Target: Carrying costs

Reducing inventory yields savings opportunities, not guarantees

BY REGINALD TOMAS LEE

38

Industrial Engineer

As engineers and supply chain professionals, we

are always looking to make sure we have the greatest positive
impact. One area we deal with regularly is inventory. There are
always pressures to manage and reduce it. Often, we are asked,
What is the cost to carry the inventory the carrying cost?
We look for a simple way to calculate it by tying the carrying
cost to the value of inventory. For instance, a company with
$100,000 in inventory would spend $10,000 in carrying
costs if the carrying cost is 10 percent of inventory value.
This percentage becomes an important topic when talking
inventory reduction. Consultants, on one side, want the value
to be larger so that they have a bigger bogey for improvements
and a more robust value proposition. Their thinking is that
not only can they reduce inventory, they also can eliminate
a large cost associated with carrying it. They would prefer to
quote inventory carrying costs as high as 35 percent. This
number might include theft, insurance, storage space, transaction costs and about anything else that can be reasonably
added. The other end of the spectrum is finance. To some, the
only cost is that involved with borrowing the money needed to
carry the inventory. So they would like to eliminate everything
that consultants include and err on the lower side, looking at
values in the low single digits.
Who is right? How do you calculate the percentage? Is it 5
percent, 35 percent or something else?
The short answer is that there is not a number that can be
calculated and used as a de facto value, only a snapshot that
states, At this moment in time, carrying costs are x percent of
inventory value.
Once inventory changes, this percentage changes. Why?
Because the expenses associated with carrying costs are independent of the inventorys value and often its level. See the
sidebar on the right for a discussion on expenses, independence, and inventory value vs. inventory levels. If inventory
value goes up, carrying costs may remain the same, which
drops the carrying cost percentage.
This results in bad news and good news. The bad news is
that there isnt a number that works under all cases because
carrying costs generally dont change when inventory value
changes. If the inventory and the operating infrastructure remain relatively stable, a percentage can be a decent
approximation. If carrying costs or inventory value change
significantly, however, the percentage would have to be
recalculated. The good news is that by understanding this,
industrial engineers and supply chain professionals can focus
on what influences and creates carrying costs primarily the
operating infrastructure, the operating model and the type of
inventory carried.

key terms used

Cost vs. expense: In the main article, cost and
expense are used synonymously, although in certain
contexts they can be very different. For instance,
labor expenses can consume cash in one month
while building inventory. This cash does not become
a cost until the item is sold from inventory, when
it becomes a part of cost of goods sold or cost of
sales. This transaction can happen almost immediately or extend many weeks or months into the
future the longer the gap, the greater the difference between costs and expenses. However, in the
context of the points made here, it is assumed that
there is no practical difference unless otherwise
noted.
Independence: Independence suggests that two
things are not related mathematically; in other
words, one does not directly influence the other.
Figure 1 demonstrates this. For dependent relationships, the y, or vertical, value depends upon what
the x, or horizontal, value is.
What happens when y doesnt depend on x? The
value for y will remain the same regardless of what
the value of x is.
What does this have to do with carrying costs?
Everything. If the carrying cost y changes based
on the value of inventory value x, then there may
be a dependent relationship. However, if y doesnt
change as x changes, the values are independent.
This limits our ability to say that carrying costs y
are a percentage of the value of inventory x.
Inventory value versus inventory level: Inventory
value represents the financial value of the inventory,
while inventory level here reflects the amount and
number of items in inventory. The difference might
be having a diamond worth $50,000 versus having
$40,000 worth of pencils. It is important to distinguish because sometimes large quantities of low
value inventory can have an impact that lower levels
of higher valued inventory do not have.

Why creating a de facto percentage

will not work
To determine the carrying cost percentage, you first have to
define the factors involved in carrying inventory and calcuAugust 2013

39

target: carrying costs

its not always relative

Figure 1. Carrying costs arent always related to inventory value. In this example, total carrying costs remained the same even though
inventory value increased.

