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Beginning Inventory Value ($): The value of inventory at the start of a period, like a year.
Ending Inventory Value ($): The value of inventory at the end of a period, like a year.
Cost of Capital (%): The percentage rate that represents the financial cost of holding inventory.
For example, if the cost of capital is 10% and the average inventory during the year is $600000, that means the financial cost of holding an inventory of $600000 is $60000.
By the way, how to determine this cost of capital (%)? Well, simply decide on the minimum return you could earn if the money wasn’t tied up in inventory. For example, if the inventory value is $600000, that means this is money tied up in the inventory, right? What’s the return you could earn if you invested this $600000 somewhere else? If you could invest this $600000 elsewhere and earn 10%, this means 10% is the cost of capital (%).
But why’s this called the “cost” of capital? Because it’s the cost (sacrificing the return you could have earned elsewhere) you’re paying to hold the inventory.
Now, what if you took and bank loan and financed the inventory? Well, the cost of capital in this case would be the interest rate on the loans. Why? Because this is the minimum return you expect so that you can service the bank loan.
What if your inventory is financed partly by a bank loan and partly by your own funds? Well, the cost of capital in this case would be the weighted average of the cost of capital of the bank loan fund and your own fund.
Makes sense?
Storage Costs ($): Expenses for physically storing inventory for a particular period, like a year. Includes warehouse rent, utilities, and labor.
Service Costs ($): Costs of maintaining inventory from a compliance and support perspective for a particular period, like a year. Includes insurance, property taxes, inventory software subscription, etc.
Risk Costs ($): Costs related to inventory losing value. Includes shrinkage and theft.
Inventory Carrying Cost (%): The total cost of holding inventory for a particular period, expressed as a percentage of the inventory value.
Step 1: Calculate the average inventory value
Average inventory value = (Beginning inventory value + ending inventory value) / 2
Average inventory value = ($500000 + $700000) / 2 = $600000
Step 2: Calculate the capital cost
Capital cost = Average inventory value x cost of capital (%)
Capital cost = $600000 x 10% = $60000
Step 3: Calculate the carrying cost ($)
Carrying cost ($) = Capital cost + Storage cost + Service cost + Risk cost
Carrying cost ($) = $60000+ $25000 + $10000 + $20000 = $115000
Step 4: Calculate the carrying cost (%)
Carrying cost (%) = Carrying cost ($) / Average inventory value
Carrying cost ($) = $115000 / $600000 = 19.17%