Inventory Carrying Costs Explained: Calculation & Reduction Strategies
Stocks Over Socks: US businesses typically hold inventory worth $1.32 for every dollar earned, maintaining a steady ratio over the years, except during COVID warehouse lockdowns.
Inventory Pile-up: A high inventory-to-sales ratio signals excess stock that isn't selling, leading to increased carrying costs and reduced profit margins.
The Shelf-Cost Puzzle: Holding excess inventory burdens businesses with carrying costs, affecting their financial health. This often means extra expense and lower profit margins.
COVID Inventory Story: During the COVID-19 pandemic, US merchants faced disruptions as they had to lock up inventories, impacting the typical inventory-to-sales ratio.
Can We Clear The Clutter?: US merchants are challenged to optimize their inventory levels to reduce costs and improve profit margins, emphasizing a need for better inventory management.
US businesses hold $1.32 worth of inventory for every dollar of revenue. This number has remained fairly steady for a long time, except when merchants had to lock their warehouses during COVID.
A high inventory-to-sales ratio indicates you’re holding more inventory than you’re able to sell. And holding inventory comes with carrying costs that lower your profit margin.
Can US merchants do better?
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Maybe when you throw in inventory management software, AI, and inventory management best practices, you can minimize inventory levels, lower carrying costs, and boost your bottom line.
In this guide, we explain how you can calculate and keep track of carrying costs, as well as discuss strategies to minimize carrying costs. Let’s dive in.
What are Inventory Carrying Costs?
Inventory carrying cost refers to the sum of all expenses incurred to order and hold stock during a specific period.
These expenses include labor, insurance, shrinkage, depreciation, handling, taxes, and the cost of capital (also called the opportunity cost).
Carrying costs typically make up about 25% to 30% of total inventory value—although this can vary greatly from business to business—and are one of the most pressing challenges for inventory-heavy businesses.
Here’s why: Inventory adds to your expenses with every ticking second. It’s like an expensive guest—every day it stays, it costs you more money.
Let’s make a few assumptions about a brand we’ll call the New York Shoe Company (NYSC).
Suppose NYSC has 10,000 units of green sneakers, which have a cost per unit of $100. The annual carrying cost of a green sneaker is $25. The item went out of trend two years ago, and NYSC has been holding those 10,000 units for two years.
Do some quick math, and you’ll see NYSC has already spent $50,000 ($25 x 10,000 x 2 years) to just hold this inventory, which is worth $1,000,000.
See the problem?
What do high inventory carrying costs mean for small businesses?
Inventory carrying costs can be bad news for small businesses because they can result in:
Cash flow problems
You’ll need to spend on insurance premiums and utilities out of your pocket as long as you keep holding the inventory without selling it.
If you’re strapped for cash, carrying costs can exacerbate the issue.
Let’s go back to NYSC again. If the brand was running low on cash and has to spend upwards of $2,000 just to hold dead stock, it’s probably going to push the brand closer to bankruptcy much faster.
Just ask Matt Tomkin. Even after his ecommerce brand made £250,000 in its third year, it still failed—due to cash flow problems.
Matt now runs a search marketing agency and a business lead-gen start-up called Quotonga. But, before that, he experienced the perils of bad cash flow with his own ecommerce business.
He recalls how his once successful sportswear brand, VO2, failed because of a cash flow issue.
All in all, it was the lack of liquid cash that ended everything, as we were growing too fast to sustain without serious backing.
Even if your bottom line looks strong and revenue is growing quickly, cash flow issues can stop your business in its tracks.
Excess inventory and dead stock are often major culprits behind this cash crunch.
Lower profitability
Carrying costs are fixed. This means you incur them regardless of how many units you sell.
But, they’re also time-driven—the longer it takes to sell your inventory, the more you spend to hold it.
Lower profits mean slower growth and a reduced valuation when seeking investment from venture capital firms.
The fix is simple: focus on holding inventory that sells quickly. This minimizes the impact of carrying costs on your profitability.
Obsolescence, damage, and shrinkage
There’s always a risk that inventory will go out of trend, get damaged, or be stolen.
When this happens, you won’t be able to sell the items easily, and they’ll continue to add to your carrying costs until you can get rid of them.
