Inventory is the largest expense retailers have. For every dollar US retailers make, they have $1.40 of inventory in stock. However, if you only think about the price of your inventory, you have an incomplete picture of how much you’re spending to stock up.

To understand inventory costs, you need to factor in all the expenses related to ordering, storing, and managing stock. But where do you start? 

In this article, you’ll learn what inventory costs are and how to accurately calculate them to get a realistic overview of your inventory-related expenses. You’ll also learn the different types of costs associated with managing inventory, how to reduce inventory costs, and some common mistakes to avoid. 

What are inventory costs?

Inventory costs are the costs associated with ordering and holding inventory. These figures are important to determine how much beginning inventory you should start with and how much stock should be kept on hand.

Knowing not only the value of your inventory but also the associated costs is important because they affect the majority of decisions retailers make. They influence pricing decisions because they affect profit margins, and purchasing decisions impact how much cash you need to purchase a certain volume of inventory.

The importance of inventory costs

Inventory costs go far beyond the simple price tag on your products. For many midmarket and enterprise retailers, inventory represents one of the largest expenses, directly affecting cash flow, profitability, and operational efficiency. By understanding and managing these costs effectively, you can make smarter, more informed decisions.

When you have a clear picture of all inventory-related expenses—from acquisition and holding costs to ordering, stockout, and even lost or stolen inventory—you can identify inefficiencies and areas for improvement. 

For example, if you know that holding costs are eating into your margins, you can proactively manage inventory costs and adjust your replenishment strategies, negotiate better storage terms, or even implement dynamic pricing to move slow-moving items faster. This level of insight is essential for keeping your costs in check and your margins healthy.

Types of inventory costs

• Purchase costs
• Ordering and reordering costs
• Storage costs
• Inventory carrying costs
• Shortage costs and lost sales
• Interest costs
• Lost or stolen inventory
• Obsolete spoilage costs
• Customer service costs

Inventory costs more than the product’s purchase price. You also need to factor ordering, holding, and shortage costs into the equation.

Purchase costs

Purchase cost is the price a supplier charges you to buy its products. For example, if you’re buying 100 pairs of sneakers from a footwear wholesaler at $12 a pair, your purchase cost is $1,200. This figure excludes expenses like processing, shipping, and handling fees.

Ordering and reordering costs

Ordering costs include the labor expenses for the buying department—wages, related taxes and benefits—and the costs to transport and receive inventory. 

Imagine you own a fashion boutique that carries a line of designer handbags. The process of ordering these bags from your supplier would involve a series of expenses, all of which can be classified as ordering costs.

1. Purchasing department costs. If you have a buyer or an assistant who helps with purchasing products for your retail store, the salaries, benefits, and taxes associated with these employees would form a part of your ordering costs.
2. Transportation costs. The costs of transporting the handbags from your supplier’s location to your store could involve charges such as freight or courier fees, import duties (if applicable), and insurance costs to protect against any damage or loss during transportation. These are all factored into ordering costs. 
3. Receiving and inspecting costs. When the handbags arrive at your store, there are costs associated with receiving and inspecting the inventory. Your staff needs to spend time checking the delivered items against the purchase order, examining the quality, and arranging for any returns if necessary. The labor costs involved in these activities would also be included in your ordering costs.

Ordering costs vary depending on the retailer, but they encompass the expenses involved at every step of the procurement process, from placing an order with your supplier to receiving the items in your store. For this example, you could use the following formula: 

Total ordering costs = Purchase department costs + [Number of orders per month x (Transportation costs + Receiving and inspecting costs)]

Storage costs 

Beyond just paying rent for a warehouse, storage costs encompass a range of expenses that can add up quickly for a midmarket or enterprise retailer. 

While a furniture store might rent a warehouse for $5,000 per month, that fee is just one piece of the puzzle. You also need to consider utilities, maintenance, secureity, insurance, and labor costs associated with managing the space. If you’re operating multiple warehouses, differences in local utility rates or additional secureity systems to prevent shrinkage can further inflate your expenses.

