Inventory costs are a big part of managing a product-selling business. Online retailers still hold their inventory somewhere, adding an array of costs. Additionally, money tied up in inventory costs isn’t available for other business needs and puts a hamper on your cash flow. Here’s a closer look at inventory costs and how you can best manage them in your ecommerce business.
What are inventory costs?
Inventory costs are a major factor for product businesses. Even with healthy markups, business owners have to outlay funds to buy inventory before reselling it to customers. Inventory management is a business practice of optimizing inventory to have just enough to meet customer demand without holding too much inventory or locking funds into product on the shelf.
Inventory costs are end-to-end costs from when materials, products, or raw goods are shipped from your supplies until the product reaches your customer. The inventory management umbrella includes shipping, storage, processing, and other needs.
Types of inventory costs in ecommerce
Ordering costs, holding costs, packaging, and shipping are only a small piece of the puzzle of inventory cost management. When looking at cost of inventory, major factors include:
Storage: If you have a warehouse, you’re paying mortgage or rent, utility bills, insurance, and for all of the equipment in the building. When renting or outsourcing fulfillment, perhaps using a drop shipper, you’re paying fees to that vendor for storage and fulfillment.
Staffing: When running your business with an in-house operation, staffing costs include salaries, benefits, taxes, insurance, and anything else required to keep your employees and contractors happy and dedicated to your business.
Shipping: Inbound and outbound shipping costs borne by your company are part of inventory expenses. Logistics costs vary by industry. Comparing shippers and freight providers may offer significant savings.
Depreciation: Inventory may lose value on the shelf, a cost known as depreciation. Further, the shelving, desks, packaging equipment, and other tools have a limited useful life, losing a portion of their value yearly through depreciation.
Opportunity cost: If you spend $10,000 on inventory, that’s $10,000 you can’t spend on Facebook and Google ads, research and development, or buying new equipment to expand your operation. This isn’t a direct cost that’s easy to measure, but it’s important to consider when designing your inventory management plan.
While all businesses are wise to work to lower shipping costs, it’s not always possible to achieve rock bottom pricing. Even within industries, it’s important to compare to the right competitors. Sushi restaurants requiring overnight shipping of perishable products are likely higher than a local farm-to-table restaurant or a business ordering from a generic nationwide vendor.
Accounting tip: Inventory costs are often included in multiple parts of your income statement or profit and loss statement. That may include costs of goods sold and sales, general, and administrative (SG&A) expenses.
How to calculate your inventory costs
Inventory carrying costs shouldn’t be a mystery to business owners and managers. Here’s a formula to calculate your inventory costs:
Inventory Carrying Cost = Capital costs + Service costs + Risk costs + Space costs
Total inventory costs are made up of four components. Capital costs are the costs of goods or raw materials, plus any financing or loan charges. These may be referred to as costs of goods sold on your financial statements.
Service costs are indirect costs required to hold inventory, such as insurance, taxes, equipment, and inventory management software. Risk costs include depreciation or obsolescence of goods held in inventory and losses due to damage or theft. Space costs, or storage costs, are costs such as rent or mortgage interest, utilities, HVAC, warehouse staff, and related costs to keep the facility running.
When outsourcing to a third party for fulfillment, space and storage costs may be replaced by a single fee to your vendor. In either case, keeping inventory levels within a tight range can help lower this section of your supply chain cost. But when inventory is too low, you could miss out on sales, also known as stock-out costs. To avoid shortage costs, consider automatic reorder plans with your preferred vendors.
How to reduce your inventory costs
Who wouldn’t want to save on inventory costs? As a savvy business owner, you can look at all parts of your business to find places to save. That goes far beyond the cost of materials or products to include these operating costs:
Automation: Humans are expensive, need breaks, require benefits and insurance, and are extremely prone to human error. Automation takes humans out of the process and turns a big one-time cost into long-term savings.
Financing: Loan and lease costs can be significant for a small to mid-sized business. With high financing costs related to buying and holding inventory, you’re putting expenses into your business that doesn’t offer any long-term benefits. Negotiating or shopping around to keep interest rates and inventory financing costs low can lead to major savings.
Outsourcing/insourcing: Some businesses pay a bundle to manage warehouses and inventory and are not very good at it. They could save time and money by outsourcing to a third-party vendor for inventory management and fulfillment. Conversely, some companies operate in low-cost areas and could save by sending orders with an internally managed logistics team.
Improved controls: If items at your workplace vanish or break often, you could use a review of security and inventory controls. Preventing theft and breakage is critical to maintaining high margins in some industries.
Business owner tip: While financing may be important for inventory, you shouldn’t be paying any financing costs to pay for online advertising. Learn how dash.fi can save you money on your digital marketing while offering up to 3% rewards on every digital ad dollar you spend.
Inventory costs shouldn’t be an afterthought for business owners. By keeping inventory management in clear focus, you’re taking smart steps to increase profitability and long-term business success.