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Inventory Costs: Types, Formulas & How To Reduce

inventory costs
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Inventory costs are a big deal for any business, small or big, and getting a grip on them can really help you keep your cash flow healthy, set the right prices, and boost your profits. It’s not just for the top dogs; if you’re running a small shop, managing a warehouse, or crunching numbers as a financial analyst, understanding these costs can give you a leg up.

We’ll break down inventory costs into easy-to-understand pieces, show you how to figure them out with some simple maths and share some smart tips to keep them as low as possible. This is all about making smarter decisions that push your business forward.

Types of Inventory Costs 

Inventory costs cover everything you spend on getting, keeping, and handling your products, and they can really affect your profit. This includes the obvious costs, like buying goods and the less obvious ones, like what you spend to store and look after it. Being good at managing your inventory can save you a lot of money and make your operations smoother.

Purchase Costs

Purchase costs are a big part of keeping track of inventory expenses. They’re about how much you pay to get your stock, and this can change a lot depending on how much you buy, the deals you have with suppliers, and how much you pay for shipping. These costs directly affect how much profit you can make.

Inventory Holding Costs 

Also known as inventory carrying costs, these include things like warehouse rent, bills for utilities, security, and the risk of perishable items going bad or out of date. It also includes the money you could have used for something else but instead have tied up in stock sitting on shelves.

Ordering Costs

Ordering costs pop up each time you restock. They cover everything from the nitty-gritty of handling orders—like paperwork and calls—to shipping and receiving the goods. For businesses making their own products, this also includes the costs to get production going each time you need more inventory.

Shortage Costs

Shortage or stockout costs happen when you don’t have enough stock to meet demand. This means you miss out on sales, spend more handling backorders, and even lose customers who decide not to come back. It’s a tricky balance because having too much inventory can cost you, but not enough can lead to missed opportunities and unhappy customers.

Other Inventory Costs 

Other inventory fees consider all other expenses associated with managing inventory that aren’t purchasing, holding and ordering inventory.

Interest Costs

When businesses buy inventory with borrowed money, they face interest costs. These are the fees you pay on the loan, and they change with the interest rates and how the loan is set up. Keeping an eye on these costs is necessary for businesses that want to smartly manage how they finance their inventory and keep overall expenses in check.

Spoilage Costs

For businesses with items that can go bad or get outdated quickly, like food and beverage, pet food, or fashion, spoilage costs are what you lose when inventory can’t be sold because it’s expired or damaged. This includes the direct hit of losing the value of the products and all the effort and resources spent storing and managing them. Managing these costs well is super important in industries where products don’t last long on the shelf.

How to Calculate Inventory Costs 

To manage and optimise your inventory management system, you must understand how to accurately calculate your inventory costs for any given time.

Total Inventory Costs = Purchase Costs + Ordering Costs + Holding Costs + Shortage Costs

Inventory Cost Calculator

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Inventory Cost:

Example of Calculating Total Inventory Costs

Imagine a retail business that sells watches. Here’s a breakdown of their inventory costs for a specific period:

Purchase Costs 

Formula: Purchase Costs = (Quantity Purchased x Cost per Unit)

  • The business purchased 1,000 units of a watch at £50 per unit.
  • Purchase Costs = 1,000 units x £50/unit = £50,000

Ordering Costs

Formula: Ordering Costs = (Number of Orders x Cost per Order)

  • The business places an order with the supplier 10 times a year.
  • Each order incurs costs of £100 for processing and handling.
  • Ordering Costs = 10 orders x £100/order = £1,000

Holding Costs

Formula: Holding Costs = (Average Inventory x Holding Cost Rate)

  • The cost rate of storing inventory is 2% of the inventory value per year.
  • Average inventory value (for simplicity, assume purchase cost represents inventory value) = £50,000
  • Holding Costs = £50,000 x 2% = £1,000

Shortage Costs

Formula: Shortage Costs = (Number of Stockouts x Cost per Stockout)

  • Due to stockouts, the business lost sales on 20 units, with a profit margin of £30 per unit.
  • Additionally, expedited shipping for restocking cost them £200.
  • Shortage Costs = (20 units x £30/unit) + £200 = £800

Now, let’s sum up these costs to get the total inventory costs for the period:

Total Inventory Costs= £50,000 (Purchase) + £1,000 (Ordering) + £1,000 (Holding) + £800 (Shortage)

Total Inventory Costs=£52,800

Interest Costs 

Formula: Interest Costs = (Average Inventory Value x Interest Rate)

  • The business’s average inventory value is £50,000.
  • The interest rate is 5% per year.
  • Interest Costs = £50,000 x 0.05 = £2,500 per year.

Spoilage Costs 

Formula: Spoilage Costs = (Number of Spoiled Units x Cost per Unit)

  • A business finds 100 units unsellable due to spoilage
  • Each unit costs £10
  • Spoilage Costs = 100 units x £10 = £1,000 loss from unsellable units.

How to Reduce Fulfilment Costs

Keeping a good balance among the different inventory costs is key to staying profitable and efficient. You might accidentally bump up another when you try to cut down on one cost. For example, keeping less stock to save on storage costs could lead to running out of products. However, buying in bulk to save money can increase your storage costs. Smart inventory management means looking at the big picture, understanding how reducing fulfilment costs affects each other, and making choices that keep everything in harmony.

Reducing Shortage and Inventory Holding Costs

Implement Just-In-Time (JIT) Inventory

JIT inventory management means you order and get goods just when you need them for making products, which cuts down on storage costs and reduces waste. To pull this off, you need to be precise at predicting what you’ll need and have a solid relationship with your suppliers.

Improve Demand Forecasting

Using smart analytics and prediction tools helps cut down on running out of stock or having too much of it. Getting your forecasts right means you can order just enough to meet demand without filling up your storage with extra stock.

Adopt an Economic Order Quantity (EOQ) Model

The EOQ model helps businesses figure out the best amount to order, keeping storage and ordering costs as low as possible. By using this model, businesses can avoid spending more than they need to by ordering just the right amount.

Increase Inventory Turnover

Boosting how fast you sell inventory, maybe by lowering prices on items that aren’t moving fast or upping your marketing game, can cut down on storage costs and free up money to put back into the business. A quicker inventory turnover shows you’re managing your stock well and matching up better with what customers want.

Reducing Ordering and Purchasing Costs 

Consolidate Suppliers and Orders

Using fewer suppliers and making bigger orders less often can make managing your inventory easier. But, it’s important to keep an eye on this approach, as it might lead to higher storage costs.

Implement Vendor-Managed Inventory (VMI)

In a VMI setup, the supplier takes care of keeping the right amount of their products at the customer’s location. This means inventory can be more on point, storage costs can be kept in check, and relationships with suppliers can get stronger.

Partner with a 3PL

Working with a third-party logistics (3PL) provider like us at Delta Fulfilment can really help businesses cut down on costs. 

Our cost-effective and scalable warehousing solutions eliminate the need for fixed expenses associated with owning or leasing space. By optimising shipping routes and consolidating shipments, we also lower transportation costs, leveraging our expertise and industry connections. Our clients gain access to advanced technology for inventory and warehouse management, saving them from making hefty investments in these tools on their own.

Simplify your Inventory Management with Delta Fulfilment 

Getting your inventory management right is a big deal and can really set you apart in today’s competitive market. Partnering with Delta Fulfilment means you can simplify your inventory costs. We bring our logistics and supply chain management know-how to help streamline your operations, cut down on extra costs, and let you focus on growing your business. Let us turn your inventory challenges into chances for success. Contact us to see how we can customise our services to fit your needs and help push your business ahead.

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