Inventory is often the largest asset of ecommerce merchants. Inventory defines merchants’ businesses and their position in the marketplace. It defines customers’ expectations of the business.
For most ecommerce merchants, the cost of inventory is the largest expense item and what leads to the most financial woes. There’s typically a direct correlation with inventory turns and company success. This seems obvious: You sell more, you turn more. However, even successful companies carry too much inventory and don’t fully recognize the financial impact.
In “SKU Management Ensures Inventory Profits,” my July article, I addressed SKU selection, answering the question: “Do I have the right item at the right margin?”
In this article, I expand the focus on profitability to managing the cost of inventory.
The true cost of inventory extends far beyond the inventory itself and the cost of goods sold. The cost of managing and maintaining inventory is a significant expense in its own right. But the true cost of inventory doesn’t even stop there. Inventory carrying costs add about 20 to 25 percent to the actual cost.
Understanding Inventory Carry Costs
To get a better understanding, one must measure the cost of carrying inventory. Let’s review some of the costs.
- Financing inventory. In its simplest form, you can calculate the cost of borrowing money to purchase inventory by looking at the interest rate payments. However, for some companies inventory financing may include part of a line of credit that is also used for working capital.
In many cases when you try to evaluate the real cost, this one line item may become daunting. But don’t be discouraged; come up with a best guess. It’s more critical to understand what is being financed externally versus internally to know what should be measured.
- Opportunity costs. This cost is almost always overlooked. For opportunity costs, we’re answering the question, “How else could I invest my money?” If it were invested in something else, what is the realistic return I can expect? If you’re unsure, default to the interest rate from a tax free municipal bond as a consistent and conservative way to apply this cost.
- Insurance and taxes. Many merchants overlook this cost, too. It should typically be a variable cost: It goes up and down with the amount of inventory you carry. Depending on the volume of your business and the swing in inventory, this number could be adjusted as frequently as every quarter.
If the inventory value is fairly consistent or if the value is small, don’t bother calculating this more than yearly. However, if you do have large swings from one season to another, any savings will go straight to the bottom line. Many companies today self-insure and keep a reserve to cover the associated risk. That reserve constitutes an additional opportunity cost that should be considered.
- Handling expenses. These expenses are made up mostly of wages and benefits, but also include lease payments and depreciation on material handling equipment, depreciation on automation, and miscellaneous expenses for supplies such as pallets, packaging, labeling materials, and the like.
- Warehouse overhead. The quickest way to measure this is to split the total expenses for rent, utilities, repairs and maintenance, and property taxes by the percentage of the building associated with processing customer orders.
Here is an example. Assume a merchant uses a third-party fulfillment company. The average rate for pallet space in the U.S. is $15.00 per month. For simplicity, assume 30 items occupy that space. The first month the merchant is paying $.50 per item. At the end of the second month, assume the merchant has 25 items left and therefore pays $.60 per item. So at the end of two months, the first 5 items cost the merchant $.50 each to store and by the end of the second month the remaining items costs $1.10 to store.
Therefore, the merchant’s margin shrinks each month that it carries this item. This is a simple example, but the way you are charged can vary. Many fulfillment companies —such as Fulfillment by Amazon — now charge more the longer the inventory sits.
- Inventory control and cycle counting. These expenses typically are comprised of wages and benefits, but may also include the depreciation or operating expenses of equipment, as well as any miscellaneous expenses directly related to your inventory control team.
- Inventory shrinkage, damage, and obsolescence. Accounting for these costs can become quite complicated. But for the sake of simplicity, capture these costs in the fiscal year they occurred or preferably in the same month.
Calculating Overall Carrying Cost
To determine your overall inventory carrying cost, roll up the components in each category annually and see how close you come to the 20 to 25 percent average. Don’t get bogged down with other aspects that should only be considered if you have a skilled accounting team. For example, in reality many of these carrying costs will vary by item, warehouse, product line, category, product size, and volume. You don’t have to get that detailed.
Here’s a example of how to calculate the overall carrying cost for a hypothetical item with a purchase cost of $10.00.
Purchase Cost of Item: $10.00
Opportunity Costs: $.50
Insurance and Taxes: $.10
Handling Expense: $.90
Warehouse Overhead: $.45
Inventory Control: $.12
Inventory Shrinkage, Damage, Obsolescence: $.10
True Cost: $12.47
Once you determine the true cost of inventory, you can better address how to evaluate and manage. You’ll also discover what inventory is essential and what is not. When you reduce inventory, not only are you freeing up capital, but you are also creating opportunities to reduce expenses, improve profitability, and increase cash flow.
It can be the difference between success and failure.