Setting the Right Inventory Carry Cost Percentage
Executive Summary
- Inventory carry cost is a controversial topic because of the assumptions.
- We cover how to set the inventory carry cost properly.
Video Introduction: Setting the Right Inventory Carry Cost Percentage
Text Introduction (Skip if You Watched the Video)
Inventory carry cost is necessary for the supply chain as it allows a company to determine its costs of keeping inventory. It is also a key input into the economic order quantity, which in its base formulation trades off the cost of carrying inventory versus the cost of ordering inventory. EOQ sounds like a very straightforward formula until you ask companies to estimate their inventory carry cost and order cost, and once you do, more often than not they cannot quantify these values. You will learn about some of the problematic issues that surface when trying to implement the EOQ formula.
Our References for This Article
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Inventory Carrying Cost Inputs
You generally cannot directly go to the finance department in a company as they tend to know the cost of money or the company’s capital cost, but not the other costs associated with inventory carry cost. This is a combined cost which accounts for:
- The cost of capital
- The cost of the storage facility for the product
- The cost of the product becoming obsolete or going bad (say as in in the case of perishables)
- The cost of the product being damaged while being stored
Experience in Estimating Inventory Carry Cost
I have asked about this value for many clients to perform modeling and create EOQ driven ordering quantities and frequencies. They almost always tell me that they don’t have a good number. They then ask me if I know of one.
George Plossl does an excellent job of explaining the arbitrary nature of such estimations in the book.”
Production and Inventory Control.” I have a quote from the book below:
“Inventory Carrying Cost: The inventory carrying cost is a useful concept (albeit an artificial one) required by the mathematical formulas used in lot-sizing calculations. As listed earlier, many separate elements are assumed to make up this cost. Obsolescence is a reality in any inventory but this cost element in the inventory carrying cost varies widely with time and is not the same for different items in an inventory (that is, it is highest for style items). This would indicate that a different carrying cost might be used for each item in the stock list. This is obviously impractical and an average figure is usually chosen, either for all products or for each major type of product. Identical reasoning applies to deterioration costs. The whole discussion is purely academic. The inventory carrying cost has practical use only as a management policy variable which, rather than being a fixed. magic number, is one that should be manipulated to attain the overall objectives of the company. “- George Plossl
Estimating Inventory Carrying Cost
Inventory carrying cost is an estimation of the percentage of the product cost that is consumed in holding the product for one year. It is often used in inventory formulas as well as cost optimization. In many popular articles that cover the subject superficially, a proper inventory carrying cost is between 20 to 25%.
I could spend lots of time estimating this for each company. As pointed out by George Plossl, the value would always be an average. And it will be too high for some products and too high for others. The primary item I look for is how perishable the company’s product is. If it is more towards the perishable end of the spectrum, I increase the inventory carry cost; If it is not, I decrease the inventory carry cost.
How Best to Perform Inventory Valuation
In this article, we will cover the cost of inventory. The cost of stock is critical to both how inventory is managed and the final determination of the profits of a company. And the calculation method of the cost of inventory must be set up within the entity’s inventory management and financial system or systems.
There are many methods of determining inventory cost that relates to inventory accounting, inventory valuation, etc.
The Types of Inventory Cost
The types of inventory costs are related to things like the purchasing cost of the inventory. However, other types of inventory costs are absorbed into things like facility costs. This is included in the carrying cost formula that many companies use to estimate the cost of holding inventory for a year or a month.
Other types of inventory costs include obsolescence and breakage. The types of inventory costs are quite numerous and impact a balance sheet in a multitude of ways.
Inventory Cost, Inventory Price, Inventory Valuation Methods and the Valuation of Inventory
Inventory will almost always have an inventory cost and sometimes an inventory price if the inventory is a finished good. That is, an inventory price is only necessary for an inventory that is sold. And the margin is determined by subtracting the inventory cost from the inventory price when the same items are purchased and sold. But this becomes more complex when a material is converted into a finished good and then sold. In that case, the combined costs of goods sold that went into the finished good must be estimated. This means subtracting the inventory cost of various materials from the final inventory price of the finished good.
This means using inventory valuation methods that allow an entity to determine the valuation of inventory. The particular country’s tax laws constrain inventory valuation methods, but typically there are some standard inventory valuation methods to choose from in almost every country.
An inventory cost or inventory valuation is necessary for all of the inventory that a company maintains.
Inventory Accounting with the LIFO Method or Last In First Out Method, FIFO Method or First In First Out Method
An entity will typically choose an inventory accounting method and then configure its system to operate that way. One of the complexities is that costs change over time. Therefore, raw material “A” may cost $20 on Jan 20th but cost $25 on Feb 25th.
