Different Types of Inventory Costs & Mistakes to Avoid (2024)

Inventory costs are one of the most important metrics to consider if your company hopes to turn a profit. That’s because the cost of inventory substantially affects your bottom line and can impact your profitability for better or worse (depending on how things are managed). Understanding the nuances of inventory costs and knowing how to calculate them for your business will be pivotal in strengthening your overall approach to inventory management.

It's also imperative to understand and remember that as your business grows, you may encounter scenarios where managing inventory costs becomes increasingly challenging. At such a pivotal juncture, astute business leaders recognize the need for evaluation. They may consider expanding their inventory management capabilities through additional arms, such as partnering with a third-party logistics (3PL) provider.

Read on to learn the different types of inventory costs, how to calculate them, and mistakes to avoid to better manage inventory costs.

What are inventory costs?

Inventory costs encompass the overall cost of goods and all expenses associated with ordering, holding, and managing a product-based business's inventory or stock levels. Total inventory costs are frequently broken down into three distinct categories: ordering costs, carrying costs, and stockout costs. Business owners and/or management often assess or examine these amounts to determine how much inventory to keep on hand at any given time.

Main Categories of Inventory Costs

Ordering Costs

Every time your company purchases from a supplier, you’ll have to consider the relevant ordering costs; even if the order in question is fairly small, ordering costs will always be involved. To estimate how much an order is going to cost, you’ll need to track purchase requisition, purchase orders and invoicing, labor costs, and fees for transportation and processing. While some of these costs will be relatively insignificant—like preparing invoices, for example—others, like purchase orders and transportation, will run much higher.

Carrying Costs

Inventory carrying costs (also referred to as inventory holding costs) are the fees a business pays for keeping its inventory items in stock. Carrying costs can vary and include anything from taxes and insurance to inventory bin occupancy fees to employee costs and the price for replacing perishable goods. An accurate view of your carrying costs is critical to knowing how much profit your current inventory can make. Fortunately, businesses can reduce these costs by utilizing an efficient warehousing layout and leveraging innovative inventory management software (IMS).

Stockout Costs

Stockout costs represent any lost (potential) sales from insufficient product—the lost income and expense due to an inventory shortage. For instance, this can happen if a customer orders the last of a stock keeping unit (SKU) you have in stock, but that item turns out to be defective. It will be a loss since you can’t ship a defective product, and you don’t have available inventory to fulfill the order. Alternatively, stockout costs can occur if customers see the product they want is out of stock on your website, so they purchase it elsewhere.

Ecommerce retailers who also operate brick-and-mortar storefronts face additional other risks for stockouts. When your website ships inventory located at a store for online orders, additional uncontrollable variables might cause an item to be unavailable for an omnichannel order. For example, a customer might have the last unit in hand waiting to purchase in a store while another places an online order for that same item.

7 Sub-Types of Inventory Costs

Storage Space Costs

Storage space costs cover recurring payments like rent, security, lighting, heating, upkeep, and other utility fees. In addition, they also include the wages for your security workers and janitors (i.e., the labor needed to uphold a clean, safe, and organized inventory storage facility). Although the costs of storing inventory tend to add up pretty quickly, they’re still a necessity, considering it’s impossible to maintain any stock if you have nowhere to store it. 

Handling Costs

Handling costs cover the safe inventory handling at your ecommerce warehouse; they’re the tools and labor costs of employees who move stock from one location to another within your space. Common handling costs include material handling equipment, forklift truck drivers, and the people who manage your products. Even so, handling costs don’t just include wages—they also extend to any taxes applied by your government, employee benefits, and extra duty hours.

Capital Costs

More often than not, capital costs are the highest carrying costs you’ll have to deal with. Capital costs involve the one-time fees required to physically carry and house inventory, such as purchasing land, building, and equipment. However, they’re also linked to any interests on your working capital and the opportunity costs of all the money invested in your stock. You can figure capital costs by calculating the weighted average cost of capital (WACC). 

When capital costs feel too burdensome, outsourcing inventory management and fulfillment to a 3PL can be a great way to future-proof your business for scalability. Consider it a strategic investment to ensure your operations evolve with your company's growth so you can focus your working capital on business growth instead of fixed assets. The journey toward optimal profitability involves understanding the nuances of inventory costs and having the foresight to adapt your strategies when needed.

Taxes & Insurance

Taxes and insurance always seem to present a challenge, and retailers likely don’t look forward to dealing with these aspects of their business. Still, ecommerce business owners need to take these costs seriously, as there can be huge implications for your brand if you don’t. Since we can’t share any legal advice, you’re encouraged to consult on these issues with a business lawyer familiar with your particular state (and your industry) who can offer more direction.

