As an online retailer, you’ll know that your inventory represents a large portion of your assets. That’s why you need to understand your true cost of inventory, so that you can reduce your carrying costs and improve your profitability.
In fact, many business owners don’t realize the cost of carrying excess inventory – striking the balance between stocking just enough items can be challenging at the best of times.
In this article, we discuss what carrying costs are, with examples of common holding costs experienced by retailers.
We also list ten ways in which you can reduce your inventory carrying costs to increase your profits and improve the daily running of your business.
Read the article: Inventory management techniques: 7 methods for success.
What are inventory carrying costs?
Carrying costs (also known as inventory holding costs or cost of inventory) can be defined as the cost of holding goods in stock. If you’re looking for ways to reduce your inventory cost, chances are you’re stocking too much inventory.
Minimizing inventory costs is an important supply chain management strategy.
In fact, carrying costs typically range between 20-30% of a company’s inventory value.
That means for every £1 million worth of products, you’re paying between £200,000 to £300,000 to store them in a warehouse and move them in and out of your inventory.
Therefore, inventory management is incredibly important to your business’s bottom line. In fact, we’ve summarized all of the core benefits here.
Some common inventory holding costs include:
Warehousing and logistic costs
Think of these expenses as regular warehousing costs that your retail business must factor in, such as rent, labour and utilities.
Logistic costs related to managing inventory include the organisation and running of an inventory and order management system, including modes of transport to ship goods from customers to suppliers.
It’s likely that you’ll have insurance costs to keep front of mind in order to insure your inventory and stock against theft, losses and destruction.
You may find that these holding costs can be quite substantial, depending on the industry and location that you operate in.
Materials handling costs
These refer to the costs of moving materials and products from one place to another, either in the same warehouse or across greater distances to customers.
Examples of such costs can include buying or leasing materials handling equipment, such as forklifts, pallet trucks, palletisers, small trucks or vehicles, as well as the labor to operate these machines.
Capital inventory carrying costs include the total cost to purchase the inventory items that are being stored.
Within this category of holding costs, examples include the actual cost of inventory items, financing fees, loan maintenance fees and any interest accrued.
Storage carrying costs are expenses that are related to both the physical infrastructure required to store inventory and any supporting costs involved.
Such holding costs include facility maintenance and upkeep costs, organizational infrastructure (such as shelving and automation tools) as well as facility security.
Risk holding costs can affect your overall cost of inventory either directly or indirectly.
These costs may include:
- Inventory depreciation (items depreciate over time and do not retain 100% value)
- Write-offs (a portion of a company’s inventory that no longer has value)
- Shrinkage (loss of inventory)
- Stock outs (a situation in which an item is out of stock)
- Strategic planning costs
Handling inventory carrying costs are related to all costs required to facilitate safe and cost-effective inventory handling within the warehouse.
Such costs may extend to inventory management technology, insurance and any associated taxes.
Ways to reduce inventory carrying costs
Watch out for minimum order quantities
A minimum order quantity (MOQ) is the minimum order size accepted by a supplier.
Lowering the MOQ means that you’ll be holding less stock but purchasing more frequently, therefore reducing your cost of inventory. Smaller, more frequent orders enable your business to have more flexibility when there’s demand shift.
The best strategy to reduce MOQ is to create strategic relationships with your key suppliers.
It’s easier to negotiate lower orders when suppliers recognize that you are serious about creating a long-term mutually beneficial business relationship with them.
There are a couple of other ways to avoid minimum order quantities:
For example, if you know another business owner who requires the same stock, you could put your money together and then split the stock between yourselves.
Another way to reduce your MOQs is to offer to pay your supplier a little more money for less inventory, which may end up saving you more money in the long run and reduce your cost of inventory.
Calculate a reorder point
An ideal reorder point ensures that your inventory does not dip below your safety stock levels. It helps to minimize holding costs by alerting you when you need to buy more stock from your suppliers.
A benefit of using a reorder point is that you will avoid shortage costs, which is the risk of losing a customer order due to low inventory levels. If you know your reorder point, you’ll know when’s the right time to place orders for new shipments.
It does have to be said that the bigger your business grows, the more challenging this will get, as the reorder point is different for every product variant.
For example, if you sell clothing then you will need to resolve the reorder point formula separately for every color variant and every size variant of each clothing item.
There are lots of ways to decide how to determine your reorder point.
