Everything Retailers Need to Know About Inventory Costs

Inventory is one of the largest expenses retailers incur. However, if you only think about how much your inventory costs to purchase, you have an incomplete picture of how much you’re spending to stock up. To understand inventory costs, you need to factor in all the expenses related to ordering, storing, and managing stock.

What are inventory costs?

Inventory costs are the costs associated with ordering and holding inventory, and administering related paperwork. These costs are evaluated by managers to determine how much inventory should be kept on hand.

Inventory is the largest expense retailers have. For every dollar US retailers make, they have $1.35 of inventory in stock. When you have a holistic understanding of your inventory costs, you can control them more easily. 

“Knowing inventory costs is extremely important because they affect the majority of decisions one makes as a retailer,” says Abir Syed, co-founder of ecommerce accounting firm UpCounting. 

They influence pricing decisions because that affects your margin. They influence purchasing decisions because they affect how much cash you need to purchase a certain volume of inventory. And inventory costs can affect stocking decisions because knowing your margins can determine how you price other products so that low-margin products don’t cannibalize sales from high-margin products.

Types of inventory costs

• Purchase costs
• Ordering costs
• Holding costs
• Shortage costs

Inventory costs more than its purchase price. Retailers also need to factor ordering, holding, and shortage costs into the equation.

Purchase costs

Purchase cost is the price a supplier charges you to buy its products. For example, if you’re buying 100 pairs of sneakers from a footwear wholesaler at $12 a pair, your purchase cost is $1,200. This figure excludes expenses like processing, shipping, and handling fees.

Ordering costs

“Ordering costs include the labor expenses for the buying department, including wages, related taxes and benefits, and the costs of transporting and receiving inventory,” according to Frances Gunn, Associate Professor at Ryerson University’s Ted Rogers School of Retail Management. 

This is where processing, shipping, and handling fees come into the picture. Any expense related to getting your inventory from the supplier to your warehouse or store is an ordering cost.

Holding costs

“Holding costs include the cost of the space where inventory is held, the interest cost related to the inventory purchase funds, and the cost of inventory which is not used or damaged,” Frances explains.

This includes warehouse or storage rental costs and obsolescence costs related to liquidating inventory.

Shortage costs

There are also expenses incurred when you don’t have enough inventory in stock. Any costs related to managing stockouts, such as payroll for your customer service team or expenses related to reordering, are considered shortage costs.

How to calculate inventory costs

The formula for inventory costs is:

Inventory costs = purchase costs + ordering costs + holding costs + shortage costs

Calculating inventory costs is simple once you’ve gathered all of these data points. Not sure where to find these figures? Check reports from your POS system, inventory management software, and payroll provider.

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Sample inventory costs calculation

Let’s see how easy it is to calculate inventory costs. Let’s pretend you run a sneaker store and need to reorder inventory after a stockout during your anniversary sale.

Purchase costs

You need 100 pairs of sneakers. The supplier charges $12 per pair, which makes your purchasing costs $1,200.

Ordering costs

Your wholesaler is in China and charges $100 for express shipping to North America, which you need to fulfill backorders.

You need to hire a truck to transport the shipment from your store to your warehouse. Truck rental for three hours costs $60.

According to reports, payroll costs associated with recording this inventory totalled $200.

Combine all of those figures together, and your total ordering costs are $360.

Holding costs

You pay $800 each month for your warehouse. This sneaker order represents one-tenth of your total inventory and your inventory days on hand is 30 days. Therefore, your holding costs are $80.

Shortage costs

This shipment is a reorder because you sold out of these sneakers during your sale, so there are shortage costs associated with it. Your main expense was payroll for your customer service and marketing teams, who fielded customer questions about the stockout. That cost your business $400.

When we add our purchase costs ($1,200), ordering costs ($360), holding costs ($80), and shortage costs ($400) together, we discover that our total inventory costs for this shipment of sneakers is $2,040.

Inventory costs: $1,200 + $360 + $80 + $400 = $2,040

How to reduce inventory costs

“When continuously monitored, inventory costs can be adjusted, thereby reducing their impact on profits,” Frances says. The better you understand your inventory costs, the more control you have over them, and the more you can improve your margins.

Follow these tips to reduce your total inventory costs.

Leverage data for accurate forecasting

When you rely on data, rather than a gut feeling, to order inventory, you’ll be able to avoid overstocking and stockouts and their associated costs. 

“With the new data analytics tools that we have available, you can do a very good job of understanding how demand works,” says Javad Nasiry, Associate Professor at McGill University’s Desautels Faculty of Management. 

