The Real Cost of Holding Inventory

etailer we studied, for example, used a rate of 6 percent while an electronics
company used a 15-percent rate.
There are several challenges in estimating inventory noncapital carrying costs. For
one, many companies' information systems do not capture these costs in a way
that provides useful information for decision making. While this cost information
may be captured at an enterprise-wide level and applied to total inventory, often
it is not available for a product line, geography, customer group, or channel.
Another challenge is understanding how these costs, which can be fixed or
variable, vary with changes in inventory. For example, a reduction in inventory
resulting from improved supply chain management tends to reduce obsolescence,
insurance, and taxes. But unless there is a significant change in the network
design, warehousing and other inventory-related costs tend to remain about the
same.
When evaluating supply chain initiatives, companies often discount or even omit
the benefits of reducing inventory noncapital carrying costs because they do not
possess credible estimates of these costs. Most agree that these benefits exist.
But without credible estimates, the benefits typically are excluded from the
analysis. This practice is understandable. Nevertheless, if the impact on these
costs cannot be reasonably measured, the true value of many supply chain
initiatives will be understated.
For example, suppose an initiative is expected to permanently reduce inventory
by $10 million. The variable noncapital carrying costs as a percentage of
inventory are 10 percent. The marginal tax rate is 40 percent and the after-tax
cost of capital is 9 percent. The equation below shows that the value of this
initiative is the change in the total value of inventory. That value is $10 million if
noncapital carrying costs are excluded. However, the value is substantially
higher—almost $7 million higher—when the impact on noncapital carrying costs is
included.
Illustrative Valuation of Change in Inventory*
Noncapital Carrying
Costs
Included Excluded
Inventory Change $10.0m $10.0m
% Noncapital Carrying 10.0% N/A
Change in Noncapital Carrying Costs $1.0m N/A
Tax Rate 40.0% N/A
Taxes $0.4m N/A
Change in Annual After-Tax Profits $0.60 N/A
Present Value (PV) of After-Tax Profits @ 9.0%
Cost of Capital ($0.6m/9%)
$6.7m N/A
Total Value
(Inventory Change + PV of After-Tax Profits)
*Excludes cost of initiative.
$16.7m $10.0m
This example highlights the need for supply chain professionals to build more
credible estimates of inventory noncapital carrying costs. Failure to do so results
in understating the real value of supply chain initiatives, which can lead to
rejection of projects that should be accepted. As a starting point, we recommend
focusing the estimates on the noncapital carrying costs components of
obsolescence, insurance, and taxes for these reasons: (1) these typically are most
likely variable, (2) data for these components are often available or can be
extracted without significant effort, and (3) they do not require allocation of fixed
overhead costs.
Inventory Capital Charge
The inventory capital charge is calculated as: inventory × cost of capital. When
calculated correctly, this charge often exceeds the noncapital carrying costs.
Unfortunately, the capital charge often is underestimated because the wrong cost
of capital is applied. Typically, this is the result of one of two factors: (1) a
mismatch between the risk of inventory and the cost of capital, or (2) the mixing
of after-tax capital charges with before-tax noncapital carrying charges. Let's first

explore how to properly match the risk of inventory with the appropriate cost of
capital.
The cost of capital is one of the most important concepts in finance and a key
building block in valuation and in estimating total costs. Unfortunately, it is often
viewed as one of the more esoteric financial concepts. Plus, it's one of the most
confusing for those who must use it for decision making. This confusion often
stems from a lack of understanding of what comprises the cost of capital and the
nature of risk-return relationships.
Simply stated, the cost of capital is the opportunity cost of investing in an asset
relative to the expected return on assets of similar risk. This is comparable to how
we evaluate investments in our personal lives. For example, suppose that over
the last year you earned 8 percent on a portfolio of stocks. How well did your
portfolio perform? To answer this question, many of us compare the return on our
portfolio to the performance of an index of stocks of similar risk. If our portfolio is
comprised of a well-diversified group of stocks, we likely would use an index like
the S&P 500. Suppose that over the last year, the S&P 500 returned 6 percent.
Then our return of 8 percent compares favorably. If the S&P 500 returned 10
percent, on the other hand, then that 8-percent return was less favorable.
