Inventory carrying cost, also known as holding cost or carrying cost, refers to the total amount of expenses a small business must pay to hold and store unsold merchandise. This includes direct costs such as warehouse leasing, employee wages, insurance, utilities, and taxes, as well as indirect costs like depreciation and shrinkage.
How to Calculate Inventory Carrying Cost
As a general rule of thumb, carrying costs typically represent 20%–30% of inventory value. To get an estimate for your business, you can use the following formula:
Estimated inventory carrying costs = annual inventory value / 4
But the exact metric is highly dependent on your business’s data. So if you want to know your personal inventory carrying costs, you’ll want to do some more exact math, multiplying by 100 to get your percentage value:
Inventory carrying costs = (storage expenses / annual inventory value) * 100
Here’s what to include in your storage expenses:
- Warehouse rent/lease/mortgage/loan
- Employee wages
- Cost of inventory
- Transportation to/from warehouse
- Administrative fees
- Software and technology fees
- Opportunity cost
Inventory Carrying Cost Example
Let’s take a look at a hypothetical inventory carrying cost example to see how it works in the real world.
Manifesto Mocktails sells premixed mocktail drinks. It’s interested in knowing inventory metrics, especially because its products are perishable. Manifesto Mocktails needs to make sure it can sell its inventory before it expires, so it’s decided to look more closely at carrying costs.
The beverage retailer rents a climate-controlled warehouse storage space for $1,000/month, averaging around $250/month in utilities. This is where it keeps $5,000 worth of product. Warehouse labor expenses are approximately $2,000/month, insurance is $500/month, and shipping is another $500/month. Manifesto Mocktails also calculates $300/month in depreciation, shrinkage, obsolescence, and opportunity cost.
The retailer’s inventory carrying costs calculation looks like this:
Inventory carrying cost = ((1,000+250+2,000+500+500+300) / 5,000) * 100
Inventory carrying cost = (4,550 / 5,000) * 100
Inventory carrying cost = 0.91 * 100
Inventory carrying cost = 91%
In this scenario, Manifesto Mocktails has a significantly higher than average inventory carrying cost. Average carrying costs, remember, are 20%-30% of inventory value. This means the company should look for ways to lower its holding costs.
How to Reduce Your Inventory Carrying Cost
There are several reasons why your holding costs may be high:
- Too much stock on hand/safety stock
- High rent/utilities
- Ineffective marketing and advertising
- Slow-moving inventory
- Poor inventory management and forecasting
- Lack of inventory systems and technology
- Expensive products
Luckily, there are many approaches small businesses can take to reduce holding costs.
Negotiate With Wholesale Suppliers
First things first: You can lower your capital investment in inventory by negotiating better deals with your suppliers. Your approach depends largely on your relationship with the supplier, but also on factors like order volume, order value, and account history. The supplier may not be able to budge on the wholesale pricing, but you can ask for other discounts like free or reduced shipping.
Negotiate With Your Warehouse
Warehouse space isn’t cheap, but it is important. One estimate puts the average cost per square foot of warehousing to be $6.53. If you lease a warehouse space, you can ask your landlord to cut you a deal. Much like negotiating with manufacturers and suppliers, your approach and success rate depends on a variety of unique factors.
Optimize Your Warehouse
Whether you have luck or not with your negotiations, there are other ways you can reduce warehousing expenses that are more in your control. To start, you’ll want to optimize your warehouse layout. Are you getting the most out of your space? Is it easy and efficient for your staff to navigate and do their job? Your organizational efforts may even reveal an opportunity to downsize. Moving to a smaller warehouse can be especially helpful competitively, considering the average size of retailers’ warehouses is growing and 87% of businesses have warehouse expansion plans through 2024.
Invest in Inventory Management Software
Poor planning is one of the biggest culprits when it comes to high holding costs—and you can use technology to combat it. Finding the best inventory management software for your business will give you more accurate reporting, better forecasting, and a more comprehensive picture so you can plan accordingly. It’s no surprise that demand for inventory management software doubled from 2015 to 2020, yet, still, only 18% of small businesses use it, opening the door for a competitive advantage to those that do.
