What it means
In an operating business the carrying charge is dominated by four components: the cost of the capital sitting in stock, the cost of the space and handling, insurance and property taxes, and shrinkage, damage and obsolescence. Added together these typically come to something between 15% and 30% of the inventory's value each year.
That is far more than most managers assume when they order an extra pallet just in case. The figure matters because it converts an operational habit into a cash number.
Once a business knows that stock costs, say, 22% a year to hold, questions about order quantities, safety stock, supplier lead times and slow moving lines all become arithmetic rather than opinion. It is also the reason a warehouse full of unsold goods is a warning sign rather than a comfort.
Calculating it is a matter of setting a carrying rate and applying it to average inventory value rather than to a single point in time. Average inventory is normally taken as opening plus closing divided by two, or as an average of monthly balances where seasonality is strong.
Applying the rate to a year-end figure alone will usually understate the true burden. In commodities the concept is called cost of carry and includes storage, insurance and financing until delivery.
When futures prices rise with maturity because of these costs, the market is described as being at full carry or in contango, and a trader who can store more cheaply than the market implies can profit from the difference. Some consumer lending also uses carrying charge as a label for the finance charge on an instalment plan.
In practice
Real-world examples.
Example
A builders' merchant reviews slow moving lines and finds $180,000 of stock that has not moved in a year. At a 22% carrying rate that stock is costing $39,600 annually, which justifies clearing it at a discount rather than waiting for full price.
Example
A grain trader compares the spot price with the six month futures price and finds the gap covers storage and financing with a small margin left. The trader buys the physical grain, sells the future and earns the difference between the market's implied carry and its own lower storage cost.
Example
A furniture retailer decides whether to accept a 5% bulk discount that would double its stock of one range for six months. The extra carrying charge over that period outweighs the discount, so the buyer negotiates staged deliveries at the same price instead.
Formula
Calculation
Annual carrying charge = average inventory value x carrying rate. Carrying rate = cost of capital + storage and handling + insurance and taxes + shrinkage and obsolescence.
A distributor holds average inventory of $500,000. Its carrying rate is built from 9% for the cost of capital, 7% for warehouse space and handling, 3% for insurance and property taxes and 3% for shrinkage and obsolescence, so the rate = 9% + 7% + 3% + 3% = 22%. Annual carrying charge = $500,000 x 22% = $110,000, made up of $45,000 of capital cost, $35,000 of storage, $15,000 of insurance and taxes and $15,000 of shrinkage. If better forecasting cuts average inventory to $380,000, the saving = ($500,000 - $380,000) x 22% = $120,000 x 22% = $26,400 a year.Case study
Seen in the real world.
Camberhill Supply Company is a fictional industrial parts distributor used purely as an illustration. It carried 6,000 stock lines, prided itself on same day availability and had never calculated what that availability actually cost.
An illustrative review set the carrying rate at 24%, which turned $2,100,000 of average inventory into a $504,000 annual charge against operating profit of $1,600,000. Splitting the range showed that the fastest 900 lines produced most of the revenue while the slowest 2,000 lines held $600,000 of stock and generated $144,000 of carrying charge for very little turnover.
Camberhill's fictional response was to keep same day service on the fast lines, move the slow ones to a two day supplier drop ship model and clear the genuinely dead stock. Average inventory fell to $1,500,000, the annual carrying charge fell to $360,000, and service levels on the lines customers actually asked for were unchanged.
Watch out
Common mistakes.
- Counting only warehouse rent as the carrying cost and leaving out the cost of the capital tied up, which is usually the largest component.
- Applying the carrying rate to a year-end inventory figure that happens to be unusually low, which flatters the result.
- Treating bulk purchase discounts as automatically worthwhile without deducting the extra carrying charge over the holding period.
Questions
People also ask.
What carrying rate should a business use?
Many companies use a figure between 15% and 30%, built from their own cost of capital, space costs, insurance and historical shrinkage rather than a borrowed rule of thumb.
Is the carrying charge an accounting entry?
No, it is a management figure used for decisions, since the individual components already appear in interest, rent, insurance and write-down lines in the accounts.
How does carrying charge relate to cost of carry in futures?
They describe the same idea, with cost of carry expressed as the storage, insurance and financing needed to hold a commodity until the delivery date.
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