Types of Inventory Management Costs [+9 Myths & Mistakes To Avoid]
Inventory management is vital to any e-commerce business. If you don’t establish an effective inventory management approach, you risk frustrating customers, losing vital sales or investing in inventory that doesn’t sell. The following article is part of our Inventory Management Blog Series which covers all aspects of developing an effective inventory management strategy so you can optimize your sales and profit.
Inventory management — it’s a breeze, isn’t it?
Not exactly. If you understand what inventory management is, you know there are many aspects to establishing an effective system.
You need to account for where to house the inventory, the equipment used to move and store inventory, and the staff to help you manage it all, among other things.
These all have costs tied to them. If you aren’t properly managing your inventory, your costs can quickly get out of hand.
Unfortunately, there are many myths about inventory management that can lead you to neglect it. This can negatively affect your company’s bottom line.
For example, “inventory management is easy” is one of the most common myths in business. But before we dive into these myths, let's review a quick definition.
What are Inventory Management Costs?
Inventory managements costs are all costs associated with ordering, holding and managing the inventory or stock of an operation or business. These inventory costs are broken down into three main categories: ordering costs, carrying costs and stock-out costs.
Taking the wrong approach to inventory management can land a business in hot water. Costs begin to spiral, stress adds up, and there isn’t enough inventory to keep up with customer orders, all causing a huge headache.
If you don’t know what the common inventory costs and myths are, you could be at risk of mismanaging your inventory. In this article, we will give you the low-down on which costs to monitor and debunk some common myths so you can effectively manage your inventory.
- The Three Types of Inventory Costs
- How to Bring Your Carrying Costs Down
- Common Myths Associated With Inventory Management
3 Categories of Inventory Costs
The three main categories of inventory-related costs are:
- Ordering Costs
- Carrying costs
- Stock-out costs
Let’s look at what each one means to your business.
1. Ordering Costs
Each time you purchase from a supplier, you have to consider ordering costs. It doesn’t matter if an order is tiny — there will always be ordering costs involved.
To determine how much an order will cost you, there are a few things to keep track of:
- Purchase requisition: the internal process of requesting your purchasing department to buy products from an outside vendor.
- Purchase orders and invoicing: negotiating and processing a purchase order with an outside vendor.
- Labor costs: hours spent on accounting, communicating with vendors, or tracking the status of purchase orders.
- Transportation and processing: shipping costs to get the inventory to your warehouse, as well as the costs of receiving and inspecting inbound goods.
Some of these costs will be small — such as preparing invoices and issuing payments to suppliers. Other costs, such as the actual purchase order, will be higher. Having a solid purchase order template will help keep this process running smoothly.
2. Carrying Costs
Carrying costs include storage and space, taxes, insurance and more. They are the costs your company incurs over the time it stores and holds its inventory.
Having an accurate view of these costs is critical to know how much profit your current inventory can make.
3. Stock-Out Costs
Stock-out costs represent any lost potential sales opportunities caused by you not having stock for a product.
For example, a stock-out cost can occur if a customer orders the last unit of a product you have in stock, but that unit turns out to be defective. Since you can’t ship a defective item and you don’t have available inventory, it can’t be fulfilled.
A stock-out cost can also occur if a customer goes to your site and sees the product they want is out of stock. Instead of buying the product from you, they will look for it elsewhere.
7 Types Of Inventory Costs To Track
Here are the common inventory carrying costs your business needs to monitor:
1. Space and Storage Costs
Space and storage costs cover recurring costs like rent, security, lighting, heating, upkeep, and other utilities.
It also includes the wages of security workers and janitors —the labor needed to maintain a clean, safe and organized inventory storage facility.
These costs quickly build-up, but they are a necessity because it is impossible to keep an inventory if you have nowhere to store it. You may even need to purchase or rent an additional warehouse if you carry a high volume of inventory.
If your company uses a third-party logistics (3PL) warehouse, these individual costs may not be as relevant to your total inventory carrying costs, which we’ll discuss shortly.
