What Are Inventory Carrying Costs And How To Reduce It?

Inventory carrying cost refers to the expenses that a business must pay to hold and store merchandise. It includes direct costs such as warehousing leasing, employee salaries, utilities, insurance, and indirect costs like shrinkage and depreciation.

This article will explore the definition of monthly carrying costs and 5 best practices to reduce them.

What are inventory carrying costs?

Monthly inventory carrying cost is the expense of keeping inventory items before you sell them. It consists of operating expenses, mortgage payments, real estate taxes, lender-required reserves, interior and exterior maintenance, and other utilities like water, electricity, trash pickup, etc.

This expense is commonly expressed as a percentage compared to the entire stock value. For a general rule of thumb, you can expect holding costs to take up 20%–30% of the total inventory value.

The cost to store inventory accounts for a big portion of your supply chain expense and affects your bottom line. Let’s find out what makes up this cost and the formula to calculate it.

Inventory carrying cost formula

To measure your holding cost, you can use the following formula:

Inventory Carrying Cost = (Capital costs + Service costs + Space costs + Risk costs)/ Total inventory value * 100,

in which:

• Capital costs: Capital costs involve necessary raw materials or stock items, together with other related costs like financing and loan maintenance fees. This component is the largest contributor to your carrying expenses.
• Service costs: This is the cost to maintain inventory in a warehouse, including insurance, hardware investments, taxes, inventory management software fees, and costs for staff to conduct periodic inventory counts.
• Space costs: Space fees are the costs to purchase or rent warehouse space, handling fees to move items in and out of the warehouse, utility management, physical security, and climate control costs.
  • If you have your own warehouse, these are fixed costs.
  • If you outsource your warehousing and fulfillment operations to a third-party logistics provider (3PL), the costs will vary based on usage and product volume.
• Risk costs: Stock risks mean the threat that your currently stored products can become unsaleable. These risks hurt your capital tied in the stock and make it very hard to recover sales. Additionally, if you keep items too long in stock, their value may decrease compared to their original value. There’re 2 main factors leading to stock risks:

• • Shrinkage: loss because of damage, theft, or errors in the stock record;
  • Obsolescence: loss due to product expiration or retirement.

Here’s an example to calculate your stock holding cost:

A sporting store has a total inventory value of $100,000 and the following cost components:

• Capital costs: $20,000 for raw materials and associated costs;
• Service costs: $1000 per month for software, hardware, and insurance costs;
• Space costs: Rent a climate-controlled warehouse space for $1,200/month, with $300/month in utilities;
• Risk costs: $500/month in depreciation, shrinkage, obsolescence, and opportunity cost.

Their inventory carrying cost will be: (20,000+1,000+1,200+300+500)/100,000*100 = 23%

How to reduce inventory holding cost

Here are the 5 methods to lessen your stock-carrying expenses:

1. Keep the right amount of stock

Keeping too much stock than you need is a common issue for retailers that makes your carrying costs high. To optimize this expense, you can adjust the replenishment frequency with your suppliers depending on actual customer demand.

A good inventory management software with a forecasting tool will help you predict the right inventor balance based on your historical sales performance and trends.

Below are the software features you need to make just-in-time restocking decisions:

• Measure your inventory KPIs
• Evaluate your SKU list to select which items deserve a location in your shop or warehouse
• Determine the proper inventory level to maintain
• Notify the time to re-order and recommend the quantity to purchase
• Forecast inventory demand

2. Speed up inventory turnover time

Another effective way to reduce the holding cost of inventory is to improve the turnover rate. It means increasing the percentages of products sold and reducing the time your stock stays in the warehouse.
To reduce obsolete inventory, offload them while they still have value. If you don’t act quickly, these items may end up being disposed of or thrown away:

• Evaluate product performance regularly to check their selling rate
• Identify which SKUs are selling slowly. You can then take actions to push sales like launching a promotion program;
• If a deep discount doesn’t work, consider removing the items by giving them away, donating them to a charity, or selling them to a liquidator.

The ability to predict market demand also contributes to a healthy turnover rate. If you know what customers are looking for, you can stock the right products and fulfill orders quickly.

3.  Organize your warehouse

Many retailers don’t know how to optimize their storage space. Since the warehousing fee is an important component of carrying costs, redesigning an effective storage layout can help you reduce this cost. A well-organized warehouse can prevent inventory loss or misplacement.

To modify a warehouse arrangement, you can take some actions like:

• Using standardized bins and pallets to store your goods for efficient storage and location searches.
• Installing a stand to increase vertical storage space
• Putting popular items in an easily accessible location.

If you work with a 3PL partner, you can review your warehouse layout and improve the way you store products of different shapes and sizes. Then you can optimize the holding costs by moving to a smaller warehouse.

In addition, you can rearrange your warehouse to boost your employees’ productivity. Try different methods to pick and pack items, keep the high-volume products near packing stations, and adopt automation tools to outline the most efficient picking routes and shorten the order fulfillment process.

4.  Embrace a digital inventory management solution

Traditional methods of stock recording like paper and Excel spreadsheets are not the best ones for accuracy. Instead, you should invest in a retail system with an inventory management feature to streamline your supply chain with accurate, real-time data.

Good software brings you various benefits that help optimize inventory levels and cut your carrying expenses:

• Update real-time changes in inventory when a product is sold or returned;
• Create consistent workflows in receiving, shipping, and fulfillment;
• Keep track of all customer order details and status;
•  Provide a single view by centralizing all data on sales, stock movement, customers, and employee management;
• Improve inventory visibility to make smart decisions;
•  Recommend the ideal inventory balance;
• Control SKUs and warehouse layout;
• Analyze and interpret data to detect trends.

5. Negotiate with suppliers

To decrease the stock holding costs is to negotiate with your vendors to ensure you don’t incur too many expenses and risks before buying these items.

Talk to your suppliers about the chance to purchase strategically with the best price based on inventory forecasting. This way will reduce your capital costs and your storage costs:

• Add a contract term for suppliers’ responsibility for theft damage or administrative costs during the transit to your warehouse;
• Determine a maximum inventory retention period with suppliers and charge for each day after the period to offset the inventory carry expenses.

In conclusion

Regularly check your carrying cost of inventory to see where you can improve. You can recognize and remove bottlenecks with an efficient inventory management system to guide your business decisions. This will help you lower your inventory costs and establish lean operations for your retail business.