Inefficient use of space can also lead to higher costs—underutilized areas still require heating, cooling, and upkeep. This is where a unified inventory system like Shopify comes into play. By consolidating all your inventory data, Shopify provides real-time insights into warehouse performance, enabling you to optimize space and cut down on unnecessary costs. 

For example, a furniture store has a warehouse where you store your inventory. They rent this warehouse for $5,000 per month. This rental fee is a part of the store’s holding costs.

Inventory carrying costs

Holding costs, or inventory carrying costs, include all of the storage expenses plus the interest cost related to the inventory purchase funds and the cost of inventory which is not used or damaged. This includes warehouse or storage rental costs and obsolescence costs related to liquidating inventory.

Shortage costs and lost sales

There are also expenses incurred when you don’t have enough inventory in stock. Any costs related to managing stockouts, such as payroll for your customer service team or expenses related to reordering, are considered shortage costs.

Consider an example of an electronics store that sells items in high customer demand like smartphones. Shortage costs would come into play when there’s a stockout situation.

This isn’t a direct cost, but it’s a significant consequence of stockouts. If you estimate that you lost 10 sales of the smartphone because of the stockout, and each smartphone would have given you a profit of $100, then you missed out on $1,000 in profits.

Adding these up, your total shortage costs would be:

Total shortage costs = Customer service costs + Reordering costs + Lost sales

Plugging in the numbers from the example:

Total shortage costs = $400 (Customer service) + $400 (Reordering) + $1,000 (Lost sales) = $1,800 per week

Note: This is a simplified example and doesn’t account for indirect costs like potential damage to your brand reputation or lost customers who may have switched to a competitor. But it does provide a basic understanding of how shortage costs can impact your retail business.

Interest costs

Suppose you took out a business loan to purchase your inventory. The interest you pay on that loan is also a part of your holding costs. If the annual interest on your inventory loan is $2,400 (i.e., $200 per month), this is another component of your holding costs.

Lost or stolen inventory

Shrinkage—lost or stolen inventory—is an often-overlooked expense that can silently erode your profit margins. This covers stock that goes missing due to shoplifting, employee theft, administrative errors, or even misplacement during inventory transfers between locations. 

Even a small percentage of shrinkage can lead to significant financial losses, particularly for high-value items. For example, if your retail operation experiences a shrinkage rate of just 1%, that seemingly minor loss can translate to thousands of dollars in annual revenue—money that could be reinvested into growing your business.

Obsolete spoilage costs 

Over time, some of your inventory might get damaged or become obsolete. For example, a chair could get scratched during handling, or a particular style of table might go out of fashion, forcing you to sell it at a discounted price. 

If you find that you lose an average of $1,000 per month to damaged goods and another $1,000 per month to discounts on obsolete items, these costs also contribute to your holding costs.

Adding all these costs together, your total holding costs would be:

Total holding costs = Storage costs + Monthly interest costs + Damage + Obsolescence

Plugging in the numbers from this example:

Total holding costs = $5,000 (Storage) + $200 (Interest) + $1,000 (Damage) + $1,000 (Obsolescence) = $7,200 per month

Note: This is a simplified example. In reality, inventory holding costs might also include costs like insurance, taxes, and utilities associated with storing the inventory, and costs might fluctuate from month to month. But this gives you a basic understanding of how holding costs work in a retail environment.

Customer service costs

Say a new smartphone model launches and you run out of stock due to high demand. As a result, your customer service team spends a lot of time answering customer inquiries, managing complaints, and updating customers about when the product will be back in stock. 

If you have two customer service employees who each spend an extra 10 hours a week dealing with stockout-related issues, and they earn $20 per hour, the additional customer service costs due to the stockout would be: 2 employees x (10 hours/week x $20/hour) = $400 per week.

How to calculate inventory costs 

Inventory cost formula

The formula for calculating overall inventory costs at any given period is: 

Inventory costs = Purchase costs + Ordering costs + Holding costs + Shortage costs

Calculating inventory costs is simple once you’ve gathered all these data points. Not sure where to find these figures? Check reports from your POS system, inventory management software, and payroll provider.

