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What Is Inventory Carrying Cost? The Ultimate Guide for 2024

3 minutes

In this article, we explain what inventory carrying cost is and why it matters. We will also walk you through our 5-step framework to reduce carrying costs, with examples. Read on to learn more.

what is inventory carrying cost

What Is Inventory Carrying Cost?

Inventory carrying cost refers to the total cost of holding inventory, including storage, insurance, taxes, and other related expenses. 

Example: TechBridges Ltd. pays $5,000 monthly on warehouse rentals and incurs another $3,000 on insurance, labor, and other associated costs. This leads to a total inventory carrying cost of $8,000 per month.

Significance of Inventory Carrying Cost

Understanding inventory carrying costs is crucial for businesses to manage cash flows and maintain profitability. Here are some key reasons why:

Efficiency: Helps businesses streamline operations and minimize wastage.

Cash Flow Management: Ensures adequate cash flow by not over-investing in stock.

Profitability: Reducing carrying costs can boost profit margins.

Pricing Strategy: Enables businesses to price their products more competitively.

Risk Management: Minimizes risks associated with obsolete or deteriorating stock.

Operational Flexibility: Provides insights to adapt to market demand changes.

what are inventory carrying costs

How to Calculate Inventory Carrying Costs

To determine your inventory carrying costs, you need to sum up all costs associated with holding your inventory over a specific period.

Formula: Inventory Carrying Cost = (Storage Costs + Insurance + Taxes + Obsolescence + Other Costs) x Average Inventory Value

As an example, GadgetWorld Inc. has monthly storage costs of $2,000, insurance of $500, taxes of $300, obsolescence of $200, and other costs of $1,000, and an average inventory value of $100,000.

Hence, their inventory carrying cost would be ($2,000 + $500 + $300 + $200 + $1,000) x $100,000 = $4,000.

5 Simple Steps to Reduce Inventory Carrying Costs

Reducing inventory carrying costs can lead to significant savings for a business. Here's our simple 5-step process:

Step 1: Optimize Inventory Levels

Analyze sales data and patterns to predict future demand accurately. Ensure you have neither too much nor too little stock.

Example: EcoFabrics minimized overstock by using demand forecasting, saving $15,000 annually.

Step 2: Leverage Just-In-Time (JIT) Inventory

Order inventory only as needed. This reduces the need for extensive storage and lowers carrying costs.

Example: AutoMakers Corp. adopted JIT, reducing their warehouse space and saving $20,000 monthly.

Step 3: Improve Supplier Relationships

Foster regular communication with suppliers and renegotiate terms, aiming for shorter lead times and flexible return policies.

Example: Print Magic renegotiated contracts, leading to a 5% reduction in costs, saving $10,000 yearly.

Step 4: Sell or Dispose of Obsolete Inventory

Periodically review inventory for outdated or slow-moving items. Implement discount sales or donate these items to clear space and minimize losses.

Example: Book Barn sold old editions at a discount, recovering $8,000.

Step 5: Implement Efficient Warehouse Management

Adopt warehouse management software or systems that optimize storage layouts and track inventory real-time.  

Example: After Health Essentials used software to optimize storage, they saved $12,000 annually.

inventory carrying cost

Case Study

FreshFruits Inc. is a fruit distributor facing high inventory carrying costs due to seasonal fluctuations and unpredictable demand.

Here's how they followed our step-by-step plan:

Step 1: Optimize Inventory Levels

By assessing their sales data, FreshFruits Inc. identifies patterns and forecasts for future demand. As a result, they reduced their apple stock, which often got overstocked, and boosted their orange stock to meet demand, saving $6,000 annually.

Step 2: Leverage Just-In-Time (JIT) Inventory

Rather than bulking up on seasonal fruits early, FreshFruits Inc. worked with their suppliers to ensure timely deliveries throughout the season. This strategy led to a 30% reduction in storage requirements and a savings of $4,500 per month.

Step 3: Improve Supplier Relationships

Engaging more closely with their suppliers, FreshFruits Inc. negotiated shorter lead times for berry deliveries and secured more flexible return policies for unsold items. This improved efficiency resulted in an annual savings of $3,500.

Step 4: Sell or Dispose of Obsolete Inventory

In their periodic inventory reviews, FreshFruits Inc. identified batches of overripe fruits. They then ran discount promotions and donated some batches, ensuring minimal losses and recovering $2,000.

Step 5: Implement Efficient Warehouse Management

By investing in a new warehouse management system, FreshFruits Inc. optimized their storage layout and implemented real-time tracking of inventory. These improvements led to faster inventory turnover and an annual savings of $5,000.

Understanding and managing inventory carrying costs can significantly influence a business's bottom line. We hope you now have a better understanding of what inventory carrying cost is and how you can reduce it.

If you enjoyed this article, you might also like our article on what inventory valuation is or our article on how much inventory you should have. 

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