There are a lot of costs that go into buying and maintaining inventory that can often go unaccounted for by small businesses. Inventory costs make up a significant portion of your operating expenses, and that is why it is so important that a company utilizes as many methods as possible for keeping the cost of inventory down.
Let's start this discussion with the inventory itself. Every company spends a great deal of time and effort working to lower the cost of the products and materials that it buys. The lower your purchasing costs, the higher your profits.
The Management Study Guide mentions a term referred to as the "ordering cost" as a more comprehensive way of looking at product expenses. The ordering cost is the price you pay when you place your order, as opposed to the cost of paying market price. For example, if you buy a product in bulk, then your ordering cost would be lower than the market price because you are getting a quantity discount. The price of gasoline fluctuates daily, which makes the ordering cost much different than the market price. If you can lower your ordering cost, then you will be able to keep your inventory costs down.
The best way to lower ordering cost is to negotiate pricing from your suppliers and lock in the best possible price with a sales agreement. If you buy a product in bulk in January at $1 per unit, then that is your ordering cost. If the market price for that product goes up to $3 per unit in March, then your inventory costs just dropped by $2 per unit.
Another good way to lower inventory costs is to always have multiple suppliers on hand in case of emergency purchases. It is conceivable that you will not be able to get every supplier you have to agree to purchase agreements that help keep your ordering costs low. If that is the case, then you need to have multiple suppliers available at all times and you can buy based on the most aggressive pricing that you receive.
Holding onto inventory is a cost that can really take a chunk out of your company profits. If you purchase inventory on a quarterly basis and you only sell 60 percent of that product in the first quarter, then you have several costs that could start to accrue.
You will need to warehouse the product, which takes up valuable floor space in your facility. You will also need to figure in the financing costs for holding onto product for more than 30 days. The money you used to purchase the inventory accrues interest every day and the cost of holding onto that inventory will start to put a big hole in your bottom line.
The solution here is to cycle old inventory out every quarter and reduce your losses. You can work out an agreement with your supplier where you return the product, but pay a restocking fee. It sounds like you are losing money, but you are actually breaking even because returning the product stops the interest from accruing on the money that was used to originally purchase the product at the beginning of the quarter.
Inventory costs can become a huge problem if they are not addressed immediately. If you keep an eye on your inventory costs, then you will be able to generate more profit.