The Little Black Book Of Strategies To Reduce Inventory Costs

High inventory expenses take a big bite out of your working capital. Here’s how to reduce inventory costs and increase cash flow.

In 2022, Modloft, a multi-million dollar DTC furniture company, sold out of its annual inventory in less than two months — all thanks to high demand.

But due to ongoing international supply chain issues, the company had trouble restocking its inventory quickly or cheaply (a struggle many DTC brands face post-pandemic).

Eventually, Modloft solved its production plight by moving manufacturing to North America. Shifting production facilities alleviated the brand’s supply chain struggles. It also hiked up product costs.

But you don’t have to resign yourself to high inventory costs just to solve supply chain issues.

If inventory costs are clogging your cash flow or eating into your profit margins, you can reduce these expenses. Here’s how.

8 factors that affect your inventory costs

Inventory costs are what you pay to order and store your products (like renting warehouse space, for example).

When your inventory costs are low, you have higher margins — which means more profits. And the best part? You can invest those extra profits to grow other areas of your business.

But before you dive into reducing your inventory costs, you’ll need to understand the eight reasons inventory costs might be inflated in the first place.

Factor 1: Production change costs

First up: As the name suggests, production change costs are variable expenses with peaks and valleys. In other words, this is a cost that adjusts as you create more (or fewer) products.

For example, when you increase production, related costs like electricity, labor, and raw materials will also increase.

And the opposite is also true — when you reduce production, manufacturing, utilities, materials, and other related costs decrease.

Factor 2: Ordering costs

Ordering costs are any expenses you rack up when placing an order with your suppliers. Think accounting, invoicing, and any other administrative costs. Utilizing invoicing software is the most effective method for monitoring cash flow and managing expenses.

Factor 3: Shortage costs

When you don’t have enough inventory to meet customer demand, you’ll incur shortage costs. This includes missed opportunities like lost revenue if customers buy from competitors during a stockout.

Even if these expenses aren’t apparent immediately, you could lose your customer’s trust and loyalty, eventually leading to lost sales.

In fact, 30% of consumers say stockouts hurt their shopping experience. And 54% say they’ll stop shopping with a brand after just one bad experience. (You do the math.)

Factor 4: Shipping and transportation

Shipping and transportation costs refer to any expenses in getting your inventory from your vendor to your warehouse. And these are the ones that tend to give the most sticker shock.

That’s because your shipping costs could spike significantly, depending on where your inventory comes from, the size of the order, transportation method, market changes, and so on.

For example, US domestic shipping costs rose 23% in 2021 to move goods via road and rail (mostly thanks to pandemic-induced supply chain issues). That’s no small sum for businesses to pony up.

On top of that, if your supplier is from another country, you’ll likely have to pay potentially hefty import duties, which will depend on your warehouse’s location.

Factor 5: Carrying costs

Carrying costs (or holding costs) refer to any expenses accrued to store your inventory. And they stack up the longer your stock sits unsold.

Holding costs usually include storage, insurance, labor, and the price of any damaged products.

Factor 6: Inventory risk costs

Often, your inventory can cost you in ways you didn’t expect. Inventory risk costs are any losses from unexpected shrinkage (think: theft, misplaced stock, or even damaged inventory due to natural disasters).

So, if your warehouse floods and damages $1,500 in stock, that’s an inventory risk cost.

Factor 7: Labor costs

You can divide labor costs into two categories: direct and indirect. Direct expenses are those you pay as an employer, like wages, salaries, benefits, and payroll taxes.

In contrast, indirect labor costs are those you can’t trace directly to production (also called “overhead”) and include expenses like security for your warehouse.

Factor 8: Capital costs

Capital costs are one-time, fixed expenses that help you set up operations.

For example, let’s say you’re new to the business and just starting production. You decide to manufacture in-house at your factory.

Any upfront costs to get the machinery, land, and building needed to get the company off the ground are considered capital costs.

How to calculate your inventory costs

When you know how much you’re spending on inventory, you can figure out where to cut back. But as you know, many factors affect your inventory costs. So, keeping track of them isn’t an easy task.

That’s where inventory valuation and cost of goods sold can help.

Inventory valuation

Inventory valuation is part of a DTC brand’s crucial accounting activities. Essentially, you’re calculating the value of any unsold inventory for a specific period of time (i.e., Q1, FY 2022).

This process helps you determine, for example, how much any dead stock or damaged inventory is worth (since it’s likely lost value over time).

And there are four generally accepted accounting principles (GAAP) for calculating ending inventory value that will satisfy the Internal Revenue Service (IRS).

GAAP 1: First-in-first-out (FIFO)

The first-in-first-out (FIFO) method is based on the idea that the first inventory purchased is the first inventory sold. Because prices typically rise, this method helps decrease inventory risk by first selling the most expensive (AKA the longest-sitting) products.

