11 24 2015

Understanding the True Cost of Inventory for Small Businesses

11 24 2015

Understanding The True Cost Of Inventory

Sometimes one of the most necessary reasons to obtain working capital from an alternative lender is to maintain an adequate stock of inventory. As a small business owner, you know the importance of ensuring your company has just the right amount of goods to sell without overstocking when demand is low, or running out of inventory when demand is high.

Inventory is no trivial matter either, since it can account for roughly 15 percent of all total firm assets, FoundryMag reported. For companies that are inventory heavy, this number can be significantly higher too. If you’re not paying careful attention to the extra costs associated with inventory, you’ll quickly run into a budgeting problem.

Not only does it cost money to purchase inventory, but it also comes with a carrying cost as well. According to the Institute for Supply Side Management, a company’s carrying cost, also called the capital cost, is the amount of overhead necessary to carry inventory, which manifests itself in a variety of forms, some of which many owners might not know about. There are both variable factors and fixed costs that must be accounted for when measuring true inventory costs.

Initial costs

The most accurate measure of inventory costs is the actual price paid to purchase it. Excluding all other costs, this is the smallest amount an owner can pay for inventory. Unfortunately, most businesses end up paying considerably more for the inventory than the initial cost. This is due to all the other costs associated with the inventory including costs for handling, storage, service and taxation. Combined, these additional costs greatly increase the overhead required for this inventory.

Handling costs

You cannot discount the amount of work that goes into the movement of inventory. Workers’ wages and benefits can quickly add up, especially for larger operations. Not only do handling costs include employees’ salaries, but there are also expenses for packaging, labeling and transportation costs, including shipping and postal rates.

Warehousing overhead

Storing inventory and goods can eat up a big chunk of your budget, and the longer an item sits in storage, the more profit margin it ultimately consumes. For example, say you’re paying $10.00 per month for pallet space and you have 20 items stored there, meaning it’ll cost $.50 per item for storage. After a month passes, say you sold five items, leaving 15 left. However at the end of that month, you’ll have paid $.67 per item for storage. This process will only continue, and it will cut into more of the profit margin each month. In some instances, many fulfillment companies will even raise the storage price the longer the inventory sits there.

To figure out your warehouse overhead, Practical Ecommerce recommended dividing the combined cost of rent, maintenance, property taxes and utilities by the percentage of the building used to process, store and ship orders to customers.

Service costs

Many small business owners might not have or perhaps have not even considered obtaining insurance to cover inventory, yet having this coverage can provide a solid fallback plan in the event of an emergency or unexpected catastrophe. Not only does it provide monetary relief if the inventory is stolen, damaged or totally destroyed, but it also offers owners peace of mind knowing their property is secure.

However, there are costs associated with this coverage. Owners should carefully consider whether they want the insurance to cover the full replacement value of the inventory, which would come with higher premiums, or instead cover the depreciated value, with its lower premium rate.


The one cost that’s inescapable no matter what is taxes. However, despite the persistence of this cost, there are ways to reduce the overall expenditure. Many municipalities tax the amount of inventory a company holds. By reducing inventory levels stored in your warehouse space, you can potentially lessen your tax burden. However, be careful not to under stock inventory to avoid the taxes, because if you don’t accurately measure and allocate your product levels according to demand, you can easily find the wares depleted before a customer can purchase them.

Opportunity costs

With so much of the budget tied up in purchasing inventory, owners and managers can sometimes find themselves asking whether this is the best way to allocate funds. This gets to the bottom of the nagging question of if you’re investing your money properly. This is especially true of companies working on a small business loan. There’s no surefire way to say for certain that if you invested the capital in something else it would pay off, but there are ways to check if there’s a realistic return on the investment. A good way to measure this rate is to use a tax-free municipal bond’s interest rate as a indicator of how to apply this opportunity cost.

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