Inventory Management Costs: A Comprehensive Guide

Stockouts and overstocking have been bothersome—let’s admit it. The hassle and cost associated with these situations can burn out businesses. 

But here’s the good news: Reducing stockouts and overstocking with inventory management cost control can lower overall inventory costs by 10%.

Since the business landscape has become more competitive than ever before, businesses must learn that effective inventory management can either make or break their profitability. 

And it can be done without understanding inventory management costs, crucial for businesses of all sizes. 

Keep in mind that inventory management costs often account for 10% to 40% of the total inventory value.

Ready to boost your profitability? If yes, learn about these costs in detail. Here’s everything that you need to know, various dimensions of inventory costing, why it matters, how implementing inventory management strategies can transform your bottom line, and much more… 

What Is Inventory Cost? Starting with the Basics

Inventory cost covers all expenses associated with acquiring, storing, and maintaining products throughout the supply chain until they’re used in production or sold. These costs include much more than just the purchase price of goods. More precisely, inventory management costs extend to every aspect of handling inventory, from order placement to final sale. 

Many businesses underestimate the true cost of inventory. They focus more on the purchase price and overlook numerous additional expenses that accumulate over time. 

Result? Such narrow perspectives lead to significant financial blind spots in their operations management. 

Types of Inventory Costs

If you have been lacking effective management in your supply chain or warehouse operations, understanding the different categories of inventory costs becomes crucial for you.

1. Ordering Costs

These are the costs or expenses incurred every time you place an order to replenish inventory:

Ordering costs include:

• Purchase requisitions and order processing
• Administrative costs for approving purchases
• Transportation and shipping fees
• Labor costs for receiving and inspecting deliveries
• Software and systems for processing orders

Pro Tip: Businesses that frequently order in small batches often face higher cumulative ordering costs. So, in such a case, determining the correct Economic Order Quantity becomes crucial for optimizing their supply chain and minimizing ordering costs. 

2. Inventory Carrying Costs

Also known as holding costs, the inventory carrying costs refer to the expenses related to storing products until they’re sold. 

These costs typically make up the largest portion of total inventory costs, often ranging from 15% to 30% of inventory value annually. 

Carrying costs can significantly impact profitability for businesses with limited storage space or high-value products. 

Inventory carrying costs include:

• Warehouse rent or mortgage payments on warehouse facilities
• Utilities and facility maintenance
• Insurance premiums protecting stock
• Employee wages for warehouse staff
• Security systems and personnel
• Spoilage, breakage, and deterioration
• Opportunity cost of capital tied up in inventory

3. Shortage Costs

These costs are often the most difficult to quantify. Also, they can have the most severe long-term consequences for your business. Why? Because the financial impact of running out of stock extends far beyond just the immediate lost sale. 

These result in:

• Revenue loss from unfulfilled orders
• Long-term customer relationship damage due to late or no supply
• Expedited shipping costs for emergency replenishment
• Potential contractual penalties with retail partners
• Administrative costs handling back orders
• Brand reputation damage

4. Capital Costs

Capital costs include the opportunity cost of money invested in inventory.

5. Risk Costs

Risk costs include expenses associated with potential inventory problems. These costs alone can account for 5-7% of your total inventory value annually. 

These account for:

• Obsolescence occurs when products become outdated
• Shrinkage due to theft, fraud, or poor security
• Damage during handling or storage
• Depreciation of product value over time
• Insurance premiums to cover potential losses

The Hidden Impact of Poor Inventory Management

This is the most crucial part for you to understand as a business. 

When businesses fail to optimize their inventory levels, they face numerous challenges:

Financial Strain

Businesses can face financial strain in many ways, including:

• Reduced cash flow from capital tied up in excess inventory
• Decreased profitability due to higher carrying costs
• Increased operational expenses from managing unnecessary stock
• Higher risk costs from obsolescence and depreciation

Operational Inefficiencies

Operational inefficiencies can strike your business in the case of unmanaged inventory. The results can impact your business in the form of:

• Warehouse overcrowding leads to handling difficulties and potential safety hazards
• Difficulty locating products in overstocked facilities
• Labor inefficiencies from managing excess inventory result in overtime or excess labor requirements
• Increased complexity in tracking and managing stock

Customer Satisfaction Issues

Businesses can face the following challenges with unmanaged inventory, other than increased costs. 

• Stockouts, which lead to disappointed customers
• Product quality issues from aging inventory
• Delayed order fulfillment from disorganized systems
• Inconsistent service levels

How to Calculate Total Inventory Cost

Understanding your total inventory costs requires careful analysis of all components:

Carefully analyze all the components to understand your total inventory costs. 

