What are the types of inventory costs?

Inventory costing can be a tricky task for any business owner. But assessing inventory costs can help businesses determine how much profit can be made on inventory, how costs can be reduced, and where to allocate capital.

In this guide to inventory costs, we explain the common types of inventory cost and how they’re kept in check with inventory management software.

What are inventory costs?

Inventory costs are the costs related to storing and maintaining a business' inventory over a certain period of time. Typically, inventory costs are described as a percentage of the inventory value on an annualised basis.

It is commonly accepted that the carrying costs alone represent 25% of inventory value on hand.

What are the types of inventory costs?

To determine how much your inventory is costing the business, it's important to break each product down into its individual costs. To help with this, we've identified the main categories of costs associated with stock.

The 5 types of inventory costs include:

• Ordering costs
• Carrying costs
• Shortage costs
• Spoilage costs
• Service costs

Let's explore each of these in more detail.

Knowing which inventory costs can be reduced will help you improve cash flow and efficiency in your business

Inventory ordering costs

Ordering costs, also known as setup costs, are essentially costs incurred every time you place an order from your supplier. Examples include:

• Clerical costs of preparing purchase orders — there are many kinds of clerical costs, such as invoice processing, accounting, and communication costs
• Cost of finding suppliers and expediting orders — costs spent on these will likely be inconsistent, but they are important expenses for the business
• Transportation costs — the costs of moving the goods to the warehouse or store. These costs are highly variable across different industries and items
• Receiving costs — these include costs of unloading goods at the warehouse and inspecting them to make sure they are the correct items and free of defects
• Cost of electronic data interchange (EDI) — These are systems used by large businesses and especially retailers, which allow ordering process costs to be significantly reduced.

There will be an ordering cost of some amount, no matter how small your order might be. The more orders placed, the greater the ordering costs. This ordering cost can be spread out if you placed a bulk order to use goods over a long period of time.

However, if your business orders raw materials only as needed so that it keeps little stock on hand, you might be able to tolerate high ordering costs as this is balanced by an overall lower holding cost

The Unleashed Inventory Management Guide

Inventory carrying costs

Also known as holding costs, inventory carrying costs are costs involved with storing inventory before it is sold.

• Inventory financing costs — this includes everything related to the investment made in inventory, including costs like interest on working capital. Financing costs can be complex depending on the business
• Opportunity cost of the money invested in inventory — this is found by factoring in the lost alternatives of tying money up in inventory, such as investing in term deposits or mutual funds
• Storage space costs — these are costs related to the place where the inventory is stored and will vary by location. There will be the cost of the storage facility itself, or lease payments if it is not owned. Then there are facility maintenance costs like lighting, heating, and ventilation. Depreciation and property taxes are also included in this
• Inventory services costs — this includes the cost of the physical handling of the goods, as well as insurance, security, and IT hardware, and applications if these are used. Expenses related to inventory control and cycle counting are further examples
• Inventory risk costs — a major cost is shrinkage, which is the loss of products between purchasing from the supplier and final sale due to any number of reasons: theft, vendor fraud, shipping errors, damage in transit or storage. The other main example is dead stock

Inventory shortage costs

These costs, also called stock-out costs, occur when businesses become out of stock for whatever reason.

• Disrupted production — when the business involves producing goods as well as selling them, a shortage will mean the business will have to pay for things like idle workers and factory overhead, even when nothing is being produced
• Emergency shipments — for retailers, stock-outs could mean paying extra to get a shipment on time, or changing suppliers
• Customer loyalty and reputation — aside from the loss of business from customers who go elsewhere to make purchases, the company takes a hit to customer loyalty and reputation when their customers are unhappy

Inventory spoilage costs

Perishable inventory stock can rot or spoil if not sold in time, so controlling inventory to prevent spoilage is essential.

Inventory spoilage and waste is not simply a result of isolated cases of poor inventory control, spoilage is now a global environmental concern. When you consider that in the United States alone, an estimated $200 billion is spent growing, processing, transporting and disposing of food that is never eaten.

Solid inventory control is your front line to preventing spoilage and waste. With the right inventory system, you can improve forecasting, boost efficiency, access real-time inventory data and up-to-date information on the lifecycle of your stock, enabling staff to rotate and manage stock to ensure older products get sold first.

Service costs

Inventory service costs include insurance, physical handling and taxes. The cost of servicing your inventory means protecting it from issues such as theft or workplace accidents, or keeping it on the right side of the law.

