Carrying Costs

Carrying costs are the recurring costs of holding an asset over time, incurred because the asset is still owned rather than sold, used or finished. On inventory they cover storage and warehousing, handling, insurance, taxes on the goods, losses to obsolescence and shrinkage, and the cost of the money tied up in the stock. On real property they cover property taxes, insurance, utilities, mortgage interest and association dues for every month the owner keeps the property.

The Two Senses the Term Carries

Both senses answer the same question, what it costs to keep owning something, and they differ only in what is being owned. The inventory sense, also written holding cost, applies to goods standing in a warehouse. The real property sense, also written carrying charges, applies to a lot, a building under development or a house an owner is holding through a renovation or a vacancy. Neither is the default reading of the term, so the sense has to come from the asset in front of you.

Federal tax law uses the second wording as a heading of its own. Section 266 of the Internal Revenue Code is titled Carrying charges, and it provides that no deduction is allowed for amounts paid or accrued for such taxes and carrying charges as are chargeable to capital account with respect to property, if the taxpayer elects to treat them as so chargeable (26 U.S.C. 266).

What Sits Inside an Inventory Carrying Cost

Four groups make up the usual build. Space costs are the rent, utilities, security and maintenance of the facility the goods sit in. Service costs are the insurance on the stock, any tax levied on the goods themselves, and the labor of moving and counting them. Risk costs are the value lost while the goods wait, through obsolescence, damage, and the count shortfall covered in shrinkage. Capital cost is the return the money invested in the stock would have earned elsewhere.

That fourth group behaves differently from the other three, and the difference matters for anyone reconciling a schedule to a ledger. Rent, insurance, tax and handling are recorded transactions with an invoice behind them. The capital cost is not recorded at all, because nothing was paid to anyone, which makes it an implicit cost in the sense set out in explicit vs implicit cost. It belongs on a management schedule and it will never tie to a general ledger account.

Tax law draws that same line and draws it explicitly. Among the carrying charges a taxpayer may elect to capitalize on real property under development, the regulation names interest on a loan but not theoretical interest of a taxpayer using his own funds (26 CFR 1.266-1(b)(1)(ii)).

The Inventory Carrying Cost Percentage

The measure is expressed as a share of the stock it is holding, so a warehouse cost is read against the value it is protecting rather than in isolation.

inventory carrying cost percentage = annual carrying cost / average inventory value

Annual carrying cost is the total of the four groups above for one year, for the same stock. Average inventory value is the inventory balance across that same year, at the same cost basis the books carry it on, usually the opening balance plus the closing balance divided by two.

Neither the accounting standards on inventory cost nor the uniform capitalization rules define this percentage or set a level for it, so it is a management figure rather than a reported one. It is built from whichever components the person building it chose to include, which is why the comparison that means something is the business’s own prior year on an identical build. Two companies that draw the boundary differently produce percentages that are not on the same scale.

A Worked Example

Say a distributor’s inventory balances and holding costs for the year are the figures below.

Inventory, opening                              740,000
Inventory, closing                              860,000

average inventory       (740,000 + 860,000) / 2  =  800,000

Warehouse rent, utilities and maintenance        48,000
Handling and warehouse labor                     37,000
Insurance on the goods                            6,000
Property tax on the goods                         9,000
Write-downs for obsolete and damaged stock       20,000
Capital cost, 8% on the average balance          64,000
                                                --------
annual carrying cost                            184,000

carrying cost percentage  184,000 / 800,000     =   23.0%

the same stock and the same year, capital cost left out
annual carrying cost      184,000 - 64,000      =  120,000
carrying cost percentage  120,000 / 800,000     =   15.0%

Nothing about the distributor changed between those two answers, only the boundary of the schedule, and that is the whole reason a percentage lifted from one business cannot be used to judge another.

Where a Carrying Cost Lands on the Books and on the Return

Most of these costs are charged to the period that incurs them rather than added to the inventory figure, which makes them a period cost on the books. Cost as applied to inventories means in principle the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location (Accounting Research Bulletin No. 43, Chapter 4, Statement 3), and the cost of keeping goods somewhere after they have arrived is generally not that. The risk group is the exception, and it works by a different route: obsolescence and damage push goods below cost and produce a write-down of the carrying amount, the mechanism handled in inventory accounting and expensed as incurred.

The return can answer differently on the same goods. For a client subject to the uniform capitalization rules of section 263A, whose general machinery and small business exemption sit in costing overheads, storage costs are generally capitalized to the extent they are attributable to the operation of an off-site storage or warehousing facility, while storage costs attributable to the operation of an on-site storage facility are not required to be capitalized (26 CFR 1.263A-3(c)(5)(i)). An on-site storage facility is one physically attached to, and an integral part of, a retail sales facility (26 CFR 1.263A-3(c)(5)(ii)(A)).

Handling costs for a reseller split on the same line and carry a definition of their own: costs attributable to processing, assembling, repackaging, transporting and other similar activities with respect to property acquired for resale, generally required to be capitalized, except where they are incurred at a retail sales facility with respect to property sold to retail customers at that facility (26 CFR 1.263A-3(c)(4)(i)). A workpaper that lumps every warehouse cost onto one line has thrown away the distinction the test turns on.

The Section 266 Election

Section 266 lets a taxpayer move a carrying charge that would otherwise be deducted onto the basis of the property instead. On unimproved and unproductive real property the items the election reaches are annual taxes, interest on a mortgage, and other carrying charges (26 CFR 1.266-1(b)(1)(i)). On real property being developed or improved, whether or not it is already productive, they are interest on a loan, taxes of the owner measured by compensation paid to employees, taxes imposed on the purchase, storage, use or other consumption of materials, and other necessary expenditures, in each case paid or incurred up to the time the development or construction work has been completed (26 CFR 1.266-1(b)(1)(ii)). On personal property the parallel items run up to the date of installation or the date the property is first put into use, whichever is later (26 CFR 1.266-1(b)(1)(iii)).

The election has one limit worth stating before anyone reaches for it. Its sole effect is to permit those enumerated items to be charged to capital account even though they are otherwise expressly deductible, and an item not otherwise deductible may not be capitalized under section 266 (26 CFR 1.266-1(b)(2)). It converts a deduction into basis; it does not create one.

Making it is a filing act with a fixed life. The taxpayer exercises the election by filing with the original return for the year a statement indicating the item or items it treats as chargeable to capital account (26 CFR 1.266-1(c)(3)). For unimproved and unproductive property that election is effective only for the year for which it is made, so it is a decision the preparer revisits annually (26 CFR 1.266-1(c)(2)(i)). For development and construction items it runs until that work is completed (26 CFR 1.266-1(c)(2)(ii)).

There is no picking and choosing inside a type. If expenditures for several items of the same type are incurred with respect to a single project, the election must, if exercised, be exercised as to all items of that type, though a taxpayer may still capitalize one type and deduct another on the same project (26 CFR 1.266-1(c)(1)).

One case reaches this election only after another rule has already run. Where the charge is interest on property the taxpayer is producing, the uniform capitalization rules are applied before the election is available, and the order they run in is set out in capitalized interest.

What Carrying Cost Is Confused With

Carrying cost and carrying amount are not the same measure. A carrying cost is a recurring expense of continuing to hold an asset, while a carrying amount, also called carrying value, is the figure the asset itself is reported at on the balance sheet.

The two do meet in one place, which is why they get collapsed. A carrying cost that is capitalized under section 266 stops being an expense and becomes part of the carrying amount, so the same dollar changes category rather than appearing twice.

Common Questions

Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a trial task lets a firm’s own reviewer grade a block of its inventory and fixed-asset work before any client file moves.