Businesses that carry inventory incur several different types of costs just for having inventory on hand. Companies try to effectively manage the types and quantities of inventories they have in order to operate in the most cost-effective manner possible. Costs associated with inventory are generally categorized as either direct costs or indirect costs.
The cost of the actual inventory is considered a direct cost. Companies must purchase inventory in order to resell it, and most companies must have it in stock so that it is available to sell to customers. Companies must examine inventory levels often to keep the right amount in stock at all times. By having too little inventory, companies can miss sale opportunities. If a company has too much inventory, its money is tied up in it, possibly causing a negative cash flow. The cost for the money tied up in inventory is referred to as an indirect cost directly associated with inventory.
Another direct cost associated with inventory is the cost of freight. To have inventory, a company must either pick it up or have it shipped. These costs generally are not free and usually the purchaser is responsible for paying them.
The last type of direct cost associated with inventory is called carrying costs. These are costs that relate to storing and moving the inventory goods. To store inventory, a business must have a warehouse or stockroom. Along with the cost of the warehouse are costs for insurance, salaries and taxes. All costs related to storing, moving and handling the goods are included in carrying costs.
Shrinkage is a common problem for businesses with inventory. Shrinkage refers to inventory that is missing, stolen or damaged. This is not commonly detected until a physical inventory count is taken. At that time, the amount of inventory the company should have is greater than the inventory the company actually has. This indirect cost causes the price of goods to increase to make up for the cost of goods breaking or disappearing.