FIFO is also the most popular option for perishable goods or products with a short shelf-life.

GAAP 2: Last-in-first-out (LIFO)

The last-in-first-out (LIFO) method is based on the idea that the newest inventory is sold first. Most DTC brands won’t use LIFO unless inventory prices are rising (and they need to get rid of the most expensive stock first).

Generally, the LIFO method tends to increase the cost of goods sold and decrease inventory value.

GAAP 3: Weighted average cost method

In the weighted average cost method, the average cost of all inventory is divided by the number of units available (regardless of the purchase date). This method is ideal for mass-produced products that don’t need to be broken down by SKU.

To calculate your weighted average cost, use the following formula:

GAAP 4: Specific identification method

The specific identification method tracks every item in your inventory from when it’s stocked to when it’s sold.

This method is ideal for high-margin products with varying costs.

That said, brands will need a system for tracking individual items, such as an RFID tag, serial number, or receipt date. As such, this method cannot be done manually and maintain accuracy.

Cost of goods sold

Cost of goods sold (COGS) is the direct cost of producing your company’s products.

Direct costs like buying inventory for resale, labor costs, raw materials to create products or packaging, and taxes (or tariffs or duties) are calculated into your COGS. However, indirect operational costs (like warehousing or shipping) do not.

To calculate COGS, use the following formula:

But why calculate COGS when you can calculate your inventory’s value? Simple: Inventory value changes. COGS do not.
By calculating COGS, you can make data-backed decisions on pricing that are sure to turn a profit. For instance, if your COGS for an item is $10 and you sell it at $30, you’ll make $20 in gross profits.

Then, why calculate both inventory value and COGS? Simple – you probably won’t recoup those losses if an unsold item’s value falls below its COGS.

In this case, it’s better to offload that inventory for whatever you can get to prevent further losses.

12 methods to reduce inventory cost

Since various factors impact inventory costs, you can cut these expenses and increase your margins in a few ways.

1. Centralize purchasing

When each department places its own orders, the purchasing process at your company can get messy quickly.

So, you can lower unnecessary capital costs by centralizing all your buying (or filtering every purchase through a procurement tool or dedicated operations department).McKinsey calls this more cohesive workflow “next-generation procurement.”

The size of your company can help you determine your setup — whether that means using software, hiring a procurement manager, or bringing on an entire team.

However you go about it, building this kind of procurement hub within your company allows you to create procurement policies, standards, and responsibilities to improve your inventory purchasing process.

If that wasn’t enough of a reason, centralizing your purchasing also:

• Increases efficiency with clear procedures for procurement
• Gets software to do the heavy lifting and reduce time-consuming, redundant manual work
• Obtains better internal control over purchases (which also makes it easier to control your expenses)
• Increases inventory visibility, which better aligns your purchasing process with your company’s long-term goals
• Improve your procurement data’s accuracy, so you can make more strategic financial decisions easier
• Leverage information on sales history and demand forecasts to negotiate better prices with your suppliers (and build better relationships)

2. Diversify your supplier network

Remember Modloft, the DTC furniture brand we mentioned earlier?

Well, you don’t have to uproot your manufacturing and move it stateside to (hopefully) lower inventory costs and strengthen your supply chain. Instead, you can make some less extreme changes to take on turbulent times.

One way is to build a diverse supplier network that makes your brand more resilient. Having multiple options helps you lower costs and get the best deal for your brand.

This essentially comes down to risk management. In the ideal world, you’d establish a long-lasting, loyal relationship with a single supplier.

But when markets take a dive, you might need to partner with someone else to ensure your brand survives. And one way to do that is to shop for the best deal.

Gartner recommends considering six factors to determine your supplier network’s level of resilience, including risk appetite, identifying critical partners, and balancing trade-off decisions.

With these answers in mind, you can decide how many vendors to partner with, when you’ll work with each partner, and how to foster those relationships.

3. Shorten your production cycle

Changing your production levels impacts all related costs, like how much you spend on utilities and raw materials.

So, when you shorten your production cycle, you can slash those related expenses, which lowers your overall inventory costs.

You can shorten your production cycle in a few different ways.

For example, you could meet your minimum order quantity (MOQ) but ask your supplier to manufacture and deliver in smaller batches (smaller runs mean faster turnaround).

This strategy also helps you prevent overstocking and enables you to keep more capital on hand — just in case.

Along those same lines, demand planning can also help you simplify your production cycles.

With an accurate demand forecast, you be transparent with suppliers about what orders you’ll need for the coming months.

You can leverage this information to secure a better deal (since suppliers know you’ll order more inventory over the long term) and minimize costs per order.

