Inventory carrying cost

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Russian: Стоимость поддержания запасов

The inventory carrying cost is a key performance metric that is used to evaluate the amount of cash tied up in inventory. The rate may be evaluated for the entire firm, for specific product categories, for specific regions or facilities, and for specific time periods. For example, the firm may evaluate the amount of cash tied up in inventory for a product category at a warehouse for a month. The inventory carrying cost is comprised of two elements:

\text{Inventory carrying cost}=c \cdot v

Where:

  • c = the carrying cost rate
  • v = replacement value of inventory

The carrying cost rate is expressed as a percentage or ratio and represents the variable costs associated with holding inventory. It is important to note that there is no common accounting rule on how to evaluate a carrying cost rate and thus different sources, while providing similar methods of estimating a carrying cost rate, will not be identical.[1]

Example

The following table provides an example of how to evaluate the carrying cost rate. From internal records the firm determines that the sum of storage and handling, inventory administration, loss / theft / pilferage, and obsolescence equals €34.1 million. This value is then divided by the replacement value of inventory. Note that the replacement value does not reflect the market value but rather purchase and freight costs of inventory to a specific location. The remaining costs are often better understood as rates: a financing charge reflected in the cost of capital, property taxes on inventory (if applicable), and insurance on inventory. In this instance the carrying cost rate equals .392 or the sum of the separate rates. If the replacement value of inventory for the entire firm equals €244 million, then the business has €88.2 million of cash tied up inventories.

Evaluating the Inventory Carrying Cost
Element Annual Spend (€ 000,000) Rate
Storage and handling 12.5
Administration 1.0
Loss / theft/ damage 5.6
Obsolescence 15.0
Total 34.1
Total / Replacement value of inventory 34.1/225 .152
Cost of capital .100
Taxes (on inventory) .100
Insurance .040
Annual carrying rate (c) .392
Amount of cash tied up in inventory = c x v = .392 x 225 = €88.2

Two additional points require attention. The inventory carrying cost rate varies significantly across business contexts. Commodity goods often have a low carrying cost rate due to the lack of product obsolescence. High technology and fashion products possess much higher rates and may face obsolescence costs in excess of 30-40% per year. Second, the inventory carrying cost rate is an important input into a range of other calculations. For example, the value of inventory on a firm’s balance sheet is connected to profit through the income statement and the carrying cost. The carrying cost rate and value of inventory are variables in both economic order quantity and transportation mode selection models. Supply chain investments may be evaluated using net present value (see also financial logistics).

References

  1. Lambert, D.M. and Stock, J.R. (2000), Strategic Logistics Management, Irwin: Chicago, IL.
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