Inventory Costs Explained and Mistakes to Avoid

Inventory costs are one of the assets and liabilities a company has on its balance sheet. Managing inventory costs is crucial for success. Managing inventory is a complex process that involves multiple vendors, suppliers, fees, and reports. Striking the delicate balance of ordering and storing the right amount of inventory is tricky. Companies don’t want to under-order but they don’t want to over-order. Establishing what to track and when to make adjustments can confuse companies. This article will explain the main inventory costs and common mistakes companies should avoid when creating an inventory management process.

Inventory Costs Explained – Categories

What are the main costs associated with inventory? There are four primary categories of expenses related to inventory management.

inventory costs explained

Purchasing Costs

Purchasing costs are the price paid to a supplier or vendor for a product. If you purchase 100 vintage-style handbags at $15 per item, your purchase cost is $1500. This line item does not include shipping, handling, taxes, or insurance. Some companies calculate the purchase cost within the ordering cost category. It depends on personal preference and the level of detail you desire.

Ordering Costs

Ordering costs typically encompass labor, fees, and transportation involved in shipping your product from the manufacturer to your storage facility. Although these expenses typically represent minor amounts compared to purchase costs, inaccurate measurement can lead to their rapid accumulation.

Carrying Costs

Carrying costs, also known as “holding costs,” refer to fees associated with maintaining inventory in stock. This category encompasses various expenses, ranging from employee wages to warehouse rents. Carrying costs vary significantly depending on the type of product being sold and managed. Particularly, products with a limited shelf-life or requiring consistent handling, movement, and restocking tend to incur higher expenses.

Stockout Costs

Stockout costs encompass any expenses related to revenue loss due to inventory shortages. These costs can accumulate for various reasons, such as failing to update your in-store or online inventory management system before running out of a product. When a customer purchases an unavailable product, it triggers a refund process, potentially resulting in a lost sale if a suitable alternative cannot be offered. Additionally, stockouts lead to lost sales, as many consumers turn to competitors when a product is listed as “out-of-stock,” representing a missed opportunity cost. Fortunately, many of these expenses can be avoided or minimized. Companies can increase their supply chain resilience by partnering with a competent 3PL.

Inventory Costs Explained – What to Track

inventory costs explained

Storage Costs

Storage costs include repetitive payments related to inventory storage management. These include warehouse rents, heating and cooling costs, lighting, security, and employee wages. Any fee for maintaining a clean, organized, and pest-free space would be considered a storage cost. Holding onto inventory that is slow-moving or considered deadstock increases storage costs quickly.

Capital Costs

Capital costs are typically the largest upfront investment regarding inventory costs. They are a one-time fee required to physically store and carry inventory to the designated storage facility. Capital costs can include land purchases, building or buying a warehouse, and sourcing inventory equipment (e.g., forklifts, pallets, storage racks/shelves, etc.).

Damage & Obsolescence

Tracking inventory costs closely is crucial as items often get banged, bruised, and battered during the shipping and receiving process. Recognizing patterns of damage enables corrective action; otherwise, it’s akin to wasting money. Similarly, obsolete items represent money left on the shelf, as businesses continue to bear the costs of unsold and outdated products on their balance sheets.

Theft and Fraud

Solving theft and fraud related to inventory costs necessitates meticulous tracking and the use of precise inventory management systems. While it won’t catch every criminal that threatens the bottom line, it will undoubtedly show where items are going missing.

Taxes and Insurance

“There is nothing certain in life but death and taxes.” (Paraphrase Ben Franklin) Inventory costs of taxes and insurance are determined by many factors, including but not limited to; types of product, location, and local ordinances related to product distribution. It is best to consult a lawyer regarding the nuances and costs associated with this category. Alternatively, partnering with a 3PL with extensive experience in your industry can typically provide introductions to legal counsel and help ballpark costings where appropriate.

Inventory Costs Explained – Mistake to Avoid

inventory costs explained


There is nothing worse than missing out on a sale because of stockouts. Proper inventory management systems and tracking can help forecast accurately and avoid losing sales. It is more important to overstock than understock. For one, you miss a sale. Second, you can lose a customer permanently. Third, you have to issue refunds which costs you additional money in employee wages and customer service strain. Include inventory management in product forecasting to help avoid understocking whenever possible.

Failing to Include Inventory Management in Forecasting Sales

The entire process of managing inventory is complicated. Including inventory management in forecasting will improve accuracy and minimize overstock or understock situations. Inventory management data will include product levels, cycles and highlight stock value categories. This helps businesses forecast not based on sales numbers alone but the overall health and movement of products through the inventory management process.

Launching a Product and Retroactively Managing Inventory

Launching the business and then getting around to managing inventory can be tempting. This is a significant mistake because by the time inventory management is a need; it has become a problem. Implementing inventory management before a product launch can help with forecasting, restocking timelines, and reducing stockouts. Accurate sales data, stock levels, and performance are readily available by preparing to track inventory management from the beginning.

Always Buying in Bulk

It is important to buy what you need when you need it. Sometimes bulk purchasing is ideal. Other times, it is a gamble. It might be tempting to buy 1000 units of your most popular product, but it could cost you if that item trends out or becomes obsolete before you can sell them.

Beginner’s Guide to Third-Party Logistics (3PL)

The world of e-commerce is always changing, therefore understanding the roll of Third-Party Logistics is integral to keeping up. In light of this our beginner’s guide to third-party logistics (3PL) will delve into the essential aspects, offering insights into fulfillment services, warehousing, and much more.

Read More…

Explaining or managing inventory costs involves a lot of information. Many owners lose sleep over this area of business. Falcon Fulfillment relies on a proprietary inventory management system boasting a 99.9% accuracy rating. We take pride in providing our clients with accurate data, enabling them to make optimal decisions for their businesses.

If you would like to learn more about how Falcon can help streamline your inventory costs, get in touch with one of our agents today.

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