Inventory Cost: Definition, Methods & Types

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  • 0:01 Inventory Costs
  • 0:46 Ordering Costs
  • 1:29 Carrying Costs
  • 3:25 Shortage Costs
  • 4:08 COGS
  • 5:33 Lesson Summary
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Lesson Transcript
Instructor: Rebekiah Hill

Rebekiah has taught college accounting and has a master's in both management and business.

Have you ever thought about how much it costs a business to keep inventory in stock? It's not just the price the business pays for the items that it keeps in stock. It is so much more. In this lesson, we will discuss exactly what constitutes actual inventory cost.

Inventory Costs

Have you ever been to a Shopper's Club Warehouse? If so, then you know how amazing it is to walk into this big building full of all sorts of items. I love going and buying things in bulk, and I'm always amazed at how much inventory there is stocked up on the shelves! I've never really thought about how much that inventory has to cost the company. In my mind, if they bought it wholesale, then the price of the inventory is the actual purchase price that was paid for the item.

However, my way of thinking is incorrect. You see, in all actuality, inventory costs are not only the price that was paid to purchase an item but also the cost of storing and maintaining that item for however long it takes it to sell. Inventory costs can be broken down into three categories: ordering costs, carrying costs, and shortage costs.

Ordering Costs

When I think about my trip to my local Shopper's Club Warehouse and why I love going, it really is because of the variety of products that they have. You know, somebody had to order all this stuff. Somebody had to deliver the products, and somebody had to receive the products and then put them on the shelves. Did you know that all these things are part of ordering costs? Ordering costs are the costs that are incurred to prepare and process purchase orders and to receive and inspect merchandise that has been ordered. The pay that is received by the people that order inventory, deliver inventory, and receive and stock inventory is considered an ordering cost. If purchase orders are written up or printed, the cost of the purchase orders is also considered an ordering cost.

Carrying Costs

The next component of inventory costs are carrying costs. Carrying costs are the costs that are related to keeping inventory in stock. Do you think that inventory purchased is paid for by money that the company has in its bank account? Well, maybe some of it, but a part of the money used to purchase inventory comes from financing activities, whether it be bank financing or investor-centered financing. Both types of financing result in interest fees. These interest fees are part of carrying costs.

I mentioned previously how I was amazed at the amount of inventory items that were stored in visible areas of the warehouse. I can't even imagine how much was stored that I couldn't see! Regardless of where it's stored, the expenses of storing the inventory and keeping it in good condition are all considered storage space costs. These include the electricity that is needed to provide lights, air, and heat for the warehouse. They also include any building rent that's paid on the warehouse and business locations, the purchase cost if a building is purchased, and the real estate taxes associated with each. Storage space costs are also part of carrying costs.

Another important part of carrying costs comes in the form of risks that are made by a company when inventory purchases are made. What if all the inventory doesn't sell? What if competitors lower their prices on the same item? What if inventory is stolen or damaged? These are all risks that have a monetary value to them.

For instance, say I walked into the store and saw that they had grapes on sale for $1.69 a pound. When I go to look in the bin and get a nice bundle, I see that there are also containers of grapes that are discounted to $1 a pound. These are grapes that are older and not as pretty as the more expensive ones. If any of these grapes sell, then the company loses $0.69 a pound on them. If they don't sell, then the company loses all the money that they spent purchasing the grapes as inventory. That risk of losing money on inventory is part of carrying costs.

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