In this example, the return on the S&P 500 is the opportunity cost of money. If
we expected the S&P 500 to earn 10 percent in the future, then we would use this
benchmark in evaluating investments with similar risk in planning for retirement,
children's education, and so forth.
Now let's suppose that our risk tolerance was much lower than that required of
stock investments. Suppose that we are retired and focused more on income
generation and maintaining the value of our investment principle. In this case,
the benchmark—opportunity cost of capital—might be the return on corporate
bonds, which currently yield approximately 6.5 percent. If we were even less risk
tolerant, the opportunity cost of capital may be the return on U.S. Government
Treasury bonds, currently around 5 percent. Suppose we were extremely risk
averse and placed a high value on maintaining the worth of principle value and, at
the same time, wanted a very high degree of liquidity because we are going to
make a down payment on a house or other major purchase in a few months. In
this example, the opportunity cost of capital likely would be the return on a
short-term certificate of deposit, or about 1.25 percent.
Ascertaining the risk of inventory is key to deciding what cost of capital should be
used to calculate the inventory capital charge. The major risk of holding inventory
is that its value becomes impaired because of price reductions, lower demand,
and obsolescence. Recent events in the high-tech industry have underscored the
risk of holding inventory.
To illustrate, memory giant Micron Technology in its fourth quarter of 2002
wrote-off $174 million of inventory because the market had shifted to
double-data-rate DRAM from SDRAM. In 2001, Cisco Systems declared $2.2
billion in inventory to be worthless. Substantial write-downs also were reported by
bellwethers like Nortel Networks, Lucent Technologies, Corning, and JDS
Uniphase. While these write-downs may be extreme, they underscore the fact
that investment in inventory is not without risk.
The Weighted Average Cost of Capital
Given the inherent risk of inventory, we recommend that companies use a
weighted average cost of capital (WACC) to calculate the inventory capital charge.
WACC is the opportunity cost for a company's average risk investment.
Theoretically, a different WACC should be applied to investments of different risk.
But as a practical matter, the same weighted average cost typically is applied
internally to all investments unless there is a substantial difference in risk.
WACC is comprised of the cost of equity and the after-tax cost of debt. The cost
of equity is the cost of providing shareholders competitive returns on their
invested dollars. The cost of debt is simply the overall interest rate on the debt
taken on to finance the project, reduced by the tax benefit of interest expense.
Expressed as a percentage, cost of capital is the average of the required return on
equity and the interest rate on debt, weighted by the proportion of equity and
debt, respectively, to total capitalization.
The concept of the weighted average cost of capital can be explained within the
context of one's personal investment portfolio.
Suppose your portfolio has 30 percent invested in corporate bonds that

have an expected return of 6 percent.
The remaining 70 percent is invested in stocks with a long-term expected
return of 11 percent.
The weighted average expected return on your portfolio is approximately
9.5 percent (30% × 6% + 70% × 11%).
In evaluating the future value of retirement savings and other decisions,
you would use the blended rate of 9.5 percent.
A company's weighted average cost of capital is calculated as:
WACC = % Equity × Cost of Equity + % Debt × Cost of Debt × (100% - Marginal
Tax Rate)
where:
% Equity is the targeted percentage of capital financed by equity
% Debt is the targeted percentage of capital financed by debt
% Equity + % Debt = 100%
Estimating the cost of equity is the most challenging part of deriving the weighted
average cost of capital. A review of the various methodologies used to estimate
the cost of equity is beyond the scope of this article. But suffice it to say that
most companies update the cost of equity estimate as well as the other WACC
components once a year. While the WACC may range anywhere from 7 to 15
percent depending on the company's operating risk and financial risk (percentage
of debt financing), the average for U.S. companies is approximately 9 percent, as
determined below:
70% Equity × 11% Cost of Equity
+ 30% Debt × 6.5 Cost of Debt × (100% - 40% Marginal Tax Rate)
= 9.0% Weighted Average Cost of Capital
It is important to note that the WACC is an after-tax rate. The 11-percent cost of
equity used here is an after-tax cost because it comprises dividends paid to
shareholders and growth in stock price, neither of which are tax deductible. The
6.5-percent cost of debt is a before-tax cost that is adjusted to an after-tax rate
by multiplying it by the term (100% - 40% marginal tax rate). This adjustment
accounts for the tax-deductibility of interest.
