Carrying Costs Essay

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Carrying cost is an accounting term that refers to the cost of holding a financial position. The position may be purely financial such as the cost of holding securities. Or, it may be the cost of holding physical inventory for manufacturing, for shipping, or for sale. Businesses all over the world have to handle carrying costs in fairly similar ways because they are the natural conditions of business.

In finance the carrying cost of holding a position is determined by whether it is long or short. If the position is long and is on a margin account then the cost of the interest on the margin account is a part of the carrying cost. However, if the position is short then the dividends become a part of the cost to carry that position. Even if the inventory is financial there has historically been a carrying cost between the time of sale and the time of delivery of the security. Computerized transactions may minimize the handling costs but the carrying costs still have to include the costs of transfers.

Another way that carrying costs are figured is in terms of opportunity costs. If an investor takes a position in a market, then other opportunities are excluded from the capital invested or owed because of that position. If the position is in a piece of real estate then the purchase of a house or a building ties up the capital of the investor so that it cannot be used for other investments, thereby creating a carrying cost until the property is sold.

Carrying costs can be viewed as the cost of doing business that may yield a higher rate of return than the return that would accrue from a risk-free interest rate in a security such as a U.S. treasury bill. The investment earns but it is not cost free, even in the case of a treasury bill, because there is the potential for foregone opportunities. In some very secure investments such as money market certificates of deposit there may also be a penalty for early withdrawal.

When the carrying cost of inventory is calculated there are several factors that cost accounting has to consider. These are the investment in the good(s) such as gasoline, or “widgets,” or yarn. Then there is the cost of storage of the product. If the product has any significant hazard such as the flammability of gasoline then the cost rises because of the safety requirements that have to be added to the costs. In addition insurance to cover the inventory adds costs.

The cost of storage includes the cost of warehousing goods which in the case of food, furs, or other perishable products means that careful attention has to be given to the care of the product. This means that not only the cost of the storage facilities has to be figured as part of the carrying cost but so is spoilage and the cost of labor to supervise the inventory until it is moved.

In the case of agricultural commodities the cost may be the cost of grain elevator storage or of some other storage facility. The costs of storage are often figured as a percentage of the spot price. If the commodity is some kind of material such as gold or copper the cost of storage is a part of the carrying cost. In the case of perishable goods the carrying cost includes losses due to aging or to shrinkage. For example, bananas may rot or wine may spoil.

Many governments have inventory taxes that go by a variety of names. Many also have an “intangible tax” on positions held in stocks and bonds. In either case the inventory is taxed according to some formula. Taxes also add costs. Some jurisdictions allow goods in transit to be held in a “free port” position, which means they will not be taxed unless consumed or sold locally.

Inventory Models

To avoid carrying costs businesses may use a just-in time inventory model (JIT). However, this may on occasion cause delays in production, the loss of sales, loss of good will when customers are disappointed, and even the loss of customers. Instead of a JIT model many firms carry excess inventory at a re-order point that keeps a reserve of stock available for production, use, or sale. This is the cyclical stock model for handling excess inventory. This model allows for delivery of the inventory to be restocked even if there are transportation delays. For example an Italian restaurant would be embarrassed if it were to be out of a basic commodity such as olive oil.

The safety stock model for managing inventory used a built-in period of time to account for supplier lead time to manufacture the goods, if necessary, and to deliver them. There may also be variability in the quality controls of supplies that are due to materials and manufacturing methods that can affect sales and later consumption. An example of lead time is the annual manufacturing of influenza vaccine. It has to be manufactured ahead of time and then delivered globally over the flu season.

A third reason for businesses to carry excess inventory is the psychic stock model. When customers, especially at retail businesses, arrive and see only small quantities of stock, they may feel that their choices are too limited and then look elsewhere to make their purchase. An inventory that is excessive will give the perception of plenty, creating a positive attitude among customers that there are plenty of items available from which to choose.

Bibliography:

  1. Edward Frazelle, World-Class Warehousing and Material Handling (McGraw-Hill, 2001);
  2. Charles T. Horngren, George Foster, and Srikant M. Datar, Cost Accounting (Prentice Hall, 2005);
  3. Michael R. Kinney and Cecily A. Raiborn, Cost Accounting: Foundations and Evolutions (Cengage Learning, 2008);
  4. Courtney Smith, Option Strategies: Profit-Making Techniques for Stock, Stock Index, and Commodity Options ( John Wiley & Sons, Inc., 1996).

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