The Formula For Calculating Cost Of Goods Sold Is The Full Cost of Inventory – Exploring Inventory Carrying Costs

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The Full Cost of Inventory – Exploring Inventory Carrying Costs

For many retailers, wholesalers and distributors, inventory is the biggest asset on your landing page. In many ways, your inventory defines who you are, and your marketing strategy. It describes your customer’s needs and what they expect from you. Legions of cost accountants are employed to accurately capture and apply all direct inventory costs. The cost of inventory is the largest expense item on each Income Statement.

Most companies evaluate the productivity of their inventory by measures such as inventory turn, gross margin return on investment, gross margin return per square foot and the like. These are all valuable tools for evaluating inventory production, but they are all limited because they use inventory costing as the cost basis for their analysis.

The true value of inventory goes beyond inventory at cost or cost of goods sold. The cost of managing and maintaining inventory is a significant expense in itself, but the true cost of inventory doesn’t end there. The total cost of inventory, in fact, is buried deep within the many costs below the gross margin, almost defying any executive, manager or cost accountant to extract, measure and actually manage them.

A study of inventory carrying costs estimated that these costs are approximately 25% per year as a percentage of a typical company’s inventory. Although this information is interesting, it is not very useful. In order to control the cost of carrying inventory it must first be measured.

Generally accepted components of inventory carrying costs include inventory financing charges or inventory investment opportunity costs, inventory insurance and taxes, material handling costs and warehouse overhead not directly related to picking and shipping customer orders, inventory management and costs cycle counting, and inventory decreases, damage and obsolescence.

Let’s take a closer look at each of these components to better understand how they can be measured and managed.

List of financing payments: This may seem easy to calculate, but measuring list financing payments accurately is not as easy as it may first appear. For some companies, working capital may be a series of financing, and a little more, but for many others it may be financing accounts. Moving between payables and receivables may in fact be a partial financing arrangement. For importers, this can be straight forward to measure if they open letters of credit before their sellers send them overseas. In this case, LC facility costs can be easily identified as inventory financing charges. Finally, it is important to be able to measure what part of the inventory is financed externally and what part is financed by internal cash flows. For that share financed from the financial network the opportunity cost of the investment must be weighed.

Opportunity cost: When considering the opportunity cost associated with investing in inventory, it’s easy to focus strictly on the opportunity cost of the inventory being dead or underutilized. In fact, the opportunity cost is proportional to the value of the entire inventory. If this amount were not invested in stocks, what return would be expected if it were invested in something else, such as stocks, mutual funds, or a money market account.

Inventory insurance and taxes: These items should be straight forward measured as a percentage of average inventory value. And because both insurance and taxes fluctuate greatly with inventory value, any reduction in average inventory value will deliver savings directly to the bottom line, not to mention improving cash flow.

Material handling costs: Estimating material handling costs not directly related to picking and shipping customer orders can be tricky. These expenses are mainly made up of salary and benefits, but also include lease payments or depreciation of handling equipment, depreciation of automation, robots and systems, and miscellaneous costs of supplies such as pallets, corrugated, UPC labeling equipment and the like. .

Warehouse overhead: The quickest way to calculate this is to divide the total cost of rent, utilities, maintenance and upkeep, and property taxes by the percentage of the building that is related to processing customer orders, picking and shipping, and that portion of the building that is related. receiving and maintaining inventory. While that share related to acquisition and storage may seem fixed, it actually changes quickly when you think about what you could rent as a contract warehouse if your inventory wasn’t there!

Inventory management and cycle accounting: These costs may be primarily salary and benefits, but may also include depreciation or amortization of handheld radio (RF) units and other related equipment, as well as any direct miscellaneous costs. related to your asset management team.

Inventory depletion, damage and obsolescence: Capturing and measuring these costs seems straightforward at first. Depreciation, spoilage and obsolescence expense is the cost of depreciation taken, or expressed as a percentage, of the value of those depreciation items in a given period divided by the inventory for that period. This assumes, however, that all cancellations were canceled in time for the year. Is cycle counting done regularly? Was everything calculated on a planned basis, was that plan followed, and were high-speed items calculated regularly? Are they deleted in time? Damaged and obsolete inventory written off in the current period was allowed to accumulate in the prior period. In contrast, write-offs were postponed in the current period, resulting in the build-up of damaged and obsolete inventory that will have to be written off in the future. Experience has taught us that in the most difficult cases this deletion can be avoided for years!

To determine your inventory value these components are rounded up annually and expressed as a percentage of your average annual inventory. You can now see if the 25% annual cost estimate closely reflects your business, or if your business has certain characteristics that lead to a significantly different percentage.

Just as it is unwise to assume that your carrying amount percentage will be the same as the combined average of many companies, it is not wise to assume that everything in your inventory has the same carrying amount percentage. Of course, handling costs may vary for your company by distribution center (if you have one DC), product line, category, subcategory or item. Carrying costs may vary for high volume, high speed “A” items, slow turn or consistent “B” items, or slow turn “C” items. Larger, larger items may have significantly different carrying costs than smaller items that take up much less space in the inventory dollar. Understanding the various handling costs in your inventory helps you identify where the biggest savings opportunities might be.

Once the total cost of inventory is estimated and calculated, those costs can be evaluated and controlled. And what is immediately apparent is not only the cost of inventory that is necessary for the business, but the cost of inventory that is not important, excess, dead or under-performing, and what is the deduction of money for this list in the inventory. company.

Reducing unnecessary inventory, whether it’s strengthening frontline stock, critical inventory, or dead or underperforming inventory has the benefit of freeing up capital for other uses and reducing variable costs directly through inventory levels, and it also provides an opportunity for payback. -assess mixed and fixed costs to identify potential cost savings. When you reduce inventory, you not only free up capital, but you create opportunities to reduce costs, improve profits, and actually increase cash flow!

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