Inventory Cost

See Also:
How to Manage Inventory
Inventory Turnover Ratio Analysis
Days Inventory Outstanding Analysis
Inventory to Working Capital Analysis
Freight on Board (FOB)

Inventory Cost Definition

Defined as the total cost that a company experiences while holding inventory, inventory cost is often one of the most substantial factors in the success of a business. Inventory cost control has many facets, including financing, equipment, labor, protective measures, insurance, handling, obsolescence, losses by pilferage, and the opportunity cost of choosing to deal with inventory. These factors all combine to create the total cost of holding inventory.

Inventory Cost Explanation

Inventory cost, explained by each business owner with varying importance, plays a major role in the working capital requirements of a business. Based on the overall inventory needs, a company can can plan the cash flow cycles properly to avoid problems which may even cause the business to cease operations. This makes sense when one keeps in mind that perhaps the most common reason a business closes is lack of cash.
There are a variety of inventory cost methods to minimize expenditure. On the material side, a business can set up equipment, ranging from simple placement of items for optimal usage to accounting systems which serve as inventory management, which simplify and change based on the needs the business has for its inventory. In reference to processes, employees can be trained to use available resources to achieve maximum effect. When you understand the science of supply chain management, you can make sense of the most complicated of inventory projects. For smaller assignments, the average person can turn a catastrophe to a working system with a foundation of proper planning. Inventory can be as affordable or costly as the business and manager allow it to be.

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Inventory Cost Formula

The inventory cost formula, summing total cost of inventory, is often referred to as inventory carrying rate.
Inventory Carrying Rate = (Inventory Costs / Inventory Value) + Opportunity Cost (as a percentage) + Insurance (as a percentage) + Taxes (as a percentage)

Inventory Cost Calculation

When one has the proper information, inventory cost calculations can be very simple.
Example:
If:
Inventory Costs = $5,000
Inventory Value = $50,000
Opportunity Cost = 10%
Insurance = 4%
Taxes = 7%
Inventory Carrying Rate = ($5,000 / $50,000) + 10% + 4% + 7% = 10% + 10% + 4% + 7% = 31%

Inventory Cost Example

For example, Stan is the warehouse manager for a distribution plant. His work has made him an expert in the science of managing inventory operations. Stan understands his work and enjoys doing it.
However, Stan wants to assemble inventory cost accounting figures. As the essence of the business, Stan makes sure to keep track of this value on a regular basis.
First, Stan calculates inventory costs:

If:
Equipment = $2,500
Labor = $1,500
Protective measures = $300
Handling = $500
Obsolescence = $100
Pilferage = $100

Then:
Inventory Cost = $2,500 + $1,500 + $300 + $500 + $100 + $100 = $5,000

Next, Stan finds the ratio of inventory costs to inventory value:

If:
Cost of Inventory = $5,000
Value of Inventory = $50,000

Then:
Inventory Cost / Inventory Value = $5,000 / $50,000 = 10%

Stan then does research to find the cost of opportunity, insurance, and taxes. These are found as a percentage:

Opportunity Cost = 10%
Insurance = 4%
Taxes = 7%

Finally, Stan adds these percentages together to finally find inventory carry rate:

Inventory Carrying Rate = 10% + 10% + 4% + 7% = 31%

Stan’s inventory carry rate has remained unchanged. Stan is happy about this. Therefore, he keeps constant research in the industry magazines, with professional contacts, and the newest products and services. As long as Stan maintains this research he can keep his warehouse running in peak condition.
If you want to find out more about how you could utilize your unit economics, then click here to download the Know Your Economics Worksheet.