Cutting Carrying Costs and the Art of Reducing Waste
Congrats — you've turned your passion into your next adventure in the world of manufacturing. Of course, the more you learn, the more questions come up:
— What will I do with all the stuff here?
— What’s the unique selling point of my finished product?
— How can I scale up my business without breaking the bank?
— How can I keep track of all my online orders?
— What on earth are carrying costs? Wait, what?
If you haven’t asked yourself the last question, you may be asking it very soon. To put it simply, it’s the cost of everything you do to deal with your inventory.
We understand your frustration. You started your manufacturing business to free yourself from sitting behind a desk. Thankfully there are tools out there to help you keep costs to a minimum so you can get back to what you do best.
What Are Carrying Costs?
Like many accounting metrics for business, this concept is simple to pick up, yet has many nuances.
The carrying costs definition is the total cost of holding inventory to your business. Carrying costs can also be known as carrying cost of inventory or holding cost.
Some examples of carrying costs are warehouse rent, work hours spent handling inventory, transport costs, and security costs. To some, these costs may seem like hidden costs. You are well aware of the cost of buying raw materials, but you might not have known you are also paying to store, and literally carry them.
So, holding inventory that you intend to sell, but have not yet done so, increases your carrying costs. Every business that sells a physical product is subject to these costs.
Every second you have inventory (raw materials, work-in-progress, finished goods, and so on) sitting on your shop floor is money diverted from your profits and growth. That’s why there’s been a small manufacturer’s revolution to greatly cut down on these zero-benefit costs.
Something to note: the costs of carrying inventory do not include the cost of producing your finished goods. While your business still retains its inventory during the production process, it is important you do not conflate these expenses.
The list of expenses you should leave out of your total carrying costs include: raw material costs; assembly and machining costs; direct labor costs; COGS; picking and packing; and shipping costs.
It’s important to get this right because there are legal and business implications. You might mistakenly report higher expenses than you have and artificially reduce your taxes. Another reason is that your prices will go up. If you over-report your expenses, then you might put up your prices to make up for this. This might put off customers for no reason.
This is why having a full understanding of standard accounting practices is essential for today’s small business owner. You can’t afford to not understand every cost that your business incurs.
Learning to differentiate carrying costs from production costs is one of the tricks of the trade. It might be a good idea to keep just the right amount of stock ready to be sold as soon as possible. If you go down this route, be ready for shortages of supply or spikes in demand.
Don’t forget the less obvious costs to hold inventory. For example, the reduction in bank interest as you convert cash into stock. Another often overlooked cost (in all walks of life) is the opportunity cost of keeping excess inventory – could the cash be better spent elsewhere?
After all that, you might already be asking: “How can I reduce this money drain in my business?”
How to Calculate Carrying Costs
Total Carrying Cost is the sum of the following:
Utilities (Electricity etc.);
*To do with handling and other inventory issues (not labor related to production).
Does it come to more than you were expecting? Many small manufacturers are shocked when they find out how much they’ve been spending on inventory.
Focus on reducing one part of your total carrying costs, and this number will go down over time.
A good way to make your total carrying cost more understandable is to calculate cost per square foot of storage.
To calculate square footage for a rectangular space, simply multiply the length of the area by its depth. If it is an irregular shape, then you need to work out the area of the additional or missing parts and add or subtract these from the total.
Then follow this simple calculation:
Carrying costs per square foot = Total Carrying Cost / Total Square Feet
Are you using your space wisely? Remember, these costs apply as long as your excess stock sticks around.
This is also useful for working out your inventory turnover ratio as you can do this calculation for different areas of your warehouse. You can find out which products are selling faster than others, which you can use to better inform your purchase decisions.
Don’t have dead weight in your business. If you have stock that is not getting sold, cut your losses and get rid of it.
It could be that you are paying for your stock many times over. The stock you brought in to get you out of a tight spot could be slowing your business down.
Think about it: do the benefits of having lots of spare stock outweigh the ever-increasing costs of housing it?
You can practice lean manufacturing without living on the edge and see your bottom line rise. You don’t need to copy the large manufacturer’s mantra of “more is more”, when your business can thrive on “less is more”.
Why Do Manufacturers Hold Inventory?
Here are some examples of carrying costs that all product-based businesses have to deal with. As a business grows, their holding costs can spiral out of control due to the increased management requirements. That’s why it is important to start thinking about these costs early, before they slow your business down to a halt.
Safety Stock — also known as buffer stock or strategic inventory. The idea is that it safeguards against a sudden requirement for more stock. This could be an unusually large order, or to make up for temporary problems in the supply or production chain.
Cyclical or Seasonal Demand — businesses make to stock more when they know there’s going to be high demand, such as in the holiday season. This helps a business keep running without burning out at a very profitable time. Extra carrying costs are offset by higher sales, while excess stock can be cycled out with a post-season sale.
