Inventory Costs: Definition, Calculation, Mistakes to Avoid, Affecting Factors, 3 Lowering Methods, Types of Inventory Costing Methods and 5 Types of Inventory Costs in 2023
Inventory is debatably the most important asset of any retail business. By selling it, businesses can make up the expenses they spent on research and development, production, marketing, fulfillment, and more, and eventually start becoming profitable. This is why it is imperative for companies to constantly monitor and analyse their inventory and the costs associated with it.
Inventory costs comprise of various components and if steps aren’t taken to keep them in check, each cost can skyrocket, reducing the profit margins of the business and placing an immense burden to try and bring them down. This can be avoided by simply being aware of what inventory costs are, how they can be calculated, common mistakes to avoid, elements that affect them, methods to lower them, the types of inventory costing methods you can use and the various types of inventory costs, all of which will be covered in this blog so read along.
- What are Inventory Costs?
- How Can Inventory Costs be Calculated?
- Recurring Mistakes Associated With Inventory Costs to Avoid in 2023
- Elements That Affect Inventory Costs
- 3 Methods to Lower Your Inventory Costs
- Types of Commonly Used Inventory Costing Methods in 2023
- 5 Types of Inventory Costs
- Conclusion: Utilize InventoryLogIQ’s Advanced Solutions to Regulate Your Inventory Costs
- Inventory Costs: FAQs
What are Inventory Costs?
Inventory costs are the expenses that are associated with storing, managing and maintaining inventory. All of these costs can add up quickly and have a significant impact on a company’s bottom line, which is why inventory management is an important part of any business strategy. The lower the overall inventory costs, the higher the profit margins and the more successful your business will be. There are various strategies that can be used to reduce the various types of inventory costs, which will be covered later on in the blog.
How Can Inventory Costs be Calculated?
Using the Inventory Cost Formula
You can learn how to calculate inventory costs using the inventory cost formula with the help of this real-world example. Suppose you begin your business operations for the year with inventory that is worth around $20,000. As the year progresses, you purchase more inventory needed to fulfill orders that is worth around $100,000. At the end of the year, you are left with inventory that is worth $50,000. We will now use the inventory cost formula to calculate your total inventory cost for the year. It is as follows:
Inventory Cost = (20,000 + 100,000) – 50,000
Inventory Cost = $70,000
Using Inventory Cost Calculators
You can also use various inventory cost calculators that can be found online to streamline the calculation process. They will help in automating the calculation process, saving you time and enhancing the accuracy of ascertaining your inventory costs. You simply need to enter the relevant information pertaining to your beginning inventory, inventory purchases and ending inventory over the course of the year. After that, the tool will automatically perform the calculation for you, greatly enhancing the effectiveness of the calculation.
Recurring Mistakes Associated With Inventory Costs to Avoid in 2023
Misjudging the Value of Using Inventory Management Software
The process of managing inventory is complex. It is insufficient to rely solely on manual procedures and spreadsheets, which can be error-prone and inefficient. You can get your business out of these sticky circumstances by using the strategic inventory solutions offered by inventory management software. Using a dedicated software solution will enable you to be ready for scenarios that would otherwise have a significant negative impact on your business by keeping track of your inventory in real-time and putting backup plans in place for possible future inventory issues.
Constantly Purchasing Large Amounts of Inventory
Bulk purchases can frequently result in lower spending but they may not always be the greatest choice if you don’t consume or sell the products before they become obsolete. Unsold products that are no longer in use or have expired may cause you to lose money. This is why it is important to conduct accurate inventory forecasting of the upcoming demand your business expects to face and plan your inventory purchasing and stock replenishing strategies accordingly.
Understocking Fast-Moving Products
On the other hand, some companies might aim to cut costs by keeping fewer units of stock on hand. Being overstocked is probably more preferable to being understocked because you can still fulfill orders when they come in as opposed to losing out on that business entirely. If you make the mistake of underestimating your demand, your products will frequently be out of stock, which will irritate customers and cause them to shop elsewhere, resulting in negative feedback and a poor impression on prospective customers.
Refusing to Use Inventory Management Software for Forecasting
Even while historical sales data is frequently used to anticipate future sales, it is insufficient in providing precisely accurate forecasts. Many businesses undervalue the impact of inventory management software during the process of inventory forecasting, which gives you crucial information to keep your inventory levels ideal. In order to conduct forecasts about when and how much you need to refill, you can track product performance, the inventory turnover rate, average lead times to obtain fresh stock and more with the aid of an inventory management system.