As with the NYSC example, the out-of-trend green sneakers will keep adding to your carrying costs until they’re sold.
If you think you can’t sell them even at a deep discount, it makes more financial sense to just dump them in a junkyard.
Types of Inventory to Consider
It’s not just the finished products that add to your inventory carrying costs. Here are the types of inventory you should consider when calculating carrying costs:
- Finished products: These are the items you sell directly. If you’re a fashion brand, clothes, shoes, watches, and cosmetics are your finished products. These are products you know the best and unless you offer customized products or manufacture them yourself, you most likely have finished products in your warehouse.
- Raw materials: Raw materials are items you don’t sell directly but use to produce final products. For example, if you sell personalized t-shirts, plain t-shirts would be your raw materials. They incur the same carrying costs as finished products.
- Work-in-progress: If you process items before selling them, you may have work-in-progress inventory. For example, if you sell tailor-made garments, any orders with your tailor would be considered work-in-progress inventory. Whether or not this inventory incurs carrying costs depends on where it is in the production process.
Think about custom-made garments for example.
If the fabric is with your tailor and not in your warehouse, you’re no longer paying storage costs. However, capital costs may still apply if you haven’t received an advance payment.
- Maintenance, repair, and operating (MRO) supplies: Maintaining equipment and operating your warehouse requires various supplies—lubricants, detergents, PPE, and other items—to keep your assets in top condition.
Calculating inventory holding costs for all inventory types is critical to ensuring you’re working with an accurate figure.
Raw materials and work-in-progress contribute a major portion of your total carrying costs, sometimes even more than the carrying costs of finished products.
Components of Inventory Carrying Cost
Inventory carrying costs can be explicit (out-of-pocket) or implicit:
- Explicit costs are those you pay directly. For example, if you borrow money from a friend and pay $100 in interest, that’s an explicit cost.
- Implicit costs represent the money you could have earned by doing something else. For example, if you spend the money borrowed from your friend on a fancy suit instead of investing it in a bank deposit that would have earned you $50 in interest, then $50 is the implicit cost of buying the suit.
Both of these impact profitability, but only explicit costs impact your cash flow.
To understand this better, let’s look at the four broad expense categories that are summed up when calculating carrying costs.
Capital costs
Capital costs can be both implicit and explicit.
If you borrow working capital to finance inventory, the interest you pay is an explicit cost. On the other hand, there’s an implicit cost to tying up funds in inventory.
If those funds weren’t tied up in inventory, you could have invested them in marketable securities and earned interest. That forgone interest is your opportunity cost.
Let’s say you currently hold $200,000 worth of inventory, and it’s not borrowed. You could’ve invested the money in marketable securities and earned a 2% return ($4,000).
Since the funds are tied up in inventory, you’ve missed out on that $4,000—your implicit cost of holding inventory.
The more inventory you hold, the higher your cost of capital. That’s why optimizing inventory levels is mission-critical.
Storage costs
Storage costs refer to the expenses of storing your company’s inventory in a warehouse. Most of these costs are explicit, but some may be implicit.
Here’s what storage costs include:
- Warehouse space: If the space is rented, the rent is an explicit storage cost. For ecommerce businesses, warehouse rent is one of the largest carrying costs, averaging $8.84 per square foot. If the warehouse is owned, the opportunity cost of tying up capital in it becomes an implicit storage cost.
- Labor costs: All labor costs are explicit and include the cost of warehouse staff and contractors hired to perform any warehouse-related tasks.
- Depreciation of warehouse assets: Assets like air conditioners and forklifts depreciate over time. For example, if you have 10 AC units, each costing $10,000 and lasting five years, the annual depreciation cost would be $20,000 [10 x ($10,000 / 5 years)].
- Utilities: You need electricity to run ACs and internet to allow the manager to update records in the inventory management system. These costs are explicit.
Service costs
Service costs include expenses incurred to manage inventory. This includes:
- Taxes: Taxes on property and inventory go here.
- Insurance: Insurance premiums paid to insure against risks like theft, fire, damage, and natural disasters go here.
- Software subscription costs: The cost of inventory management and warehouse management software subscriptions go here.
There may be additional inventory service costs depending on the services you use.