Cycle Stock Inventory — this is the stock you have available at any time to fulfill your usual demand. If you have a physical store, this includes “shelf-stock” that customers view and purchase. This stock should allow you to fulfill the majority of purchases. If you are in a low-volume industry (like many small manufacturers) then this can be kept to a minimum.
Inventory in-transit — this is inventory you have ordered from a supplier and has not yet reached your workshop. Large time gaps from the point of order to the completed delivery brings down the fluidity of your production process.
Dead stock — unsold stock due to obsolescence, cancelled sales orders, and other stock that cannot be sold.
Carrying Costs and Waste
Is it possible to completely eliminate carrying costs? You can try, but no matter how much you sell, you will probably want to keep some stock around for urgent deadlines, or samples.
It might be tempting to view all carrying costs as waste. Lean manufacturing does not mean stripping your business down to its bare bones. It’s all about finding what is optimal to your business.
If you run a completely online business, then perhaps you don’t need any demo stock, but what about safety stock? Is your business prepared for eventualities like your machinery or supply chain breaking down? Of course, you can keep spare machines on hand, but ask yourself this: Which is cheaper? Keeping extra stock for emergencies, or a second sewing machine?
Have a ready-made plan for your safety stock and apply a safety stock formula. That would allow you to calculate carrying costs like a pro.
Sometimes incurring carrying costs could be the cheaper alternative. Every bit of efficiency in manufacturing is gained from some kind of trade-off.
This trade-off can come in the form of an upfront cost, which pays off afterwards.
How do the masters deal with this? Avoiding waste is a modern manufacturing principle, coming from the “Kaizen” philosophy which originated in Japan. This was the origin of lean manufacturing which propelled brands like Toyota to global success.
This is what has evolved into Agile Scrum Methodology. This is suited to small manufacturing businesses as change can be very fluid. You can pull staff from one workstation and post them on others, depending on the day’s task. Because you are running a lean workshop, you can have “sprint” periods of productivity far greater than your normal output.
One downside of this is that it takes time to train staff in these new practices. Again, maybe an investment in the here and now will pay off down the road.
Having an agile workshop brings Samurai-like effectiveness to your workshop. It’s how small manufacturers can get one up on large enterprises.
But before you get into reducing carrying costs, you first need a plan.
Tips on Reducing Carrying Cost of Inventory
No one likes avoidable costs. While you may not be able to cut your inventory holding costs down to zero, you can still save a packet with these handy tips.
Keep up-to-date inventory levels — these days the only inventory method for small businesses is perpetual inventory. This system lets you know exactly how much of everything you have in stock. The more accurate your information, the less time needs to be spent preparing for “what-if” scenarios. Knowing this information takes all the guesswork out of supply orders. You can set up reorder points to automatically order more of an item when it gets low.
Evaluate SKU intensity — track your sales data so you can see which product variations are sold as a ratio of how much of each is produced. It could be the case that some of your products sell like hot cakes, and some leave your workshop rather sluggishly. Once you identify slow-moving stock, you can focus less on that, and more on what is selling. The key is to measure your data effectively with smart software.
Adopt a make to order model — One phrase that gets thrown around a lot is Economic Order Quantity. Your EOQ is the optimum stock your business should purchase to bring down annual holding costs as much as possible. However, some of the assumptions it makes are unsuitable for small businesses. A better compromise is to adopt a just-in-time approach of making to order.
Improve your logistics — are there obstacles in your production process? They could by physical or procedural. Maybe distance could halt your productivity. Are you buying materials that take weeks to come into your workshop? Do your staff have to spend valuable minutes locating and retrieving materials? Sometimes shaking up things in your workshop can pay off.
Adopt the Kaizen philosophy — make your company’s culture one of always striving for improvement. How can costs be cut? Can something be done quicker? Why are my raw materials going on an epic journey, rather than coming straight to me? These are just some of the questions you can ask yourself to constantly evaluate your workshop’s efficiency.
You might now be thinking: “All of this is easier said than done”. Well, it might be easier than you expect. Everything will fall into place below.
Slice Through Carrying Costs with a Katana
Speaking of waste, it seems like an awful amount of paper and time to keep track of all this, doesn’t it?
There is enough to make anyone’s head spin.
Thankfully, the technology is there to make your life easier.
It combines the vision of the old Japanese masters with cutting-edge 21st century tech.
It realizes that “less is more” when it comes to streamlined manufacturing for the small business.
It negates the need for excess buffer stock as you can measure demand to a razor’s edge.
In short, you can use it to reduce your carrying costs:
— Spend less man-hours counting and finding stock;
— Sell stock before it becomes obsolete; and
— Get finished products shipped before it becomes a loss for your business.
Get inspired by Samurai discipline and cut down costs with a Katana!