As an online business owner, it's vital to understand the value and importance of your inventory.
It is one of your most significant assets, and effectively managing it can substantially impact your business's success.
However, keeping daily track of inventory costs can be challenging due to the various components associated with overall costs.
In this article, we will go in-depth into the different types of costs linked to inventory, provide insights on how to track and calculate them effectively, and offer valuable suggestions on managing your inventory more efficiently by comprehending the common factors that influence inventory costs.
Inventory costs encompass the various expenditures associated with purchasing, storing, and managing inventory within the ecommerce supply chain.
They go beyond the initial purchase price, incorporating expenses related to storing inventory and holding unsold finished goods.
Why do you need to keep an eye on inventory costs?
Monitoring inventory costs is crucial as it directly impacts your financial performance.
For example, when a significant amount of capital is tied up in inventory, it can harm your bottom line.
A precise understanding of your inventory expenses enables you to manage this important aspect of your business strategically, aiming to minimize costs and maximize profits.
Several approaches to achieve this include:
We can classify inventory-related costs into several key categories:
1. Ordering costs are the expenses incurred when replenishing inventory, for example, order processing, supplier communication, and transportation fees.
2. Carrying/Holding costs occur when inventory remains in stock for an extended period. They include costs associated with rent for space, security, depreciation costs, and insurance.
3. Shortage or stockout costs arise when inventory levels are insufficient to meet customer demand. They encompass missed sales opportunities, customer dissatisfaction, rush order charges, and potential damage to your brand reputation.
4. Spoilage costs are linked to products susceptible to deterioration if not sold within a specific timeframe. To maintain inventory control, preventing spoilage is a top priority, mainly if you sell food and beverage, pharmaceutical, healthcare, or cosmetics products.
5. Disposal costs arise when removing or disposing of obsolete or unsold inventory. These costs include write-offs, salvage value, and any associated logistics expenses.
Most business owners make the mistake of disregarding the expenses associated with holding inventory, which show as rental costs in the profit and loss statement.
Typically, when calculating gross profit, they often neglect the carrying costs of inventory and consider only the initial cost of the goods stored in warehouses.
So, in the following sections, we will provide examples and explanations of different types of costs within each category.
The accuracy of calculating inventory costs is crucial as it directly influences your profitability.
To understand how much you need to invest in inventory, you need to calculate your inventory costs precisely.
Below is a broad overview of the steps involved in calculating inventory costs.
Calculating the inventory costs is a crucial ongoing practice, as these costs directly impact your profits and profit margins.
While there is a simple formula you can use to determine these costs, you also have the option of using a cost calculator to streamline the process.
Using the inventory cost formula, you consider the beginning inventory value, ending inventory value, and purchase costs during a specific period.
Suppose you start the year with an inventory value of $100,000 and purchase inventory worth $25,000 over the next twelve months.
If the value of your inventory by the end of December is $50,000, your inventory costs would be: ($100,000 + $25,000) - $50,000 = $75,000.
While manual cost management is possible, inventory cost calculators are generally more efficient. As a result, you will gain improved accuracy and free time to focus on other aspects of your business.
Inventory carrying costs, or "holding costs," encompasses all your expenditures to buy and retain inventory over a specific period.
As a general guideline, these costs typically range between 15% to 30% of the total value of your inventory.
Businesses commonly encounter various holding costs, which include tangible expenses such as:
Additionally, there are intangible expenses such as opportunity costs, product deterioration, and obsolescence.
It's worth noting your inventory level will differ based on its size.
Small businesses generally maintain lower inventory levels compared to medium-sized or enterprise companies.
Furthermore, inventory requirements can vary across industries, with specific sectors like healthcare having higher operating costs than bakery businesses.
To track holding costs accurately, you need to pay attention to the following:
1. Capital costs encompass the total monetary investment in your business inventory, including the principal amount and the interest paid.
For instance, if a company's capital cost is 25% and its total inventory value is $100,000, the capital cost would be $25,000.