In fact, a recent study from GetApp found that retail businesses use three key methods:
- Information from previous months (46%)
- Forecasting software (15%)
- Reorder point formulas (13%)
- Other (26%)
Knowing your reorder point can ensure you never order too much and risk obsolescence, but never order too little and risk stock-outs, which helps to reduce carrying costs.
Reduce supplier lead time
Lead time is the length of time it takes from the moment an inventory order is placed up until the supplier delivers the goods. In other words, it’s the amount of time the supplier takes to fulfill an order.
When the supplier lead time is high, you have to stock more safety stock in your warehouses so that you can fulfill all your customer orders. This leads to larger holding costs as you need to store extra inventory.
You can keep inventory levels, and therefore your cost of inventory, lower by speeding up supplier lead times.
The best way to do this is to develop strong relationships with your suppliers.
Remember to highlight that if they can reduce the lead time that you’ll be making more frequent orders as this should work in your favor.
By negotiating faster supplier lead times, you have more flexibility when reordering inventory. The benefit is that it allows for less stock to be carried, which reduces your carrying cost and the long-term risk of holding items that could end up becoming obsolete.
To do this effectively, you’ll need to optimize your order size and purchasing frequency.
One way in which you can achieve this is through demand forecasting – the use of historical sales data to develop an estimate of an expected forecast of customer demand – which allows you to meet demand and not carry too much extra inventory to reduce your costs.
Get rid of obsolete stock
Obsolete stock is a common problem that many online retailers experience.
Generally speaking, when you overestimate the potential of a product, you can end up with a number of items that don’t sell due to a lack of customer demand.
The disadvantage to this is that it increases your holding costs as you are storing inventory that cannot be sold and taking up valuable space in your warehouses that could be put to better use.
One way in which you can minimize this issue is to monitor the product life cycles of each of your products and make better estimations when purchasing.
In fact, better knowledge of both the product lifecycle and the pattern of customer demand will help you make better decisions when ordering more inventory.
If you’re looking for ways to reduce your inventory, and therefore minimize your holding costs, then there are many ways in which you can achieve this.
- Product bundling:Combine dead stock with popular items and sell the products at a significant discount.
- Return to supplier:Check to see if your supplier has a returns policy that supports returns after long periods of times, but keep in mind there may be extra fees.
- Donation:If your residential country gives you tax deductions for the market value of donations to charities then donating old stock may be the way forward.
Once you’ve gotten rid of the obsolete stock, you need to prevent it from building back up.
You can do this by adjusting your demand forecasting based on expected future sales so that you’re ordering the correct quantities of stock. This enables you to reduce your cost of inventory quite substantially and ensures you’re not overstocking or understocking.
Improve the layout of your warehouse
An organized warehouse helps you to efficiently sort your inventory and improve the overall layout of your facility, therefore reducing some of your carrying costs.
On the other hand, a disorganized warehouse is likely to increase the chances of misplaced or damaged inventory and can increase travel expenses, which is especially true in large warehouses where workers travel thousands of square feet for a single product.
The most effective way to design your warehouse is to put your fast-moving items up in the front in the staging area as this optimizes your pick, pack and ship process.
You can find your fast-moving items (or items that require regular replenishment) by analyzing your inventory flow through rates.
Identifying these items helps you to prioritize putaway (the process of taking products off your receiving shipment and storing them in your warehouse) and picking locations within your warehouse, putting fast-moving products closer to staging areas.
Through the strategic organisation of your warehouse, you can reduce travel time and other associated carrying costs such as maintenance on forklift trucks, labor hours and more.
Implement a Just in Time (JIT) inventory system
Just in Time (JIT) inventory management means having the right products and materials, at the right time and in the right place and the right amount of materials to make a product.
In other words, JIT is a method for keeping almost no inventory in your warehouse at all, instead ordering everything you need the moment you need it.
It is a form of lean manufacturing that mostly eliminates the cost of inventory as items and materials are ordered when they are needed rather than weeks or months in advance.
What’s more, with a minimal amount of inventory being stored, you won’t need a large warehouse which minimizes your warehouse costs.
In order to make best use of JIT inventory management, you’ll need to:
- Develop strong relationships with your suppliers
- Locate long-term suppliers for each purchased part
- Shorten your production cycles
- Separate your repetitive orders from your one-stop business
- Improve your quality control program
Of course, it does have to be said that that JIT isn’t suitable for every retail business, but it is a proven way to dramatically reduce your inventory holding costs.