Expected
Actual

Carrying
costs

Inventory value
late their costs. Factors range from the space, labor and
equipment employed to the money borrowed to fund these
activities. Comparing this total cost to the value of inventory
gives a percentage (carrying costs divided by inventory). There
is a concern, however. Logically, some of these costs dont, and
shouldnt, change with inventory value. The challenge is determining which costs change and which dont. Only when costs
change with inventory value can a percentage be applied broadly.
In almost all cases, you cannot create a carrying cost percentage based on Buy
inventory value that works
broadly for four
Build
product
reasons: A inventory
large portion of costs result from
the infrastructure
that supports carrying the inventory; the operating model can
A infludetermine infrastructure cost; the type of inventory can
ence cost; and the costs that truly change with value are relatively
small.
Infrastructure costs. When a company decides it wants
Time
to store inventory, it must make a commitment to do so. This
involves getting space, equipment and people to move and
manage inventory and other people. The result is expenses associated with the labor, equipment and space. Whether completely
empty or filled to the brink, the costs to lease the space, lease lift
trucks or pay people will be the same. Hence, they are independent of inventory value, as shown in Figure 1. These are all costs
involved with carrying inventory, but they do not change when
value changes.
Operating model. Consider two warehouses of the same
size. One has $1 million in inventory that turns once or twice per

40

Industrial Engineer

year. Its a lights out operation that people only visit for the occasional order. The other has an average inventory of $1 million
as well, but it turns the inventory 52 times per year. Trucks
arrive, are unloaded, materials come in, are stored, pulled and
prepped for shipment and loaded daily. Based on this description alone, the second warehouse clearly is more expensive to
operate because it needs more infrastructure. The first facility
might Sell
need only one person and a lift truck due to infrequent
product
activity. The second has many lift trucks buzzing up and down
B planning and operating the facilities
the aisles and more people
and moving inventory. Although both have the same inventory
value,Store
the operating model itself determines
the costs required
Sell
to operate
the site. These costs,product
too, are independent of invenproduct
tory level.
B
The operating model often reflects culture. Damages and
theft can result in operating models with poor cultures. These
other carrying costs are tied loosely to the operating model, and
they must be considered and also serve as improvement opportunities.
Inventory type. The makeup of the inventory could cause a
company to incur costs that are independent of inventory value.
Special conditions such as environmental requirements for
temperature and humidity make certain inventory types more
expensive to maintain. Similarly, low cost items that require
special protection or packaging can be more expensive to own
and maintain than more expensive items that do not have such
requirements.

Inventory value

extended borrowing
Figure 2. Up to point A, all products are the same. Then one product is sold, and the other is stored. For the stored product, this creates a
time delay between A and B where borrowed capital is not generating any return. Infrastructure costs remain the same, however, as they
already have been accounted for.

Sell
product
Buy
inventory

Build
product

Store
product

Sell
product
B

Time
Finally, inventory level could influence the cost to carry inventory independently of value. Maintaining a vehicle lot with one
$200,000 car may be easier to manage than a dealership that
has to clean and maintain 40 cars worth $5,000 each.
Some costs do vary with inventory value. These include any
insurance or taxes that are paid based on the value of inventory.
The payment is determined when a periodic value assessment is
performed. Another cost that comes up in this conversation is
the cost of the money borrowed to build inventory. This is often
accepted as a percentage of the inventorys value. But is it? The
answer is: partially.
Consider a company that buys materials, produces an item
and sells it immediately. The items value as inventory starts
as raw material. Value is added throughout the production
process as a function of the labor, additional materials and, in
some cases, equipment used. The process creates a salable item.
When it is sold, its value is the primary contributor to the cost
of goods sold line item on the income statement.
Now consider the same scenario, but instead the item is
placed in inventory instead of being sold, as we see in Figure
2. The value of the same item goes onto the balance sheet as an
asset rather than the income statement. When sold, it is transferred off the balanced sheet and onto the income statement as
the cost of the good sold.
What costs have increased as a result of putting the item into
inventory versus selling it? The biggest change is that the money
for the investment in materials might be borrowed for a longer
time. This cost penalty is tied only to the material costs. The
other costs that increase value exist whether the item is sold or
inventoried, so they are not tied to the choice to inventory the
item.
Many mistakenly tie the cost of money to the overall value of

inventory. The cost of money should be tied only to the portions

of inventory that required you to borrow money, and only from
the time you borrow until it is paid back. Another incorrect
calculation would to be to assess this value from when the item
is purchased until it is sold using the entire value of inventory,
which is inflated by the value added in production.

