Inventory Holding Cost Meaning
Inventory holding cost in cost accounting refers to the total amount of money that a business spends on holding inventory in a particular period. This cost entails not only tangible storing expenses such as rent and utility costs but also the cost of the money stock used to fund inventories and the resulting lost investment opportunities.
Additionally, it includes the risk costs which may be related to stock shrinkage, spoilage, or even theft. Thus, storage cost in the form of insurance and taxes which is incurred in providing the service also forms part of the holding cost.
The longer goods remain in the inventory, the bigger these costs become – thus, affecting the overall financial health and earning capabilities of a firm. Hence, costs relating to inventory are best controlled to enhance stock turnover and ensure organizational stability.
Need of Managing Inventory Holding Cost
Here are four key points on the need for managing inventory holding costs:
- Enhances Cash Flow: Depletion of holding costs improves the cash resource envelope by releasing cash for other uses either to fund expansion or to repay borrowings among others.
- Increases Profit Margins: When specific facilities provide storage solutions that are not required to conserve cash, firms can increase their gross margins, and therefore be able to compete effectively on the pricing of products.
- Mitigates Risk: Valuable management of holding cost of inventory minimizes the risk of obsolesce, perishable, or damaged products that serve useful purposes in the market.
- Improves Operational Efficiency: Administrative control over the inventory ensures that there is limited excess stock and handling hence improving operation efficiency and utilization of resources.
5 Types of Inventory Costs
Inventory costs can be broadly categorized into the following types:
- Ordering Costs: These are the costs of ordering for the inventory, receiving the goods, and management costs that are incurred in the procurement of the inventory.
- Holding Costs / Carrying Costs: This includes warehousing costs, insurance, taxes, and depreciation as well as the cost of capital tied to holding inventory.
- Stock-out Costs: These costs are incurred when a business lacks the inventory to supply customer orders and, as a result, customers’ orders have to be backed up, and the firm risks losing its reputation among the clients.
- Setup Costs: In manufacturing, it is the cost that is incurred during the process of making preparations for a new batch of products, and this includes the labor, time, and other material used in the process of preparing machinery and equipment for the production of a new batch of products.
- Shortage Costs: These arise when a business firm is unable to store sufficient stocks that would enable it to meet the market needs in the future thus hampering its revenue income, customer strike, and high order processing charges resulting from rush orders or even back orders.
Formula and Example of Inventory Holding Cost
The formula for Inventory Holding Cost is:
Inventory Holding Cost = Total Holding Costs / Total Value of Inventory
Total Holding Costs=Storage Costs + Employee Salaries + Opportunity Costs + Depreciation Costs
A solved example for inventory holding cost is below:
A company stores the inventory in the warehouse and incurs expenses.
Storage Cost = 30000
Employees Salaries = 45000
Opportunity Cost = 15000
Depreciation Cost = 22000
Total Value of Inventory = 250000
Total Holding Cost = 30000+45000+15000+22000
Total Holding Cost = 112000
Inventory Holding Cost = 112000 / 250000
IHC = 0.448
IHC Percentage = 44.8%
Reasons for High Inventory Holding Cost
Here are some common reasons for high Inventory Holding Costs (IHC):
- Overstocking: Excess inventories held beyond what is necessary cause more storage cost, handling cost, and insurance costs hence increasing the IHC.
- Inefficient Inventory Management: Some of the consequences of weak demand forecasts, inability to monitor the existing inventory, and inefficient methods of inventory restocking include overstocking and increased holding costs.
- Large Storage Requirements: Stock that needs special conditions like temperature or security may push up the warehousing expenses and therefore the IHC.
- Slow Inventory Turnover: Slow-moving or items with low stock turnover extend the time they spend in the warehouse; hence the higher cumulative cost of holding these products in the long run.
- High Capital Costs: Inventory being a current asset, a huge portion of a firm’s capital tied to inventory implies high opportunity cost, which pushes up the IHC.
- Risk of Obsolescence: Committing an inventory that is very sensitive to changes in the economic cycle, for instance, technological or fashion-related items, contributes towards high depreciation and loss, thus contributing to IHC.
7 Ways to Reduce Inventory Holding Cost
Here are some effective 7 ways to reduce Inventory Holding Costs (IHC):
- Implement Just-In-Time Inventory Management: Through high accuracy of ordering inventory when it corresponds to the schedule of production or adequate demand, various firms can be capable of lowering their stocks and hence minimize storing costs.
- Improve Demand Forecasting: Enhance the tools used in forecasting, to enable one to have an accurate understanding of the anticipated customer traffic to avoid overstocking which comes with high holding costs.
- Optimize Inventory Levels: In a production process, make routine checks on safety stock and reordering points so that inventories are not piled for a longer time.
- Enhance Supplier Relationships: For higher order readiness and to avoid creating a huge buffer stock arrange for regular and close relations with the suppliers.
- Utilize Drop Shipping: Some of the strategies include, for some products, the use of a drop-shipping system which eliminates the need for stocking inventory from the actual supplier products to the consumer.
- Economic Order Quantity (EOQ): Maintaining an economic order quantity helps in inventory holding cost reduction. EOQ provides an optimal amount of inventory that meets the demand and minimizes the total cost.
- Reduce Product Variety: Reduction of the number of products slows down the need for complex inventory control and reduces holding costs by providing services to popular products.
Conclusion
IHC as one of the SG&A costs should be managed efficiently to ensure that it does not hurt the organization’s bottom line. Such costs for example include carrying costs, ordering costs, inspection costs, acceptance costs, and other related costs and such costs can be lowered by applying strategies such as adopting Just-in-Time inventory management; better forecasting, and automation. Reduction of IHC ultimately helps to retain cash for other investments while also reducing potential catastrophes like obsolescence and depreciation that are characteristic of overstocking.
