry. As you can see there are quite a few variables that go into calculating it. However, a general rule of thumb for the cost to carry inventory is about 10%-20%.
Why is Inventory Carrying Cost Important?
There are many reasons this cost is important. For one, reducing these costs can mean better financial reporting for a business. For example, by reducing scrap, shrinkage, and obsolescence there is less financial "waste" and the business will have more sellable goods, or it will spend less to maintain correct inventories. Additionally, by reducing these costs and coming up with greater efficiencies it will also have a positive impact on demand forecasting and it will, in theory, provide more optimal inventory levels required to meet business needs.
Holding all things equal, when carrying costs are higher (than they could or should be) a forecasting model will say buy less because it increases the total cost per order. This will result in sub-optimal inventory levels and potentially lead to lower service levels, or worse, lost sales.