The implications
Inventory carrying costs are real, and they can be substantial.
To determine carrying cost improvement opportunities from
reducing inventory, one must look at changes that are enabled
by the reduction. Those include:
1. Reducing the amount of infrastructure
2. Creating a lower cost operating model
3. Creating cost reductions from inventory types
4. Reducing the length of time money is borrowed
The focus on infrastructure should be on whether inventory reductions will reduce the amount of capacity (space,
labor, equipment) the company needs to buy. The term buy is
important because if inventory improvements do not reduce the
amount of capacity needed to be purchased, there will be no true
reduction in carrying costs. Business cases that attempt to create
a dollar value for carrying costs based on space saved, equipment
utilization or labor productivity will create false expectations of
savings. Remember, regardless of how much space is consumed
by inventory, the lease cost stays the same. Reductions will only
occur if you have to purchase less infrastructure.
This doesnt mean that inventory reduction wont enable cost
savings elsewhere. For instance, in some cases a third-party
logistics provider could, at a lower cost, handle everything from
August 2013

41

target: carrying costs

outsourcing inbound logistics to warehousing inventory items.
Such an arrangement could free space for the company to create
new production lines and improve production capability. This
can save the company money by freeing it from the need to buy
more space.
When a company changes its operating model, its emphasis
should be on creating the lowest cost solution. For instance,
there can be high cost and low cost versions of a rapidly turning, high transaction warehouse. Inefficiency can create the
need to buy more space, labor and equipment. Warehouses can
employ too many people because of simple things such as not
planning and scheduling inbound receiving, leading to spikes
in demand when multiple trucks arrive. Then procedures arent
followed and excessive movements are created, which can lead
to the need for more equipment, more people and overtime. And
when mistakes are made, a team of people to perform physical
inventory counts and cycle counts is required to understand and
mitigate the result of poor practices.
Lower cost locations have many activities planned down to
the minute. In such facilities, trucks arrive at the scheduled time,
employees adhere to proper processes and controls, material is
handled once during put-away and things are stored in the right
location, all leading to improved inventory accuracy.
Less capacity in space, people and equipment might be
required when a company is lean. However, a slower turning
warehouse might require even less capacity. In this context, it
is important to compare the cost associated with the operating model versus the financial improvements enabled by faster
turning inventory. Since carrying costs and how money is tied
up in inventory arent always properly calculated, companies
often increase the cost to operate a warehouse to reduce inventory. These improvements could cost much more than the
money they save.
To understand the cash perspective, a complete cash flowbased economic analysis should be performed to understand
the cash implications of inventory policies. However, avoid
using cost per metrics with such analyses. The cost-per-pick
concept assumes that doing work such as picking items in a
warehouse costs something. So an employee who does more
picks in an hour lowers costs. But where do those savings show
up? Youre paying for an hour of work regardless of whether the
employee picks 10 cases an hour, 14 or some other number. The
cost-per metric really measures efficiency, not costs.
Carrying costs also can be affected by changing the type of
inventory. In many cases, the changes are an all-or-nothing proposition. For instance, eliminating one of many items that require
refrigeration might have a marginal impact on cost. If carrying
cost is considered as a percentage of the value of inventory, one

42

Industrial Engineer

assumes that if the item is eliminated, the carrying cost goes away.
That is not true. The refrigeration costs are there, and the change
likely wont be substantial. The costs that are spread equally to
all items will now be spread to fewer items, increasing the carrying cost percentage. Making a major dent in actual carrying costs
might require eliminating all items that require refrigeration.
When considering adding or dropping inventory, determine
what you can eliminate by reducing inventory and what you will
have to buy to support that inventory. That will give your operations a clear understanding of how the type of inventory carried
affects costs and keep you from thinking that costs will go away
when they will not.
Any time revenue is generated faster from investments, it
is a good thing. A positive about lower inventory levels is that
they will tie up less investment money than higher inventories. Spending the money to buy items that have to wait in a
queue before being sold is an unnecessary financial waste. Any
decisions that can speed the cycle from when you borrow for
inventory until you are paid for the products created can have an
impact on carrying costs.

Capacity is the key

Inventory carrying costs are likely to be higher than they are
lower. The cost to buy, renovate and prepare locations is not
inexpensive, nor, with the equipment and people involved, is
operating them. This is not a bad thing. The key is to understand
that carrying costs have to be eliminated by themselves. Reducing inventory wont reduce carrying costs, but it could enable
you to reduce carrying costs by creating excess capacity.
When creating your carrying cost improvement plan, stay
focused on the idea of how much capacity you can avoid buying
as a result of the improvement. That will lead to financial
improvements.
If youre buying inventory services, make sure those selling
to you work with you to develop a plan to reduce capacity costs.
Without this, savings will be inflated, the realized benefits will
be compromised, and your companys improvement plan will
be at risk. d
Reginald Tomas Lee is a business scientist at Business Dynamics &
Research. His research work focuses on innovation in profit management and developing leading edge corporate performance tools and
approaches. His client work emphasizes applying leading edge concepts to
help executives and their teams improve cash flow and understand and
manage performance. Lee has a Ph.D. in engineering, highlighting optimization solutions. He is the author of Explicit Cost Dynamics: An
Alternative to Activity Based Costing and Essentials of Capacity
Management.

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