For example, you might conduct regular inventory audits to ensure accuracy. The labor, time, and technology required for these audits are also part of service costs.
Inventory risk costs
Inventory sitting in your warehouse is prone to various risks. Depending on the items in your inventory, the risks include:
- Shrinkage: Shrinkage occurs due to theft, misplacement, fraud, or administrative errors. Electronics like smartphones and tablets, clothing, and cosmetics are common examples of inventory items prone to shrinkage.
- Obsolescence: Changes in market demand and technological advances can make your inventory obsolete, even with heavy discounts. Apparel is especially at risk, as short-term trends can quickly fade with changing styles.
- Damage: Physical damage during transportation or handling can make goods unsellable. Fragile items like glassware, ceramics, and complex machinery parts are particularly vulnerable.
How to Calculate Inventory Carrying Costs
Monitoring carrying costs is the first step to controlling them. If you fail to pay attention, carrying costs can pile up and put a big dent in your profitability.
Carrying costs can be calculated either in dollar terms or as a percentage of your inventory value. Calculating as a percentage is often more useful, as inventory value fluctuates year to year.
Inventory carrying cost formula
Inventory carrying costs = [Total holding costs / Total Annual Inventory Value] x 100
This formula expresses carrying costs as a percentage of the total annual inventory value.
It’s easier to compare carrying costs year over year using the carrying cost percentage formula since the denominator generally fluctuates each year. You can also just sum up the holding costs and consider the total inventory carrying cost for additional context.
Example calculation
Suppose NYSC’s total holding costs for green sneakers worth $100,000 (at cost price) are $25,000:
- Cost of capital: $10,000
- Storage costs: $9,000
- Service costs: $5,000
- Shrinkage: $1,000
According to the carrying costs formula, NYSC’s carrying costs are 25% of the inventory value.
Strategies to Reduce Inventory Carrying Costs
An upward trend in carrying costs is a red flag for your bottom line, but there are strategies you can use to protect against rising costs.
The right strategy depends on the cause. Let’s discuss some strategies you can use when cost control is due.
Automate your inventory management with inventory management software
Automating your inventory management is a great first step to minimizing carrying costs. Here’s how it helps:
- Automated and more accurate demand forecasts. It’s nearly impossible to determine the exact number of units you’ll see the next month, quarter, or year. But inventory management software can be your crystal ball. Rub it, and it will give you a reasonably accurate forecast using AI and data analytics.
- Lower labor costs. You can save on labor by automating stock counts, reordering, and tracking. Automation will also keep human error out of the equation, so you won’t have to spend time and money to fix costly mistakes.
- Minimize obsolescence and shrinkage. Inventory management software makes it easier to identify obsolete items. Use discounts or bundle slow-moving items to free up space in your warehouse and minimize carrying costs. Real-time tracking also helps reduce shrinkage from theft and misplacement.
There are a few dozen inventory management systems on the market, but most aren’t worth your while.
We researched the top inventory management systems, and here are the ones we found to be the best:
Optimize inventory levels
It’s tempting to have a bit of everything in inventory, just in case. But those “just in case” piles can quickly become dead weight, tying up capital and bloating inventory storage costs.
Here’s how you can put inventory optimization on autopilot:
- Forecast demand. Use AI-powered inventory software for accurate demand forecasting. If you already have a good understanding of your sales trends, you can also forecast demand manually.
- Calculate safety stock. Your inventory software can handle this, or you can calculate it manually by multiplying the supplier’s lead time by your demand during that period. For example, if your supplier takes five days to deliver and you sell 25 units a day, your safety stock should be 125 units. You can also add a 20% margin of safety to avoid stockouts.
- Calculate economic order quantity: Calculate the economic order quantity using the following formula:
EOQ = √(2 x S x D) / H
Where:
D: Annual demand
S: Order cost per order
H: Annual holding cost per unit
- Configure inventory management software. Configure the reorder point in your inventory software so it automatically places an order whenever the stock reaches the safety level.
Minimize on-hand inventory
I get it—it’s tricky. How do you minimize on-hand inventory while ensuring you never turn customers away due to stockouts?
You need two things to be able to hold minimum inventory:
- Accurate demand forecasts. While forecasts aren’t always perfect, use data analytics and AI to get as close as possible. Then, add a safety margin. For example, if you estimate demand at 100 units, plan for 120 units.
