Welcome to Chapter 12 of our inventory management guide. This chapter focuses on the typical expenses associated with inventory management.
There are many costs associated with inventory management, some more important than others. However, you should be familiar with them all.
Typical expenses that inventory management incurs, such as software, services, employees, and utility bills, should never be neglected.
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Why Are Inventory Management Costs Important?
Inventory management costs are before the sale of goods and are important because they impact your company’s bottom line and your ability to get tasks done.
Inventory management costs are just as important as any other costs your business incurs to operate, such as fulfillment, and arguably more than other areas, such as marketing.
It’s easy to underestimate inventory management costs. After all, products just sit around on a shelf all day doing nothing, right?
Nope. Plenty is going on that needs to be accounted for, and it would be foolish to think inventory management costs companies nothing.
There will always be pressure from above to lower costs and increase efficiency, which is easier said than done, and inventory management is no exception.
Analyzing inventory management costs must be a regular task for inventory managers. After analyzing your inventory management costs, you may look to lower them in some areas.
You can create KPIs for certain costs to aim to lower them. This is particularly important if your business’s margins are very thin.
Furthermore, it should be investigated if a particular inventory management cost is higher than usual.
If you need to convince your superiors to invest in new tech, such as software, it will help you considerably if you already understand your current inventory management expenses.
You can also inform them that investing in warehouse inventory management software can help you lower inventory management costs.
Most often, you will need software with accounting features to track these expenses and to produce the reports, which you can then analyze and isolate costs that can be lowered.
If you don’t track these expenses, they can get wildly out of control if you’re not careful.
16 Most Common Inventory Management Costs
You might not need to monitor every cost associated with inventory management. You should track the expenses that make the most sense for your business.
You may prefer more of a general overview or to dig into specific costs, enabling you to pinpoint costs you might want to reduce.
Here are the most common inventory management costs you will encounter. Note that some of the costs listed can encompass other costs; many are known by multiple names.
1. What Are Ordering Costs?
Also known as ‘set up costs,’ ordering costs are the expenses associated with placing and receiving inventory orders from suppliers. Ordering costs can include:
- The price of creating a purchase order from a supplier.
- Payment processing fees.
- Administrative costs.
- Transportation.
- Inspection costs.
- Shipping fees.
Ordering costs are typically larger when you make many orders. Merchants can reduce ordering costs by making larger orders instead of multiple smaller orders.
However, larger orders may increase the chance that you overstock on products.
2. What Are Holding and Carrying Costs?
‘Holding’ and ‘carrying’ costs are interchangeable terms associated with holding inventory not yet sold, such as storage, insurance, obsolescence, etc. How you calculate the cost of inventory waiting in a warehouse can vary.
Holding costs and ordering costs are interrelated. If holding costs are low, some companies may be able to handle higher ordering costs. However, there is a tradeoff.
Reducing ordering costs involves ordering larger quantities less frequently. This can lead to higher holding costs because more inventory needs to be stored.
Conversely, reducing holding costs may involve ordering smaller quantities more frequently. This can increase ordering costs due to the higher frequency of orders.
So, when it comes to ordering and holding, a company must determine which is a better financial decision—holding more and ordering less or holding less and ordering more.
3. What Are Stockout Costs?
Also known as ‘shortage costs,’ stockout costs are the costs associated with running out of inventory, such as lost sales.
For example, because some products are no longer in stock, you miss several orders you could not fulfill. The total cost of those orders could be considered your stockout costs.
Stockout costs can also include the cost of rush orders and backorders, which are orders that need to be processed and expedited sooner than standard orders.
Rush orders can be costly because, aside from costing more to ship to customers, they are also costly to order from suppliers and manufacturers.
Adopting a proper inventory control system can help reduce the likelihood of running out of stock.
4. What Are Overstocking Costs?
We’ve discussed the problems caused by overstocking in the other chapters of our inventory management guide. It should be no surprise that having all that extra stock lying around is an unwanted expense.
Overstocking costs companies in several ways:
- It takes up storage space and costs to maintain.
- It can cost companies even more if it becomes obsolete.
- It is increasingly more likely to expire.
- Costs the company more in holding costs.
According to a study by ROI Hunter, as many as 62% of companies struggle with overstocking.
5. What Are Capital Costs?
Capital costs are another expense that includes several other costs, some of which we have already mentioned.
Capital costs come with acquiring and holding inventory (holding/carrying costs), including the initial purchase price of goods, shipping costs, and sometimes the related financing costs.
Capital costs are also known as ‘acquisition costs.’
6. What Are Inventory Shrinkage Costs?
Inventory shrinkage is where inventory is lost due to reasons other than sales. It can result from employee theft, expiration, damage, obsolescence, administrative errors, or operational loss.
The median inventory shrinkage rate is approximately 1%.
7. What Are Expiration Costs?
In inventory management, expiration costs are associated with the gradual decline of product quality the longer it remains unsold.
Expiration costs can be unavoidable and are often expected. You can’t expect products to last forever. Perishable products are more at risk of expiring than others and will likely have higher costs.
You can reduce expiration costs with proper storage, particularly perishable ones. Faster fulfillment will also reduce the chances of you having to deal with expired inventory, as will regular inspections.
8. What Are Damage Costs?
Damage costs are the costs of damaged inventory. This inventory must be repaired, returned to the manufacturer, or destroyed. You will also likely have to order more stock to replace it.
According to Packing Digest, the average cost of damaged inventory arriving at distribution centers is approximately 2%, though it can be as high as 11% in some instances.
Damage costs can also include expired inventory (mentioned above) and losses due to theft, deterioration, or mishandling during storage or transportation.