Attempting to Manage Inventory Costs Only After a Product Launches
The idea that you should only manage your inventory costs once a product launch is a frequent one. By doing this, you run the danger of having to cope with costly inventory purchases and supply problems. For instance, if you didn’t plan ahead for an unforeseen situation, it could take months to produce and refill your inventory levels if you wind up selling out quickly after a successful debut. Therefore, throughout the protracted waiting period, you may run the risk of losing potential clients.
Elements That Affect Inventory Costs
Lack of Storage Space
It is difficult to store inventory and make place for additional seasonal products when warehouse vacancies are scant. Retailers must therefore turn to other solutions that could have a negative effect on their inventory expenses and storage quality. Total inventory expenses, for instance, can be impacted by the price of leasing new space, the added costs of getting rid of outdated goods and transporting your inventory from the existing warehouse to the new one.
Fluctuations in Demand
A multitude of variables could cause varying degrees of demand for certain products for any and every type of business. A negative press report could result in a sharp decline in demand, whilst a positive influencer evaluation could possibly have a reverse impact. Geopolitical concerns and other metrics can also potentially cause unanticipated surges and declines in demand, which will have an impact on your inventory prices and your purchasing decisions. If not accounted for correctly, it could cause your inventory costs to skyrocket.
Hindrances in Transportation
Transit delays might occur while transporting inventory to your fulfillment centers as a result of bad weather, traffic delays and other unforeseen circumstances. Due to delays while products are being transported, several businesses experience clogged supply chains, which cost them money and cause them to lose customers. This can also make journeys longer, more perilous and increasingly expensive than initially anticipated, resulting in overall higher inventory costs.
3 Methods to Lower Your Inventory Costs
Avoid Ordering in Bulk Just to Save Costs
To get rid of excess inventory, certain suppliers may offer certain promotions, such as “buy one, get one free” or “50% off” if the order quantity is above a certain level. While this may sound attractive initially, going through with it will raise your carrying costs, which will raise the overall cost of your goods and reduce your profit margins. Be careful not to order items in bulk specifically because you receive an enticing offer. To avoid the significant expenses involved in overstocking products, stay true to your initial inventory management approach.
Get Rid of Dead Stock
Dead stock refers to products that a business has not been able to sell and has been sitting in inventory for a long period of time, often becoming outdated or obsolete. Even while you would want to convert unsold inventory into a profit, if it stays on the shelves for too long, carrying costs would quickly cut into your margins. To save money on storage space and make room for additional items that have a genuine chance of fetching you a profit, make sure to actively track and eliminate the accumulation of dead stock.
Streamline Replenishment Procedures
You can improve your ability to replenish inventory in the right quantities by using several inventory management strategies and investing in a good software solution. To prevent the probability of stockouts and overstocking from occurring, take extra precautions not to order too much or too little based on the current demand for those commodities. A coherent inventory management software will employ the use of analytics and forecasting to make sure that your inventory levels are always ideal. You can also easily restock your inventory by establishing precise reorder points and getting automated reorder notifications.
