Inventory carrying costs can be defined as the cost related to hold / store in the inventory. The inventory costs are considered to be the highest hidden and unknown costs in the world of business. Most of the managers consider inventory holding costs normally from 15 to 35% of the inventory value, but on the other hand there are also some businessmen and co-operations which do not consider the inventory carrying cost even though these costs are real and substantial and matter a lot.
The cost of carrying inventory has a direct relation with the number of ware houses that a company have but also on the firm's distribution polices, for example if we have same customer service level, low inventory carrying cost could result in the use of different ware houses which can also slows down the mode of transportation such as railroads. Whereas the high inventory carrying costs could lead in limited number of stock ware houses which save time and results in faster transportation by motor carriers or aircrafts in order to provide same service in both the cases. If we don't know the exact and accurate estimation of inventory carrying cost of a firm, then that firm or company will not be able to choose the distribution policies which would minimize its costs, but if we know the accurate total cost associated with carrying cost of inventory then we know the cost tradeoffs which can be made within the logistics system.
Fig-1 illustrates the tradeoffs that are necessary when developing policies like customers service levels, purchasing policies, transportation policies and warehousing systems if maximum corporate profitability is to be realized.
The basic Cost Categories
There are 4 basic types of cost which should be considered wile calculating the inventory carrying cost which are:
Inventory service costs
Storage space cost
Inventory risk costs.
These are explained in detail as follow
Most of the businessman is of the view that investing inventories is relatively liquid and riskless investment because they feel that they will get somewhat a lower return on the inventory investment. However holding inventory requires capital which could have been used in other investments and by investment money as inventory the company/ firm foregoes the rate of return that could be obtained by doing such type of investment. Therefore the company's opportunity cost of capital should be applied to the investment in inventory. Moreover this cost of capital should be made by out of pocket investment in inventory.
Many companies also use some variation of absorption for the inventory valuation; in this they consider only the manufacturing costs that are relevant which are cost of capital, the company's minimum acceptable rate of return should be applied to the variable costs which are directly related with the inventory.
The measurement of the cost of capital is very complex. Let's consider an example
From the article same to same
The coupon rate on bounds is not an accurate measure of cost of debt capital, so to measure the cost of debt capital; the impact of the marginal use of debt on the market price of common stock must be eliminated. Also from the fig. used for the cost of capital will depend on whether the security valuation is made on the basis of investment opportunities, stream of dividends, stream of earnings or discounted cash flow. What is required is a straightforward method of calculating the cost of capital that can be easily understood and applied by businessmen.
In most business situations available capital must be rationed to the most attractive investments possibilities.
James Moa has explained the concept of a "hurdle rate" the rate over which the projects will be accepted rate of return for use in the situations where capital is rationed. He defined the rate as the rate of return on the marginal investments, due to the principles of opportunity costs. Consider an example, a firm which pays 10% for funds that it acquires and because of capital rationing the marginal investments promising annual returns of 15%, although the cost of capital is only 10%. This means that relevant time value of money is measured by the return on the most profitable investments. Of course this 15% hurdle rate could also be selected as the cost of capital to the firm.
The hurdle concept should be used in order to calculate the actual cost involved. It must be used by the companies experiencing capital rationing, and where the capital rationing is not used the capital invested in inventory is expected to earn a rate competitive with a marketable security and other liquid investments of a firm.
Inventory Service Costs:
The inventory service costs include the insurance and tax costs. The tax costs vary from state to state depending on the state the inventory is held. If the inventories are exempt to 19.8% of the assessed value than the tax rate may range from zero in those states like in Indiana State. Generally the taxes have a direct relation with the inventory levels like if the inventory level is increasing than the tax rate will also increase or vice versa. While on the other hand the insurance rates are not strictly proportional to the inventory levels, because insurance is usually purchased for a specified time period and insurance policy will be revised periodically based on the expected inventory changes. There are other different reasons that how the insurance rates vary like, they could be affected by the types of materials used in the construction of the building to house the inventory, the building's age and considerations such as the types of fire prevention equipment installed.
Storage Space Costs:
In storage space cost 4 types of facilities should be considered which are:
Rented (leased) warehouses.
Privately owned warehouses.
These are explained in detail as follow:
The costs related to plant warehouses are mostly fixed in nature but there are some variable costs such as the cost the cost of taking inventory and other direct expenses should be included in inventory carrying costs. Incase if the warehouse space is rented or used for some productive purpose but not for storing inventory only then fixed charges and allocated costs are concerned otherwise they irrelevant.
Space in Public warehouses:
Some things Copied
The space in public warehouses is usually rented on a dollar per hundred weight or on a volume occupied basis. As the public warehouses is the most economical way to provide the desired level of customer service without incurring excessive transportation costs. Due to this reason mostly the costs related to public warehouses are considered as throughput costs and only charges for recurring storage that are explicitly or implicitly|(select other words) included in costs. and more the cost of capital related with holding inventory in public warehouses must be included in the cost of carrying inventory. This cost is equal to the variable manufacturing cost plus variable distribution cost, multiplied by the opportunity cost of capital or the hurdle rate.
Rented (leased) warehouses:
Rented or leased warehouses are normally contacted or leased for a specified period of time. The amount of space which is rented depends upon the maximum amount needed for the period of contract. The warehouse rental charges are fixed and do not vary from day to day with the change in the inventory level, but while on the other hand the rental charges may vary to month to month or year to year until a new contract is made. In most case the rented warehouse charges are mostly fixed but some may vary with the amount of inventory held. In any case these costs could be abolished by not renewing the contract. However these costs should not be included in the inventory carrying cost but in the warehousing cost category. (See exhibit 1).
Privately Owned warehouse
All the operating costs could be eliminated by closing down a privately owned warehouse or the net savings resulting from change to public warehouses should be included in warehousing costs and not I the inventory carrying costs.
Inventory Risk Costs:
Inventory risk cost is a type a variable cost that varies from company to company. It includes charges for obsolescence, damage, pilferage, and relocation of inventory. The cost of obsolescence is the cost of each unit which must be disposed of at a loss because it becomes old.
The costs associated with the damaged goods should be included only for the portion of damage which is directly attributable to the volume of inventory held. The damage incurred during shipping is considered a throughput cost since it will continue regardless of the inventory level.
Problems associated with the inventory risk cost:
The problem of shrinkage occurs due to pilfering. (i.e. inventory theft) for American businessmen. They consider this problem more an important than cash frauds or cash embezzlement, because it is hard to control and this cost may be closely related to company security measure than inventory level depending upon the number of warehouse locations.
Relocation cost: (copied)
Relocation costs are the cost associated with the transshipment of inventory from one warehouse to another to avoid obsolescence. Mostly these costs are the result of tradeoffs between transportation and warehousing costs and not relevant for the inventory holding cost.