Inventory Cost: Definition and Calculation

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What Is an Inventory Cost?

Inventory cost is defined as the costs connected with the acquisition, repository, and administration of inventories. The inventory cost consists of an overall amount of orders, carrying costs and shortage or stockout expenses. As an example, a bakery’s inventory consists of all the raw materials used in making baked products and the goods sold or produced from it. But the bakery’s machines like the oven used in creating these baked goods cannot be classified as inventories. They are classified as expenses.

Cost Of Inventory Should Be Classified As

Costs Inventory classification helps businesses control and manages their tally in decreasing the quantity of stock on hand and increases the inventory ratio turnover management. Both of these make the company or business’ distribution system more effective and lessen their overall expense. Recording items or products are usually classified into 3 categories and it follows the ABC approach. This approach presents an efficient way on how to categorize products or items which is the most important factor in the inventory costs and has a big impact on it. This is the best way for supply managers too in identifying products or items that require different management or controls. These categories include:

  • Inflated revenue items accounted for 80% yearly sales and 20% inventory. (Class A)
  • Products and items accounted for 15% yearly sales. (Class B)
  • Products and items accounted for 5% yearly sales and classify as low-volume sales. (Class C)

Classifying these inventories permit supply managers to conduct a review schedule and check tally levels to organize inventory control. Among the classifications, Class A receives the high-frequency review and schedule them right away for strict controls. Class B products must have a periodic schedule review to initiate and utilize reorder analysis moderately. While Class C must be controlled moderately as well because supervising an increase in stock levels of these items will costs the company too much and lessen the ratio turnovers.

What Is Carrying Costs?

Inventory Carrying cost is one important category under inventory storage costs and it refers to the amount sustained towards maintenance and storage. When talked about inventory storage, it includes building rental expenses and other infrastructure owned and maintained in preserving the company’s assets. The inventory carrying costs, on the other hand, is dependent and varies only with the management’s decision on how to manage overall inventory costs in the house itself through third-party services and related providers.

Carrying cost is known as an accounting term that signifies the company’s expenses with regards to storing and holding those unsold goods they have. The total amount would also include warehousing expense, transportation, salaries, insurances and taxes which are the basic things related to accounting that every entrepreneur must know.

The total carrying cost can be seen as a percentage of the company’s total inventory in a specific period of time. The total figure acquired is what the company has been using to identify if how much income collected based on the recent tally level. This can also help businesses to determine whether there’s a need for them to generate more or less income stream.

How To Calculate Cost Of Inventory?

The cost of inventory is considered the most important factor every business must learn if they want to make a favorable profit. Identifying the rising amount will have a direct impact on the company’s profitability. To calculate their inventory cost related to the company, they must identify first the starting and ending point value of the recorded checklist itself. Aside from that, they must determine as well all the purchases amount in a given time period.

Here’s to summarize the formula:

  • Identify the time period. This is the time you want to know the inventory cost over a one-month phase.
  • Identify the starting point cost. This is the total value of the company’s inventory from the time it started off the one-month phase. For example, the starting inventory is $30,000.
  • Add then the purchases cost from that one-month time period. For example, you have a purchase cost of $10,000 over the last month.
  • Now, lay hold of the physical amount of the inventory cost at the ending point period. This is the cost of inventory acquired every end of the month. For example, the ending point period cost you $5,000.

Here’s to calculate the figures from the example given:

The costs of inventory = Beginning Inventory Plus (+) Inventory Purchases Minus (-) Ending Inventory.

To calculate, it goes like this: $30,000 + $10,000 – $5,000 = $35,000

How To Calculate Inventory Cost?

If you have a company, it’s important that you learn the inventory aspect of the business. This is considered as one of your biggest assets in order for your business to grow and prosper. It has a big impact on the overall value of your expenses and profit at the same time. You can’t avoid thinking that you might have a lot of opportunity cost when you do the tally. Doing business thinks that way but without knowing how to calculate it, you will never know the status of your company, and your finances as well. This is the reason why it is important for you to learn these things as an entrepreneur and identify the cost of the money going in and out of your business. This is the smartest business decision you could ever make because you can wisely and effectively organize and analyze all the amounts and expenses you make in managing the business. And for you to be able to get the right value for the analysis, you must learn about the Inventory Cost Total.

Here’s the Formula:

  • Compute amount from ordering cost inventories (Ordering Costs)
  • Compute amount arising from inventory shortages (Shortage Costs)
  • Compute amount from holding inventory costs and carrying inventories (Holding Costs/Carrying Costs)
  • Add them all now to identify your total inventories.

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