Why Use WACC?
The overall weighted average cost of capital is driven by the risk of the company's
assets like inventory, property, plant and equipment, and accounts receivable. For
many industries, inventory is a significant portion of its net operating assets.
Exhibit 2 shows inventory as a percentage of net operating assets for a sample of
companies from manufacturing, distribution, and retail. From an investor's
perspective, inventory is a significant contributor to overall risk, given its
underlying risks and its percentage of operating assets. Consequently, it is
reasonable to apply the overall weighted average cost of capital in calculating the
inventory capital charge.
Use of the weighted average cost of capital is common practice in those
companies using a financial management system like economic value added
(EVA). However, many other companies apply a cost of capital that is
substantially lower than the WACC. For example, they often use a short-term
borrowing rate like the bank prime loan rate, which is currently at 4.25 percent.
Or they use a short-term investment rate like commercial paper, currently around
1.25 percent. Both of these rates understate the capital charge that is

commensurate with the underlying risk of inventory. This can lead to nonoptimal
decisions for activities such as transportation mode selection, network design, and
sourcing that balance inventory investment against operating expenses. The
discussion below lays out the shortcomings of these common approaches to
setting the costs of capital.
The Short-Term Borrowing Rate
One rationale for using the short-term borrowing rate is that inventory is a
short-term asset that is financed by short-term loans. Technically, inventory is a
short-term asset, or what is called a "current asset." For example, suppose a
company has $100 million in inventory, which represents a 60-day supply of
goods. On average the $100 million in inventory is converted into either cash
and/or accounts receivable every 60 days. However, the flaw in the short-term
asset argument is that as long as the company continues to have 60 days in
inventory, it will need to invest $100 million in inventory to maintain its current
sales. In this case, inventory should be viewed as a "permanent current asset"
even though it turns over every 60 days. Therefore, a long-term cost of capital
should be used in calculating the inventory carrying charge.
Another common argument for the short-term borrowing rate is that inventory is
used as collateral in asset-based lending arrangements. It is true that loans
against inventory are common. However, there are several flaws in using the
short-term borrowing rate as the overall cost of capital for inventory. One is that
creditors seldom lend funds up to 100 percent of the inventory's value. A more
typical lending arrangement is up to 50 percent of the value. The percentage may
be lower (like for high tech) or higher (commodities), based on the inventory's
underlying risk. Also, a lending arrangement often requires that a company
commit cash flow from all other sources as a means to repay the loan, even if
inventory is used as collateral.
Suppose that a company with $100 million in inventory finances 50 percent ($50
million) with a bank loan. This leaves 50 percent to be financed through other
sources like trade credit, bonds, and equity—all of which have significantly higher
costs than the short-term borrowing rate. Trade credit, in particular, is commonly
viewed as providing funding for inventory. Trade credit increases the purchasing
company's accounts payable (a liability) that funds the inventory asset. In recent
years, however, many purchasing companies have demanded longer trade-credit
terms from suppliers. Our research shows the following ratio of accounts payable
to inventory for a sample group of companies: manufacturing (57 percent),
distribution (62 percent), and retail (53 percent). The results suggest that trade
credit is 50 percent or more of inventory, which argues against using a short-term
rate.
Another flaw in the use of the short-term borrowing cost for the inventory cost of
capital is that it does not consider the company's "targeted capital
structure"—that is, what percentage the company desires in the long term to
finance with debt (the sum of short-term and long-term debt) and what
percentage to finance by equity. The targeted capital structure is a senior
management decision that is driven by such factors as asset risk, product
lifecycle, and useful economic life of fixed assets. The level and percentage of
debt financing that creditors are willing to provide are important factors as well.
For example, many loans include restrictions on the total amount of overall debt
financing.
Earlier, we showed that for the average company, the capital structure is
approximately 70-percent equity and 30-percent debt. However, this structure
varies by industry. High-tech companies in computers, storage devices, and
computer peripheral devices sell products with very short lifecycles and volatile
demand. Their average capital structure is approximately 95-percent equity and
5-percent debt. At the other end are companies providing electric and gas
services, which have an average capital structure of approximately 50-percent
equity and 50-percent debt. The higher percentage of debt reflects the more
stable demand for utility services and the long useful lives of its generation and
transmission plant and equipment. Exhibit 3 shows the 5-year average capital
structure for sample manufacturing, distribution and retail companies. The results
suggest that the targeted capital structure for these companies, on average, is
comprised, of 70 percent or more equity.