2. Handling Costs
Handling costs facilitate safe inventory handling at your warehouse; they are the tools and labor costs of employees who are involved in moving stock from one location to another in your warehouse.
The costs include material handling equipment, forklift truck drivers, and people to manage your products and handle damaged goods.
Handling costs don’t just include wages, but also extend to any taxes applied by your government, employee benefits, extra duty hours and so on.
Technological investments can be made to reduce handling costs.
3. Working Capital and Capital Costs
Capital cost is typically the highest of all the carrying costs.
It includes one-time expenses required to physically carry and house inventory, such as purchasing land, building, and equipment. It also includes investments, any interests on the working capital, and the opportunity costs of all the money invested in your inventory.
The capital cost for manufacturing companies is generally between 7% and 12% of their total carrying cost.
Your company can determine its capital costs by calculating the weighted average cost of capital (WACC). The WACC is the minimum average rate of return your company must earn on the current assets it holds. This can often be a subjective figure.
When calculating your capital costs, always remember to consider the risk attached to your inventory. It’s often higher than you might think, especially if you have a lot of perishable goods.
4. Taxes and Insurance
Insurance and taxes are always complex, and anyone who goes into business doesn’t exactly look forward to organizing these aspects.
But if it’s true the only certainties in life are death and taxes, you must take these costs seriously. There can be huge implications for your company if you don’t. We can’t offer legal advice, so please consult with a business lawyer familiar with your state and industry for direction.
In contrast, the Last In, First Out (LIFO) method decreases corporate tax liability. Before you use LIFO, you must complete and file the Form 970, Application to Use LIFO Inventory Method.
How much tax you pay on your inventory will also depend on your location and industry.
Most business insurance policies cover inventory. But if your inventory is high value, you might need a separate coverage policy.
Your insurance policy can cover theft, the damage that occurred during the transport of your goods, as well as damage incurred by a natural disaster.
Obsolescence is an inventory risk cost that refers to items in your inventory you can’t shift, or which might perish before they sell, such as flowers or food.
Obsolescence can be costly because you’re effectively leaving cash on the shelf. Products could sit in your inventory for months, causing you to incur costs for carrying them only to never make a profit.
Many small businesses incur obsolescence costs, but there are ways to reduce them.
Consider selling perishable stock on marketplaces like eBay or Amazon at a lower price. Or you can offer sitting products in a bundle with faster-selling products to move them out of your warehouse.
With Amazon projected to sell over $23 billion in groceries by 2021, you should leverage the marketplace to get a slice of the pie from your perishable products. Amazon Fresh is currently invite-only, but you can request to sell on it by contacting email@example.com.
What is the inventory? It’s an investment.
For small businesses that haven’t worked out an effective inventory management strategy yet, it’s a pretty costly investment.
We all have a finite amount of money at our disposal, and we need to be careful with how we spend it. View your inventory as an investment. This will help your company strike the right balance with your resources so you don’t overspend.
Make sure to work out how much of your budget needs to be spent on your inventory and how much should be dedicated to other core aspects of your business.
7. Criminal Activity
If you fail to implement the proper controls, you’re leaving your inventory open to criminal activity. This can be costly.
Shrinkage — which includes all kinds of criminal activity — is hugely damaging. It cost U.S. retailers as a collective over $46.8 billion in 2017, which equates to almost 1.33% of total sales.
Criminal activity can include theft from your warehouses, but it can also include fraud and dishonest employee activity.
Use data to understand when, where and how losses occur so you can protect your inventory better in the future.
You and the customer lose in both scenarios.
Running out of stock can be very bad for businesses, especially if the customer decides to cancel the order. If the customer doesn’t want to purchase a product from your company anymore because you were out of stock, it can have major implications for future sales.
How To Bring Carrying Costs Down
When you bring your inventory costs down, you free up capital. You can then use this money in other areas of your business to grow and scale. There’s a big chance your inventory is where a lot of your cash is going — too much perhaps. This is normal, but here are a few ways you can bring carrying costs down.
