Inventory costs will surprise you
Inventory is a necessary evil. After all, to keep customers happy, you need the right stock, at the right time. But how much inventory do you need? And more importantly, what’s your inventory cost in real terms?
From the cost of purchasing the inventory in the first place to storing it in your warehouse, and moving it throughout your network, inventory costs start building from the moment you place the order. The problem is, that most businesses have no idea just how much their inventory is costing them every day!
But what if you could change this? What would happen if you reduced your inventory by 10, 20 or even 30%?
Balancing the books
Holding too much stock has some potentially disastrous financial consequences. After all, money tied up in inventory cannot be used anywhere else.
Furthermore, capital tied up in items that you can no longer sell (e.g., obsolete stock) may be lost forever.
However, poorly invested working capital is not the only concern. There is a range of additional costs associated with holding inventory which must be taken into account.
For example, your business may have to pay interest if money was borrowed to buy the stock in the first place.
Additionally, you will have to pay for warehouse space as well as invest in tools & equipment to keep things running smoothly. Moreover, you will have to pay people to physically manage this stock.
All of these things combined come at a great cost to the business. But how much exactly?
What’s the size of the prize?
By adopting more effective inventory practices, businesses can attain significant reductions in inventory. As an example, many of our customers attain up to 30% reductions in inventory within just 12 months of launching their optimisation project with many enjoying continuous year-on-year inventory reductions long after the initial project is complete.
Sure, some of the benefits of reduced inventory are obvious. For example, free up space in the warehouse, reduce waste, and improve cash flow. But the full extent of the reward may surprise you.
In this whitepaper, we will explore how to calculate the true cost of your inventory as well as its impact on your cash flow.
Ultimately, in this whitepaper, we will reveal:
- How to calculate your current inventory holding costs?
- What potential ROI you can expect by reducing inventory?
- What hurdles do you need to overcome to cut inventory costs?
How to calculate inventory costs?
If you are a wholesaler, retailer or any type of company that holds inventory, many of the costs you incur will in some way relate to the items you have in your warehouse. However, we will limit ourselves to three main cost components of the inventory cost formula:
- The cost of capital
- Inventory handling costs
- Inventory risk costs
1. The cost of capital
What is the cost of capital?
Capital costs are the costs that a company will encounter when borrowing money.
In many businesses, the inventory is financed through many means including shareholder equity, bank loans and other sources of capital. And of course, this money is never free!
However, the cost of capital can differ hugely depending on the situation.
For instance, if a director or major shareholder was to invest money into the business, they may accept a 5% return on their investment. An investment company, on the other hand, may expect to see a return of something more like 25%.
If the money used to finance the stock investment is borrowed from a bank, the cost of capital will depend on the given interest rate.
An objective way to measure how a company is financed is the so-called Weighted Average Cost of Capital (WACC). According to a 2021 report from KPMG, the WACC for European businesses is typically between 7-9% (after corporation taxes).
In simple terms, the cost of capital to hold inventory is a significant expense, to say the least!
2. What is inventory carrying costs, Inventory handling & stock holding costs
The next set of costs we will explore are the so-called handling & holding costs. These are defined as the costs that are incurred from the moment the goods are controlled by the business until the moment that they are sold.
You can calculate these costs in two ways depending on whether or not the cost components are fixed or variable.
What are variable costs?
These are the direct costs associated with the inventory. These typically include the costs to pick, pack and transport the inventory among other things.
Variable costs increase in direct relation to the level of inventory you hold. For example, if a business increases its inventory levels, the variable handing costs will also increase.
If you have outsourced your warehouse activities, the variable inventory costs are easy to determine. These costs usually refer to the cost per pallet charged by the service provider. However, these costs will vary between different service providers.
You have to take into account the fact that you will have to pay a fee per pallet each week. There will also be costs associated with the administration of goods in and goods out but we will not consider these costs here.
Total costs of £150-200 per pallet are not uncommon but these numbers will need to be verified for specific circumstances.
It is common to calculate the outsourced costs as a percentage of inventory value. For example, if your inventory has a purchase value of £1,000,000 and the service provider may charge 10%. Therefore, your costs will be £100,000 annually.
Alternatively, you can calculate variable handling costs yourself. However, you must consider all of the relevant costs: rental of your property, depreciation of equipment such as shelving and storage systems, energy costs and personnel costs, etc. You then must come up with a formula that allows you to allocate these costs to your inventory. There are various business economics techniques available.
If you keep all of your warehouse operations in-house and do not outsource, it is advisable to calculate the handling costs yourself. However, if you are not able to do this, a practical solution is to base an estimate upon the costs that a logistics service provider will charge for this. With just a few calls, you should be able to get a good understanding of the costs involved.