Inventory costs are one of the largest expenses incurred by retailers. However, if you are only considering the cost of your inventory, you are getting an incomplete picture of how much you are spending to store it. To understand inventory costs, you need to account for all expenses related to ordering, storing, and managing inventory.
What are Inventory Costs?
Inventory costs are the costs associated with ordering and storing inventory. It’s important to assess these costs to determine how much inventory you should keep on hand.
Inventory is the largest expense for retailers. For every dollar that retailers earn in the United States, they have $1.40 of inventory on hand. When you have a comprehensive understanding of your inventory costs, you can control them more easily.
“Knowing your inventory costs is incredibly important because it affects most decisions that a retailer makes,” says Abeer Syed, co-founder of the online accounting firm UpCounting. “It impacts pricing decisions because it affects your margin. It affects purchasing decisions because it influences the cash amount you need to purchase a certain volume of inventory.”
Types of Inventory Costs
Inventory costs consist of more than just the purchase price of the product. You also have to consider ordering costs, holding costs, and stockout costs.
How to Calculate Inventory Costs
The formula to calculate inventory costs for any given period is: Inventory Costs = Purchase Costs + Ordering Costs + Holding Costs + Stockout Costs
Calculating inventory costs is straightforward once you gather all this data. Not sure where to find these numbers? Check your point-of-sale system reports, inventory management software, and payroll provider.
How to Reduce Inventory Costs
Utilize data for accurate forecasting
Find the right balance between purchasing costs and ordering costs, as well as holding costs
Optimize holding costs
Take advantage of automatic replenishment
Increase inventory turnover
Eliminate unsold inventory
10 Inventory Cost Mistakes to Avoid
1. Miscalculating carrying costs: Carrying costs are often inaccurately estimated by retailers. When calculated incorrectly, the overall inventory cost can be significantly distorted, leading to poor decision-making. Accurately calculate carrying costs, taking into account all related factors and regularly updating these figures as costs may change.
2. Ignoring unsold inventory costs: Unsold inventory can quietly drain your finances. Paying holding and managing costs for these items, only to generate no income, leads to increased inventory costs. Regularly review inventory and identify products that are not moving to help avoid this mistake.
3. Neglecting supplier cost changes: In retail, it is common for supplier costs to fluctuate. Neglecting to account for these variations can lead to inaccurate inventory cost calculations. Regular communication with suppliers and tracking price changes are critical steps for accurate inventory management.
4. Ignoring defective goods costs: Goods can be damaged during handling, storage, or transportation, and failing to account for these losses can lead to significant cost errors. Ensure you have a proper system in place to track and record defective goods, ensuring that the cost of these losses is factored into the total inventory cost.
5. Inaccurate physical counts: Sometimes the importance of an accurate physical count is underestimated. Any discrepancies between actual and recorded inventory can lead to inaccurate inventory cost calculations. Regular physical counts and reconciliation with recorded inventory can help avoid this mistake.
6. Failing to account for stockout costs: There are also expenses incurred when you do not have enough inventory on hand. Any costs related to managing stockouts, such as payroll for customer service teams or expenses related to reorder, are considered stockout costs.
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Overstocking: While having sufficient inventory is necessary, overstocking can lead to increased costs through additional storage costs, handling, and potential damage or spoilage. Inventory forecasts and supply strategies can help prevent overstocking.
8. Ignoring Seasonal Fluctuations: Seasonal fluctuations can significantly impact inventory costs, and not accounting for them can lead to errors. Adjust inventory forecasts and stock levels according to seasonal demand patterns to ensure accurate cost calculations.
9. Ignoring Shrinkage Costs: Shrinkage, or the loss of products due to theft, fraud, or error, can significantly impact inventory costs. Retailers often overlook this aspect, leading to significant cost errors. It is essential to implement strategies to reduce shrinkage and account for these costs in inventory cost calculations.
10. Ineffective Inventory Management Systems: An outdated or ineffective inventory management system can lead to numerous mistakes and increased costs. Inaccurate data, lost sales opportunities, and poor forecasts are all potential outcomes of a bad system. Invest in modern, comprehensive inventory management systems to ensure efficient inventory handling at a reasonable cost.
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