Manufacturers are often faced with the decision of whether or not to acquire (in the case of raw materials) or produce (finished goods) additional inventories. The reasons a manufacturer may want to do so are many and varied, and may include the following: to take advantage of a volume discount from a supplier, reduce the risk of a supply shortage or impending price increases, lower the risk of stockouts and the accompanying customer dissatisfaction, or reduce idle time on the shop floor. On face, any of those can be a valid business reason in a given circumstance, and the “cost” of that decision is seemingly obvious – it ends up being reflected in the company’s inventory account on its balance sheet. But is that the true total cost of inventory?
In reality, there are significant additional costs of carrying that inventory – overhead, if you will - that are incurred by the company and charged as period costs in the income statement. The following additional costs must be considered when deciding whether or not to increase inventory levels:
- Capital costs – the cost of money used in acquiring or producing the inventory, such as financing fees or interest on a working capital line of credit, or the opportunity cost of using your own capital.
- Storage costs – the cost of the physical storage area (measured in rent or mortgage/depreciation), utilities, maintenance and security.
- Handling/service costs – the cost of moving the inventory about the warehouse, insurance, taxes, etc.
- Inventory risk costs – the cost of obsolescence, degradation or shrinkage.
Inventory carrying costs are typically stated as a percentage of total inventory on hand at a particular point in time, which is the sum of the above costs for a year divided by total inventory. While these costs vary among businesses, most research has shown that inventory carrying costs generally fall in a range of 20% to 35%, with 25% often considered to be a good rule of thumb. In other words, the true cost of inventory is likely at least 25% higher than the actual amount reflected in a company’s inventory reports. Such an amount can potentially undermine the perceived benefit of that supplier discount or of keeping people or machines busy.
Manufacturers and any businesses maintaining inventories would be well served to consider – if not specifically measure - their inventory carrying costs and apply them in their inventory planning processes. While some of those carrying costs may be fixed costs, and somewhat unavoidable, the variable costs associated with that additional inventory – including that of the inventory itself – represents capital that may be freed up and better deployed in other areas of the business.
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