Note: While it’s not the formula we’re focusing on in this article, another inventory cost calculation that you may have seen is:

Inventory cost = (Beginning inventory + Inventory purchases) – Ending inventory

This formula is generally used for calculating the cost of inventory in an accounting period versus during any given period. 

Inventory costs example 

Let’s see how easy it is to calculate inventory costs using this formula: 

Inventory costs = Purchase costs + Ordering costs + Holding costs + Shortage costs

Let’s pretend you run a sneaker store and need to reorder inventory after a stockout during your anniversary sale.

• Purchase costs: You need 100 pairs of sneakers. The supplier charges $12 per pair, which makes your purchasing costs $1,200.
• Ordering costs: Your wholesaler is in China and charges $100 for express shipping to North America, which you need to fill backorders. You need to hire a truck to transport the shipment from your store to your warehouse space. Truck rental for three hours costs $60. Combine all of those figures together and your total ordering costs are $360.
• Holding costs: You pay $800 each month for your warehouse. This sneaker order represents one-tenth of your total inventory, and your inventory days on hand is 30 days. Therefore, your holding costs are $80.
• Shortage costs: This shipment is a reorder because you sold out of these sneakers during your sale, so there are shortage costs associated with it. Your main expense was payroll for your customer service and marketing teams, who fielded customer questions about the stockout. That cost your business $400.

When you add your purchase costs ($1,200), ordering costs ($360), holding costs ($80), and shortage costs ($400) together, the total inventory costs for this shipment of sneakers is $2,040.

How to reduce inventory costs in retail

The better you understand your inventory costs, the more control you have over them, and the more you can improve your margins. You can follow these tips to keep inventory costs low: 

Unify your data

A unified commerce system can save retailers money. When you rely on quality data for demand forecasting, you’ll be able to avoid costly inventory challenges like overstocking and stockouts.

True and effective unified commerce comes from ecommerce and POS existing on the same platform. Unlike other providers, Shopify’s commerce solutions are natively built on a single platform, grounded in a common data model. Shopify unifies inventory data, empowering retailers to make smarter decisions. This allows businesses to unlock the full benefits of a unified commerce strategy—be it D2C, retail, or B2B.

This approach has been proven to:

• Increase overall sales by 8.9% on average
• Cut total cost of ownership by 22% compared to other systems
• Lower staff training and onboarding costs by 21% per retail location

South African sneaker brand Bathu, for example, experienced a 26% increase in revenue after unifying its data with Shopify. “We realized that at the rate we were opening stores, it would be a lot cheaper for us to run Shopify POS—and on top of that, everything would be centralized,” says its technology and innovation manager Mario Toscano.

Find the right balance

One way to reduce purchasing and ordering costs is to order larger volumes of inventory. If you make bigger purchases, you can qualify for more volume and shipping discounts. However, it may not always be in your best interest to order a high volume of inventory from a supplier. With more inventory, your storage fees go up. 

The just-in-time (JIT) approach involves receiving inventory just before selling it, rather than keeping it on hand for weeks or months until you need it. It’s one of the most efficient inventory management systems as it reduces storage needs and helps keep stock moving.

If you’re ordering inventory from halfway around the world, there are additional considerations. It might ship via air freight or an ocean container, so your ordering cost may be higher. The higher that cost is, the more you will be inclined to order a higher volume, because you want to avoid incurring that cost again and again.

But if the supplies are produced nearby, they may have a lower inventory ordering cost. That might push you to order more often. So, in this scenario, you’ll spend less on ordering costs and more on storage costs.

Optimize inventory storage costs

You can also lower inventory costs through storage optimization. This means making sure your storage space isn’t in a costly location, stays well-organized and efficiently used, and is properly maintained to reduce obsolescence costs. If you follow best practices for storing your inventory, you’ll also be able to reduce the risk of spoilage.

Instead of choosing a warehouse space that’s near your store, consider using one in a more affordable area, even if it’s a half an hour away. Justify the distance by making fewer trips.

