Carrying costs are costs which a business incur on maintaining its intended level of inventories. These include storage costs (such as warehouse rent, fire insurance, spoilage costs, etc.) and opportunity cost of capital tied up in inventories.
It is important for a business to keep track of its carrying costs because they are a significant component of total cost of inventories.
Since, there is an inverse relationship between carrying costs and ordering costs, businesses normally apply the economic order quantity model to minimize their total cost of inventories by reaching a trade-off between both of these costs.
Jadeja Textiles is a business engaged in textile manufacturing in Indian state of Punjab. Its key raw materials include cotton and artificial fibers. It pays an amount of INR 1,200,000 as annual rent of its raw materials warehouse. Cotton occupies 80% of the floor space of the warehouse. It maintains an average inventory of cotton of INR 20,000,000 and average inventory of artificial fibers of INR 10,000,000 and its cost of capital is 12%. It pays INR 200,000 as annual fire insurance. Calculate the annual carrying cost of cotton.
In this example, the carrying costs of cotton include the proportionate rent of warehouse, proportionate fire insurance and the opportunity cost of capital. Proportionate rent of warehouse is INR 960,000 (80% of INR 1,200,000), proportionate fire insurance is INR 133,333 (200,000/(20M+10M)*20M) and opportunity cost of capital is INR 2,400,000 (12% of INR 20M). Total carrying costs of cotton are hence INR 3,493,333.
Written by Obaidullah Jan, ACA, CFA