Types of Commonly Used Inventory Costing Methods in 2023
FIFO (First In, First Out)
The FIFO method for inventory costing is based on the straightforward tenet that a company should sell its oldest inventory first and that not all inventory has the same value. This inventory costing approach is frequently used by companies that sell perishable goods or products that can go out of style. Making use of older items before they expire or become out-of-date is a key component of this strategy. However, due to its clarity, precision and simplicity, it is also well-liked in a wide range of other industries. The FIFO approach is also well-liked because it results in better profit margins. The cost of goods sold using FIFO can be calculated using the following formula:
Cost of Goods Sold Using FIFO = Cost of the Oldest Inventory x Units of That Inventory Sold
LIFO (Last In, First Out)
The LIFO method, which is the polar opposite of the FIFO method, is predicated on the notion that a company should sell its most recent inventory first. The fundamental benefit of employing LIFO is that, in terms of accounting, it enables you to compare your most recent expenses to your most recent revenues, raising the value of your inventory while reducing your net income. Since there are rarely compelling reasons to sell newer inventory over older SKUs, the majority of retailers do not opt to adopt LIFO. The cost of goods sold using LIFO can be calculated using the following formula:
Cost of Goods Sold Using LIFO = Cost of the Newest Inventory x Units of That Inventory Sold
Weighted Average Cost
The weighted average cost method averages the cost of all purchased items using a predetermined weighted cost. The inventory value of a certain unit determined using this method is a compromise between the newer and older units of acquired stock. When products are somewhat identical to one another or when it is impractical to assign precise costs to individual products, this strategy is frequently utilised. Since only one formula or calculation is required, it is also among the simplest methods for tracking and costing inventory. The weighted average cost can be calculated using the following formula:
Weighted Average Cost = Cost of Goods Available for Sale ÷ Number of Units Available for Sale
5 Types of Inventory Costs
The initial bulk investment charges needed for physically holding your goods are referred to as investment costs. Purchasing warehouse space is just one example of this kind of expense. The most expensive costs for businesses that are associated with inventory are often investment costs, since it is responsible for getting all the infrastructure in place to be able to store it. There also may occasionally be problems pertaining to warehouse space. Auditing your storage space several times a year is crucial because needing to increase your storage capacity can also result in increased investment costs.
Maintenance expenses for inventory storage systems are referred to as storage costs. This can cover ongoing expenses like rent, utilities, security and personnel salaries. Remember that if you hang onto merchandise for a long duration, especially if a portion of it has become unsellable, storage fees can soon mount up. Additionally, storing unsellable inventory for too long can quickly affect your bottom line owing to greater expenditures and fewer sales until these products have either been disposed of or donated elsewhere.
Tax and Insurance Costs
The expense of paying taxes and insurance that must be taken into account by businesses is referred to as tax and insurance costs. Avoiding these expenses could have major long-term effects and legal implications for your company. We advise seeking expert advice on this subject because the real costs and requirements may differ based on the type of industry your company falls in, the nature of your products, your yearly sales volumes and more. Additionally, it is best not to skimp on getting good insurance for your products to safeguard them in the case of accidents or mishaps.
Improper Budgeting Costs
Without having a suitable budget or strategy, you run the danger of losing a lot of money when you invest in inventory. You will have the risk of purchasing inventory that you don’t truly need, for instance, if you don’t calculate how much to purchase before you acquire it. If it remains unsold, it will increase your carrying costs in the future. To ensure that you aren’t overpaying for inventory, demand forecasting should be conducted by keeping track of historical order data and putting in place a system to keep track of inventory in real-time so that you can successfully plan for the future.
Damage and Theft Costs
The price of inventory shrinkage brought on by illegal activities like theft and fraud must also be taken into account. Your inventory expenses could be seriously threatened by dishonest staff and malicious customers. Thus it is critical to invest in safety facilities to guard against these dangers. Inventory can also sustain damage while in storage or transit, which entails extra expenses. There is also the chance of your inventory becoming outdated if you have an excessive amount of unsold stock that is near the end of its useful life. Due to the high expense of obtaining and transporting these commodities, your business could wind up losing money on them.
Conclusion: Utilize InventoryLogIQ’s Advanced Solutions to Regulate Your Inventory Costs
Keeping inventory costs in check should be one of the most important priorities for every company. Since selling inventory is the number one method that a business uses to make their money back and eventually become profitable, maintaining and purchasing inventory cannot have the opposite effect by losing money. If enough attention is paid to regularly monitoring inventory costs, your business can regulate them. There are many procedures that can be put in place to accomplish this, some of which include using advanced inventory management software, conducting accurate forecasting, replenishing inventory on time and storing accurate amounts of inventory to successfully meet demand. If you need assistance with any or all of these procedures, InventorylogIQ can be of service.
InventoryLogIQ is an inventory management platform that uses advanced technology to manage every aspect of your inventory, from tracking and managing to recording and forecasting. Some of the ways we can help you regulate your inventory costs are listed below:
- We provide a custom OMS that can track your inventory and update you in real-time
- We enable automated inventory replenishment triggers whenever a certain SKU is running low
- We offer inventory purchasing suggestions to help you store precise levels of inventory so that it doesn’t go to waste
- We provide accurate inventory forecasting by tracking your historical inventory and sales data
- We help you lower operational and holding costs by optimizing all of your inventory management procedures