Know When To Reorder Stock
Unless you know when to reorder, there’s a good chance you’ll run out of stock, or worse, have an overstock. Overstock is very costly, as it means you’re carrying stock you don’t even need.
Working out when to reorder doesn’t require a sixth sense and it shouldn’t be a guessing game. Inventory management software like Skubana can predict likely sales and product demand by providing you with accurate forecasts. You can also calculate your minimum threshold of inventory to help know when it is time to replace your stock.
Understanding when it is appropriate to reorder stock will prevent a stock-out from hurting your sales and overstocks from driving up costs.
Clear Out The Dead Stock
For some businesses, the dead stock is what can bring them down. Dead stock is stock that isn’t selling and won’t sell. This can be for various reasons, such as the product becoming outdated. Dead stock can be costly because it contributes to your carrying costs.
Remember, all stock in your inventory is costing you something while you hold it, including stock that analytics shows isn’t going to sell.
With dead stock, it’s usually better to give up and get rid of it. If you’re set on making some money from it, offer it as part of a bundle. Otherwise, return it to the supplier or donate it.
Either way, you need to get rid of it to reduce your carrying costs.
Don’t Overstock on a Deal
Some suppliers might offer you “buy one, get one free” deals when you are purchasing a product from them.
This is great for them, as it helps them to ship unwanted stock. It also sounds like a great idea for you, because you are purchasing inventory at a steal.
The problem is this can easily lead you to overstock on those products.
Remember, the more you order, the higher your carrying costs will be. Don’t give in to temptation.
Stick to your inventory management strategy and decide if it’s worth taking advantage of an offer. If you do take advantage of the offer, make sure you have a plan for moving the extra inventory out of your warehouse.
9 Inventory Management Mistakes To Avoid
Inventory is such a crucial part of any retailer’s success, but so many small businesses keep getting it wrong.
They think it’s easy because it is treated as an afterthought once their business has launched.
However, going into inventory management blind is a huge mistake that can set you back.
Here are some of the most common myths to be aware of.
Inventory Management Is Easy
Let’s start with the myth we mentioned at the beginning of this chapter: “Inventory management is easy.”
What’s so easy about managing numerous locations, reordering new stock, evaluating staff candidates or reviewing technologies to use?
Or how about generating reports, cutting out fraud, or identifying why things are going missing?
Even with the help of software, inventory management is still challenging. It’s never been easy and never will be. And because inventory management can make or break a company, there’s absolutely no reason to subscribe to this myth.
Start Managing the Inventory After Your Business Has Launched
Another common myth is thinking you can manage your inventory after your business launches.
Your team launches their small business, gets excited … and then decides to prepare an inventory management system.
The problem is at this point, your inventory has already become disorganized and could be hurting your bottom line.
For many e-commerce newbies, inventory management isn’t a priority. They want to get the ball rolling with their business before they even think about something like managing inventory.
But before your business is up and running, your inventory needs to be structured. Otherwise, it will quickly get out of hand. Costs will spiral and you might be left in the embarrassing situation whereby a customer tries to buy an item that isn’t in stock.
For all fledgling companies, this is the last thing that’s needed. Always prioritize an inventory management system and implement it before you launch your business.
Change Is Hard And Time-Consuming
The essence of business is change and innovation. If anyone leading a business doesn’t embrace change, they will quickly find they need to adjust their mindset if they want to succeed.
Some e-commerce retailers feel changing their current systems simply isn’t worth it. Even though implementing an effective inventory management system will take time, in the long run, it will improve efficiency and contribute hugely to the success of any business.
Inventory Management Isn’t Needed For Forecasting
Some businesses believe they can precisely predict future sales using past data only.
This is untrue and it can cost small businesses a lot of money.
A precise inventory management system can improve the precision of sales forecasts while also helping you track other inventory KPIs. It will help you follow the right sales trends, maintain the right amount of stock at your warehouses, gauge what isn’t selling, and calculate the lead time for inventory restocking.
Only Inventory Specialists Should Place Orders and Track Inventory
Restricting order placements and inventory tracking to a select handful of employees can be extremely limiting. This can cause your receiving and purchasing process to bottleneck, which can delay the availability of stock for orders.
