Inventory Carrying Cost

Tags: Glossary

One of the elements comprising a company's total supply chain management costs are as follows: Opportunity Cost: The opportunity cost of holding inventory should be based on your company's own cost of capital standards using the following formula: Calculation Cost of Capital x Average Net Value of Inventory. Shrinkage: The costs associated with breakage, pilferage, and deterioration of inventories usually pertain to the loss of material through handling damage, theft, or neglect. Insurance and Taxes: The cost of insuring inventories and taxes associated with the holding of inventory. Total Obsolescence for Raw Material, WIP, and Finished Goods Inventory: Inventory reserves taken due to obsolescence and scrap, including products exceeding the shelf life (i.e., spoils) and those that are no longer suitable for their original purpose (do not include reserves taken for Field Service Parts). Channel Obsolescence Aging: Allowances paid to channel partners, provisions for buy-back agreements, etc. This includes all material that becomes obsolete while in a distribution channel. Usually, a distributor will demand a refund for material that goes bad (shelf life) or is no longer needed due to changing needs. Field Service Parts Obsolescence: Reserves taken due to obsolescence and scrap. Field Service Parts are the inventory kept at locations outside the four walls of the manufacturing plant, such as a distribution center or warehouse.

What is Inventory Carrying Cost?

Inventory carrying cost refers to the expenses incurred by a company for holding and managing its inventory. It is an essential aspect of supply chain management and plays a significant role in determining the overall cost efficiency of a business.

There are several components that contribute to the inventory carrying cost. One such element is the opportunity cost. This cost is based on the company's cost of capital and is calculated by multiplying the cost of capital by the average net value of inventory. Essentially, it represents the potential return that could have been earned if the capital invested in inventory had been used elsewhere.

Another component is shrinkage, which refers to the costs associated with the loss of inventory due to breakage, pilferage, or deterioration. These losses can occur during handling, transportation, or due to theft or neglect. Shrinkage adds to the overall inventory carrying cost and needs to be minimized through effective inventory management practices.

Insurance and taxes also contribute to the inventory carrying cost. Companies need to insure their inventory against potential risks such as damage, theft, or natural disasters. Additionally, taxes may be levied on the inventory held by a company, further increasing the overall cost.

Total obsolescence for raw material, work-in-progress (WIP), and finished goods inventory is another factor that adds to the inventory carrying cost. This includes inventory reserves taken due to obsolescence and scrap. For example, products that exceed their shelf life or are no longer suitable for their original purpose may need to be discarded or sold at a loss, resulting in additional costs.

Channel obsolescence aging is another component of inventory carrying cost. It refers to allowances paid to channel partners or provisions for buy-back agreements when material becomes obsolete while in the distribution channel. Distributors may demand refunds for inventory that has gone bad or is no longer needed due to changing market demands.

Lastly, field service parts obsolescence contributes to the inventory carrying cost. These are reserves taken due to obsolescence and scrap of inventory kept at locations outside the manufacturing plant, such as distribution centers or warehouses. Managing the obsolescence of field service parts is crucial to avoid unnecessary costs.

In conclusion, inventory carrying cost encompasses various expenses associated with holding and managing inventory. It includes opportunity cost, shrinkage, insurance and taxes, total obsolescence, channel obsolescence aging, and field service parts obsolescence. By understanding and effectively managing these costs, companies can optimize their inventory management practices and improve their overall supply chain efficiency.

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