As a small business with a product focus, your profitability is heavily influenced by your inventory carrying costs. Maintaining excess inventory will reduce your company’s cash flow, making it difficult for you to cover operating expenses or break even. However, your inventory shouldn’t be too low or fall short of customer demands at the same time.
Calculating Inventory Costs: Holding Costs & Lost Sales
What is the cost of inventory formula?
Cost of inventory is calculated as initial inventory less purchases of inventory minus final inventory.
The cost of inventory formula is most frequently used by businesses and companies to determine their inventory costs over a specified time period. Therefore, if a business wants to calculate its cost of inventory over a year, it will add the value of its initial inventory to the total of its inventory purchases over that period, then deduct the value of its final inventory from the total.
As an illustration, if a business wanted to determine its cost of inventory for the previous three months, it would add its $30,000 initial inventory value to its $3,000 in recent inventory purchases. After the three months, they would deduct their final inventory value of $12,000. Their calculated cost of inventory would then be:
= $30,000 + $3,000 – $12,000
= $33,000 – $12,000
= $21,000
Tips for using the cost of inventory formula
You can use the following advice to determine the cost of inventory:
Understand buying vs. manufacturing
It can be crucial to understand the differences between calculating inventory for businesses that manufacture their goods versus businesses that purchase their goods from suppliers when figuring out the cost of inventory. A company that produces its own products must account for both the final products of production and the inventory of raw materials used in the manufacturing process.
As an illustration, if a supplier of frozen pizzas wanted to determine their cost of inventory, they would need to determine both the number of finished pizzas produced and the number of pizza ingredients.
For other businesses and companies, the only goods that matter when figuring out the cost of inventory are the items that they buy from suppliers.
A clothing store, for instance, would include all of its wearable items in its inventory, but would exclude items like printer ink or receipt paper because they cannot be sold to customers or consumers.
Know the different inventory costs
You can more easily determine the value of your goods and products and manage your inventory by being aware of the various inventory costs and how they apply to your goods and products. These costs can include:
Ordering costs are incurred when purchasing goods from suppliers and vendors. These expenses may relate to the handling, locating, gathering, and moving of your inventory from one place to another. Bulk purchases of inventory can occasionally lower ordering costs while also increasing the quantity and value of inventory on hand.
Between buying inventory and selling it, there are costs known as holding costs or carrying costs. These expenses may include inventory storage facilities, maintenance or repair costs, and risk costs due to theft or damage. The holding costs may increase the longer the inventory is kept in one place without being sold to customers.
When a company or business runs out of inventory of a particular product or good, shortage costs frequently result. These costs can include emergency shipments, which are frequently more expensive than regular shipments, but they can also include reputational or customer loyalty losses, which are harder to quantify in terms of money.
Determine inventory write offs
You can future money and inventory costs by knowing when you can no longer sell specific items of inventory. In order to make room for more relevant or necessary goods and products, inventory that has become damaged, stolen, or unusable by consumers can be written off.
Writing off inventory simply means assigning a financial value that the business will need to adjust in the future to the current inventory. Although doing so might present a short-term challenge for a business, it is advantageous to do so when necessary so the enterprise doesn’t waste time attempting to sell out-of-date goods.
For instance, if a company that produces specialty coffeemakers learns that its coffee bean suppliers are closing shop, this may render their niche products obsolete. Finding a new coffee bean supplier, producing their own coffee beans, writing off some of their inventory, or working to boost sales of their more pertinent products would be the company’s only options.
Calculate the average inventory
Because it can be used to calculate other things, like the inventory turnover rate, and because it can help you understand the cost of your inventory, calculating the average inventory is crucial. By combining two or more values from the start and end of a selected period and dividing by the number of numbers chosen, you can determine the average inventory. Utilizing the values of their starting and ending inventories, some businesses can determine their average inventory for an entire fiscal year.
To determine how their sales fluctuate, however, it can frequently be more advantageous for businesses to calculate their average inventory every month or season.
For instance: If a car dealership observes a decline in sales during the colder months of fall and winter, they can decide whether to increase inventory purchases during those months or whether to improve customer purchasing incentives. Otherwise, if a business notices that its holiday sales have doubled, it will know to buy more inventory to avoid a shortage.
Understand turnover rate
When estimating your business expenses, it can be helpful to know how quickly your inventory is being bought and sold. It can also alert you to any products or goods that aren’t performing well. Inventory turnover rate, which is calculated by dividing sales by average inventory over a selected period, typically a fiscal year, is a great way to determine your repeated inventory sales. It can be helpful to develop selling initiatives, such as promotions or employee rewards for achieving product selling goals, if some inventory items aren’t selling well.
For instance, if a business finds that its turnover rate is 90 days, which indicates that it sells through its inventory every three months, it may indicate that it is either buying or manufacturing too many products, or that it isn’t moving its inventory quickly enough. By reducing the amount of time it takes to sell your products, calculating this information can help you lower your inventory costs and boost your revenue.
FAQ
How do you calculate cost of inventory?
Use the following formula to determine the cost of inventory: The Cost of Inventory = Beginning Inventory + Inventory Purchases – Ending Inventory The calculation is: $30,000 + $10,000 – $5,000 = $35,000.
What is the formula for inventory?
Beginning inventory plus net purchases minus COGS equals ending inventory is the basic formula. Your beginning inventory is the last period’s ending inventory. The items you purchased and added to your inventory count are the net purchases.
What are included in inventory costs?
The total cost of all storage-related expenses is known as inventory carrying cost. The total includes warehousing expenses as well as intangibles like depreciation and lost opportunity cost. Typically, a company’s inventory carrying costs range from 20% to 30% of its total inventory costs.