Total Inventory Cost = Ordering Costs + Carrying Costs + Shortage Costs

Consider the following example for a business with:

Total inventory costs thus will be $1.25 million (25% of inventory value). That’s over $4,300 per day spent on managing inventory. 

Common Mistakes in Inventory Cost Management

Avoid the following mistakes that most businesses often experience. 

❌Delaying proper inventory management until after the product launch. 

❌Separating demand forecasting from inventory management.

❌Limiting inventory access and knowledge to a small group of employees, like the warehouse.

❌Lacking a clear understanding of reorder points and safety stock levels. 

❌Purchasing in bulk without proper demand forecasting.

❌Understocking to reduce carrying costs. This leads to stockouts. 

❌Holding onto dead stock instead of liquidating it.

❌Reluctant to adopt modern inventory management systems. 

❌Undervaluing the return on investment from inventory software.

❌Failing to use inventory data for strategic decision-making.

Strategies to Reduce Inventory Costs

You can significantly reduce the costs associated with inventory management by implementing effective inventory management strategies.

1. Adopt Lean Inventory Practices

✔️You can try implementing the following solutions:

✔️Implement Just-in-Time inventory systems

✔️Use Kanban systems to improve material flow

✔️Focus on demand-driven replenishment and implement the pull system

✔️Keep eliminating waste throughout the supply chain

2. Leverage Inventory Management Software

The present era is more about automation, AI, and technology. Try the following to gain an edge over your competitors:

✔️Track real-time inventory levels across all channels

✔️Automate reorder points and purchase orders

✔️Generate detailed cost analysis reports

✔️Integrate inventory data with accounting systems

✔️Use predictive analysis for demand forecasting

3. Optimize Safety Stock Levels

✔️Try out the following for safety stock optimization and avoid costs. 

✔️Calculate appropriate safety stock based on lead times and demand variability. 

✔️Differentiate safety stock levels by product importance

✔️Regularly review and adjust safety stock parameters

✔️Balance stockout risk against carrying cost

4. Implement ABC Inventory Classification

To do so:

✔️Categorize products based on value and movement speed

✔️Apply different management strategies to each category

✔️Focus resources on fast-moving, high-value items

✔️Develop strategies for slow-moving inventory

5. Improve Supplier Relationships

Strong relationships with the supplier will always benefit your business in unforeseen situations. Here’s how to do it:

✔️Negotiate better payment terms and volume discounts

✔️Develop vendor-managed inventory systems

✔️Establish collaborative forecasting with key suppliers

✔️Reduce lead times through strong partnerships

6. Enhance Demand Forecasting

✔️Use historical inventory data and market trends

✔️Incorporate seasonal variations into planning

✔️Account for marketing campaigns and promotions

✔️Regularly review forecast accuracy and adjust methods

The ROI of Better Inventory Management

Why have we been stressing better inventory management and costs? Because implementing strategic inventory management can yield significant returns, such as:

1. Potential to reduce inventory levels by 20-30%
2. Improved cash flow from freed working capital
3. Reduced carrying costs by thousands or millions annually
4. Higher profit margins from operational efficiencies
5. Enhanced customer satisfaction from better  product availability
6. Increased business valuation from improved financial metrics

Key Takeaway

Inventory cost management effectively involves a comprehensive understanding of all the expenses involved in storing, handling, and maintaining your products. Often, these costs are too high, posing financial risks for businesses. 

This can be sorted by implementing strategic inventory management strategies. Not only will the costs be reduced, but operational efficiency and customer satisfaction will also witness a boom.

Most successful approaches balance the various types of inventory costs rather than focusing on reducing just one category. Your goal should be the optimization of your entire supply chain. This is only when you will be able to maintain appropriate inventory levels, supporting your business objectives without unnecessarily tying up capital. 

Your business can transform with proper attention to inventory costing and management — something that is often seen as an unnecessary expense. 

Ready to Transform Your Inventory Management?

Here’s how you can do it:

➡️Start by conducting a comprehensive audit of your current inventory costs.

➡️Identify where your biggest expenses lie and which strategies would yield the greatest returns.

Share Your Insights on Inventory Cost Management

What’s your experience with managing inventory costs? We’d love to hear from you. Write to us and share your lessons, strategies, or even the challenges you’ve faced. Why do we need you to share?

Your knowledge could be valuable to others in improving their inventory management! 

Let’s spread awareness.