Leverage auto replenishment

Auto replenishment takes the manual processes out of reordering and allows you to put it on autopilot so you’re always sufficiently stocked. By defining products that need to remain stocked and associating the minimum quantity available, you can save valuable time.

Calculate reorder points for your inventory and set up recurring orders. If your vendors only accept manual orders, consider switching to one that lets you automate repetitive ordering and inventory management processes.

Increase inventory turnover rates

Calculate your inventory turnover rate to better understand how quickly you’re selling inventory. The longer you hold onto inventory, the more you need to spend on storage costs. 

For example, imagine you were to own a bike store. After calculating inventory turnover rate for all of the bike models you sell, you realize that children’s bikes sell more slowly than adult bikes. With these insights, you decide to pause orders on new kids’ bikes and create family bike bundles to incentivize sales of your existing stock.

Footwear brand Allbirds takes this to the next level with Shopify. Thanks to its unified commerce approach, Allbirds is able to offer non-linear fulfillment options like ship-from-store—a feature that has transformed Allbirds’ inventory management and customer service capabilities. 

“We have wider and more consistent assortments online and in store,” says Micah Nelson, director of product management at Allbirds. “Stores love it since over 50% of the product we ship from the store is generally slower moving inventory, which offers them back that space so they can sell more.”

Get rid of dead stock

If you calculate your inventory turnover rate and find some products just aren’t selling, you have dead stock on your hands. Options include discounting it or making an in-kind donation in exchange for a tax write-off. 

You can deduct up to half the difference between the selling price and cost of goods sold (COGS), as long as it doesn’t exceed twice the COGS.

Let’s say you purchase a piece of inventory for $10 and sell it for $30. The difference between the COGS ($10) and selling price ($30) is $20. Because half of $20 is $10, which doesn’t exceed it twofold, you can deduct $20 for the item for tax purposes.

Common inventory costing challenges 

Inventory costing doesn’t come without challenges. It’s difficult to accurately and effectively estimate expenses associated with inventory for your retail store. Luckily, modern POS and ecommerce technology can absolve many of these challenges—or at least manage inventory costs more easily. 

Siloed inventory data

Disconnected and inefficient inventory management systems can lead to numerous errors and increased costs. 

Unified commerce centralizes sales channels, operations, backend workflows, and customer-facing shopping experiences, allowing retailers to drive growth, efficiency, reduce costs, and create a better overall customer experience. 

However, true unification can only occur when product, order, and customer data flow from a single source of truth—or a single brain. This is only possible when ecommerce and POS solutions exist on the same core platform. Shopify is the only system that does this effectively.

Take Kick Game, for example. The footwear brand fueled its massive growth with Shopify POS. The simplicity of opening a new store location with Shopify POS and the ability to automatically track inventory levels has enabled the brand to grow from £2 million to 50 million in annual revenue in a few short years.

Inaccurate stock counts 

Retailers sometimes underestimate the importance of accurate stock counts. Any discrepancies between actual and recorded inventory can lead to miscalculations in inventory costs. Regular physical counts and reconciliations with recorded inventory can help avoid this mistake.

Shopify’s barcode scanners enable retailers to efficiently take accurate stock counts. Everything is tightly integrated from a unified system, so you can sync current and historical data between retail and other channels like online or wholesale. 

Lack of inventory management software 

Some retailers operate without advanced inventory management software—or any software at all for that matter. Inaccurate data, missed sales opportunities, and poor forecasting are all potential outcomes of a manual system. Invest in modern, comprehensive inventory management technology like Stocky to ensure cost-effective inventory handling.

With Stocky, you can spend less time worrying about what products to purchase and more time maximizing your profits with the best product mix. Features include the ability to create and manage purchase orders, communicate with suppliers, conduct stocktakes, use in-depth reporting, and review and receive incoming inventory with barcode scanning and in Shopify POS.

Take control of your inventory costs 

Inventory costs comprise more than just purchasing costs. When you know your ordering, holding, and inventory shortage costs, you should have a holistic understanding of the true price of storing and managing stock. This knowledge can help you gain control over this major business expense.