The calculation below for a sample distribution company illustrates the need to
account for the impact of financing inventory with debt and, in turn, to apply the
correct cost of capital in estimating the inventory carrying cost.
Capital
$ %
Inventory $100m 60
All other $67m 40
Total $167m 100%
Capital Structure
$ %
Debt $50m 30
Equity $117m 70
Total $167m 100%
This calculation is based on the results in Exhibits 2 and 3 for a distribution
company with $100 million in inventory. Inventory is 60 percent of total capital,
and the capital structure is 70-percent equity and 30-percent debt. All other
capital of $67 million is composed of net investment in accounts receivable,
property, plant and equipment, and other assets. The $50 million in debt is a loan
on the $100 million in inventory. The terms specify that 50 percent of inventory
may be financed by the loan ($50 million loan = $100 million inventory × 50%
loan financing).
This example highlights the need to account for the impact of inventory debt
financing on a company's debt capacity. The company's total debt capacity is $50
million ($167m capital × 30% debt) with a 30% debt/70% equity capital
structure. If the company finances 50 percent of inventory with a loan of $50
million, then no additional debt is available to finance other assets like accounts
receivables, property, plant, and equipment. These assets must therefore be 100
percent financed by equity in addition to the $50 million in inventory financed by
equity. For decision-making purposes, it is unreasonable to apply 100 percent of
the cost of equity to these assets. This is why modern financial practice is to apply
the weighted average cost of capital to most assets since this methodology
allocates the costs of debt and equity, accounts for the targeted capital structure,
and compensates for an asset's risk if it is not significantly different from the
company's average risk.
The Short-Term Investment Rate
A short-term investment rate such as the yield on a money-market instrument
like commercial paper or a certificate of deposit (currently around 1.25 percent) is
also commonly used as the opportunity cost of holding inventory. But short-term
investment rates, like short-term borrowing rates, ignore the basic risk/return
principle underlying application of the cost of capital. These rates significantly
understate the cost of capital that is commensurate with the risk of inventory.
Several factors cause commercial paper, certificates of deposits, and other

money-market instruments to exhibit lower risk and, therefore, a lower expected
return. Specifically:
There is a legally binding contractual obligation that the issuer will pay to
investors a fixed amount on interest and repay principle on specific dates.
Because the maturity is short term (typically one, three, or six months),
investors do not have long-term credit risk exposure.
Money-market instruments are fairly liquid and can be sold in secondary
markets if investors needed to sell the investment prior to the maturity
date.
These factors are in sharp contrast to the realities of investment in inventory:
Most investment in inventory is speculative, especially in
wholesale/distribution and retail. There is no legally binding contract that
customers will buy the inventory. In cases where inventory is built to
order, the purchaser often can change or cancel the order without fully
compensating the selling company for the inventory's total value.
Inventory may turn over every 60 days, for example, but a company must
continue to reinvest in inventory in order to maintain sales. This is the
"permanent current asset" nature of inventory discussed earlier.
Inventory typically is not liquid. Disposal of inventory prior to its sale in
the normal course of business often results in net proceeds that are
substantially less than the original inventory investment. Exceptions to this
are raw materials inventory invested in commodities like agricultural
products and precious metals.
It is reasonable to assume that for many companies, the risk associated with
investment in inventory is substantially higher than the risk of investing in
money-market instruments. Using the yield on a money-market instrument as a
proxy for the inventory cost of capital, significantly understates the inventory
carrying charge. This, in turn, can lead to incorrect inventory-related decisions.
Summarizing our discussion, we believe that neither the short-term borrowing
rate nor the short-term investment rate should be used to calculate the capital
charge for inventory. Both ignore the fundamental risk/return principle underlying
the use of cost of capital for decision-making purposes. Moreover, they both
significantly understate the opportunity cost of holding inventory, which, in turn,
impairs the decision-making process. The weighted average cost of capital is a
much more appropriate rate to use in calculating the inventory capital charge.
WACC is commensurate with the risk of holding inventory and the contribution
inventory makes to a company's overall operating risk. This methodology also
accounts for a company's targeted capital structure and debt capacity.
