5 Types Of Inventory Costs [Explained with Examples]

Inventory cost includes the costs to order and hold inventory, as well as to administer the related paperwork. This cost is examined by management as part of its evaluation of how much inventory to keep on hand.

Inventory Management is one of the most crucial aspects of a small business. Just like cash flow, it can make or break your business.

Business owners have always been looking for ways to optimize inventory levels without hurting their profits.

It is essential to evaluate your business on a regular basis to ensure that you are on track to succeed. That is why, in this article, we will be focusing on inventory costs and how to manage it.

How has your small business's inventory management turned out so far?

Have you had the right products available when you needed them?

Did you lose out on business when items were out of stock?

Did you lose money due to excess inventory stock?

Before we go into the above, let us understand the different kinds of inventory management and inventory costs.

5 Types of Inventory Costs

Ordering, holding, carrying, shortage and spoilage costs make up some of the main categories of inventory-related costs. These groupings broadly separate the many different inventory costs that exist, and below we will identify and describe some examples of the different types of cost in each category.

The other requires a certain amount of calculation to understand the impact it has on your Gross Profit. Let's look at types of costs :

1. Ordering Costs

Ordering costs include payroll taxes, benefits and the wages of the procurement department, labor costs etc. These costs are typically included in an overhead cost pool and allocated to the number of units produced in each period.

• Transportation costs
• Cost of finding suppliers and expediting orders
• Receiving costs
• Clerical costs of preparing purchase orders
• Cost of electronic data interchange

2. Inventory Holding Costs

This is simply the amount of rent a business pays for the storage area where they hold the inventory. This can be either the direct rent the company pays for all the warehouses put together or a percentage of the total rent of the office area utilized for storing inventory.

• Inventory services costs
• Inventory risk costs
• Opportunity cost - money invested in inventory
• Storage space costs
• Inventory financing costs

3. Shortage Costs

Shortage costs, also known as stock-out costs, occurs when businesses become out of stock for various reasons. Some of the reasons might be as below :

• Emergency shipments costs
• Disrupted production costs
• Customer loyalty and reputation

4. Spoilage Costs

Perishable inventory stock can rot or spoil if not sold in time, so controlling inventory to prevent spoilage is essential. Products that expire are a concern for many industries. Industries such as the food and beverage, pharmaceutical, healthcare and cosmetic industries, are affected by the expiration and use-by dates of their products.

5. Inventory Carrying Costs

This is the lesser-known aspect of inventory cost. This cost requires a certain amount of calculation to understand the extent of its impact on your P&L statement. Inventory carrying costs refers to the amount of interest a business loses out on the unsold stock value lying in the warehouses.

Business owners often miss out on understanding the impact of the above factors while calculating the impact inventory has on their business. The inventory holding costs does show up as part of rental expense in the Profit & Loss statement.

While the inventory carrying cost is seldom considered while calculating the gross profit, we usually take into account only the principle cost of the goods held in the warehouses.

Bonus: Download a free guide that will show you how to save your inventory costs

Example of Inventory Carrying Cost

To understand the inventory carrying costs better, let's take an example of an importer of goods. When he imports goods into his country, they are first received at a dock.

Multiple customs department clearances are required before they can be transported to the company warehouse. Now let's say, due to some deficiency in the documentation, the goods get held up in the customs clearance department.

As everyone is aware, until the goods get cleared, there are charges that the customs department levies to hold these goods, and these charges rise exponentially. The costs further depend on the value of goods being held and the volume/area they use up to store them at the dock.

We can compare this by considering these additional charges that a business owner has to bear on the goods similar to the interest charges the business owner bears, which is a normal scenario that is invisible.

The dock is the warehouse, while the customs department's charges can be compared to the interest income the business loses out on the principle value of the goods.

While these custom department penalties are still visible, the only difference is the interest a business loses out on the stock is never taken into account.

How do I track Inventory Costs ?

A crucial question that arises is - What should a small business owner do to keep both the types of costs in check?

The answer is pretty simple - Use an efficient inventory management system, which gives you real-time reports for all your stock items.

Let's understand some aspects of an efficient accounting system that can help you keep these costs under control. An example of a good accounting and inventory management system is Deskera.

Checks & Balances on Inventory Masters

It is essential to understand that you need to follow multiple steps to ensure that these costs are kept in check as a small business owner. A single report cannot highlight all these costs. The way inventory is managed on a day-to-day basis should have, checks & balances elements to make sure the costs are always optimized.

As an example, an organization that does not maintain re-order levels and minimum order quantity levels for its stock items will always end up ordering stocks at the wrong time and with the incorrect quantity.

This will thus result in higher inventory carrying costs. If a business keeps stocks for a more extended amount of time, the higher is the interest lost out on them.

Stock Ageing Report

Another essential element is stock ageing reports, which gives a good insight into which inventory has been lying with for the longest time.Regular analysis of this report can provide us with a good understanding of which inventory to keep in our warehouses and the quantum of these stocks.