- Strong supplier relationships. The just-in-time (JIT) inventory system, developed by Toyota, is highly efficient, but it’s not always easy to apply in ecommerce. However, with strong supplier relationships, you can aim to keep stock levels lean. Reliable suppliers who deliver on time, every time, give you the confidence to hold just enough inventory to prevent stockouts.
- Inventory management software. You want to be able to track inventory levels and automate orders. Tracking inventory and placing orders manually leaves room for costly mistakes.
Improve warehouse efficiency
Warehouse chaos is a major inventory cost driver. Think of your warehouse as a machine, not just a storage facility.
Every inefficiency is a wrench in the gears.
A chaotic layout makes it easier for staff to misplace inventory, reducing visibility and leading to unnecessary reorders.
Using barcodes and automated inventory tracking in your warehouse is a good starting point to address this problem. However, optimizing your warehouse layout is the most effective solution because it allows workers to quickly search and move items, lowering labor costs.
An optimized layout can also accommodate more units, which reduces your per-unit carrying costs.
If your budget permits, and you like staying ahead of the curve, consider investing in automated storage solutions like:
- Vertical lift modules (VLMs): A VLM is an automated storage system with trays stored in columns and a lift in between. When an operator requests an item, the lift moves to the tray, retrieves the item, and delivers it to an ergonomic access point.
- Horizontal carousels (HC): An HC is a rotating conveyor system with storage bins and shelves mounted on a track. When an item is requested, the carousel rotates to bring the bin or shelf containing the item to the operator.
Picture your current warehouse for a moment. Now compare that with a warehouse with VLMs:
See the difference?
Get rid of dead stock
Inventory that hasn’t moved in months or years is dead weight.
Take action to get rid of it—it’s costing you money without bringing in any revenue. Run promotions, offer discounts, or bundle it. If that doesn’t work, donate the inventory and claim a tax write-off.
Dead stock clogs up storage space.
Each month, part of your rent and utilities goes toward storing dead stock. Instead, sell it at a discount, recover what you can, and make room for inventory that moves and makes you money.
That’s why many brands took a proactive approach to getting rid of dead stock last year.
In 2023, 27% of surveyed retailers said they were selling inventory in the secondary market to get rid of dead stock because the elevated storage prices were taking a toll on the company's bottom line.
This isn’t even the worst of what we’ve seen dead stock do to a business.
Burberry burns burdensome backstock
In 2018, Burberry burned $38 million in dead stock because the company thought no sales were better than heavy discounts.
Destroying dead stock is a common practice among luxury brands.
One of the reasons is that there’s a financial incentive for destroying goods—US Customs and Border Protection allows companies to recover most of the taxes or fees paid on imported merchandise if it’s unused, exported, or destroyed under Customs supervision (19 U.S.C. § 1313).
It’s not just Burberry, though. Brands like Louis Vuitton also indulge in destroying stock because they have a policy that all customers should have to pay the same price for an item, as explained by an ex-employee on Quora.
Of course, burning your stock should be your last resort, but the solution depends on your situation.
In NYSC’s case that we used in our example earlier, the green sneakers could’ve been easily sold at a discount to customers or to another brand.
Alternatively, NYSC could’ve donated them to an NGO for a tax write-off.
Carrying Costs: A Silent Killer, But Not Always
You don’t see carrying costs on your income statement.
The reports from your finance team likely don’t explicitly state carrying costs, which is why many ecommerce owners are unaware of them.
Carrying costs are a combination of multiple implicit and explicit expenses, which makes them hard to track. It takes deliberate effort to calculate them accurately.
If you’ve got a warehouse full of inventory, you can always trim unnecessary carrying costs and optimize your inventory for maximum profitability.
But there are times when holding excess inventory can be a risk mitigation strategy.
For merchants who need to hedge against price volatility and supply chain uncertainty, holding more inventory is often a more lucrative choice.
With ongoing wars and volatile prices, merchants are currently willing to hold more inventory, says Tracy Smith:
For the environment we’re in, I would say companies are willing to carry more inventory and, therefore, will have more inventory cost, (even though) for some, it’s still a struggle to get materials.
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