Using effective inventory management software allows you to more easily purchase the right amount of stock, plan marketing and advertising campaigns accordingly, and set yourself up for sustainable success. Inventory management software can also lower administrative costs and, by optimizing inventory levels, lower the amount you need to pay in insurance and taxes.
Use these guides to help you find the best inventory management tool for your business:
- Best Inventory Management Software
- Best Free Inventory Management Software
- Best Restaurant Inventory Management Software
Alternatively, you can download our free inventory management workbook if you just need a simple solution.
Invest in Warehouse Management Software
Warehouse management software has similar benefits to inventory management software, except these platforms are specifically focused on managing and optimizing your physical warehouse space. Inventory management software specifically focuses on the inventory that occupies that space.
Your warehouse management software plays a key role in lowering holding costs because it helps you better optimize your space for cost-effectiveness. Plus, you’ll gain insight into your space, how it’s organized, how your staff maneuvers in it, and how your inventory is stored in it. Effective warehouse management also supports the order fulfillment process, making it more efficient and easier for your staff to get orders out.
Pro tip: Find a warehouse management software that integrates with your inventory management platform.
Apply First In, First Out Principles
The first in, first out (FIFO) approach is exactly that: The first item you put on your shelves is also the first item you distribute when you make a sale. This is especially impactful for businesses that sell perishable goods, like Manifesto Mocktails, because you reduce the risk of expiration. FIFO is a way to mitigate obsolescence holding costs.
Automate What You Can
The more human power you need to accomplish inventory-related tasks, the more you make your business susceptible to human error and rising labor costs. Automation can help take some of the tedious tasks off your employees’ plates so they can focus on more challenging and rewarding tasks while you boost efficiency and cost-effectiveness.
Inventory shrinkage is when stock goes inexplicably missing. Shrink happens under a number of circumstances, including external and internal theft, human error, and inaccurate data. There are many ways you can fight shrink and simultaneously lower carrying costs.
Conduct regular physical inventory counts and compare the numbers to your software-provided data—investigate any discrepancies. Train and invest in your employees so they’re more engaged in their jobs and less likely to commit theft. And finally, fight customer fraud.
Outsource Warehousing and Fulfillment
For growing online businesses, outsourcing your warehousing and fulfillment can be cheaper than managing everything in-house. You’ll save on warehouse, employee, and software costs. See our top picks for the best fulfilment services and 3PL companies.
Why Inventory Carrying Cost Is Important
If you want to start a retail business, inventory carrying cost is one important metric to consider. Inventory management is one of the most vital aspects of running a product-based business—inventory ties up a lot of capital and stockouts are costly. Luckily, carrying costs are largely within the merchant’s control.
- High carrying costs impacts profit margins: Any time you can reduce your expenses as a business, you’re increasing your profit margin. The same principle applies when it comes to carrying costs. And today’s small businesses have a bevy of analytics tools to help make informed and data-backed decisions when it comes to retail inventory management.
- Inventory ties up cash flow: Carrying costs greatly impact small business cash flow. Inventory itself ties up capital, and when those assets demand ongoing investment, merchants lose even more capital than the inventory value itself.
- Examining carrying costs can reveal excess expenses: Looking at your carrying costs can give you a quick glimpse into overall business health and a look at where your cash flow is going. Warehouse staff start at $11.44/hour, and managers start with $47,478 salaries. Have you accounted for this in your business metrics?
- High costs could indicate poor planning: Maybe you keep too much stock on hand, for instance. Low costs, on the other hand, may merit further investigation into stockouts and being able to meet customer demand.
Knowing your inventory carrying costs is beneficial for more than just cost savings. When you understand your holding costs, you get a better picture of your overall business. This metric, combined with other key retail analytics, is key to understanding, improving, and growing your small retail business.