Depending on the type of coverage, insurance will cover your inventory in the event of natural disasters, theft or accidents. Taxes must be paid on the levels of inventory kept on hand also, and the higher the inventory, the higher the taxes.

Finally, if you have large amounts of inventory that need to be tracked, inventory management systems or applications may be needed to ensure no inventory goes missing.

Inventory costing strategies

There are a variety of costing methods to measure the value of your inventory. If you’re a business owner, you might look at different tactics to see what work best for you. This may include the last-in-first-out method, the first-in-first-out method or the weighted average method.

First in, first out

Under FIFO, the first units purchased are assumed to be sold first and the ending inventory is made up of the most recent purchases. Inventory is sold in the chronological order of acquisition with beginning inventory sold first, followed by purchases within the period.

In a periodic accounting system, inventory levels are checked at fixed intervals on a weekly, monthly or yearly basis. The first products purchased are assumed to be the first products sold.

Using this method, the oldest inventory costs are assigned as the cost of goods sold with the cost of recent inventory acquisitions remaining as ending inventory.

Last in, first out

Using LIFO, the most recent purchases are assumed to be sold first and the ending inventory is made up of the first units purchased.

The actual flow of inventory does not have to match the cost flow method used. For example, companies dealing in perishable goods may move inventory on a first in, first out basis to clear older stock even when using the LIFO cost flow method for accounting purposes.

Reducing inventory costs requires extrapolation so that each individual cost may be analysed and improved.

Weighted average

The weighted average method divides the cost of goods available for sale by the quantity of goods available for sale, resulting in the weighted-average cost per unit.

In this calculation, the cost of goods available for sale is the total beginning inventory plus additional purchases within the period. The weighted average uses the average unit cost to determine ending inventory and the cost of merchandise sold.

When the average cost is used in a perpetual system, an average unit cost for each item is computed each time a purchase is made. The unit cost is then used to determine the cost of each sale until another purchase is made and a new average is computed.

Real-world application of the weighted average method

Let’s break this down with an example. Perhaps your company sells hammocks. Your beginning inventory is 500 hammocks, with a value of $5.00/unit, totalling $2,500. You make several purchases to top up your inventory stock throughout the month. Have a look at the following purchases below:

• 750 hammocks at $7.00 per unit = $5,250
• 400 hammocks at $4.00 per unit = $1,600
• 300 hammocks at $6.00 per unit = $1,800

Then, you add up all of the hammocks (500 + 750 + 400 + 300) = 1950 hammocks. Next tally up your costs, ($2,500 + $5,250 + $1,600 + $1,800) = $11,150. To determine the cost per hammock for all hammocks available to be sold take $11,150/1950 = $5.72/hammock.

Zero inventory stock

Zero inventory management threatens the traditional supply chain and is behind the success of some of the worlds biggest businesses. Toyota and Dell, for example, have for decades both popularised and benefited from forms of zero inventory management at the vastest scales.

While it isn't a new idea, it's only now being widely realised and used by companies big and small around the world, largely thanks to advances in digital stock management technology.

Benefits of holding zero inventory

1. Zero inventory stock saves money

Zero inventory management will reduce, if not eliminate, the traditional costs of holding stock, driving down total manufacturing costs and thereby maximising profits.

2. Zero inventory stock speeds sales

With a zero inventory management strategy, businesses can reduce the time taken to fulfil orders and meet delivery deadlines, improving customer service and increasing stock turnover - both key indicators of a healthy, highly-performing business.

3. Zero inventory stock frees capital

With less capital tied up in maintaining inventory, a manufacturing business has the freedom to invest in and/or pursue other profitable business projects.

Why is accurate inventory costing so important?

Inventory costing impacts on almost every facet of the business. 

Perhaps the most obvious impact is on product pricing. While a number of factors, including supply and consumer demand in the market, will determine the price your business charges for its products, one of the most important factors is inventory cost.

Inventory costing also has significant tax implications. If you are failing to capture all of your inventory costs, you are likely paying more in tax each year than you are required to. In the unlikely event that you are materially overestimating inventory costs, then you may be paying too little tax.

Effective inventory management begins with understanding and reducing all the costs associated with your products and materials.

How poor inventory control can negatively affect inventory costs

Now that we have a handle on the importance of good Inventory Control in keeping the (many and varied) costs of holding stock under control, let’s look at some of the major pitfalls that businesses fall into.