Obsolescence

Obsolescence is an inventory cost risk related to the items in your inventory you cannot shift or might deteriorate before they sell (think flowers, nutritional supplements, cosmetics, and foodstuffs). Similarly, depreciation can occur with non-perishable inventory as it becomes obsolete (think seasonal and holiday-specific items). In truth, obsolescence (and spoilage) can be rather pricey because you’re effectively leaving cash on the shelf. Products might sit in your inventory for months, causing you to accumulate carrying costs without ever making a profit. Small businesses often incur obsolescence costs, though many of these can be avoided or minimized by consistently tracking inventory age.

Investment

At its core, inventory is an investment. However, it can be a costly investment for companies that haven’t yet worked out an inventory management strategy. Because every brand has a finite amount of money at its disposal, it’s imperative to use caution as you spend it. When you’re careful with how you invest, you’ll have a better chance of striking the right balance with your resources, so work out a realistic budget you can stick to.

Shrinkage

If you fail to implement proper inventory control, you’re essentially leaving your inventory open to shrinkage, which can be incredibly costly. While theft might be the most obvious criminal activity to try and prevent, fraud and dishonest employees can pose a serious threat. That’s why it’s so important to stay on top of when, where, and how your losses are happening to protect your inventory and serve your customers well. 

Top Mistakes to Avoid for Managing Inventory Costs

Deprioritizing Inventory Management

Inventory management isn’t simple. Not much is easy about managing multiple locations, reordering new stock, evaluating employee candidates, and reviewing new technologies to implement. And that goes without mentioning the intricacies of generating reports, minimizing shrinkage, optimizing your inventory turnover ratio, and identifying when products have gone missing. Even with the help of proficient, intuitive software, inventory management remains complex; it’s never been easy, and it never will be. But, given that inventory management can make or break a company, you can’t afford to neglect it or do the bare minimum.

Launching a Product Before Managing Inventory

Another common misconception is that you can manage your inventory after your business launches. Say your company makes its debut and then decides to onboard an inventory management platform; the problem at this point is that your inventory has already had a chance to become disorganized and potentially hurt your bottom line. Like it or not, it’s best to structure your inventory well before your first sale. Otherwise, you will run into inventory issues (and related costs) that could’ve been easily avoided.

Segregating Forecasting & Inventory Management

Some companies falsely presume they can predict future sales using their previous sales data. Not only is this untrue, but it can cost small businesses a lot of money they can’t afford to lose. By utilizing affordable, advanced inventory management software, brands can improve their sales forecasts' precision while tracking other pertinent inventory key performance indicators (KPIs). This move will help you follow the right sales trends, maintain the right amount of stock at your warehouse(s), gauge what SKUs aren’t selling, and calculate the lead time for inventory restocking with ease.

Gatekeeping Inventory Tracking

Enrolling order placements and inventory tracking to a select handful of employees can be extremely limiting and counterproductive. Assuming that inventory tracking is reserved for the ‘pros’ can cause a bottleneck in your receiving and purchasing process, ultimately delaying stock availability to fulfill customer orders. As long as you have the right software in place and you’re using barcode scanners, there’s no reason other employees can’t take care of receiving, ordering, and shipping your products.

Not Knowing When to Reorder Stock

Unless you have a handle on your reorder points and safety stock levels, the possibility you’ll run out of stock (or create an overstock situation) still exists. Those who’ve encountered an overstock know it can be very costly, since you’re carrying products you don’t need. Thankfully, inventory management software like Extensiv can take the guesswork out of reordering by predicting likely sales and product demand via accurate inventory forecasting.

Purchasing Bulk Stock to Reduce Supply Costs

As you’re purchasing products from a supplier, you may run into a ‘buy one, get one free’ offer. While this arrangement is beneficial for the supplier (since they can let go of unwanted stock), it can quickly lead to an overstock on your end if you decide to partake. It’s important to remember that bulk procurement doesn’t automatically mean you’re saving money. For example, if someone buys bananas in bulk but doesn’t eat them all before they go bad, that’s money lost that’ll have to be thrown out. The same principles can be applied to business. If your company purchases goods or raw materials in bulk quantities but doesn’t use them before expiration, you’ll lose money on those unsold items. And yet, if you insist on bulk buying, be sure to use forecasting data to gauge what will sell (and what won’t).

Understocking to Save Money

Simply put, having too much or too little inventory at your warehouse is risky. The goal of every retailer—regardless of their size or business model—should always be to meet customer demand. You're likely in a good position if you have enough stock to do that. If you’re debating whether to purchase a smaller order quantity to save resources, know there’s a chance you’ll be understocked, which can cost you opportunities for more sales. That’s why managing inventory is a balancing act—one that requires you to wield your budget effectively. Additionally, smaller-than-necessary inventory orders may limit your negotiation power with suppliers and unnecessarily elevate your per-unit purchasing costs.