The more you know about your demand, the less uncertain you are about demand. That means you can manage your inventory better and reduce inventory levels in your warehouses, because keeping inventory is costly.

Find the right balance between purchasing, ordering, and storage costs

Finding the sweet spot between purchasing, ordering, and storage costs can help you reduce inventory costs.

One way to reduce purchasing and ordering costs is to order larger volumes of inventory. “If you make bigger purchases, that will usually lead to volume discounts. And bigger purchases can often mean big savings on shipping too,” Abir says.

Think about it: as a consumer, you can usually get free shipping by spending a minimum amount, or can get a discount for committing to a subscription. Suppliers can offer retailers similar discounts. 

There are other ways to save money on inventory.

Depending on the purchasing volume, vendors may offer allowances for scenarios such as prompt payment, which further drive down inventory costs.

However, it may not always be in your best interest to order a high volume of inventory from a supplier. 

“When you are buying inventory, your money is tied to inventory that is sitting in the warehouse,” Javad says. “You are paying something to buy these products, and your customers are going to later pay you for those products.” Javad continues:

“You could have spent this money to invest in some other projects. You don’t want to order too much inventory, because if you order too much, you are the one who is paying to hold this inventory in your warehouse.”

With more inventory, your storage costs go up. So you need to find the sweet spot between how much inventory you order and how much you keep in storage.

“Ordering inventory is costly and holding it is costly. You need to find the best trade off between these two costs,” Javad explains.

If you’re ordering inventory from halfway around the world, Javad says, “You will have to arrange for either air freight or maybe an ocean container, so your ordering cost may be high. The higher that cost is, the more you will be inclined to order a higher volume, because you want to avoid incurring that cost again and again.”

However, he adds, “If the factory I am supplying from is on the next block, the inventory ordering cost for me is low, so I may say, ‘OK, I will order more often because they’re very close, so getting a shipment is not that expensive.’” In this scenario, you’ll spend less on ordering costs and more on storage costs. 

Optimize storage costs

“Inventory costs can also be reduced by ensuring that inventory space is not in a costly location, is well organized, is efficiently used, and is properly maintained to reduce obsolescence costs,” Frances says.

Instead of choosing a warehouse that’s around the corner from your store, consider using one that’s half an hour away, in a more affordable area. Justify the distance by making fewer trips.

If you follow best practices for storing your inventory, you’ll be able to reduce the risk of spoilage.

Leverage auto replenishment

“I am a huge proponent of auto replenishment,” Nilesh says. “By defining products that need to remain stocked and associating the minimum quantity available, businesses can save themselves headaches and save valuable time by putting reordering on auto-pilot.” 

To take advantage of auto replenishment, calculate reorder points for your inventory and set up recurring orders. If your vendors only accept manual orders, consider switching to one that lets you automate repetitive processes.

Increase your inventory turnover rate

The longer you hold onto inventory, the more you need to spend on storage costs. Calculate your inventory turnover rate to better understand how quickly you’re selling inventory. Knowing this figure can help you set benchmarks and help you gauge which products are performing well and which ones are struggling. Use this data to make decisions about pricing, promotions, and inventory order volumes.

For example, let’s say you run a bike store. After calculating inventory turnover rate for all of the bike models you sell, you realize that children’s bikes sell more slowly than adult bikes. With these insights, you decide to pause orders on new kids’ bikes and create family bike bundles to incentivize sales of your existing stock.

Get rid of dead stock

If you calculate your inventory turnover rate and find that some products just aren’t selling, you have dead stock on your hands. Get rid of dead stock by discounting it or making an in-kind donation in exchange for a tax write off. 

Section 170(e)(3) of the Internal Revenue Code states that when C Corps donate their inventory to qualified nonprofits, they don’t just receive a tax deduction—they can receive a tax deduction equal to up to twice the cost of the donated products.

You can deduct up to half the difference between the selling price and cost of goods sold (COGS), as long as it doesn’t exceed twice the COGS.

Let’s say you purchase a piece of inventory for $10 and sell it for $30. The difference between the COGS ($10) and selling price ($30) is $20. Because half of $20 is $10, which doesn’t exceed it twofold, you can deduct $20 for the item for tax purposes.

Making an in-kind donation can help you reduce losses on dead stock. 

Get control of your inventory costs

Inventory costs comprise more than just purchasing costs. When you know your ordering, holding, and shortage costs, you have a holistic understanding of the true price of storing and managing stock. This knowledge can help you gain more control over this major business expense.

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