Using Excel for Inventory Management

Excel can be a really handy tool for inventory control and management when you’re just starting out. Whether you’re operating out of a garage or a small retail shopfront, Excel is great for small businesses with small staff, small inventories and a small customer bases.

But if your business starts growing (and that’s really the goal, right?) then it should quickly become obvious that Excel isn’t made to scale and grow with you. What kind of problems might Excel create for your inventory control as your business grows?

Data entry errors

The larger your inventory grows, the more likely you are to experience data entry errors.

It’s tough enough to keep track of small volumes of inventory, but with larger volumes of product flowing in and out of your business premises it becomes more difficult to keep track of the correct numbers of what’s come in, what’s gone out and what’s still to arrive – and it also becomes more difficult to find the time to double-check those numbers and catch any errors.

Shortages and overages

When you’ve got incorrect figures recorded in your inventory software it’s difficult to accurately forecast how much stock you need to order and how often you need to order it.

You might end up ordering too much of a certain product and be forced to sell it at a discount to reduce your inventory, reducing your profits in the process. You might also order too little of a certain product, resulting in shortages and forcing your customers to look elsewhere for the product.

12 ways to reduce inventory costs with better stock control

For most stock-based businesses, inventory is likely to be the business’ biggest asset. Even if a business has some other, high value, assets such as factory plant, inventory is likely to be essential to the business’ ability to trade profitably.

Because inventory is so critical to a business’ success, it is useful for business owners and managers to understand the cost of each item stocked in the store or the warehouse.

1. Employ Intelligent Demand Forecasts

How dependable is your data? Keep good records. Have systems that utilise reliable historical data and sales information, to produce more accurate forecasts. Incorporate and integrate plans from cross-functional teams for best results.

• Discover: Inventory forecasting & demand planning software from Unleashed

The following steps should be taken to help facilitate best practice demand forecasting.

Best practices for demand forecasting:

• Create repeatable monthly processes. Improved demand forecasting accuracy requires a consistent, timely process that systematically analyses previous forecasts to compare with actual market results. The data will identify when your predictions were right or not, and what the market demand was. By following a monthly process and evaluating results, you can minimise future errors
• Decide what to measure and how often you will measure it. To accurately forecast demand, you should focus on the most relevant data. Points to consider include POS data, frequency of stockouts, any amounts of obsolete stock, shipping and dispatch and even competitor sales information
• Integrate data from all sales channel and combine the data from each individual product for all channels. Once this is done for all SKUs, you can see what channels offer the highest ROI for each product. This, in turn, will guide smarter decisions for inventory control
• Measure forecast accuracy at the SKU, location and customer planning levels. A key driver of demand volatility is augmented consumer requirements

Data is crucial, it is impossible to forecast demand if you don’t have accurate data. Best practice demand forecasting revolves around precise, up-to-date sales data, and utilising the first-hand knowledge of sales staff.

An effective way to manage inventory costs is by splitting each item into a line-by-line analysis.

2. Know what you have and where it is kept

How many widgets do you have in stock, in what varieties/size and where can you find them?

A well-managed warehouse or storage system should make it easy for staff to know quantities on hand, to quickly locate items and accurately record stock movements.

One way of doing this is deploying mobile technology in the warehouse. This makes it possible for warehouse staff to continuously update inventory and logistics information as product is received and dispatched - while equipping sales staff in the field with a mobile device and internet access means they can log orders faster, preventing stock-outs and reducing lead times.

Unleashed Software has a mobile sales app that your business’ sales team can use to view inventory and make sales on the go.

3. Use your space efficiently

Is it easy to access high turnover or perishable goods? Improve the layout of your store to optimise the inward/outward flow of inventory.

Have a fixed-location storage system with clearly marked positions for stock keeping units.

4. Rethink order cycles and quantities

Can you reduce the size and frequency of stock orders? Smaller, more regular deliveries will free up space and minimise the risks of potential waste.

Reducing the dimensions of an order has the potential to provide savings in the cost of transportation.

5. Keep good records

Are your widgets on the shelf or on the loading bay? Ensure that records can be trusted to correctly reflect physical inventory.

Product barcodes, information, stock counts and movement should be timely and accurate.

6. Set par levels

Setting par levels or the minimum on-hand quantities of inventory stock for your business helps you to reduce the risk of overstocking while helping to avoid stock outs.

