Carrying costs include storage, obloselence, damage and the cost of capital (equity or debt, net of tax), and are among the significant carrying costs of inventory.
Storage
Even if the inventory is turning quickly, storage costs include the facility costs such as all the typical warehouse facility costs including building, handling, insurance and taxes. Most companies control these semi-fixed warehouse cost well. However, many times, we’ve seen slow moving goods kept on the shelf covered in dust–that “just in case inventory”. While the property tax consumes 2%-4% of its’ annual value per year. Especially in a low margin business, perhaps that inventory should be written off or better yet liquidated so the remaining cash could be better deployed on inventory that could turn and earn margin several times per year vs. sitting year after year and just taking up storage space and consuming facility costs.
Obsolesce and Damage
Inventory in a warehouse is always at risk from damage due to mishandling, fire, water or theft. If the inventory management processes are working properly obsolete inventory should be minimal unless inventory is held for specific customers or custom made. Still, a close watch on the turns in conjunction with the sales trends with the sales team is one way to help minimize large values of obsolete inventories. The longer anything is stored, the greater the opportunity for damage so tracking inventory items by turns is one way to measure the relative inventory efficiency and to help minimize damage in the long run.
Cost of Capital
Owning inventory ties up capital. Since capital is either sourced from debt and/or equity there is an opportunity or carrying cost to tie up that capital in inventory. The inventory that does not turn into sales and earns a margin, the less opportunity for that capital to earn a return, hence the capital cost.
The combination of debt equity would be the weighted average cost of capital. The cost of the debt is netted by the entity’s’ marginal tax rate:
(Debt Weighting X Cost of Debt x Marginal Tax Rate)+ (Equity Weighting X Cost of Equity)
In summary, the purchase or cost value of inventory is the beginning. The longer the inventory sits, the greater the costs and the lower the returns. Work with the inventory/production management team and the sales team to increase the turns to reduce the capital investment to increase the cash flows.