Use consignment inventory
Consignment inventory allows you to leave a portion of your inventory with your supplier until it has been sold. This means that you have lower inventory levels, therefore reducing your cost of inventory.
What’s more, as online retailers using consignment inventory don’t buy the inventory until it has been sold, unsold products can be returned.
Generally speaking, products that are sold through the consignment model are often seasonal or perishable. It’s greatly beneficial to online retailers when customer demand is uncertain.
In addition to this, by carrying the product on consignment, the online retailer takes a smaller financial risk as they do not pay for the product unless it is sold.
Use accurate demand forecasting
Another strategy to help reduce your carrying costs is to use accurate demand forecasting.
Monitoring your business in real-time lets you know when you’re low on stock and when you need to order more. You can also identify your best-selling items, your worst-selling items and trends in demand.
In other words, forecasting demand through accurate reports enables you to order just enough inventory to satisfy demand throughout the year, therefore reducing your overall cost of inventory as you won’t be overstocking or under-stocking your warehouse.
Once you are able to identify your slow-moving stock, you can focus less on that and more on what is selling – the key is to measure data effectively with software.
Many inventory management systems provide detailed reports regarding movements in your warehouse as well as help you to identify customer buying patterns and seasonal trends, enabling you to anticipate increases in stock demand.
Predictive data analysis allows you to make better business decisions past on previous months, helping you to estimate the correct size of your inventory. This way, you don’t order too much and don’t risk being too low on inventory.
In addition, closely monitoring sales trends enables your retail business to further reduce carrying excess stock which also reduces the associated storage and handling costs.
In order to predict sales and demand, there’s a few key factors you’ll need to track:
- Historical sales data
Identifying ordering patterns throughout the year helps to determine how much stock you need to purchase to fulfill future orders.
- Planned promotions and marketing campaigns
Predicting the impact that your promotions and planned marketing campaigns will have on your sales allows you to adjust your inventory accordingly.
- The overall economy
Looking towards the current state of the economy, predict how customer demand may increase or decrease for your industry and products.
Consider using an Economic Order Quantity (EOQ) system
Ordering a large number of products each month will decrease your order frequency and ordering cost, but the amount of stored inventory and your carrying costs will increase.
In comparison, making small but frequent product orders throughout the month will decrease your stored inventory and holding costs, but increase your order frequency and ordering cost.
To balance both of these outcomes, you can use the Economic Order Quantity (EOQ) system. The EOQ is the number of units that a company should add to its inventory with each order to minimize the total cost of inventory.
The EOQ system is typically used as part of a continuous review inventory system, where the level of inventory is monitored at all times and a fixed quantity is ordered whenever the stock level of a product reaches a certain reorder point.
Try to avoid overstocking and understocking your inventory
The situation of overstocking arises when you buy more inventory than you can sell, which lowers your profits. This happens because you’re spending money on stock that you won’t be able to earn back from selling.
This increases your holding costs as you are storing inventory that can’t be sold.
Here are some ways overstocking can become costly for your business:
- Your excess inventory becomes obsolete – it’s difficult to sell items because they become out of season, out of style or irrelevant.
- Your excess inventory becomes spoiled – you can’t sell items due to expiration.
- Your excess inventory leads to greater storage costs – as you inventory isn’t selling, you have to pay more in storage fees without receiving any revenue.
On the other hand, you can also lose money through not buying enough inventory.
- You fail to complete a number of orders due to not having enough stock to fulfil the maximum amount of sales.
- You lose customers by not fulfilling their orders, therefore increasing the likelihood of losing future sales with them should they become dissatisfied with your service.
- You risk overselling due to stock outs.
You can minimize the risks of overstocking and understocking – and therefore reduce your holding costs – by forecasting sales based on historical data.
Basing your future orders on how well your sales have performed in a previous period (e.g. monthly) is an effective way to ensure that you maintain more accurate stock levels.
You can also set up automatic alerts when your stock reaches a certain threshold so that you’ll know when to reorder. This can be achieved through use of an inventory and order management system.
Reduce your cost of inventory and turn a profit
Now that you understand your carrying costs and how to reduce your cost of inventory, you can start to turn more profit and build an even more successful retail business.
Although perfecting your stock levels and holding costs can be challenging at first, it’s crucial to get right if you want to grow your online business into a profitable empire.
Want to take your business to the level? Find out 50 of the most effective tips and best practices for growing your business by downloading our guide on 50 ways to grow your ecommerce business and start selling more today.