Calculating Inventory Carrying Costs Per Square Foot of Warehouse Space
Calculating carrying costs of inventory for each square foot of your warehouse is simple. All you do is take all your inventory costs and divide it by your square footage.
It all sounds easy doesn't it? If only it were that simple.
While it sounds simple enough, it's the time needed to amalgamate these costs that takes the most time.
Once you know what your inventory carrying costs are, then dividing it by your square footage is a fairly straightforward proposition.
Unfortunately, the problem most companies encounter is how to determine those carrying costs.
Better yet, most aren't even aware of what to include in these costs, and even a larger number of enterprises have resigned themselves to thinking inventory only includes the costs of financing, and nothing more.
So, what's included in these costs?
Well, it depends. Some companies in some industries may be more or less concerned with certain inventory costs, while other companies may not consider those costs important at all.
The focus must be to define your company's unique costs as they pertain to carrying or maintaining your inventory counts within your warehouse.
Once you've determined your specific costs, then you can go about performing the calculation. Afterwards, you can adopt strategies to reduce these costs moving forward.
We'll start by itemizing and explaining some of the most important costs.
Next, we'll show you how to determine your monthly carrying charges by using a google sheet (you can make a copy for yourself here) to total up all these costs relative to the amount of inventory on hand during any given month.
We'll then show these costs in a pie-chart, and finally, we'll outline the most important strategy or doctrine you should adopt to ensure a fast moving inventory.
In our example, we will leave the salaries for warehouse employees, procurement and or accounting out of our equation. While each of these roles are important in managing inventory, they aren't part of a company's inventory carrying costs.
However, we will capture warehouse employee overtime as this cost is often borne by the company due to stock outs or other issues pertaining to mismanaged inventory.
Inventory Costs - What You Need to Calculate
1. Damaged or Ruined Inventory:
The costs of damaged inventory are fairly easy to understand.
Either you scrap that inventory entirely, or assess the cost to rework and repair it.
If the costs of rework and repair are higher than what you can resell that inventory for, then it's not worth it.
In most cases, damaged inventory is either a complete write-off, or is sold for scrap.
2. Obsolete Inventory:
Every company has had those situations where it has put a product on its shelves in anticipation of high volume sales, only to be disappointed as those products were no longer needed or wanted by the company's market.
In some cases, it's the company itself that has introduced a new product offering that makes its old offering obsolete.
Either way, it's a cost of inventory and must be included in our calculation.
3. Financing (Cost of Capital):
You need capital to purchase inventory, but you can't pay off that balance until you ship the product, invoice it and collect on your receivables from your customers. Only then can you pay back the amount you borrowed.
For instance, if your interest rates on financing was 7% annually, then your daily rate would be 7% divided by 365 days.
This would provide you with a daily rate of 0.01917%.
This amount would be multiplied by your costs of goods sold (COGS) on finished goods, and that number would then be calculated by the number of days you hold those products before making sales.
This would give you a solid idea of the costs to finance individual finished goods.
However, in our example, we'll simply apply the 7% over the period of one year directly to the inventory value on hand.
4. Pilferage (Theft):
Pilferage isn't just a problem for consumer enterprises, ones where retail outlets have to deal with theft on a daily basis.
Theft is also a problem for business-to-business (B2B) enterprises, especially those who carry high-value raw materials and well-recognized brand names.
The costs to get product in and out of your warehouse must be included in our assessment.
Tracking your costs on incoming shipments is critical.
Even if your company doesn't typically cover freight on outbound shipments, you should still be aware of those special circumstances where you had to cover outbound freight.
Unfortunately, some companies merely include outbound freight as a "miscellaneous cost". However, in a number of circumstances, a company covering outbound freight was due to not having inventory.
An inventory stock out is an important cost as you have to rush shipments into your warehouse and then rush them out to your customer, all at your expense.
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6. Lost Sales and Lost Business:
Yes, losing sales, losing revenue and losing customers is a cost of managing your warehouse of finished goods. This is why having the right amount of finished goods is so important.
This issue of lost sales typically goes hand-in-hand with encountering a shortage or out-of-stock (OOS) situation.
The best way to track this cost is to have your sales team itemize each time they lose a sale or a customer because your shelves were empty.
Simply put, you lose sales, revenue, profit, customers, and eventually, you lose future outlets for sales and a portion of your market share.
7. Electricity and or Climate Control:
This cost is fairly straightforward. The costs of electricity on lights and maintaining a certain temperature within the warehouse are important costs.
Your insurance covers all the costs associated with insuring your warehouse fire, water damage, etc.
9. Warehouse Employee Overtime:
While we have decided not to include employee salaries in this analysis, it's important to note that overtime due to mismanaged inventory should be captured.
Overtime can be caused by stock outs, rush shipments both in and out of the warehouse, and or situations where employees have suddenly encountered damaged inventory and had to work overtime to resolve the problem.
Inventory Carrying Cost Calculator
The following table and pie-chart break down each of these aforementioned inventory cost drivers for an example where the average monthly inventory value on hand for a given company was $325,000.00.
Get your free copy of the inventory cost calculator here, just "make a copy" of the google sheet and input your own numbers.
Determining Carrying Costs for Each Square Foot of Warehouse Space
We now have a summary of all our carrying costs.
In our example, the company's yearly carrying costs are 39%, which means its monthly carrying costs are 3.244%. This is fairly standard.
In fact, most businesses apply 3% to their costs to hold product on their shelves on a monthly basis.
Regardless of this rule, it's always a good idea to capture your specific costs as they pertain to your warehouse.
Now we want to go about determining our costs for each square foot.
Simply put, this involves taking our total yearly carrying costs of $125,750.00 and dividing by the square footage of our warehouse.
Let's assume the warehouse is 20,000 square feet.
Our calculation is simply $125,750.00 divided by 20,000 which gives us $6.28 carrying cost per square foot for the entire year.
On a monthly basis, this amount would be divided by 12 which would give us $0.52 carrying cost per square foot.
The Most Important Doctrine to Follow in Order to Reduce Inventory Costs
While each individual situation is unique, there is one strategy, or doctrine, that will immediately reduce all of these costs.
That one all-important strategy includes doing everything possible to make sure inventory sells quickly. Granted, this is much easier said than done.
However, a number of companies hold onto inventory indefinitely in the hopes of selling it for the highest possible gross profit. Instead, you should focus on making sure your inventory turns over quickly.
First, only hold inventory of popular product offerings, ones where you have multiple opportunities for sales because you have a large list of clients interested in purchasing that particular product.
Second, reward loyal customers by providing discounts, rebates and price reductions when demand slows down.
Third, don't be afraid to liquidate or sell off slow moving inventory.
When your inventory moves faster, all of those cost drivers are reduced.
An inventory that turns over quickly is one where your costs of financing are lower and you incur less costs pertaining to damage, theft and obsolescence.
Your company needs inventory in order to keep customers. However, don't make that common mistake of trying to maximize all your margins on sales by holding onto inventory for too long.
Remember, the longer you keep those products on your shelf, the lower your profit on sales. You're incurring more costs to hold that inventory and are much better off selling it.
Calculating your carrying costs for each square foot of warehouse space allows you to identify which costs affect your company the most, while also making it easier to eliminate them as going concerns.
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