How To Calculate The Cost Of Inventory: With Steps And Tips

By Indeed Editorial Team

Published 15 November 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Businesses typically either sell goods or services. Those that sell products may have an inventory of those items to provide to their customers. Monitoring inventory costs is important for companies to stay profitable. In this article, we define the cost of inventory, explain its components, share four steps and a formula to help you calculate it and provide a few tips for doing so.

What Is The Cost Of Inventory?

The cost of inventory is the amount of money a company spends to maintain its goods or services. Inventory is typically a business's greatest asset. It includes all items a company has manufactured or purchased but not yet sold to a customer. Monitoring inventory costs helps businesses determine how much merchandise to keep on-site or in their warehouses. A company often values products at the original manufacturer's price. Customers may buy the goods for different prices.

There are opportunity costs that relate to inventory. A product surplus means money (as the merchandise) depreciates instead of generating interest, like cash in a bank account. If a company does not have enough stock to meet customer demand, it may try to avoid losing potential revenue by spending more money to rush goods to its shop. Monitoring inventory costs can help businesses decide how much stock to keep on-site and how often to order new products.

Related: 8 Inventory Management Software Solutions (With Benefits)

How To Calculate The Total Inventory Cost

This cost depends on which factors a business includes as inventory. You can calculate this value once you decide what aspects to include. Here are four steps to help you do so:

1. Determine your method

Begin by deciding how to assign your inventory cost. In most cases, the specific identification or weighted average method works. You could also use the first-in-first-out (FIFO) or last-in-first-out (LIFO) approach.

Example: Wavewood Socks decides to use the weighted average method. As it only sells socks, finding the average cost and using it for every individual product is the best method. For calculation purposes, the price of each pair of socks is ₹105.

2. Count your inventory

This process can be time-consuming, depending on how you store, ship and track products. Once you know how much merchandise you have, multiply that number by the individual inventory cost from the first step.

Example: Wavewood Socks has an inventory of 15,490 individual products. Multiplying 15,490 by ₹105 equals ₹16,26,450, which is the merchandise's cost.

3. Assess your affiliated expenses

Calculate the amount you want to include from the ordering, holding and administrative costs categories. This may be significant, depending on what you choose to include.

Example: Wavewood Socks has included its office staff's payroll and the holding costs to store the socks in a warehouse. It also adds bulk wool and cotton ordering costs to the affiliated ones, equalling ₹1,00,000.

4. Combine your costs

Add the affiliated expenses to the socks' complete cost. This provides you with your total inventory cost.

Example: Wavewood Socks has ₹16,26,450 in merchandise and ₹1,00,000 in additional expenses. The total inventory cost for the company is ₹17,26,450.

What Does The Cost Of Inventory Include?

Many factors contribute to this cost, such as time, labour, goods and storage space. It is inefficient to separate every expense relevant to stock. Therefore, some businesses choose to account for expenses (such as warehouse insurance or office staff) outside of inventory costs. A company may decide which ones to include in its inventory cost analysis. Most inventory costs include the following components:

Ordering costs

Ordering costs include all expenses that relate to obtaining merchandise. Some of them could be stocking, tax payment or the required labour for product pickup or delivery. Typically, items in this category include operational costs other than the inventory cost.

Related: Inventory To Sales Ratio (Definition And Importance)

Holding costs

This category involves all expenses relating to merchandise storage. It may include insurance, utility costs. It might also cover the warehouse employees' payroll and building's rental. These expenses also include shelving or cabinet purchases to store the merchandise. They are a large part of the total inventory cost. This is especially so when businesses have large products (such as automobiles) or temperature-sensitive goods (such as medical supplies).

Spoilage costs

Merchandise control is important because it prevents spoilage. Perishable stock can rot or spoil if it does not sell promptly. Expired products are a concern for many industries. Expiration and use-by dates affect products in the food and beverage, pharmaceutical, healthcare and cosmetic industries.

Shortage costs

These expenses commonly occur when a business runs out of a certain product. They may involve emergency shipments, which are frequently more expensive than regular ones. Also, they might account for a company's reputation or customer loyalty loss due to product shortage, which is often challenging to quantify.

Product costs

Besides the expense of managing merchandise, there is also its value. There are four accepted methods for determining the worth. Each method varies based on what a company sells:

  • Specific identification: This method assigns a unique price to each product. It is a great choice if the items are large and costly, such as refrigerators.

  • FIFO: This approach assumes that the first item a business receives is the first one it sells. Companies that sell perishable goods (such as supermarkets) utilise this method.

  • LIFO: This method assumes the last item a business receives is the first to sell and values all products at the most recent shipment's price. It is a great strategy for companies in industries with rising expenses (such as fuel).

  • Weighted average: This approach assumes that identical products have comparable prices. Companies can confidently assign the same cost to each unit.

Related: What Is FIFO Accounting? Definition, Example And Advantages

Inventory carrying costs

These are the financial losses relating to unsold merchandise storage. They are the less-familiar aspect of inventory costs. Understanding how much they impact a profit and loss statement requires some calculation.

Related: What Is An Inventory Write-Off? (Plus How To Conduct One)

What Is The Formula For Calculating The Inventory Cost?

A business often uses this formula to determine its expenses. It starts by taking its initial stock's value to measure the inventory cost over a year. Next, it adds that number to the value of its product purchases during the financial year. The company finishes by deducting the final merchandise's value.

Initial inventory + Purchased inventory − Final inventory = Cost of inventory

Example: A company that calculates its inventory cost for the past four months discovers its initial stock's value is ₹50,000. It adds this number to the purchased product amount from the same time, which is ₹5,000. Finally, it subtracts the last stock's value of ₹25,000 after the period. The final inventory cost is ₹30,000. Here is the formula:

₹50,000 + ₹5,000 − ₹25,000 = ₹30,000

Tips For Calculating The Inventory Cost

Here are a few tips to consider while calculating this value:

Differentiate buying and manufacturing

When calculating the inventory cost, differentiate between businesses that manufacture their products and those that purchase them. If a company produces its goods, it may account for raw production materials and the finished products.

Example: A garment shop's inventory may include all wearable items. It may also exclude those that it cannot sell to customers, such as paper and printer ink.

Related: What Does A Storekeeper Do? (With Skills And Salary)

Calculate the average inventory

The average inventory helps you determine other variables, such as the inventory turnover rate. It also helps you better understand inventory costs. You can calculate the average inventory by adding two or more inventory values from a specified time's beginning and end. After that, divide by the number of periods you selected. Some businesses use the beginning and end inventory values to determine their average inventory for the entire fiscal year.

Example: If a car dealer observes a sales decrease during the colder seasons, it can determine how much stock to purchase during winter. It may also decide whether to improve purchasing incentives. In contrast, a company that sees doubled sales during the holidays might decide to buy additional products to avoid a shortage.

Related: Inventory Controller Skills (With Definitions And Tips)

Understand the turnover rate

Knowing the inventory turnover rate while purchasing and selling is important. It can help you estimate business expenses and identify underperforming products or goods. You can calculate this rate by dividing the total sales by the average inventory over a selected period. If some items are not selling well, it is helpful to plan initiatives to increase purchases, such as discounts or employee incentives and meet product sales goals.

Example: If a company discovers its turnover rate is 80 days (meaning it sells all its merchandise approximately every three months), it might be purchasing or producing too many goods. Also, it may not be selling its items quickly enough. This information can help you increase revenue by decreasing the required time to sell products and reducing inventory costs.

Please note that none of the companies, institutions or organisations mentioned in this article are associated with Indeed.

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