Annual Inventory Carrying Cost =

24
Lean Six Sigma Logistics
Finally, there is a component for the variable cost of storage. This compo-
nent refers to the costs associated with handling inventory and variable storage
costs such as those associated with hiring outside warehouses to hold excess
inventory. The trick here is not to include fixed warehousing costs (costs that
do not change with the volume of inventory maintained), but to include only
those costs that increase as the volume of inventory increases. So, the fixed
costs tied to the company-owned distribution center or the plant warehouse are
not reflected here. These are fixed storage (i.e., warehousing) costs that should
be determined in total logistics cost, but distinct from inventory carrying cost.
In sum, the variable costs of warehousing belong in the inventory carrying cost
component, while the fixed costs of storage and handling belong in the “ware-
housing” costs in a total cost analysis. The components of inventory carrying
cost are summarized in Figure 3.2.
Along with challenging the carrying cost determination is the prospect of
doing so frequently. Inventory carrying cost should be dynamic, as dynamic as
a company’s business opportunities. As a company’s expected rate of return on
new investments evolves, so too must the inventory carrying cost percentage.
The percentage determined at one point in time should not be held in such
Figure 3.2.
What Costs Go into Inventory Carrying Cost? (Adapted from Lambert,
Douglas M., 
The Development of an Inventory Costing Methodology: A Study of the
Costs Associated with Holding Inventory, National Council of Physical Distribution
Management, 1976, p. 68. Diagram courtesy of the Council of Supply Chain Man-
agement Professionals [CSCMP], Oak Brook, IL.)
Inventory
Carrying
Costs
Inventory Investment
Insurance
Taxes
Obsolescence
Pilferage
Storage
Space Costs
Capital
Costs
Inventory
Service
Costs
Plant Warehouses
Public Warehouses
Rented Warehouses
Company-Owned
Warehouses
Damage
Relocation Costs
Inventory
Risk Costs

The Waste of Inventory
25
regard that it cannot be questioned over time and revisited. Inventory carrying
cost is not likely to change dramatically within the course of a year, but should
always reflect the reality of the company’s changing cost conditions and invest-
ment opportunities.
Once you have a better handle on what it is really costing you to hold
inventory, interest should turn to how sales can be maximized with the least
amount of inventory. All other things being equal, you should try to cover
demand by ordering smaller quantities more frequently from your supply sources,
thus achieving more inventory turns. “Inventory turns” refers to the number of
times each year that average inventory sells. The number of turns is usually
determined based on the value of average inventory and the sales volume at
cost, expressed mathematically as:
Inventory turns = (Sales volume at cost)
/
(Value of average inventory)
Achieving more turns means that you are holding less inventory, on average,
while presumably fulfilling demand (see Figure 3.3). Clearly, having no inven-
tory on hand when demand surfaces is not a good situation, although it can make
average inventory levels and inventory turns look appealing. Rather, the model
for frequent, small-quantity replenishment that more closely matches demand
is the method for keeping customers happy with less inventory: improving turns.
A key question is “How many turns are enough?” Many companies will
benchmark their competitors and companies in similar industries to gauge how
many turns they should achieve in their distribution network. But like inventory

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