Wednesday, August 13, 2008

Carrying Inventory

by Jon Schreibfeder
The carrying cost of inventory is the cost of maintaining your average inventory investment of inventory in your warehouse, storeroom, stockroom, or other location where you stock raw materials or finished goods. What costs do you incur in carrying inventory?

* Cost of putting away stock receipts and moving material within the warehouse. How much of your employees' time is spent in these activities?
* Rent and utilities for the portion of your warehouse used to store stock inventory.
* Insurance and taxes on inventory. If it's in your warehouse, you have to insure it, and it may be subject to tax.
* Physical inventory and cycle counting. The more material in your warehouse, the longer it takes to count.
* Inventory shrinkage and obsolescence. The more material in your warehouse, the higher the possibility of shrinkage and obsolescence. After all, it's hard to steal something that isn't there!
* Opportunity cost of the money invested in inventory. How much could you make if you were to take the money you're investing in inventory and invest it in a more traditional investment (such as treasury bills)? Or if you are financing your inventory, how much interest are you currently paying the bank?

The carrying cost percentage is calculated by dividing the sum of these expenses (along with the opportunity cost) by the average inventory value. It is the amount of money it takes to maintain one dollar's worth of inventory for an entire year.

For years many industry consultants have maintained that determining your company's actual carrying cost is too difficult to calculate in a reasonable amount of time, and that you should use a rule of thumb such as "current prime rate plus 20%." One inventory "guru" recently suggested that you should adjust your carrying cost percentage so that the economic order quantity formula suggests "reasonable" reorder quantities.

This is backwards thinking. The economic order quantity formula is designed to calculate the lowest total cost reorder quantity (i.e. your "best buy quantity") based, in part, on the cost of carrying inventory. If it costs you less to maintain inventory in your warehouse, you will tend to stock more. If your carrying costs are high, you will probably want to keep just enough inventory in your warehouse to protect customer service. Guessing at your carrying cost will not ensure that you are buying the quantity that will minimize your firm's total cost of inventory.

Just as important, using an approximate carrying cost does not help you identify areas for potential improvement in your warehouse operations. In these days of increased competition, lower margins, and greater customer demand of product availability, it is important to lower operating costs and increase productivity wherever possible. By closely examining the specific components of the inventory carrying cost and comparing the numbers to other firms in your industry and region, you can identify areas that are candidates for improvement.

With all of this in mind, EIM would like to help you calculate your cost of carrying inventory. If you will print and fill out the attached questionnaire and send it to us by email, mail, or fax, we will calculate your carrying cost and send you a comparison of your answers to each question to others in your region and industry. There is no charge for this service as long as you agree to let us add your information to our database. Please note that all responses are confidential. Data we present to other companies will not identify your company name or location.

Even if you don't fill out the questionnaire, please review it, as it includes most (if not all) of the factors you must consider as you calculate your own inventory carrying cost.

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