The “Real” Cost of Inventory

What is the cost of inventory?

Inventory is the largest expense for every retailer, and businesses need to calculate its cost in order to properly speculate their financials for the upcoming quarters. What some companies don’t always realize, though, is that there are many other factors involved in the “true” cost of inventory beyond just the cost of the goods and labor to make the items. And these factors make inventory much more expensive than originally expected and calculated.

How to calculate inventory cost

This first post of the four-part Inventory Blog Series will discuss how to calculate the real cost of inventory beyond the upfront cost of an item.

In addition to the price of the goods and labor to make the inventory, there are a number of other factors that must be taken into account to calculate the cost of inventory. These include:

  1. Warehouse costs – Owning, or renting, a warehouse for inventory is just like owning a home. Businesses have to pay for every expense involved – rent, maintenance, insurance, utilities, inspections, employees, and so on. There is a laundry list of monthly payments and salaries that need to be taken care of in order to upkeep this inventory household.
  2. Additional warehouse space costs – During the holiday season, or any busier season, many companies need to rent out more warehouse space than usual in order to house both the influx of new inventory as well as older product that is taking longer to sell. This extra space costs money and must be added into the total cost of inventory, even if the extra space is only temporary.
  3. Shipping costs – Whether the inventory is being shipped domestic or international from the manufacturer, it still costs money to ship it to the warehouse. And then it costs money to ship it to the customer, especially because now many online retailers offer customary free shipping to entice consumers. All of these factors must be taken into account when calculating cost of inventory.
  4. Interest on money borrowed – Businesses tight on cash will borrow money from creditors to use to buy new inventory. However, they will eventually have to pay back these creditors that loaned them money, and as with any loan, there is interest tacked on to the original amount borrowed. The longer businesses hold on to the loan, the more interest they have to pay, so if they pay it sooner they can free up money to pay back these creditors.
  5. Unsold merchandise or discounted items – Brands are never going to be able to sell every piece of merchandise at full price, no matter how ideal that situation would be. The items that are left on the shelves are continuously marked down until they either are sold or moved out of the store (or offline) and sold to off-price retailers at a heavy discount. And the longer the underperforming items sit on the shelves, the less value they have. Businesses must be proactive about selling the excess off before they can get no money back on these items and have to sell at cost (or below).
  6. Backorders cost – Backorders are orders that are on hold until the product hits the warehouse, and as a result they sometimes get forgotten when calculating cost of inventory. During a busy season, such as Black Friday, popular items that are backordered need expedited shipping, an added cost to the original shipping cost assigned to that product. Additionally, the overtime labor that may be required to process these orders needs to be factored in as well.
  7. Inventory damage/loss/theft – It’s inevitable that items will get damaged, lost, or stolen somewhere along the product’s lifecycle, however this is an important factor impacting the cost of inventory. NRF stated: “Employee theft from retailers (including warehouse thefts) amounted to close to $15.9 billion out of 2010’s total inventory shrinkage of $35.3 billion, more than the $10.9 billion retailers lost from customer shoplifting.” Such theft and potential damages need to be replaced, and this cost should be factored into the total inventory cost.

Though often overlooked, each of these factors directly contributes to the final cost of inventory. If businesses fail to consider these additional costs, their quarter inventory calculations could have major financial problems going forward. Given that the retail industry is in the midst of a “Retail Apocalypse”, proper calculation of cost of inventory could not be more relevant. Businesses that can manage their inventory and its cost accurately have a better chance of maintaining reasonable cash flow to ultimately avoid bankruptcy. And those businesses that have the inventory visibility to move product and limit these additional inventory costs have the best chance of success in their dire retail setting.

The next blog post in this series will discuss some of the best practices in managing inventory to control and limit these extra factors that add to the cost of inventory.