Before-Tax Total Inventory Carrying Costs
With the WACC in the equation, we can now combine the inventory noncapital
carrying charge with the capital carrying costs to estimate the total cost of holding
inventory. In our example, the noncapital carrying cost is 10 percent of the
inventory balance. As shown in Exhibit 1, these costs are composed of operations
expenses like obsolescence, warehousing, pilferage, insurance, and taxes—all of
which are stated on a before-tax basis. The cost of capital is 9 percent and is the
after-tax weighted average cost of capital.
Even when they use WACC to calculate the inventory capital carrying charge,
companies often make the mistake of adding the before-tax percentage inventory
noncapital carrying costs (like our example of 10 percent) to the after-tax cost of
capital (say 9 percent) to get the total carrying cost (19 percent). The problem is
that combining these before- and after-tax costs understates the total cost of
holding inventory and can lead to nonoptimal inventory decisions.
To arrive at that true inventory carrying picture, the two costs must be stated on
the same basis—either before-tax or after-tax. There are two options for doing
this:
Option 1: Adjust the before-tax percentage inventory noncapital carrying
costs to an after-tax figure and add this to the after-tax cost of capital.
Option 2: Convert the after-tax cost of capital to a before-tax number and
add it to the before-tax percentage noncapital carrying cost.
Total inventory carrying cost is often used for periodic internal reports and for
decisions that are evaluated at the operating level on a before-tax basis. For
these purposes, we recommend using Option 2 to estimate the total cost of
holding inventory. For traditional financial analysis involving the discounting of

after-tax cash flow, Option 1 is the required choice.
The following equation shows the derivation of the before-tax cost of capital and
total inventory carrying costs.
Total Inventory Carrying Costs as Percentage of Inventory
Percentage Noncapital Carrying 10%
After-Tax Weighted Average Cost of Capital 9%
Marginal Tax Rate 40%
Before Tax Cost of Capital (9%/(100% - 40%)) 15%
Total Inventory Carrying Cost as Percentage of Inventory 25%
The 9-percent after-tax weighted average cost of capital restated on a before-tax
basis is 15 percent, which is the 9 percent grossed-up for taxes. The rationale is
that if a company earns 15 percent before taxes and pays 40 percent of the 15
percent in taxes (6% = 15% × 40%), it earns 9 percent after-tax (15% - 6%).
Practical Applications
To illustrate the total cost of inventory approach in action, we will again use the
example of the company with $100 million in inventory and with average sales
and operating income margin. The following chart compares the difference
between using the 25 percent total cost of holding inventory and using the
15-percent figure.
The 15 percent is the sum of the 10 percent for noncapital carrying costs with a
5-percent capital-carrying cost, which is approximately equal to the commonly
used short-term borrow rate. The 5 percent is a before-tax figure and therefore
does not need to be adjusted for taxes.
Total Cost of Holding Inventory Applications
Inventory $100m $100m
Percentage Total Cost of Holding Inventory 25% 15%
Total Cost of Holding Inventory $25m $15m
Sales $750m $750m
Operating Income Margin* 4% 4%
Operating Income* $30m $30m
Operating Income Absorbed by Total Cost of Holding Inventory 83% 50%
*Excludes noncapital inventory carrying cost of $10 million ($100m inventory × 10% noncapital
carrying costs).
Using the more accurate 25 percent reveals that the total-dollar cost of holding
inventory is $10 million higher than when the lower 15 percent is applied ($25
million total cost of holding inventory vs. $15 million). To put the $10 million
difference in a practical perspective, the calculation shows that the $25 million
represents more than 80 percent of operating income being absorbed by total
inventory carrying costs. By comparison, when the lower 15 percent is applied,
inventory costs represent only 50 percent of operating income.
Communicating an accurate estimate of the percentage of operating income
absorbed by total inventory carrying costs is an effective way to:
Develop a better understanding of the relative cost of holding inventory.
Motivate an enterprise-wide view of inventory management.
Stimulate initiatives to improve inventory management.
Good communication also creates a greater sense of urgency throughout the
organization for better inventory management.