For example, Lalo built its demand plan with Cogsy, then shared it with their vendor as leverage. By doing so, the New York City-based baby label lowered its down payments on all future orders by 50%.

However, you could use your growth plan to negotiate a volume discount split across several smaller purchase orders. That way, you don’t have to (over)invest in stock upfront, lowering your inventory costs.

4. Find cross-docking services

As you know, shipping and transportation costs are some of the priciest logistical expenses, so any savings can reduce inventory costs.

For reference, in 2019, transportation costs in the US alone were $1.04 trillion!

One way to slash these transport costs is with cross-docking services. These companies transfer inventory from one carrier to another during transportation, with minimal to zero warehousing or material handling.

In other words, a cross-docking service can help you:

• Reduce your inventory’s shelf time and lower storage costs
• Cut labor costs due to minimal material handling
• Cut down on your risk of inventory damage
• Help you meet customer demand by getting your inventory to you faster
• Increase profitability

For instance, you might use Cogsy’s purchase order feature to split shipments. Meaning, you’ll place one PO that’ll restock multiple warehousing locations in the same general region (think: Canada and the US).

However, rather than paying to send several smaller shipments from your manufacturer (this can add up fast), you send that inventory as one big shipment as close to the final location as possible.

Then, you use a cross-docking service to split off the smaller shipments. That way, the inventory can go directly to its final destination.

No need for it to pass through one of your warehouses temporarily only to be instantly redistributed to another location.

5. Reduce supplier lead times

Order lead time (or supplier lead time) is the amount of time it takes a vendor to fulfill your purchase order. Order lead time is measured from the moment the order is placed until you receive that inventory.

This matters because the longer your lead time, the more safety stock you’ll need to avoid a stockout.

For one, this extra safety stock means higher up-front purchasing costs (because you’ll need to place bigger POs). But it also means you’ll hold that inventory longer, leading to higher carrying costs and a higher risk of dead stock.

Luckily, you can reduce lead times by assessing your supply chain processes, improving your vendor relationships, and optimizing your purchase order workflow with a tool like Cogsy.

That way, you can place smaller orders more frequently (because you’ll get those orders faster) and cut many of these second-wave expenses.

6. Calculate the right reorder point

Your reorder point (ROP) is a designated stock level that, when hit, signals it’s time to restock.

Ignoring your ROP (or simply not knowing it) puts you at higher risk of stockout and is one of the top causes for expedited purchase orders (which are significantly more expensive).

To calculate your ROP, use the following formula:

Reorder point must be calculated at the product level. That said, if demand increases for any of your products, so will its reorder point. The opposite is true if demand decreases.

As such, you’ll need to routinely recalculate your reorder point to ensure it hasn’t shifted, which can get tedious.

Alternatively, inventory management software can run this math on your behalf. Take Cogsy, for example. Cogsy calculates the reorder point for all your SKUs daily.

Then, as soon as your inventory levels approach that ROP, Cogsy will send you a handy replenish alert, letting you know, it’s the perfect time to restock.

7. Agree to the right minimum order quantity

Minimum order quantity (MOQ) is the lowest amount of inventory you can purchase from your supplier at one time.

For example, one vendor may require you to buy 100 units of a specific SKU while someone else needs you to purchase at least $1,000 worth of that stock.

That said, minimum order quantities are non-negotiable for most vendors. So, you’ll need to find a supplier whose MOQ aligns with your inventory needs.

For example, if your optimal order quantity is 95 units, a partner with a 100-unit minimum order quantity might make sense. However, one with a 1,000-unit MOQ would leave you so overstocked that it’d wreck your bottom line.

8. Don’t overstock

Excess inventory is expensive for any business. In fact, overstocking costs the average retailer 3.2% in lost revenue annually.

That’s because:

• Excess inventory can become obsolete quickly, depending on the product
• Storing unsold stock costs a pretty penny — and that translates to a financial loss for the company
• Warehouses have limited square footage, so overstocking can take precious shelf space away from high-demand products

For example, Noonday Collection, a DTC accessory brand, grew rapidly in 2015. Due to high demand from customers at the time, the company placed massive orders to replenish stock for the upcoming holiday season.

However, their plan backfired.

Noonday Collection relied on transparency to rebuild trust with stakeholders, which helped the brand recover.

But you can avoid this kind of crisis altogether by being proactive.

Per Pareto Principle, 80% of the outcomes are based on 20% of the inputs. How does this relate to DTC? Well, if you’re like most ecommerce brands, 20% of your product catalog will be responsible for 80% of your sales.

By identifying these more-profitable items (and less-profitable ones) using an ABC analysis, you can stock up or down accordingly.

9. Set and track the KPIs

Key performance indicators (KPIs) are quantifiable inventory analytics companies use to gauge progress toward a specific goal.