2. Storage space costs encircle all the financial resources you dedicate to the organization and maintenance of your stock.
For example, renting, leasing, or buying a warehouse and installing essential infrastructure, such as air conditioning or heating systems within your facility.
Moreover, additional variable storage costs, such as utilities and other similar expenses, for storing your inventory.
3. Inventory service costs can include subscription-based inventory management systems that assist in tracking and organizing stock effectively.
Furthermore, you may need to allocate funds to comply with government regulations, such as fulfilling tax obligations and obtaining insurance coverage.
4. Costs of inventory risks – When managing business inventory, there are inherent uncertainties, and the costs associated with inventory risks address these uncertainties, including:
You can calculate inventory carrying using two methods:
For example, let's assume you have an annual inventory value of $150,000.
The carrying cost would be $150,000/4 = $37,500.
This formula provides a rough estimate of the carrying cost, and you can calculate the ending inventory using retail or gross profit.
However, for a more accurate calculation, you should use the second method:
Let’s say you own a medium-sized retail store with a $200,000 annual inventory value.
Over the year, you’ve incurred the following costs:
Cost of Capital: $15,000
Storage Costs: $4,000
Service Costs: $6,500
Inventory Risk Costs: $5,000
To calculate the inventory carrying cost, add up these variables to obtain the inventory holding sum:
$15,000 + $4,000 + $6,500 + $5,000 = $30,500
Next, divide this sum by the $200,000 annual inventory value and multiply the result by 100:
Inventory Carrying Cost = $30,500/$200,000 x 100 = 15.25%
When your inventory carrying costs are between 20% – 30% of your total inventory value, it has several advantages, including cost savings, timely supplies, and enhanced customer satisfaction, particularly for retail businesses.
However, high carrying costs may also result in the following consequences:
So, it’s important to carefully manage your carrying costs to balance the benefits of sufficient inventory and the potential drawbacks of increased expenses.
To minimize carrying costs, you need to optimize your inventory levels.
Analyze your sales patterns and identify items with consistent demand and those that take longer to sell. By clearly understanding your inventory data, you can make informed decisions and balance supply and demand, improving inventory turnover and sell-through rates.
Online sellers often face short-term liquidity shortfalls as they strive to meet the increased demand caused by their top-selling products.
The need to purchase larger quantities reduces their flexibility and hampers their ability to test new products or invest in marketing.
Consequently, their growth becomes limited, as they heavily rely on a few key products for success.
Additional working capital ensures smooth operations, and enough funds for product launches, marketing campaigns, and expanding inventory.
1. Inventory financing allows you to finance your future orders with your manufacturer, where we take care of the deposit and balance payments for you.
2. Stock financing uses your existing inventory as collateral to fuel your store growth.
Enhancing the efficiency of your warehouse storage can significantly impact carrying costs. Consider redesigning your warehouse layout to maximize storage capacity, such as adding additional shelves, organizing items in containers, or optimizing aisle space.
It will provide better inventory visibility, potentially reducing tax costs, insurance premiums, capital investment, and depreciation.
Move away from manual inventory tracking and adopt technology-driven solutions like warehouse management systems or inventory tracking software.
These tools automate inventory management processes, updating records in real-time and generating accurate demand and supply forecasts.
Deadstock, or unsold inventory, can burden your business's finances.
Take proactive steps to address deadstock and minimize its impact on carrying costs:
Inventory costing is an essential aspect of inventory control techniques.
Effective inventory control in a supply chain helps minimize overall inventory costs and aids in determining the appropriate quantity of products you should maintain.
This information is crucial to establishing reasonable profit margins for each product or category.
In accounting, the distinction between the cost of goods sold (COGS) and inventory values is based on where accountants record them.
Companies value their inventory at the cost incurred to acquire it, considering it part of their current assets.
On the other hand, accountants record the ending inventory balance as a current asset on the balance sheet.
When inventory levels increase, it reflects an asset increase on the balance sheet.
Conversely, when inventory levels decrease, it results in a decrease in assets on the balance sheet.
