Answering the Carrying Cost Question
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June 10, 2016
Director of Business Consulting
You’re in a meeting and your CFO calmly asks YOU to describe Carrying Rate. Stay Calm. You've Got This!
For many, this is the question and situation they dread most. You wonder if you should try to dazzle them with big words or just admit that you’re not really sure.
Don't panic! I’ll try to help you understand Carrying Rate so you can confidently step up to the plate and knock this question out of the ballpark in the future.
1. Quick summary:
Simply put, Carrying Rate describes your company's cost of sitting on inventory.
2. How do I read it?
It’s described as a percentage of the average annual inventory level. So, if you have one million dollars (or Kroner or pounds) of inventory that you carry for the entire year, with a Carrying Rate of .35, the annual cost would be $350,000.
Your system needs this information to help you make strategic buying decisions.
3. What makes up our Carrying Rate?
Let's break it into two parts. Most distributors run with a total Carrying Rate between 30% and 40%, made up of these two parts:
- Physical Rate: We frequently only think about this portion
(This number typically ranges between 5% and 18%)
- Alternative Investment Rate: The frequently overlooked, but expensive portion
(This number typically ranges between 15% and 30%)
What ROI could you make if the money was free to invest elsewhere? In other words, if you could remove $1,000,000 from your inventory, where would you invest it? And what return could you make? Most likely, you’d do more than pay off a loan or stick it in a savings account.
A solid return on inventory investment is often 20% - 25%. For companies who excel with inner margin buying, it’s on the higher end.
Examples of Alternate Investments include:
- More aggressive inner margin deal buys
- New product lines
- New stores, etc.
4. Where is Carrying Rate used?
What a great question!
- Determining Order Cycle with Order Cycle Optimization/OPA: Most analysts re-perform this analysis twice a year to determine the strategy of how often to buy. Your Order Cycle Optimization tool balances the cost of carrying inventory with the costs of buying inventory to help you choose a smart, strategic, profitable cycle.
- Daily Item Order Cycle decisions when placing orders: Yes, your system actually runs another economic analysis every time an order is placed. Even if you have a line with a chosen Order Cycle of 10 days, it’s possible that every item won’t be purchased on every order. Lower cost/slower moving items might have a unique Item Order Cycle and only appear on every other order, or every third order, or so on. The Carrying Rate helps determine this.
- Forward (Inner Margin) Buys from deals: After your hard work to secure the best deal possible, your system will help look at your deal opportunity and determine how far out to buy. It balances the value of the deal with the carrying burden of the extra inventory.
- Economic Convenience Pack/Item Break Point Pricing, etc.: Yes, even areas like these are looking at your Carrying Rate to help determine how far out to buy.
5. What if the number in our buying system does not match that of our accounting team?
Don't panic. This is okay.
The information in your system is there to help you make great buying decisions. Your accounting team might have other numbers for proper legal reporting.
The difference typically lies in the cost of money. Often, accounting will need to use interest rate for reporting, and we use the alternate investment rate for making purchasing decisions.
Let me leave you with this thought. For many of you, the carrying cost number in your system is a default number. It’s used as a starting point to calculate your business carrying cost, but it’s up to you to tailor this to suit your unique business requirements. Blue Ridge is happy to help you dial this number to better suit your requirements.