Not Clearing Out Dead Stock

Dead stock refers to the products that simply aren’t selling and are instead taking up valuable space at your warehouse. Stagnant inventory levels like this can be super detrimental because they contribute to your carrying costs in a big way and tie up working capital. Any item in your inventory costs something to hold onto, so it’s usually best to give up and get rid of your lingering dead stock. This might look like selling a product bundle, executing a markdown, consolidating the inventory at an outlet store, returning the goods to your supplier, or finding a place to donate them.

Failing to Evolve

The essence of any successful business centers on change and innovation. If a company won’t willfully embrace change, it’s only a matter of time before it is required to adjust its mindset to achieve growth and keep pace with its competitors. Some ecommerce merchants believe that changing their current systems (and technology) isn’t worth their time, money, and energy. However, although implementing an inventory management system takes several weeks or months, in the end, it’s still the ideal way to improve efficiency and boost sales for any brand.

Undervaluing the Inventory Management Software

The notion that you don’t need to implement strategic inventory management techniques and corresponding software is certainly a dangerous one. If you’re currently using spreadsheets, checklists, and manual processes to oversee your inventory, your company is probably a prime candidate to benefit from an inventory management system. There’s also a good chance your competitors are already using this technology. Advanced software solutions are the answer to eliminating human errors, providing real-time data, and ensuring your operations run as smoothly as possible.

Inaccurately Calculating Return on Investment

Software and management tools are pivotal for businesses looking to scale since software automates your inventory and takes that hard work off your to-do list. If you’re worried your company can’t afford to implement such software, consider whether you can afford not to. The truth is that many next-generation software options, like Extensiv’s solutions for brands, offer services at a fraction of the price of others on the market. The key to finding the right program is understanding what issues or pain points you must address. From there, you can evaluate many different inventory management systems to make an informed decision on which best meets your requirements and fits within your budget.

How to Calculate Inventory Costs

Calculating your company’s inventory costs is an important (ongoing) practice since these costs directly affect your profit margins and bottom line. While there’s a simple formula you can follow to add these costs for yourself, you can also opt for a cost calculator to speed up the process.

With the Inventory Cost Formula

First, you’re going to need your inventory valuation. The inventory cost formula consists of beginning inventory value, ending inventory value, and purchase costs over a set period of time. More succinctly, it looks like:

Inventory Cost = Beginning Inventory + Inventory Purchases - Ending Inventory

Let’s say your company values its inventory at $100,000 at the start of the year and buys $25,000 worth of inventory over the next twelve months. If the value of that inventory is $50,000 by the end of December, your inventory costs will amount to: $100,000 + $25,000 - $50,000 = $75,000. 

With an Inventory Cost Calculator 

Those who would like to manage their costs manually can do so; however, companies can also call on the help of an inventory cost calculator to automate the task. Online calculators are available to help you with this computing, though they’ll still require you to plug in your beginning inventory, ending inventory, and purchases made during that specified period.

With an Automated Inventory System

Automated systems, like Extensiv’s Order Management platform, are the most efficient way to improve accuracy and timeliness and can take a lot of work off your plate to invest elsewhere in your business.  With an automated solution that integrates with your accounting software to track expenses and sales in real time, you save you considerable time and minimize accounting mistakes.

Control Your Inventory Costs with Extensiv

With Extensiv’s Order Management platform, your company can reap the benefits of streamlined, reliable, automated inventory management and cost tracking, which is especially helpful for brands with complex or wide-reaching inventory networks.

Get a Real-Time Inventory Overview

If you’re a multichannel or omnichannel merchant, Extensiv makes it simple to automate your inventory overview for all SKUs across all channels. Thanks to the inventory control features in Extensiv Order Management, you can dive into detailed, real-time inventory data to see where you’re making money, losing money, and which items deserve priority. Utilize precise product and inventory visibility to boost your inventory management and maximize efficiency throughout your supply chain and various selling channels.

Reduce Costs by Liquidating Dead Stock

With Extensiv’s reporting and analytics features, you’ll have a comprehensive record of your purchasing decisions so you can properly manage the money tied to your inventory services or inventory costs. This includes data on product performance, like how much it’s worth, its sitting age, and its turnover per warehouse—in other words, it reveals the amount of dead stock you’re carrying. With this knowledge, you can then work to liquidate your excess inventory, thus reducing costs on your financial statements and making room for new products.

Make Decisions Based on Inventory Trends

Extensiv’s enhanced demand forecasting and inventory planning features allow you to make decisions based on your brand’s unique supply chain and inventory trends. Using historical data, businesses can adapt their pricing models and optimize their inventory costs thanks to automatic updates on sales velocity, reorder quantities, and forecasted reorder dates. Making better cost decisions for your company is the surest way to improve your cashflow, experience a greater return on investment, and ultimately, continue to excel in your industry and scale to the next level.

Interested in learning more about Extensiv’s solutions for brands? Request a demo today, and subscribe to our blog for more tips and inventory management best practices!