The more accurate 25-percent total-inventory-cost figure can also lead to better
transportation management decisions. Consider the following illustration based on
the sample company. Suppose that this company is exploring an initiative to
lower inventory by 20 percent, or $20 million, by using expedited modes of
transportation. Using the 25-percent total-inventory-carrying-cost figure, the
estimated annualized gross benefit of this transportation upgrade is $5 million

($20m × 25%). Holding all other factors like service levels the same, this means
that the company could spend up to $5 million more in transportation costs and
break even. By contrast, using the 15-percent inventory-cost figure, the
estimated annual gross benefit and maximum transportation-cost increase is only
$3 million ($20m × 15%). To put the $2 million difference in perspective,
transportation costs often average approximately 4 percent of sales. Using this
average, transportation costs for the sample company are $30 million ($750m
sales × 4%). Thus, the $2 million difference represents almost 7 percent of
current transportation costs.
Our experience is that use of the more accurate percentage for total cost of
holding inventory that incorporates the before-tax weighted average cost of
capital has a great impact on transportation decisions and generally supports the
use of faster modes. Similarly, this more accurate figure often affects decisions on
sourcing and network optimization, which involve balancing operating expense
with inventory levels.
The Goal: Better Decision Making
Summing up our discussion, supply chain management professionals must
develop better estimates of the components of the total cost of holding
inventory—the noncapital carrying costs and the capital carrying charge. Better
estimates of these components (which are almost always higher than the current
estimates used) provide more accurate insights into the total cost of holding
inventory. And knowing this more accurate total cost can be a powerful catalyst
for exploring new solutions to manage inventory more effectively.
In particular, supply chain professionals must develop more credible estimates of
noncapital carrying costs—obsolescence, warehousing, pilferage, damage,
insurance, taxes, and so forth. Current estimates of these costs often cannot be
traced to specific line-item costs and incorporated into budgets. Therefore, they
are often excluded when calculating the value of inventory-reduction initiatives
such as investments in technology to improve forecasting and inventory visibility.
Exclusion of these costs understates the return on investment of these initiatives
and can result in rejection of projects that should be accepted. Again, we
recommend that as a starting point companies focus on estimating the
noncapital-carrying-cost components of obsolescence, insurance, and taxes.
Information on these costs tends to be more readily available at a product-line,
geographical, or line-of-business level than other noncapital carrying costs.
Obsolescence, insurance, and taxes also are typically variable costs—varying with
the level of inventory investment.
Companies also should be mindful of using a cost of capital that significantly
understates the inventory capital charge. Specifically, they often use a short-term
borrowing or lend rate instead of the more accurate weighted average cost of
capital. Use of the WACC can lead to better inventory-management decisions.
Transportation management is just one example. Inventory can be lowered by
utilizing faster modes of transportation; for example, by moving to less than
truckload (LTL) from full truckload, or to air from LTL. Although using faster
modes increases transportation costs, it lowers the total cost of holding inventory.
Applying the WACC in calculating the inventory capital charge would justify the
initiative. The reason: Although total transportation costs increase, the total cost
of holding inventory and total supply chain costs are lowered—driving
improvement in overall financial performance.
Network design is another area where use of the weighted average cost of capital
in the capital carrying charge calculation leads to better decisions. A part of
network design is balancing total transportation expenses against total inventory
carrying costs. When the more accurate WACC is used, total inventory carrying
costs are higher. This warrants incurring higher transportation costs in order to
lower total inventory carrying costs and, in turn, total network costs. Thus, in
many cases, a more consolidated network is optimal even though total
transportation costs are higher.
Finally, consider the impact of knowing the total cost of inventory on procurement
decisions. To illustrate, many companies are switching to Asia-based sourcing
because of lower purchase-price costs. However, this practice often leads to
increased investment in inventory because of higher in-transit and safety-stock
inventories. Use of the weighted average cost of capital provides a more accurate
view of the inventory's impact on total landed cost. It turns out that the source
with the lowest purchase-price cost doesn't always have the lowest total landed
cost when the weighted average cost of capital is utilized. Once again, knowing
the real costs of holding inventory leads to a better decision.

Author Information
Stephen G. Timme is president of FinListics Solutions and an adjunct professor at Georgia
Institute of Technology, where he teaches in the Executive Masters in International Logistics
Program. Christine Williams-Timme is CEO of FinListics Solutions.