Thursday, August 21, 2008

Inventory Carrying cost

It is important to know your cost of carrying inventory. It is a critical factor in deciding what products to stock and when to reorder them, as well as the best quantity to order. Too often companies and organizations use an imprecise "rule of thumb" to estimate their cost of carrying inventory. The result: Bad inventory management decisions.

In a previous article, "The Mysterious Cost of Carrying Inventory," we gave you some direction for calculating an overall cost of carrying inventory for your entire company or an individual warehouse. The calculation considers these expenses and alternative opportunities for revenue:

* Moving material from the receiving dock to the proper bin location and shifting it to other warehouse locations as necessary.
* Rent and utilities for the portion of your warehouse used to store material.
* Inventory shrinkage and obsolescence.
* Physical inventory and cycle counting.
* Insurance and taxes on the inventory.
* Opportunity cost of the money invested in inventory – that is, how much could you make if the money tied up in inventory was invested in a relatively safe, income-producing investment. Or, if you finance your inventory purchases, the amount of interest that you pay the bank.

The sum of these factors is divided by the average inventory value to determine an overall carrying cost percentage – that is, what it costs to maintain a dollar's worth of inventory in your warehouse for an entire year.

But some companies find that it costs more to stock some items. Maybe they take up more space or are more susceptible to shrinkage and obsolescence. If the carrying cost percentage is used in so many critical inventory-related decisions, doesn't it make sense to calculate as accurate a carrying cost as possible for each product? If you believe that your cost of carrying inventory may vary for different segments of your inventory, consider calculating a cost of carrying inventory for each item.

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