carrying cost of inventory

What is Carrying Cost of Inventory?

Carrying Cost of Inventory – It refers to the cost of capital that is locked up in the inventory, storage cost, insurance and obsolescence.

In simple words, carrying cost of an inventory is the resultant of the addition of three items:

  • Money locked up in inventory such as cost of capital and opportunity cost of capital.
  • The space occupied by the inventory which involves the following cost – warehouse cost, insurance, taxes, etc.
  • Cost of handling the items.
  • Cost of depreciation and obsolescence.

Most of the companies calculates the carrying cost for a years. In addition to this, this cost is calculated in certain percentage. Suppose the total inventory cost if Rs. 5,00,000 and carrying cost is 20%. Therefore the cost of carrying inventory will be Rs. 1,00,000.

One more important thing to note is that, the carrying cost varies from organisation to organisation. For example, a company with huge cash in its desk and large space for storage has low carrying cost as the probability of obsolescence is very low. On the other hand, an organisation with less space. large debt have high carrying costs. In order to determine the optimum quantity or economic order quantity, it is very important to estimate the holding cost first.

In addition to this, the estimation of carrying or holding cost helps the companies to determine the level of profit that can be made from the existing inventory with them.

Components of Carrying Cost of Inventory

1. Cost of Capital

It is the cost that a business incurred for holding a certain amount of inventory with itself. This is the largest component. It is the percentage of rupee value total inventory that the company is holding. So, if the total inventory is of Rs. 35,00,000 and the capital cost is 20%. Then the cost of capital will be Rs. 7,00,000.

2. Storage Cost

Storage cost is the sum of warehouse rent, lighting, heating, cost of moving material from one place to another, etc. These cost can be variable or fixed. Variable costs includes handling of inventory in warehouse whereas fixed cost involves rent, electricity bill, etc.

3. Service Cost of Inventory

These costs include the insurance premium paid for the protection of the inventory and the taxes paid to the government. The premium depends upon the nature if the items stored in warehouse as well as the level of inventory.

4. Inventory Risk Cost

Carrying stock always involves a certain degree of risk. When the items are stored in a warehouse, there is always a risk involve that the items will get obsolescence in the meantime when they are stored in the warehouse.