Question

Carrying materials in inventory is expensive. Previous studies have found that the typical firm’s annual inventory carrying cost is between 25 – 35% of the value of the inventory.

Elaborate any Five (5) major elements the makes up these costs.

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Answer 1

Inventory can be defined as good or materials that have been held in stock by a company in order to meet the requirements of its customers. The sole reason for holding inventory is the smooth functioning of the business. Carrying materials in inventory involves huge costs and expenses but if a company does not have proper inventory levels they might have to suffer on their sales volume and business can be interrupted, therefore it is very important to have right balance of inventory in an organization.

Inventory carrying costs can be classified into following major elements:

1. Interest charged: Many businesses these days are backed up by funding from banks or investors and they charge hefty interests on the funding raised. The large part of that funding is then converted into inventory by the companies to meet the customer's demands. Therefore, that interest being charged is one of the elements of these costs because after all that funding was converted into inventory.
2. Storage costs: Once the inventory is purchased by the company that inventory needs to be properly procured, managed and stored and for that companies either buy or rent warehouses and other storage spaces. The combination of warehouse rent, mortgage, lighting expenses, air conditioning etc forms another element of carrying inventory costs. Some of the costs are fixed in nature like rent of warehouse and some of them are variable like handling costs.
3. Taxes paid and insurance covering inventory: Another element of carrying inventory costs includes taxes paid to the local government or local body and insurance paid to insure the inventory from fire, theft or damage. As the level of inventory is high it becomes very important to have insurance, otherwise firms might have to incur severe losses due to lack of insurance cover. The premium of the insurance varies according to the level and type of inventory; higher the level of inventory, higher is the amount of insurance premium.
4. Personnel and machinery cost: For carrying materials in inventory companies need various kinds of machinery and people to handle that inventory. Machinery can vary from loading vehicles to mini trucks which again involve cost to run and manage the machines. Similarly various kinds of personnel like Computer operators, data entry operators, mechanics and engineers are required to operate those machines and handle the inventory. Therefore these personnel and machinery cost forms another element of inventory carrying costs.
5. Inventory risk costs: Carrying or storing materials in inventory comes with a certain amount of risk. Insurance can provide cover for theft or fire or water damage but still there are risks which cannot be insured. When a company stocks a certain type of goods there is always a fear or risk that item may fall in real value during the period it is in the warehouse. New version or new products can suppress the products stored in warehouses which are later sold on too low prices which is a loss for the company. In case of some items like medicines or perishable goods which come with an expiry date, such risk increases and if the items expire than they are mostly scrapped. Hence these type of costs is an another element which makes up inventory carrying costs.