In inventory management, your KPIs provide insights into costs, turnover, customer demand, revenue, and supply chain efficiency. For instance, some common inventory KPIs ecommerce brands track include:

• Stockouts: Which product offerings are currently unavailable
• Order cycle time: The average order fulfillment time
• Inventory accuracy: To what degree do your inventory records match your actual inventory levels
• Safety stock: How much excess product brands should keep on hand in case of supply chain issues
• Backorder rate: The number of orders a brand can’t fulfill when a customer tries purchasing it

Tracking and improving these KPIs enables brands to boost inventory replenishment efficiency, assess the quality of their supply chain management, maximize cash flow, and increase profitability.

Keep in mind: There’ll be times when you don’t meet your goals. That doesn’t mean it has to be a total miss for your brand.

For example, stockouts can still happen, regardless of how much you prepare. But you don’t have to miss out on sales, even when you go out of stock.

Cogsy’s backorders feature can convert customer demand into revenue — even when your shelves are bare.

Customers can still buy that high-demand product, and it’s easy for you to set expectations regarding estimated back-in-stock dates and shipping times.

10. Automate inventory management

Many DTC brands now rely on tech-like spreadsheets to make their inventory management process more efficient.

Unfortunately, using spreadsheets (think: Excel or Google Sheets) to manage inventory often leads to mistakes, which makes it hard to accurately gauge what stock you have, what you’ll need, and when you’ll need it. In fact, more than 90% of spreadsheets have errors.

Luckily, that is where a real-time inventory management system like Cogsy comes in. With it, you get 24/7 visibility into what your inventory levels are doing.

That way, you can make strategic, data-backed decisions (like what to restock, how much, and where to send that inventory) faster and more confidently.

All while reducing unnecessary labor costs and supply chain bottlenecks that drive additional inventory costs.

11. Ditch your dead stock

Dead stock refers to inventory items that a business considers unsellable. Typically, this stock has been sitting for so long that even if it were to sell at full price, it wouldn’t be at a profit.

On average, dead stock costs DTC brands 33% more than what the inventory is worth in holding costs (for reference, that’s 17% more than traditional businesses).

So, what can you do about it? Put simply: Get rid of it.

In this scenario, it’s better to sell these units at a loss and free up that warehouse space for more in-demand products than hold onto it and rack up higher inventory costs.

For instance, maybe you create product bundles that pair dead stock with bestsellers to increase turnover. Or, perhaps you run a promotion where everyone who shops with you on a specific day gets a free gift (AKA, a unit of dead stock).

12. Perfect your forecasts

The absolute best way to lower your inventory costs? Only buy stock that will sell and get those units just in time for someone to buy it. That way, you’re not working with aged inventory (that risks turning into dead stock).

But that starts by perfecting the art of inventory forecasting.

Inventory forecasting predicts how many units your brand needs to fully meet customer demand — without overstocking or stocking out. But this is easier said than done.

Most retailers end up either:

• Over-forecasting and overstocking. For this reason, holding costs are estimated to account for 20-30% of all inventory costs.
• Under-forecasting and understocking. And the consequential stockouts cost retailers $1T annually in missed sales.

Luckily, with Cogsy’s growth planning feature, you can create demand plans with pinpoint accuracy.

That way, you can confidently make purchasing decisions that satisfy demand (and budget for those anticipated inventory costs). Zero guesswork involved.

That’s because Cogsy personalizes your growth plan to your inventory levels, historical sales, and revenue goals.

You can then play with growth levers (like one-off marketing events or new product launches) to see how this impacts your inventory needs.

Lower your inventory costs with Cogsy

Cogsy is the end-to-end purchasing platform giving Shopify merchants and Amazon sellers more inventory control.

With its actionable dashboard, keep a 24/7 eye on your inventory levels. The dashboard will show you what to restock next and when.

But there’s no need to babysit this data. Whenever you’re running low, Cogsy will email you a replenish alert, letting you know it’s the ideal time to place your next PO.

And thanks to handy restock recommendations, drafting this purchase order only takes five minutes with Cogsy.

These recommendations factor in demand fluctuations (think: seasonality), safety stock, and potential supply chain delays for peace of mind. So, you can stock up to meet >actual demand while keeping inventory costs down.

Even better, you can monitor where this purchase order is (from draft to delivery) by connecting the shipment’s unique tracking URL.

And if any delays creep up along your supply chain (it happens to the best brands), you’ll know immediately.

So, you can easily side-step stockouts by transferring inventory from another location or selling on backorder. That way, this mishap doesn’t hinder your growth goals.

Best part? DTC brands that sell with Cogsy generate 40% more revenue on average and save 20+ hours weekly on inventory management.

But don’t take our word for it – try Cogsy free for 14 days.