For eCommerce businesses operating with large amounts of inventory, inventory costs account for a significant portion of their overheads. In this article, we’re going to take a look at the different types of inventory costs, how you can calculate your business’ inventory costs, and how to optimise them.
In this article
What are inventory costs?
Inventory costs are the prices your business pays to buy, hold, and manage your inventory.
Inventory costs entail much more than just the price you pay a supplier for goods; they also include warehousing costs, shipping costs, insurance costs, and more.
Types of inventory costs
Let’s take a look at the typical inventory costs most eCommerce businesses have.
Procurement includes the price you pay for goods and materials (including packaging), as well as the cost of first-mile delivery to your warehouse or fulfilment centre. The costs you pay for goods to be booked into your warehouse can also be categorised under procurement.
These are the costs associated with storing your inventory in a safe place, usually a warehouse or fulfilment centre. The main costs include storage space, electricity to run the facility, and wages for the warehouse staff.
Most companies will choose to take out insurance to protect themselves from losses if stock gets damaged or stolen. The cost of insurance will differ by sector, but it’s important to consider insurance for both stock in transit and in the warehouse.
Significant obsolescence costs are largely avoidable with good inventory management techniques, but nevertheless are still a cost to consider. It’s not uncommon for stock to go out of date or otherwise become obsolete if it’s stuck in the warehouse for too long.
Other inventory costs
Some other inventory costs that may or may not be applicable to your business include:
- Handling equipment
- Vehicles (e.g forklifts)
- Health and safety
- Inventory management software
- Capital costs
How to calculate your inventory costs
To calculate your inventory costs over a period of time, you can use a fairly simple formula. The time-consuming element is adding up all the costs associated with inventory that we mentioned above.
However, once you have those numbers, you can use the following formula to calculate inventory costs over a period of time:
inventory costs = [beginning inventory + inventory purchases] – ending inventory.
Here’s an example
For an example, let’s use a fictitious cosmetic company called Smoke and Powder. The Founder of the company, Sarah, values her business’ inventory at the end of each month, and now wants to calculate her total inventory costs over the last 12 months.
She begins by writing down her beginning inventory, which is her inventory value as it was 12 months ago. Thanks to the historical data she has, she knows that her inventory value at that time was £60,000.
Then, she adds up the cost of her inventory purchases (procurement) over the last twelve months. That was £120,000.
Next, she values her inventory as it stands today – her ending inventory – which is £90,000.
Finally, Sarah puts her newly calculated numbers into the inventory costs formula:
Inventory costs = [£60,000 + £120,000] – £90,000
Inventory costs = £90,000
Why should you calculate your inventory costs?
It’s important to regularly schedule some time to calculate your inventory costs for several reasons. Your overall inventory costs should play an important role in making informed decisions in regards to budget, resource planning, and cost saving exercises, and they’re essential for taxation purposes.
Here’s a more-detailed summary of why you should always look to keep up-to-date inventory costs.
Having accurate inventory costs helps you to make informed decisions on budgets for many elements of supply chain and inventory management, including re-ordering stock, storage solutions, fulfilment, first-mile delivery, and more.
Calculating profit margins
Failing to account for inventory costs will result in overestimating your profit margins. This is dangerous, as you might end up making purchases you can’t afford. There’s a much larger knock on effect too, as poor fiscal management can lead to eroding cash reserves, missed debt obligations, and inadequate pricing strategies.
A retail business’ inventory is one of, if not the largest assets it holds. Accounting for inventory costs is therefore essential for the balance sheet and income statement.
Your inventory costs will impact how much tax you’re liable to pay. Having accurate inventory costs means that you’ll be less likely to overpay or underpay your taxes, and will help you to stay compliant, avoid fines, and even legal action.
Factors that impact your inventory costs
There are many factors that play a significant role in your inventory costs over a given period, many of which are related to your rate of sale. Indeed, the longer it takes for you to turn inventory sales, the larger your inventory costs will be.
But there are other factors too, which mostly rely on the quality of your suppliers, as well as your ability to negotiate prices.
Let’s take a look.
Rate of sale and lead time
The longer your inventory takes to sell, the higher your inventory costs will be, which in turn drives up inventory costs. Peaks and troughs in demand are common in most niches, especially so if you specialise in seasonal items.
This is where demand forecasting comes in handy. By relying on historical inventory data to predict demand, you’ll be better equipped to purchase the right level of stock for an upcoming period, driving inventory costs down.
Order quantities and the cost of raw materials
Most businesses don’t make the same order every time. Seasonality will usually impact the size of the order you make, and larger orders will usually be bought at a better rate than smaller ones.
That’s why it’s best practice to regularly review your inventory costs, as the price you pay will fluctuate throughout the year, whether that’s due to order size or variations to the cost of raw materials.
Another factor that contributes significantly to your inventory costs is the price you pay for storage. While storage is relatively cheap per day, costs can add up if you have a lot of slow-moving lines.
Many 3PLs and warehousing companies will have policies in place that result in increased storage costs the longer stock is left in their facilities. This is done to incentivise you to proactively sell your stock, while protecting them from losing money on additional fees like picking and packing.
Costs to transport goods from your supplier to your warehouse fulfilment centre make up a decent proportion of inventory costs. This is especially true if you’re making large orders from overseas suppliers, or are using the fastest carrier services.
How to reduce inventory costs
As alluded to above, forecasting your upcoming demand accurately can help drive down inventory costs because you only pay for stock you need, which prevents your margins from being eroded by holding costs.
Demand forecasting requires you to have historical data at your disposal, so it will be difficult to do unless you have at least one year’s trading under your belt. Generally, the longer you’ve been trading, the easier it is to forecast.
Use the economic order quantity (EOQ) formula
EOQ is a lean inventory management system where businesses aim to only have stock in place to meet demand, and nothing extra. The benefits of this approach to inventory management are clear; it helps keep storage costs down and minimises waste.
That said, EOQ does provide risk, as it generally doesn’t allow for buffer stock to be in place, which means you can face serious stocking issues if demand suddenly or unexpectedly spikes.
ABC Analysis, a popular inventory management method, enables businesses to identify the most influential SKUs for their business’s success. It involves categorising SKUs into three tiers; ‘Class A’ being the most important, ‘Class B’ being the second important, and ‘Class C’ being the least important.
By identifying which lines are the most important ones for your business’ success, you can lower inventory costs by focusing time and resources on the SKUs that matter, and spend less time (and money) worrying about the ones that don’t.
Keep inventory costs in check with James and James Fulfilment
Built, maintained, and continuously improved by us, ControlPort is your gateway to make the most of your inventory, whether that’s reducing inventory costs, cutting wastage, reducing postage margins, batch controlling, and more more.