Inventory Carrying Cost Definition
Annual carrying cost formula gives the amount a business pays on holding its inventory over a period of time before it is sold. It involves the cost of maintaining, warehousing and storing the inventory in stock.
Significance of Inventory Carrying Cost in E-commerce Business
Data on the inventory carrying cost is a major aspect of e-commerce business. It helps businesses to understand if the inventory cost is optimum or can be reduced. It also helps in:
- Inventory carrying cost informs the company for how long it can hold its inventory before it begins facing a loss on unsalable goods.
- It demonstrates how much they require selling and buying to maintain proper inventory levels.
Applications of the Inventory Carrying Cost
Inventory carrying costs have a major impact on the future cash flow of a company. The formula is generally applied to know the following aspects:
- By having an overall inventory carrying cost, businesses can determine how much income they can earn depending on existing inventory levels.
- Annual carrying cost formula assists various types of businesses in determining if there is a requirement to produce less or more goods to keep a promising income stream.
- A high inventory carrying cost impacts companies’ cost of goods sold, thereby influencing overall profitability.
Inventory Carrying Cost Formula
Definition of Each Element Used in the Formula
Total value of inventory: It represents the overall value of inventory that a company holds.
Inventory holding sum: It is the total of all four elements of carrying cost. It is calculated as follows,
Inventory holding sum = Capital cost + Inventory service cost + Inventory risk cost + Storage cost
These elements are mentioned below.
Inventory service cost: It covers costs of IT hardware, tax, insurance, and applications. It depends on the level of inventory and the type of goods held in the inventory.
Inventory risk costs: It covers the drop in inventory, theft, and administrative errors (including errors in shipping, misplaced goods, or late system updates)
Capital cost: It is the biggest element of carrying costs deserved by businesses.
Storage space cost: It covers the rent paid to warehouse the inventory, transportation, lighting, heating and air conditioning, and other expenses related to the physical warehouse.
How to Use the Inventory Carrying Cost Formula to Calculate a Business’ Inventory Carrying Cost?
Suppose a laptop retailer carries inventory for all its laptop models. The total value of its inventory is ₱25,000. Its inventory holding sum is ₱5,000 (inclusive of the inventory service cost, capital cost, inventory risk cost, and storage space cost). Now let’s calculate inventory carrying cost,
Inventory Carrying cost (%) = 5,000 / 25,000 x 100
= 0.2 x 100
Hence, the inventory carrying cost incurred by the laptop retailer is 20% of its total inventory value.
Annual carrying cost formula indicates a business’ profit incurred against the inventory it holds. It ensures that a company doesn’t run into grave losses by retaining inventory over a long period.