Welcome to our guide on breaking down the inventory cost equation! 🎉In this post, you’ll gain a thorough understanding of each component of the inventory cost equation and how it can affect your business.

The Basic Inventory Cost Equation

Inventory cost = Cost of goods sold (COGS) + carrying cost + stock-out cost

Before we break down each component of the equation, let’s define what each one means.

  • Cost of goods sold (COGS) = The direct cost of producing the goods sold by a company.
  • Carrying cost = All the costs associated with storing inventory, including storage, equipment, labor, insurance, and utilities.
  • Stock-out cost = The cost associated with running out of inventory, including lost sales, rush orders, and the cost of additional production.

Now let’s dive into the specifics of each component.

Cost of Goods Sold (COGS)

The cost of goods sold is one of the most critical components of the inventory cost equation. It essentially covers all the direct costs of producing the goods sold by a business, including:

  • Production costs
  • Labor costs
  • Materials costs
  • Shipping and handling fees

To calculate your COGS, it’s best to consult with an accountant to make sure you’re including all relevant costs.

A person filling out a spreadsheet for COGS

Carrying Cost

Carrying costs are the costs associated with storing inventory, from the moment it enters your warehouse to when it’s sold. These costs can include the following:

  • Rent on warehouse or storage space
  • Utilities (electricity, water, etc.)
  • Labor costs (including staff who manage inventory)
  • Equipment (racks, pallets, software, etc.)
  • Insurance and taxes

It’s important to calculate carrying costs accurately and to consider how long each item will stay in your inventory.

A person organizing shelves with inventory that represents carrying costs

Stock-Out Cost

Stock-out costs are the costs of running out of inventory. Failing to maintain enough inventory can result in missed sales opportunities, rush orders, additional production costs, etc.

To evaluate stock-out costs, you’ll need to consider the following:

  • The length of time it’ll take to replenish stock
  • The potential loss of sales
  • Rush shipping orders and fees
  • Cost of additional production
  • Cost of lost customer loyalty

A person standing in front of empty shelves, symbolizing stock-out cost

Real-Life Example: Amazon’s Inventory Management Strategy

The way Amazon manages inventory is a great example of how effective inventory management can help a business succeed. Amazon’s inventory management strategy is based on predictive analytics, which enables the company to quickly determine which products are selling well and make sure they’re well-stocked to meet demand.

This strategy allows Amazon to keep just enough inventory on hand to fulfill orders, thus minimizing carrying costs while minimizing the risk of running out of stock (i.e. stock-out costs).

A person showing a chart with analytics that represents Amazon's inventory management strategy

Key Takeaways

  • Understanding the inventory cost equation can help you optimize your inventory management strategy.
  • Accurately calculating COGS, carrying costs, and stock-out costs is necessary for effective inventory management.
  • Amazon’s inventory management strategy is a great example of how predictive analytics can help a business optimize inventory management.

That’s it for our guide on breaking down the inventory cost equation. We hope you found this post helpful! 🤗

A person holding a clipboard and writing notes while surrounded by inventory, representing the takeaway messages in the article