HOW MUCH IS YOUR INVENTORY REALLY COSTING YOU?

When you consider inventory costs, are you including all the costs necessary for accurate, informed decision-making? When you sell an inventory item for $50 that cost $25, you’ve made $25, right? Not exactly. Just looking at how much you pay your vendors is not enough. The true total cost of inventory includes three components: material cost, reordering cost, and carrying cost.

Material cost
Material cost is the landed cost, or purchase price, of inventory. This includes any freight and customs duties.

Reordering cost
Reordering cost is the dollar amount necessary to process a line item on a purchase order. It includes all expenses involved in the entire reordering process, including the time and materials involved in:

• Deciding what products need to be ordered
• Issuing and expediting the purchase order
• Processing the paperwork for receipt of the shipment
• Approving and processing the payment to the vendor

This cost is calculated as the total annual cost of reordering stocked products divided by the total number of purchase order line items for stocked products issued during the last twelve months. For example, you determine it costs approximately $150,000 to reorder product during the year. If that number is divided by the 30,000 purchase order line items of stocked inventory in the last twelve months, this results in a cost of $5 per line item on a purchase order. If five units of that item are purchased during the year, each unit has a reordering cost of $1.

The above example is based on the idea that you spend about the same amount of time reordering a product regardless of the quantity ordered, but that processing a purchase order with a large number of line items will usually take more time than processing a purchase order with only a few line items. It may be tempting to try to reduce reordering costs by purchasing more of a particular inventory item, but carrying costs must be considered as these costs increase with the more inventory held.

Reordering costs vary significantly between distributors, ranging from approximately $4 to $9 for each purchase order line item. Reordering costs can also vary significantly between warehouses. If your company has multiple warehouses these costs need to be calculated separately for each stocking location. Additionally, for companies utilizing some form of electronic purchasing such as EDI, the costs per purchase order line item can be reduced even more.

Carrying cost
The carrying cost is what it costs to maintain the average inventory investment wherever it is stocked. This includes:

• Putting away and moving stock
• Insurance and taxes on the inventory
• Rent and utilities for the portion of facilities used to carry stock
• Cost of physical inventory counts and cycle counting
• Inventory shrinkage and obsolescence
• Opportunity cost of investment in inventory

All of these costs vary with the size of your inventory, thus the greater the inventory, the greater your carrying costs. Even rent and utilities can vary. Think of it this way, if you could eliminate half your inventory, would you still need the same amount of warehouse space? Could you rent a smaller space, or sublet a portion of your current facilities? These costs are also heavily impacted by how long inventory is held. This is because the longer that it is held; the more there is opportunity for shrinkage and obsolescence to occur.

Carrying costs are expressed as a percentage of the average inventory value of stocked inventory because of the direct relationship between the total inventory value and the carrying cost. Carrying costs typically range from 20% to 40%. Distributors with lower operating costs, such as those operating in rural areas and that own their own buildings, generally have carrying costs around 25%, while distributors with higher operating costs often have carrying costs in excess of 35%. For example, a company determines that their carrying cost for a year is $400,000 and their average inventory for that year is $1,000,000, this results in a carrying cost of 40%.

To continue our example we discussed previously, we were selling an item for $50 that had a materials cost of $25, resulting in a profit of $25. When reordering costs were calculated, it was determined that it cost $1 per item. If we take our 40% carrying cost and apply that to the $25 item, this adds an additional $10 to the cost of the item. To illustrate:

The $25 in profit you thought you were making has now been reduced by $11 to only $14 on this item! Obviously, this calculation for carrying costs would be high if the item turns frequently. But, if this item is only turning one time per year, this is a fairly true reflection of the impact carrying costs have on profit.

It is typical for a company to look at inventory levels and analyze turns. More importantly, though, a company needs to understand how these turns are impacting the reorder process and carrying costs. A slow turner will reduce reorder costs (assuming you are not stocking up on a slow moving item!) but it will unduly impact carrying costs. As you can see, calculating your reordering and carrying costs can provide more accurate inventory information and will help you make better inventory-related decisions.

Jennifer Raybon, CPA
Inventory Group Leader