What are Fast Moving & Slow-Moving Inventory Items

Another essential tool that a sound inventory management system offers, is analyzing the fast-moving and slow-moving products.Furthermore, when we attach the stock valuation of these slow-moving products, we understand its impact on the financial statements.

The right actionable item would be to keep a check on the slow-moving items and order them only when required rather than hold them in the warehouses. Along with this comes another critical concept of "Lead Time".

The lead time is the amount of time taken for a particular stock item to reach the warehouses from the date of ordering. This crucial piece of information can help you plan your high value - slow moving products very efficiently.

Longer lead times often result in inefficiencies and wastage of resources, and companies should review their processing times against benchmarks to identify ways of improving their lead times. Reducing the lead time improves overall productivity, resulting in higher revenues and profits.

Are you tracking the Lead Time on our Products?

Let's consider an example – a business sells 4 units of Product X on any single day. Product X takes 10 days to reach the warehouses after ordering. In order to fulfill orders, there must be the stock that lasts until at least 10 days in the inventory at all times.

That means there must be at least 30 units of Product X, which will last 10 days, after which the stock gets replenished. A good strategy would be to keep at least 33 units of Product X.

Understanding Stock Categorization

It is necessary to categorize all the stock items into the below four brackets

1. High Value - Fast Moving
2. High Value - Slow Moving
3. Low Value - Fast Moving
4. Low Value - Slow Moving

Let us analyze the treatment to be given to each of the 4 categories mentioned.

1. High Value - Fast Moving

You must analyze the sales trends for these items and understand the average quantity sold per day.

Based on this parameter, we should have stock in the warehouse equivalent to its lead time.

For example, if the lead time for a High-Value product is 7 days, and per day sales are 100 quantities of this product, then there must be 700 qty of this item in the warehouse at all times.

This will ensure the inventory never runs out of this stock item.

2. High Value - Slow Moving

Since the value of such items is high while they do not sell much, the inventory team can consider ordering them only when required by the customer.

It is also necessary to also analyze the ordering pattern for this kind of product by the customers.

E.g., if a particularly high-value product is usually ordered in April by a set of customers. In that case, we should keep stock of such a product only for April to fulfill its demand.

Another good strategy that can be followed for such stock items is the drop ship methodology. Drop ship methodology implies that instead of storing stocks within the warehouses, you directly ask your vendor to dispatch it at the customer's location.

This ensures you never have to bear the inventory holding or carrying charges for such stock items.

3. Low Value - Fast Moving

Since these stocks' value is low, keeping them in stock will not hurt the costs much. But a good strategy would be to estimate their lead time, per day sales, and keep at least as much stock as is required till the lead time.

This approach is similar to the one followed for Step 1. However, we can afford to have a little extra quantity that can act as a cushion for the sales team to up-sell or cross-sell.

4. Low Value - Slow Moving

This is the category that hurts the business the least, but depending on the nature of your business, this may be the most crucial category, as they can consist of spare parts required by machinery or items which are probably not available with any trader.

Many small business owners often ignore this category and do not stock these items. A good strategy would be to estimate the yearly requirement of these stocks after analyzing the sales pattern for the last 4-5 years. Based on the analysis, maintain an average monthly stock level for these stock items.

These are essential as it may help set a differentiating image of your business in competition to other businesses.

Business owners may classify their stocks into the above categories and understand their approach for their inventory. However, businesses must consider another aspect in addition to the above pointers, which is the volume of stock item.

If the volume of any stock item lying in any of the above four categories is high, it would directly impact the inventory holding charges.

They would require a bigger warehouse to store them. If such items fall in the first or the third category, you will need to follow multiple strategies to keep your inventory costs in check.

A good approach for high volume items would be one of the below.

1. Drop Shipping : Try and follow the drop shipping methodology where possible. This will ensure you need not make arrangements within your warehouse. The entire lot that you need to sell can be managed within the warehouse of your suppliers.
2. Semi Knocked Down : if the stock items can be assembled quickly at the client's place, the right approach would be to store them in a semi knocked down form. Such high volume stock items, when stored in semi knocked downstage, require lesser storage.

Key Takeaways

1. Types of costs associated with Inventory – Ordering, Costs, Inventory Holding Costs, Shortage costs, Spoilage costs, and Inventory Carrying Costs
2. Inventory holding costs is the rent paid to hold stocks in the warehouses. Inventory holding costs directly impact the Profit & Loss statement, whereas Inventory Carrying Costs are seldom taken into account.
3. Inventory carrying costs is the amount of interest a business loses out on principle value of the stocks being held in the warehouses.
4. Using an efficient Cloud-Based Accounting system like Deskera, to keep the costs in check.
5. The Lead Time is the amount of time taken for a particular Stock Item to reach the warehouses from the date of ordering