Carrying cost is the amountthat a businessspends on holding inventory over aperiod of time. It is the cost of owning, storing, and keeping theitems in stock.
Significance of carrying cost
Carrying costincludes the cost of renting the warehouse where the stock is kept,operating the warehouse, paying thesalaries of the employees working at the warehouse,anyloss of inventory due to theft and damage, andinsuring the inventory. Carrying costsareusually15% to 30%of thevalue of a company’s inventory.This is a significant figure as ittells the companyhow long they can keep their inventory before they start losing money over unsalable items. Additionally, it shows how much they need to sell and buy in order to maintain appropriate inventory levels.Calculating carrying cost and knowing how to minimize it can help a company reclaim money tied up in inventory and increase its profits.
Components of carrying cost
The four main components of carrying costare:
1.Capital cost
2.Inventory service cost
3.Inventory risk cost
4.Storage space cost
Capital cost
Capital cost is the largest component of carrying cost incurred bybusinesses.It includes the interests added and the cost of money invested in the inventory.Capital cost is always expressed as a percentage of the total value of the inventory being held. For example, if a companyreports thatit* capital cost is 30% of its total inventory costs, and the total inventory is worth $8,000, then thecompany’scapital cost is $2,400.
Inventory service cost
Inventory service cost includesIT hardware, applications, tax, and insurance. Thecompany’sinsurancecosts are dependent on the typeof goods in inventory and the level of inventory.The level of inventory is the amount of inventorythe company keeps on hand tofulfillits orders—a high level of inventory makes it easierto meet the customer demand.High levels of inventory attract higher insurance premiums and taxes, raising the total inventory service cost.
Inventory risk cost
Carrying inventory comes with risk. Inventory risk costs include the shrinkage of inventory (whichrefers to the loss of products because of factors other than sale), theft, and administrative errors (such asmisplaced goods, errors in shipping,orlate system updates).Another risk factor is product value depletion: ifitems are stored for too long in the inventory, theirvaluecan drop to a fraction of whatthey were originally worth.
Storage space cost
Storage space costincludes the rent paid to warehouse your products, air conditioningand heating, lighting, transportation, and othercosts associated with thephysicalwarehouse. This cost has a fixedcomponentand a variable component.The rent is a fixed cost, whereas the costs of handling the materials willvary constantly based on demand and the number of products stocked.
How to calculate carrying cost
Calculating your carrying cost percentage is important for calculating the profit you’re making on your inventory.Carrying costs are always expressedas a percentage of the total value of inventory.Carrying costs are always expressed as a percentage of the total value of inventory. They’re equal to the inventory holding sum divided by the total value of inventory, then multiplied by 100.
Carrying cost(%)= Inventory holding sum/Total value of inventory x100
The inventory holding sum is simply the total of all four components of carrying cost.
Inventory holding sum =Inventory service cost +Inventory risk cost +Capital cost +Storage cost
To calculate your carrying cost:
1.Calculate the value ofeach ofyour inventory cost components (inventory service cost, inventory risk cost, capital cost, and storage cost).
2.Add the inventory cost componentsto get the inventory holding sum.
3.Determine the total value of your inventory.
4.Divide the inventory holding sumby the total value of inventory and multiply by 100.
For example,let’s look at the carrying cost for a
Motorcycle retailer who carries inventory for allhis bike models. The total value of his inventory is $50,000.His inventoryholding sum is $10,000 (which includes the inventory service cost, risk cost, capital cost and storage cost). His inventory carrying cost, expressed as a percentage, is:
Carrying cost(%)= Inventory holding sum/ Total value of inventory x 100
= 10,000 / 50,000 x 100
= 0.2 x 100
= 20%
The carrying cost incurred by the motorcycle retailer is 20% of his total inventory value.
Therefore, carrying costs enables you to find out your profit against incurred against the inventory you are holding. This cost ensures that you do not run into grave losses by holding inventory over a long period of time. Always the carrying cost should only be in limits of 20% – 30% of your total inventory value.