Additionally, accountants incorporate the change in inventory as part of the COGS reported on the income statement.
To calculate COGS, accountants often adjust the income statement, presenting it as follows:
The choice of inventory costing method significantly impacts the income and inventory value you report on their financial statements.
Adopting a consistent and systematic approach to calculating and reporting your inventory turnover is essential because regulatory bodies expect to adhere to the chosen method from year to year consistently.
Here are 3 commonly used costing methods, with an example of an online store, Fashion XYZ, that sells custom-designed T-shirts.
FIFO assumes that the first items purchased or produced are the first ones sold.
Under this method, the cost of the oldest inventory is assigned to goods sold.
In contrast, the cost of the most recently acquired inventory remains in the inventory balance. FIFO results in a more accurate representation of the cost of goods sold, especially when prices increase.
The formula for cost of goods sold (COGS) using FIFO:
Assuming Fashion XYZ sold 300 T-Shirts, the COGS calculation using FIFO would be as follows:
COGS = (150 T-Shirts x $2) + (150 T-Shirts x $3) = $450 + $450 = $900
The value of the remaining inventory would be:
Remaining Inventory = (100 T-Shirts x $4) = $400
LIFO assumes that the last items purchased or produced are the first ones sold.
As a result, the cost of the most recently acquired inventory is assigned to goods sold.
In contrast, the cost of the oldest inventory remains in the inventory balance.
LIFO is often used to account for inflationary impacts and may result in lower taxable income during periods of rising prices.
The formula for cost of goods sold (COGS) using LIFO is:
Using LIFO, the COGS calculation would be:
COGS = (100 T-Shirts x $4) + (200 T-Shirts x $3) = $400 + $600 = $1000
The value of the remaining inventory would be:
Remaining Inventory = (50 T-Shirts x $2) = $100
The weighted average cost method calculates the average cost of all inventory items based on the weighted average of their expenses.
This method considers the quantity and price of each item when determining the average cost. It provides a blended cost per unit, which calculates the cost of goods sold and the value of the remaining inventory.
The formula for weighted average cost is:
To calculate the weighted average cost per T-shirt, we sum up the total cost of all T-shirts purchased and divide it by the total quantity:
Total Cost = (150 T-shirts x $2) + (200 T-Shirts x $3) + (100 T-shirts x $4) = $300 + $600 + $400 = $1300
Total Quantity = 150 T-shirts + 200 T-shirts + 100 T-shirts = 450 T-shirts
Weighted Average Cost per T-Shirt = $1300 / 450 = $2.89 (rounded to two decimal places)
Using the weighted average cost, we can calculate the COGS and the value of the remaining inventory based on the number of T-shirts sold:
COGS = (Quantity Sold) x (Weighted Average Cost per T-shirt)
Remaining Inventory = (Quantity in Stock) x (Weighted Average Cost per T-shirt)
💡 These calculations would depend on the specific quantity of T-shirts sold and the remaining inventory at the given time.
FIFO is the preferred method for many businesses due to its impact on reducing tax liabilities through lower costs of goods sold.
Additionally, using FIFO can help mitigate the harmful effects of overstocking.
However, there are situations where alternative costing methods can be beneficial.
For instance, when preparing an annual report for shareholders, you may opt for an inventory valuation method that maximizes net income or gross profits to present a clear financial picture.
Each costing method has advantages, and you should select one based on specific circumstances and reporting requirements.
In conclusion, managing inventory costs is critical to running a successful business.
You can effectively control your inventory expenses by optimizing inventory levels, implementing efficient inventory management systems, and leveraging data analytics.
It helps reduce storage costs, minimize inventory obsolescence risk, and improve cash flow and overall profitability.
Furthermore, adopting strategies such as just-in-time inventory and dropshipping can offer cost-saving benefits by minimizing the need for excessive stock.
Ultimately, a well-optimized inventory management approach balances meeting customer demands and keeping costs under control, leading to increased operational efficiency and sustainable growth.