As you go to price out some of the costs of your product lines, one cost often overlooked is the carrying cost required to finance a product line.

However, it’s also possible when it is calculated that it could be very well overstated too.

One method says to look at some of the different components and say what would be the average days accounts receivable for that particular product line and multiple that cost times your average cost to capital and secondly, what the average days of inventory and multiple that times the average cost to capital.

However, are your costs really quite that much? A better way could be to take a closer look at your working capital cycle and see just exactly what are you out of pocket for. This can especially apply if say, for example, you’re not borrowing on your accounts receivable.

Here’s how it can work. First, you look at the raw materials you have to purchase. Then consider how long you have to pay for them. The meter doesn’t really start running until you have to pay for them. Secondly, when you start producing the item and when you start spending for, in particular, the labor cost. How soon then after that do you have to pay? Are you on a 7 day cycle on payroll or, perhaps semi-monthly? Third, you look at what is your production cycle. How long does it take to produce the particular item? Fourth, then you can look at how long it takes to collect for the particular item.

So now, how do we tie all this together? We look at the different periods that can offset and see just exactly what time period are we out of pocket for money on. For example, say you got raw material in and then you had 45 days to pay for it. Then suppose you’re able to produce the goods in 15 days and then from that point the customers take 30 days to pay you for it. In this case, you’re really not out of pocket any carrying costs. You get paid by your customer at the same time you have to pay your supplier.

However, there would be some carrying costs as related to labor. If you pay on a weekly basis, then that means half way into the production you’ll be done with done with one payroll and will have to pay for that say within 15 days. The other half you have to pay within 22 days, so you can average the two out and let’s call it about 18 days. The customer pays you in 30 days (after the 15 days it takes to produce, or a total of 45 days). You are going to have to cover your labor costs for a period of 27 days, so that is a cost of capital.

You might have another factor that can be your safety stock. What if instead of made to order, you actually have to carry some safety stock for the particular customer. Let’s suppose it was 30 days for the safety stock there, then in that instance we would add the cost of carrying the safety stock. That would be your cost of the inventory for that item, times your cost of capital for 30 days.

So, next time you have to consider what the carrying cost for a particular product line, take a closer look, get deep down into the working capital cycle. We think you can find what your true carrying costs are and what product lines are the ones that are really costing you money in financing.