Inventory cost includes the expenditure required to produce or purchase products for resale and the sales cost, order cost and inventory hold cost. The cost of inventory includes the administrative fees, such as purchasing orders and other paperwork needed to purchase raw materials or finished products from various manufacturers. This cost, evaluated by management is part of determining how much inventory to keep on hand. According to accountingtools.com, “This can result in changes in the order fulfillment rate for customers, as well as variations in the production process flow.” Inventory costs can be classified in basic accounting terms, in three groupings:
1. Ordering Costs
Including the wages involved in procuring products, ordering costs also refer to related payroll taxes and benefits for the employees in the procurement department. Creating purchase orders and negotiating with suppliers are activities that are considered in ordering costs. If you are the manufacturer of the finished product, then ordering costs may involve labor costs incurred by your industrial engineering staff, in pre-qualifying new suppliers to deliver parts to the company. Typically, ordering costs are included in your overhead cost pool. There, these costs are allocated to the number of units produced in each period.
2. Holding Costs
When you manufacture or purchase products to sell, you need a physical space in which to store your inventory. Holding costs are expenses related to the space required to “hold inventory, the cost of the money needed to acquire inventory, and the risk of loss through inventory obsolescence,” according to accountingtools.com. These costs are also included in an overhead cost pool and are allocated to the number of units produced in each period. Diving deeper, holding costs include:
Cost of space:
Your largest inventory cost might be related to the facility where you store your inventory. These costs include warehouse rental leases, or the money required to buy a warehouse facility, along with hiring and training a warehouse staff. Included in space costs are warehouse equipment, such as shelving and forklifts as well as other equipment used for material handling. Packaging and shipping supplies are also included in fulfillment warehouse costs. Additionally, warehouse costs include insurance, utilities, maintenance, and depreciation. Safety features, such as fire suppression systems and security systems are part of warehouse costs, as well as the costs required to service these systems. For this reason and others, many e-commerce brands partner with a 3PL fulfillment provider, such as Phase V to defray the costs associated with in-house fulfillment expenses.
Cost of money:
An interest cost is always associated with the cost of borrowing funds used to pay for your inventory items. Reported on income statements as a non-operating expense, interest costs are derived from lending arrangements, such as loans, lines of credit, and bonds. Incurred interest amounts are typically characterized as a percentage of the outstanding amount of principal. To calculate interest expense, use the formula, (Days during which funds were borrowed ÷ 365 Days) x Interest rate x Principal = Interest expense.
Cost of obsolescence:
Unfortunately, some items in your inventory may never be sold or will sustain damage in storage. These items can be sold at reduced prices or be considered a complete loss. Perishable items and items with expiration dates such as make-up, supplements, and food make the most likely victims of obsolescence. Your 3PL provider should provide real-time technology to flag a need to sell perishable items before they spoil or reach their expiration dates. Phase V partners with you to move perishable items through your supply chain efficiently with effective inventory controls in place to save you time and money.
3. Administrative Costs
Wages paid to your accounting staff are considered administrative costs. These include time paid for compiling the costs of your inventory and the cost of goods sold. Also included in administrative costs are other inventory analysis requests, in addition to defending the results of these analyses to your business’s internal and external auditors. Administrative costs for cost accounting personnel are charged as expenses incurred.
Calculating what is included in the cost of inventory is not a simple task for any business but the numbers must be considered when deciding how to handle inventory management. Contact Phase V to discuss your inventory cost issues and how we can help solve them.