As long as you’ve put software in place and are using barcode scanners, there’s no reason why other employees can’t take care of receiving, ordering and shipping your products.
All they need is some training and the correct equipment, and they should be good to go.
Buying Stock In Bulk Is a Money Saver
Bulk buying is what some shoppers do on the weekends to save time and a bit of cash. It sometimes works and some discounts might be offered at the time of purchase.
It isn’t, however, what small businesses should be doing for their store. Why?
Even though buying in bulk can get your products at a better price, it doesn't automatically mean you are saving money.
For example, if a person buys pizzas in bulk but doesn’t have the time to eat it all before it goes bad, they lost the money they spent on the pizza. The same could be said for a small business. If they buy products in bulk but don’t sell it before its expiration date, they are losing out on their investment.
Bulk buying saves you cash at the time of purchase, but what if most of the product is left on your shelves because no one is interested?
If you insist on bulk buying, use forecasting data to help you gauge what’s going to sell and what isn’t.
Have as Few Products as Possible On Hand To Save Money
It’s risky to have too much OR too little inventory. The goal is always to meet customer demand. As long as you have enough stock to do that, you’re okay.
If you decide to purchase less stock to save resources, there’s a chance your shelves will be understocked. This is can be costly. The buyer leaves unhappy, and you lose a sale and a potential loyal customer.
Managing your inventory is a balancing act, and small businesses need to manage their budget effectively so they don’t run out of resources. This is another reason why implementing an effective system is essential.
You Don’t Need An Inventory Management Software Solution
Got a spreadsheet?
Ready to manually keep tabs on your inventory?
Your rivals have implemented automated inventory management systems and you need to keep up with them. Spreadsheets and checklists can work, but they take up so much time and are subject to inevitable human error.
Software solutions make business operations run smoother. But this leads us right into the next myth...
Inventory Software Is Too Expensive
What if your company can’t afford it? Software and tools are essential for businesses that want to scale. The software automates your inventory so the hard work is done for you.
If you look at the technology the biggest companies in the world are using to manage their inventory, then yes, we’d have to agree with the myth that some inventory software is too expensive.
But many next-generation software options offer similar services at a fraction of the price. Take a look at Skubana, a piece of inventory software that’s affordable, and offers functions and features that you’ll find on a lot of higher-priced management software.
The key to finding the right software is to understand what issues or pain points you need to address. Then you can evaluate the different inventory management software to determine which best fits your needs and fits within your budget.
These are some common costs and myths associated with inventory management.Remember, inventory management isn’t easy.
Work out the costs, unfold the myths, find the right software, and stick to your strategy.
In the next chapter, we discuss exactly how you can create an effective inventory management strategy to improve your overall operations.
Inventory Management Cost FAQ
What are the main costs associated with inventory management?
When budgeting for inventory management, you should factor in three main things: ordering costs, carrying costs, and stock-out costs. By having a solid understanding of these costs, you can identify different areas where you can reduce them and optimize your cash flow.
How to reduce carrying costs?
Carrying costs involve all storage-related costs for goods that remain unsold and generally account for 20-30% of a business’ inventory expenses. Businesses can reduce carrying costs with proper inventory forecasting that responds to changes in consumer demand and tracking inventory in real time with a system like Skubana.
What are inventory cost management best practices?
Ecommerce businesses that manage inventory will know how challenging it is to get right. To ensure that inventory costs are managed properly, costs should be planned for before launching the business, processes should be optimized on an ongoing basis, and finding the right inventory management tool (like Skubana) is key.
How much does inventory management software cost?
The cost of inventory management software depends on business requirements and complexity of business needs. Costs can range anywhere from a free app for small businesses to tens of thousands for a system that supports business growth. The best way to determine cost is to understand your business needs clearly and book a demo with a provider.
Chad Rubin is the co-founder and chief executive officer of Skubana, a multichannel e-commerce software the enables brands to unlock growth by unifying their back-office operations.