# Inventory Cost Formula: The Ultimate Guide in 2023

4 Minutes

In this article, we will explore what the inventory cost formula is and its importance. We will also cover how to apply the cost of inventory formula using an example. Read on to learn more.

## What is the Inventory Cost Formula?

The inventory cost formula calculates the total cost associated with ordering, holding, and potentially the shortage of inventory. It is typically expressed as the sum of ordering costs, holding costs, and shortage costs.

The total inventory cost is often calculated using the following formula:

Total Inventory Cost = Ordering Cost + Carrying Cost + Shortage Cost

Where:

• Ordering Cost: The cost associated with placing orders to replenish inventory. It includes costs like order processing, administrative costs, and costs related to receiving and inspecting the items.

• Carrying Cost: This is the cost of storing inventory over a certain period. It includes costs like rent for the storage space, utilities, insurance, security, and costs associated with spoilage, obsolescence, and deterioration.

• Shortage Cost (optional): This cost occurs when the inventory is too low to meet the demand. It can include lost sales, emergency shipping costs, and other expenses associated with not being able to meet customer demand.

However, it’s worth noting that the shortage cost is sometimes omitted depending on the specific context.

## How to Apply the Inventory Cost Formula

Applying the inventory cost formula requires understanding the different types of costs associated with inventory. Here’s our simple step-by-step process:

### Step 1. Gather Data:

Collect data on Ordering Costs, Carrying Costs, and Stockout Costs.

• Ordering Costs (OC): Gather data on the number of orders placed and the cost associated with each order, including processing and delivery charges.

• Carrying Costs (CC): Collect information on the average inventory level and the carrying cost per unit, which could include storage, insurance, and maintenance.

• Stockout Costs (SC): Determine the frequency of stockouts and the associated costs, including lost sales and emergency shipments.

### Step 2. Apply the Formula:

Inventory Cost Formula:

Total Inventory Cost = Ordering Cost + Holding Cost + Shortage Cost

### Step 3. Perform the Calculation:

For example:

• Ordering Costs: 100 orders x \$50/order = \$5000
• Carrying Costs: 500 units x \$20/unit = \$10,000
• Stockout Costs: 5 stockouts x \$200/stockout = \$1000

Applying the formula:

Total Inventory Cost = \$5000 + \$10000 + \$1000

Total Inventory Cost = \$16000

### Step 4. Analysis and Interpretation:

Evaluate the total inventory cost to understand the expenditure on inventory management. Analyze each component cost to identify areas for optimization and cost reduction.

### Step 5. Strategic Decision Making:

Use the total inventory cost data to make informed operational and strategic decisions. It can help in optimizing order quantities, reducing carrying costs, and minimizing stockouts to improve profitability and customer satisfaction.

## Example

A retail business aims to compute its total inventory cost to gain insights into its total expenditure associated with managing stock. Here’s how they calculated their inventory cost:

### Step 1. Gather Data:

The data gathered is as follows:

Ordering Costs (OC):

• Number of orders placed in a year: 150
• Cost per order (including processing, shipping, etc.): \$75

Carrying Costs (CC):

• Average inventory held in a year: 400 units
• Carrying cost per unit per year (including storage, insurance, etc.): \$25

Stockout Costs (SC):

• Number of stockouts in a year: 10
• Cost per stockout (including lost sales, emergency shipments, etc.): \$300

### Step 2. Apply the Formula:

The formula to calculate the total inventory cost is:

Total Inventory Cost = OC + CC + SC

### Step 3. Perform the Calculation:

Using the provided data:

• Ordering Costs: 150 orders x \$75/order = \$11,250
• Carrying Costs: 400 units x \$25/unit = \$10,000
• Stockout Costs: 10 stockouts x \$300/stockout = \$3,000

Applying the formula:

Total Inventory Cost = \$11,250 + \$10,000 + \$3,000

Total Inventory Cost = \$24,250

### Step 4. Analysis and Interpretation:

The retail business incurs a total inventory cost of \$24,250 annually. By examining each component, the business identifies that ordering costs contribute significantly to the total. This insight can lead to exploring bulk purchases or finding vendors with lower shipping costs to reduce the overall inventory costs.

### Step 5. Strategic Decision Making:

With the detailed breakdown of inventory costs, the business could decide to adjust its order frequencies and quantities, evaluate its storage solutions to minimize carrying costs and implement a more efficient inventory tracking system to reduce the frequency of stockouts.

## Importance of the Inventory Cost Formula

The Inventory Cost formula is significant for a number of reasons. Some of the most common reasons include:

### 1. Cost Optimization:

The inventory cost formula helps businesses minimize the costs associated with ordering and holding inventory. By effectively balancing these costs, companies can achieve financial efficiency and improve profitability.

### 2. Inventory Management:

It aids in optimal inventory management to ensure that businesses maintain adequate stock levels to meet customer demand without overstocking. This can lead to increased holding costs or obsolescence.

### 3. Resource Allocation:

The formula provides insights into resource allocation that assists businesses in making informed decisions regarding warehousing, staffing, and logistics to manage inventory efficiently.

### 4. Customer Satisfaction:

By facilitating the maintenance of optimal inventory levels, the formula helps in avoiding stockouts or overstock situations to ensure that products are available when customers need them which enhances customer satisfaction and loyalty.

We hope that you now have a better understanding of what the inventory cost formula is and how to calculate it to optimize your inventory costs.