- If the raw material is issued on Feb 26th, what is the raw material’s correct cost? When inventory is recorded in a location, it is not serialized (in most cases). Therefore the inventory at a location virtually “blends.”
- This makes the assignment of a cost to the material difficult as 1/2 of the inventory may have been purchased at the cost of $20, and the other half at the cost of $25.
Two of the most common inventory accounting valuation methods are LIFO Method or Last In First Out Method, FIFO Method, or First In First Out Method.
- The LIFO Method or Last In First Out Method: This method values the inventory at the cost, which goes to the last item cost received. So in the example above, the $25 per unit cost would be used.
- The FIFO Method or First In First Out Method: This method values the inventory at the cost, which goes to the first item cost received. So in the example above, the $20 per unit cost would be used.
Inventory Accounting with the Weighed Average Method, Average Cost Method
Another inventory accounting method is to use a specific price, but rather the weighted average method or average cost method.
- Weighted Average Method or Average Cost Method: This method values the inventory at the cost, which is an average of the cost received. So in the example above, the ($25 + $20),/2, or $22.5 would be the cost used.
Overall the weighted average method or average cost method has the advantage of being far less complex than the LIFO method or the FIFO method.
The Concept of Average Inventory Value
Average inventory value means taking an average of the inventory holding position and applying a particular value (as determined as explained above). The average inventory value is used to improve the value determined in the system. The article up to this point has focused on the average inventory value for a specific product or product location combination. However, the average inventory value also applies to the overall product database. The average inventory value for the whole product database is then typically tracked by companies and compared to a maximum stock level that the company wants to hold.
Cost of Goods Sold
These various inventory accounting methods are used to determine the cost of goods sold. The costs of goods sold in total, combined with the administrative and overhead, will serve as the company’s cost basis.
Inventory Value
While the inventory value is the average cost of the materials, time the number of materials, the term inventory value can mean several things. Any item can have an inventory value. Or the overall system or network-wide inventory can have an inventory value, or the inventory value can be just of the materials kept at a particular distribution center.
Most companies try to cap the overall inventory value at a specific number. Such as no more than $100 million in inventory.
How Should EOQ and Other Supply Planning Parameters be Calculated?
One would be able to, for example:
Item #1: Simulation
Set the supply planning parameters in a way that one can simulate the impact on the overall supply plan. When using supply planning systems, inventory parameters are typically managed on a "one by one" basis. This leads to individual planners entering values without considering how inventory parameters are set across the supply network.
Item #2: Interactivity of Changes
This is the ability to see the relationship between changes to service levels and the simulated output.
Item #3: Seeing Financial Implications
This is the ability to see the impact on the dollarized inventory for different aggregate settings.
Item #4: Mass Change for Efficient Maintenance
This allow the parameters to be changed en mass or as a mass change function. Both supply planning systems are designed to receive parameters; they are not designed to develop the parameters.
Getting to a Better Parameter Setting Capability
We developed an approach where EOQ and reorder points are calculated externally, which allows for a higher degree of control. And for the average inventory to be coestimated in a way that provides an observable total system inventory, holding cost, service level, and a picture of what is happening to the overall system. Calculating individual parameters like EOQ without an appreciation for the systemwide does not make any sense. Also, in many, perhaps even most cases, there is no reason to use EOQ for the purposes given above. Instead, an alternative custom order batching method can be created to replace EOQ. There is nothing magical about EOQ. It is not a "best practice." It will not provide you with "digital transformation." It is not "Six Sigma." You will not get a "black belt" for using it.
After observing ineffective and non-comparative supply planning parameter setting at so many companies, we developed, in part, a purpose-built supply planning parameter calculation application called the Brightwork Explorer to meet these requirements.
Few companies will ever use our Brightwork Explorer or have us use it for them. However, the lessons from the approach followed in requirements development for supply planning parameter maintenance are important for anyone who wants to improve order batching and supply parameters.
Conclusion
One of the current (2016) issues with using a value between 20 and 25% is that they have tended to be created when interest rates and inflation (built into interest rates) were higher. Therefore, those companies that use the higher figure would tend to overestimate inventory carry cost. One of the difficult things about using quantified values for both order cost and inventory carry cost is that the order quantities become much higher than is “politically acceptable” within companies.
This is why companies often ignore the quantification of order quantities and determine the order quantity using judgment methods.
Inventory valuation works behind the scenes in inventory but drives many decisions. At this point, most ERP systems have strong capabilities for the valuation of inventory. Once the ERP system is configured correctly, the valuation of inventory is automatic. Most ERP systems can show inventory valuation at any point in time.
Another important factor related to inventory valuation is sales and operations planning. This is where the company projects supply and demand and the impact on the overall inventory valuation of the planned inventory to be carried.
See our EOQ calculator at this link.
Also, learn about the limitations of EOQ at this link.