Key points
- Inventory costs more than its purchase price. It ties up cash and carries storage, insurance, handling and obsolescence costs.
- Carrying cost is the sum of capital, storage, handling and risk costs. Use your own rates, because they vary by business.
- Start with dead and slow stock and with safety stock that has not been reviewed. Reducing average stock frees cash that can be used elsewhere.
Why inventory is a finance problem
Buying stock looks like a purchasing decision. Holding it is a financial one. Every item on a shelf has been paid for, and until it sells it is cash that cannot be used for anything else. It also takes space, needs handling, can be damaged or lost, and may become obsolete.
When leaders talk about improving cash flow, inventory is often where the largest and least examined number sits.
What inventory really costs to hold
Carrying cost is usually expressed as a percentage of inventory value per year. It is the sum of four groups of costs:
- Capital cost: the return the money could earn elsewhere, or the interest on a credit line used to fund the stock.
- Storage cost: warehouse space, racking, utilities and the labour to move and count stock.
- Service cost: insurance, taxes on stock, and the systems used to manage it.
- Risk cost: shrinkage, damage, spoilage and obsolescence.
A worked example (illustrative numbers)
Suppose a distributor holds $2,000,000 of inventory and its finance team estimates a carrying cost of 25% a year, made up as follows:
| Cost group | Rate | Annual cost |
|---|---|---|
| Capital | 8% | $160,000 |
| Storage | 6% | $120,000 |
| Service | 3% | $60,000 |
| Risk (shrink, damage, obsolescence) | 8% | $160,000 |
| Total | 25% | $500,000 |
If a review of slow lines and excess safety stock reduced average inventory by $200,000, the business would release $200,000 of cash and save about $50,000 a year at this rate. Both effects matter. The cash can pay down debt or fund growth, and the saving shows up in the operating result.
Where to look first
- Dead stock: items with no movement in 90 to 180 days. Decide whether to sell, return, or write them down, and stop buying them.
- Excess safety stock: buffers set years ago and never reviewed against actual demand and lead time.
- Over-buying for price breaks: a lower unit price can cost more once holding costs are included.
- Duplicate or near-duplicate SKUs: the same part held under several numbers, split across locations.
Questions for the next buying cycle
Before approving the next purchase order run, ask for days of supply by item, the actual lead time from each supplier, the items bought above recent demand, and the value of stock that has not moved in six months. The answers usually show where cash can be released without putting service at risk.
If you want to see where your stock is building up before the next cycle, our Supply product tracks shortages and supplier delivery against demand, and our guide to preventing material shortages covers the other side of the same balance.