The Real Cost of Doing Business Part 1
As a business owner, you understand the basic costs of doing business in your industry. Expenses are an everyday reality of running a company, whether we’re talking about paying wages to employees, buying supplies, or stocking an inventory. But, there are many costs which are easy to overlook, and which can quickly sink a business’s budget, if you’re not careful. Taking the time to learn about some of these hidden factors can make a huge difference in the future profitability, and even the survival, of your business.
Here, we will explore some important concepts around the real costs of doing business. In this two-part series, we will first work to uncover some often overlooked issues concerning maintaining and pricing an inventory for your business. In the second part, we’ll look at some of the potential problems you might encounter when calculating the costs of maintaining an employee and paying their way in your company.
You will likely be surprised to learn how quickly costs can add up and overtake your profit margin, if you don’t carefully consider the extra expenses which will be covered in this series.
Understanding and Protecting Your Inventory
In the first part of the series, we will explore some basic concepts and language that are used in the manufacturing world, where efficiency, productivity and costs are the difference between winning and losing in a highly competitive world. These ideas can be carried over to your business; showing you how to protect and manage your company’s inventory assets, and how to properly price your products so that they drive profit, instead of sapping your budget. Once you understand these concepts, you will start down the road of significant improvements in how your business performs for you.
Burden Rate & Carrying Costs
To truly understand your inventory, you need to have a 360° view of each item and all of the costs associated with purchasing, maintaining, storing, and selling that item. An important concept to understand when discussing inventory is the burden rate. Many business owners have never been exposed to this idea, so they constantly underestimate the actual costs involved in maintaining their inventory, thus damaging their profit margin.
Put simply, a burden rate is a way to calculate all of the indirect (or less obvious) costs of an item, or a whole inventory of items. To maintain an accurate understanding of your expenses, burdens should always be tracked alongside the more obvious expenses you’d typically think about, like the basic purchase price of a unit.
Some examples of the burdened costs of an inventory include insurance for your storage space and inventory items, lease expenses for the space to store your inventory, paying for the labor required to order/purchase/receive/stock an item, lost or stolen inventory, obsolete or expired inventory which needs to be thrown away at a loss to your company, etc. You may also be paying interest, if you have financed your inventory.
These burdened costs need to be added on top of the basic material costs of an inventory item, allowing you to arrive at the true total cost to your company. Ultimately, keeping track of your total burdened cost allows you to much more accurately price a part or item for real profitability when it comes time to make the sale.
How to Determine Your Inventory Costs
Because purchasing and selling inventory carries more cost than most business owners fully understand, it is very easy to under-price your items and services, and take a loss on them. Of course, this is not a sustainable practice for any business.
It is good to always remember than an item sitting on the shelf is consuming cash until you sell it. The longer the item sits, the more it costs your company in the long run, when taking into account all of the burdened, indirect costs we’ve discussed here.
To arrive at a realistic, 360° view of the cost of any item in your inventory, you can begin by looking at (and tracking) the following elements:
- Money tied up in the inventory (such as the cost of capital, the interest you’re paying to finance the inventory, or the opportunity cost of the money tied up in that inventory which can’t be spent elsewhere.)
- The physical space being occupied by the inventory, including rent or lease payments for the space, depreciation, utility costs, insurance, property taxes, security expenses, loss of that space for other purposes, and labor requirements to maintain the inventory space itself (including building repairs, cleaning services, etc.).
- Cost of handling the items, including shipping, labor to receive the inventory, labor to purchase and stock the inventory, labor to clean and maintain the inventory items, and any equipment necessary to handle the inventory.
- Cost of deterioration, including expired items which need to be thrown away, outdated or obsolete items which need to be replaced, loss and theft of items, and the costs associated with replacement of these.
Of course, these costs will be different for every company. For instance, if a company has plenty of cheap storage space, a large cash balance on hand, and the company handles products which don’t deteriorate or become expired quickly, then the inventory carrying costs for that company will be reasonably low.
If, on the other hand, a company has enormous debt, very little space to work with, and products which have to be replaced regularly due to obsolescence or degradation, then that company can expect to have very high costs to maintain an inventory. In fact, in that case, it may not be cost-effective at all and the company should consider reducing or eliminating a standing inventory.
How to Put This Knowledge To Use
By tracking the four categories of costs listed above, begin monitoring the burdened carrying costs of your inventory each month. This will help you quickly identify any losses the company is experiencing through theft, expiration, or obsolescence. You will also discover, during the process, if you are pricing inventory items appropriately. With this information, you will be able to determine if your pricing and profit margin is sufficient, or needs to be updated.
Once you begin tracking this information consistently, you will find that you are able to quickly identify trends in your inventory carrying costs. For example, you could discover that you need to improve the design of your inventory storage space, or change stocking levels for certain items that you carry.
This information also provides an excellent tool to negotiate with customers and vendors! For instance, you could negotiate contracts with larger customers to share the inventory carrying costs and help you offset your storage costs until they receive a delivery. Similarly, you can negotiate with vendors to take discounts on early payment, or break shipments into more manageable sizes so you do not overstock certain items and take a loss on carrying costs. By taking smaller shipments (or drop-shipping items as needed), some of the carrying costs can be shared with your vendors, thus boosting your profit margin relatively easily and painlessly.
Ultimately, by reining in your indirect costs, and maintaining a thorough understanding of them, your business can achieve new levels of success. Though it might require a bit of extra work and attention in the beginning to put better tracking systems in place, the payout will be a more agile, and more profitable, company in the long run.