By setting par levels you know it’s time to order more inventory stock when it dips below those pre-set levels. Minimum stock levels will vary by product and should be based on how quickly the product sells and how long it takes to get it back in stock.

Conditions can change over time, so monitor par levels a few times throughout the business year to ensure they still make sense and to adjust up or down accordingly.

7. Match the inventory control system to the type of product

Inventory control policies should be prioritised around the nature of the inventory moving through the supply chain.

Products with a short shelf life, such as perishables, need to turnover at a much higher rate than manufactured goods or textiles. In such cases, a First-In First-Out (FIFO) policy is adopted to ensure that goods move down the supply chain in accordance with their expiry date.

Of course, without the ability to track, trace and account for inventory in real-time by using an online inventory control system, errors in order quantities due to inaccurate data-driven purchases will not be able to be rectified by a FIFO system alone.

Manufactured goods or goods that consist of sub-assemblies and multiple components require more complex inventory management systems. Here it is vital to label, itemise and store goods accurately and efficiently.

An inventory management software solution is often the only way businesses dealing with more complex inventory management challenges can cope.

This way every component used in the production of a product can accurately be traced, tracked and accounted for in real-time.

8. Monitor lead times

Lead-time is the amount of time it takes for a product to move from order placement to manufacturing to final delivery to your warehouse or facility.

Different suppliers have different lead-times, and it pays to research and check with various suppliers what their lead-times are before settling with the right one for your business.

Generally, the shorter the lead-time the better it is for your business, however, sometimes it pays to endure a slightly longer lead-time from a supplier if the quality is notably improved. Knowing the lead-times of your suppliers makes the job of your purchasing managers that much easier.

This helps to ensure that goods are re-ordered in time to meet fluctuations in customer demand. A good inventory management software system can be programmed to alert managers to low or high inventory levels and prompt timely re-ordering based off supplier lead-times.

Sourcing cheaper materials and bulk wholesale discounts can result in lower inventory costs and better warehousing efficiency.

9. Deploy cloud-based technology

Many small businesses are hesitant to invest in a sophisticated software package to effectively manage their inventory control demands.

What they fail to account for however is their business’s capacity to scale as it grows. Whereas top of the line inventory management software used to require a sizeable capital investment up front, today’s cloud-based inventory management software service providers are affordable for businesses of all shapes and sizes.

This is because the paradigm has shifted to offering on-site inventory software that requires a large capital investment, to actually looking at inventory software as a service to be provided.

It is now possible for small business owners to instantly integrate their business operations with a sophisticated, constantly evolving inventory management software solution, which is able to manage their inventory with pinpoint accuracy and full functionality.

10. Train your employees

Inventory control doesn’t come without a good team to support the system. A team of employees need proper training in order for it to operate effectively.

Training is imperative for employees to understand the implications and importance of inventory control. It also allows employees to develop alongside the business and implement best practices.

Training can also heighten employee morale. These programmes can support job security, which often leads to job satisfaction. If employees are engaged and are given a purpose through this training, then they are more likely to be satisfied in their role. 

Happy employees stay motivated and their interest in success does not stagnant as easily. Since training gives them purpose, they are more likely to come to work and less likely to quit.

11. Manage relationships

A component of successful inventory control is the ability to adapt quickly. Whether this is the need to return slow-selling stock, quickly restock fast-selling items or troubleshoot manufacturing issues, a strong relationship with your suppliers is crucial to guarantee they are willing to work with you to resolve issues.

You can build a win-win relationship with your supplier. Effective relationships require clear, proactive two-way communication.

Let suppliers know when you are expecting an increase in sales to allow them time to adjust production. Have them notify you know if a product is running behind schedule so you can halt promotions or consider a temporary substitute.

12. Strive for continuous improvement

Regularly look at every area of the business to find where you can implement and action continuous improvement: are your sales, production, inventory control and customer service activities fully optimised and running as effectively as they can be?

When looking to eliminate potential bottlenecks, a vital area to investigate is your capacity to deal with any new business. You need reliable technology to run your day-to-day business operations and the technology to provide the product the business is offering.

If you land any new business, do you have the resources available to keep up with the work?

Plan for every possibility to help anticipate and eliminate potential threats to organisational growth. This involves having the right tools in place to support business functions, documented processes and the well-trained, qualified staff to undertake the necessary activities.