Carrying Cost Of Inventory

Carrying cost of inventory, or carry cost, often refers to a certain percentage of the inventory value, which represents the cost a business incurs over a certain period of time to hold and store its inventory. This percentage could include taxes, employee costs, depreciation, insurance, the cost to keep items in storage, opportunity cost, the cost of insuring and replacing items and the overall cost of capital for the company as a whole.

Businesses and financial analysts use this figure to determine how much profit can be made based on current inventory. It also helps businesses find out if there is a need to produce more or less to keep up with expenses or maintain the same income stream.

Inventory generally represents the largest portion of current assets on a company's balance sheet. As such, the management of inventory flows can greatly influence the cost of carrying that inventory. Additionally, the cost of inventory can have a direct impact on the cost of capital and future cash flows associated with the firm.

The cost of inventory includes all costs associated with holding or storing inventory for sale. These costs include the opportunity cost of the money used to purchase the inventory, the space in which the inventory is stored, the cost of transportation or handling, and the cost of deterioration and obsolescence.

The opportunity cost of the money used depends on the source of funds – for example, if the money tied up in inventory could be better used for financing an equity project, the cost of funds obtained via internally generated activities is going to be lower than the cost of obtaining funds by issuing equity. The space used to store inventory includes expenses such as rent, depreciation, insurance and other charges associated with maintenance and operational controls such as security, workplace accidents and permits. The cost of obsolescence can be seen in the average amount of write-offs a company has. Perishable or trendy inventory may have a higher cost of obsolescence than non-perishable or staple items.

For example, if a company has an inventory carrying cost of 10 percent and the average annual value of inventory is $1 million, then the annual cost of inventory would be $100,000. Inventory costs run generally between 20 percent and 30 percent of the cost to purchase inventory, but the average rate varies based on the industry and size of the business. As such, analysts like to compare this rate against other companies in the same peer group and market capitalization, or within the same company over various periods of time.