Inventory Stock Outs: Transportation-Out Freight and COGS

The costs of incoming shipments are an essential part of a product’s cost of goods sold. As such, companies are continually trying to lower their per-unit freight costs by maximizing their economies of scale. However, what happens when a company must cover freight to salvage the customer relationship due to an inventory stock out? Should these transportation-out freight costs be applied to COGS?

Transportation-in Versus Transportation-Out

Conventional wisdom states that only incoming freight is allocated to COGS. These are often referred to as transportation-in costs. Within standard accounting practices, outgoing freight is considered another expense entirely. In most cases, it’s considered a cost of sale.

Allocating outgoing freight to the cost of sales makes sense when delivery is part of a service provided by the company. Unfortunately, the problem is when a company doesn’t include freight as a service, but must still cover freight due to an inventory stock out. In this case, the company is covering the cost to salvage a customer relationship by paying for delivery when it normally doesn’t.

Should There be an Exception to this Rule?

The aforementioned scenario is a perfect example of the consequences of an inventory stock out. Companies faced with losing a sale will invariably rush finished goods out to the customer in an effort to salvage the purchase order, retain the profit, and maintain their relationship. They’ll rush shipments from their vendor and will then cover the costs of delivery to their customer. The incoming delivery will be allocated to COGS, while the outgoing delivery won’t. Does this make sense?

Now, by no means am I trying to rewrite well-established accounting procedures. Instead, I am trying to explain how an inventory stock out can hide inefficiencies within a company’s supply chain. Allocating these emergency freight costs to a miscellaneous account doesn’t properly define the costs of low inventory counts. In turn, this lends credence to the notion that inventory only costs money when you hold it. In reality, there is also a cost when you don’t have enough inventory to make sales.

 

One solution includes maintaining a safety stock. To learn about how to do just that, please see: Calculating Safety Stock 

The Two Categories of Inventory Costs

I’ve written dozens of articles on this website about finding a balance between carrying too much inventory and not carrying enough. Carrying too much means your company covers substantial carrying charges. These are defined by financing, obsolescence, damage, pilferage (theft) and other miscellaneous costs. Simply put, carrying charges increase the longer inventory is held without consistent sales volumes to move that inventory.

On the other end of the spectrum are lost sales cost of inventory. These are costs that come from stock outs. In this case, every stock out means a lost sale. Lost business means lost gross profit. If you lose enough sales, you’ll lose customers and will eventually see an erosion of market share. However, it’s what you do to stop this from happening that ends up becoming part of transportation-out freight problem.

When companies don’t want to lose that valuable sale, they expedite shipments from their vendor. If they manufacture finished goods, they are then forced to cover overtime in receiving, manufacturing, quality control and shipping. Again, depending upon the severity of the situation, the company is likely to cover that extra cost of freight to their customer's facility.

To learn more about these two cost drivers, please see: Inventory Carrying Costs vs. Lost Sales: Both Destroy Your Bottom Line

Ultimately, this entire situation isn’t a true representation of the product’s COGS. Not accounting for this emergency freight does nothing other than inflate gross profit on the product line. This is because most companies fail to link those added freight costs to how they managed their inventory. In the end, it reinforces the perception that inventory is only expensive when it’s held and that there are few, if any, costs to not having inventory. 

A simple solution is to track the costs of losing sales due to stock outs. The next step is to find someway to link these emergency transportation costs back to their source. Success means you'll have a stronger appreciation for all your costs of managing your supply chain. 

An inventory analyst position can help you find a balance within your finished good counts. To read more, please go to: Small Business Inventory Asset Management: Using an Inventory Analyst

To see these costs depicted within a graph, please see: The Bell Curve of Inventory Management: Finding the Middle Ground