9. What Are Obsolescence Costs?
Obsolescence costs are the cost of inventory that is now obsolete (products that people no longer want to purchase because they have outworn their need—technologically or in clothing, no longer fashionable).
For example, more than ten years ago, if your company still had DVD players in its inventory after everyone had moved onto streaming services, they would be obsolete. So, storing them in your inventory is an obsolescence cost.
According to Manufacturing.net, as much as 20-30% of inventory is dead or obsolete, which can be an enormous drain on many companies’ expenses.
10. Theft and Fraud
A challenge mentioned in the previous chapter is that criminal activity, such as theft and fraud, can happen unexpectedly. It can be referred to as ‘organized retail crime’ (ORC) and costs businesses money.
According to the National Retail Federation’s 2022 Nation Retail Security Survey, retail losses from inventory shrinkage cost the retail industry $100 in 2022.
Much of that is attributed to ORC, which, in terms of inventory management, involves cargo theft and theft from employees in the warehouse.
Ideally, you want to reduce the potential losses from theft and fraud to 0. The best way around this is to properly vet your employees and use a warehouse management system with warehouse visualization features to track movements.
11. Third-party Service Costs
If you are using a third-party fulfillment service like Amazon’s FBA (Fulfillment By Amazon) or Walmart’s WFS (Walmart Fulfillment Service), this is a third-party cost.
There are also many other 3PL (third-party logistics) companies that you can pay to handle your inventory. You can ship inventory to them, and they handle the inventory and logistics and ship it out to customers when there is an order.
Of course, if you plan to handle all inventory management and fulfillment services yourself at your warehouse, this is not a cost you will have to cover.
Some smaller companies just starting out may find such services useful, though as they grow and expand, they may want to reduce these costs by bringing these tasks in-house.
Additionally, more established companies may use third-party inventory management services if they are experiencing exceptionally high demand and need help.
3PL inventory management services charge per order handled and also charge for storage space.
However, no two third-party services are the same and will probably charge users differently, so you must look into this before choosing one.
12. What Are Software Costs?
Software costs come from the software you use to keep your warehouse running and inventory management processes in operation.
Inventory management software costs can vary depending on the arrangement you have. You may pay a monthly or annual subscription or pay by the order.
Some software may have certain brackets—if you surpass a certain number of orders, you may need to pay for more.
The software you use may also charge for additional plugins and services you need, further increasing your software costs.
According to Adam Uzialko of Business News Daily, inventory management software typically costs between $100 and $3,000 monthly.
However, it’s also important to point out that implementation costs and additional costs for plugins and other services can significantly increase your monthly rate.
13. Fees, Taxes, and Insurance Costs
Never fun, easy to forget, but always there; fees, taxes, and insurance costs are a must. It’s a cost you always want to be prepared to pay.
Accounting tools can take care of many of these costs, from importing goods from Asia to sales tax.
It helps to understand these costs and find ways around them if necessary. For example, if you won’t get taxed if an order is under a certain threshold, order under that limit if possible
14. Poor Investing
You can’t predict the cost of poor investing in inventory management. It is subjective and something you can only reflect on later.
It could be the cost of implementing software that wasn’t right for your company, though more commonly, poor investing takes the form of things like overstocking.
Some years, you might not lose anything to poor investing. In other years, it could be a significant drain. Ensure you learn from this expense and avoid it in the future.
15. What Are Labor Costs?
Labor costs are the costs associated with the employees who work in inventory management and are constant requirements for businesses. Adequately trained labor will be more efficient and cost less in the long run.
These are the people who are:
- Picking and packing orders.
- Handling returns.
- Handling incoming and outgoing inventory.
- Packing shelves.
- Inventory counts.
- Ordering inventory.
- Handling kits.
The list goes on.
Labor costs can also include sourcing employees and training them, not just the hours they work at the warehouse.
Labor costs will be higher during certain times of the year. The most obvious is the holiday season. You may need to hire additional temporary employees to handle the increased workload.
Furthermore, depending on the type of business you run, you may experience more demand for labor at other times of the year.
16. What Is ‘Total Cost of Ownership’ (TCO)?
The total cost of ownership is the total cost of acquiring and owning inventory, including purchase price, transportation costs, holding costs, and disposal costs.
It may seem similar to capital costs, but there is an important difference—it also includes operating and maintenance costs. It includes direct and indirect costs.
Many expenses are involved in calculating the total cost of ownership. It might not be a cost you calculate often. You may do it annually.
To calculate TCO, you will need to know the following expenses (many go beyond inventory management):
- Purchase price.
- Transportation costs.
- Storage costs.
- Holding or carrying costs.
- Handling and labor costs.
- Insurance costs.
- Taxes and duties.
- Obsolescence and depreciation costs.
- Inspection and quality control costs.
- Inventory financing costs.
- Packaging costs.
- Environmental and regulatory compliance costs.
- Damage and shrinkage costs.
- Supplier and vendor management costs.
- Order processing and administration costs.
- Return and disposal costs.
- Technology and software costs.
- Training and education costs.
- Opportunity costs.
- Risk management and contingency costs.
Some companies prioritize investing in stock with lower TCO costs.
Key Points From Chapter 12
Remember these key points from Chapter 12 of our inventory management guide.
- Inventory management costs are important because they’re needed so your business can operate and cost your business money. Some can be reduced; others are a constant expense.
- Some costs encompass several others. You may need to combine several costs to understand a larger expense.
- You can’t calculate all the costs. Some are unexpected and can only be seen in hindsight. The best you can do is learn from them and avoid them in the future.
In Chapter 13, we’ll discuss inventory management best practices.