Components of inventory cost

One of the most important parameters that determine the success of a business is profitability. Even the smallest of factors affecting profitability must be addressed with utmost diligence. One such factor is the inventory cost or the cost incurred by businesses for storing inventory until the time it is sold. Many components together add up to the total inventory carrying cost.

What is an Inventory Cost?

Inventory cost refers to the amount of money a business must spend to hold or stock inventory in the warehouse, store/shop or distribution centre. Inventory carrying costs, also known as typical holding costs, is one of the biggest challenges a business faces in inventory management. Higher inventory costs can reflect poor and inefficient operations. A business can lose out on potential possibilities if too much capital gets blocked in inventory costs. Slow-paced inventory, excess amounts of safety stock, inefficient inventory management, and other similar factors can lead to high inventory costs.

Types of Inventory Costs

There are different types of costs that together make up the inventory costs. Mentioned below are the top eight costs that account for the majority portion of the inventory carrying costs:

• Cost of Capital

This refers to the cost required to buy the inventory plus interest or other costs if any debt was taken by the business to purchase the products. Cost of capital accounts for the majority portion of inventory carrying costs.

• Inventory Storing Costs

After purchasing, the inventory must be stored in the warehouse. Every shelf, box, and bin adds up to the warehousing costs. 

• Labour/Employee Costs

This refers to the cost of labour required for receiving, stocking, and selling the inventory.

• Obsolete Inventory Costs

Every inventory has its lifecycle, beyond which the products start deteriorating to such an extent that they become value-less and unsaleable. This is referred to as obsolete inventory. Obsolete inventory increases inventory carrying costs.

• Opportunity Costs

This refers to potential opportunities that a business misses due to excess capital being blocked/tied up in inventory. Opportunity costs add up to the inventory carrying costs and reflect the inefficiency of the inventory management process.

• Taxes and Insurance

Many businesses opt for insurance policies to protect the inventory against fires, floods, or warehouse accidents. The money invested in insurance policies is directly proportional to the number/amount of products/inventory.

The same thing applies to taxes as well. The tax amount increases with the quantity of inventory.

• Inventory Shrinkage

The inventory might get subjected to damage because of theft, damage, fraud, faulty record-keeping, etc., before being sold to customers. This is known as inventory shrinkage.

• Stock-out Costs

Companies might be required to spend on emergency shipments in case of stock-outs. Apart from the overnight shipment costs, businesses also bear the cost of lost sales resulting from unhappy customers making purchases from other businesses because of a stock-out.