Inventory Holding Cost: Meaning, Example and Ways to Reduce?

What is Inventory Holding Cost?

Inventory holding cost, also called carrying cost, represents the financial outlays a firm faces for storing inventory that doesn’t sell. The costs consist of storage fees, insurance charges, depreciation costs, handling costs, and opportunity costs from funds invested in inventory.  

Inventory holding cost is a key tool in supply chain management and inventory regulation. It enhances resource levels and reduces avoidable costs. 

The following is the formula to determine the inventory holding cost:

Inventory Holding Cost = Total Inventory Costs / Total Inventory Value x 100

Example of Inventory Holding Cost

Scenario:

Company: ABC Electronics

Product: Smart TVs

Inventory Level: 500 units

Cost Breakdown:

1. Warehouse Costs:

• Rent: Storage space costs $2,000 each month.
• Utilities: $300 per month is what it costs for (electricity, heating, etc.).
• Maintenance: I spend $200 a month on both repairs and upkeep.

Total Warehouse Costs:

Total Warehouse Costs = Rent + Utilities + Maintenance = 2000 + 300 + 200 = 2500

2. Insurance: Premium: $150 every month is the price of insuring the supply against both theft and damage.

3. Depreciation:

• Estimated Depreciation: Smart TVs fall about 10% in value each year. If each TV costs $500:
• Complete investment of 500 units = $500 × 500 = $250,000.
• Annual depreciation = 10% of $250,000 = $25,000
• Every month, depreciation comes to = $25,000 / 12 = $2,083.33

4. Opportunity Costs:

• Capital Investment: Given that the total investment in inventory is $250,000 and the company could earn a 5% return each year by putting that capital to a different use:
• By considering opportunity cost, the mathematics show that annually, this is equal to 5% of $250,000 = $12,500
• Opportunity cost each month = $12,500 / 12 = $1,041.67

Total Monthly Holding Costs

Now, we can calculate the total inventory holding costs:

Total Monthly Holding Costs = Warehouse Costs + Insurance + Depreciation + Opportunity Costs = 2500 + 150 + 2083.33 + 1041.67 = 5775

Summary

For their 500 smart TVs, ABC Electronics incurs close to $5,775 a month in inventory costs related to holding. Understanding these costs allows the company to intelligently shape its inventory management by optimizing inventory levels and lowering unavoidable expenses

Why do companies need to control inventory holding costs?

Companies need to handle inventory holding costs well because these costs can dramatically affect profitability and the efficacy of their operations.

Here’s why controlling them is essential:

Minimizing Expenses

• Storage Costs: Warehouses and storage facilities require rental, utility, and maintenance costs, as well as inventory maintenance costs.
• Obsolescence: Items that are not selling or moving too slowly may need to be updated, resulting in losses from diminished value.
• Insurance: Larger inventories increase the necessity for insurance to shield against both loss and damage as well as theft.
• Opportunity Costs: Investments tied to inventory may instead be directed elsewhere to achieve returns, so overseeing these expenses frees cash for more impactful applications.

Improving Cash Flow

Taking care of inventory holding costs strengthens cash flow control. Instead of having any unused inventory, organizations can divert that capital to important areas such as product development, marketing, or growing their business.

Reducing Waste

An overstock of inventory raises the chance that products will become outdated, spoil (if they’re perishable), or suffer damage. The management of inventory holding costs permits firms to reduce waste, resulting in enhanced environmental sustainability and greater revenues.

Enhancing Efficiency

The practice of lean inventory management guarantees that companies keep an ideal level of inventory. This permits a heightened operational efficiency by synchronizing supply with demand and lowers bottlenecks associated with either production or distribution.

Competitive Advantage

Businesses that are skilled at managing inventory costs might offer cheaper prices or allocate their cost savings toward improving business components, such as product quality or customer care, which allows them to stay ahead in the market.

5 Types of Inventory Costs

There are five main types of inventory costs that companies need to consider when managing their inventory:

Holding Costs (Carrying Costs)

The costs related to inventory storage and upkeep. They typically include:

• Warehouse/storage costs: Rent, costs for utilities, and the financial obligations related to storage facility upkeep.
• Insurance: Coverage offering protection against item theft, harm allowing, or disappearance.
• Depreciation/obsolescence: The value of inventory is decreasing as time continues.
• Opportunity costs: Funds invested in inventory that might be put to other use.

Ordering Costs

These are the expenditures that result from each time a corporation orders more stock.

Common ordering costs include:

• Administrative costs: Employees spend time and labor on both the placement and the handling of orders.
• Shipping and handling costs: Charges for carriage of inventory from suppliers.
• Inspection and receiving: The financial elements present in the acceptance and quality control of goods.

Shortage Costs (Stockout Costs)

The rise in these costs is a result of a business running out of inventory and needing help to satisfy customer demand.

They can result in:

• Lost sales: The revenue missed because necessary products were unavailable.
• Customer dissatisfaction: Damage to the company’s image and the shrinking of potential future business.
• Rush order costs: Investing more for expedited delivery in order to replenish the inventory.

Purchase Costs (Acquisition Costs)

These are the prices related to the purchase of the inventory itself. It includes:

• Unit cost of goods: How much is paid for every item in the inventory?
• Bulk discounts: Forecasted financial savings located in buying larger amounts.

Setup Costs (Production Change Costs)

For organizations that toss their products, setup costs represent the money needed for changing production methodologies.

This can include:

• Machine setup: Setting up machines for fresh production cycles takes both effort and time.
• Downtime: There’s a time loss in production that occurs while reconfiguring the equipment.

Reasons for High Inventory Holding Cost

High inventory holding costs can arise from various factors that affect a company’s operations and financial health.

The table below shows all the reasons:

Reason	Description
Excess Inventory	Holding more inventory than is essential because of either overpredicting demand or inadequate inventory management.
Storage and Facility Costs	Warehouses that charge impressive rents and operational costs include utilities, maintenance, and taxes on property.
Obsolescence	Growing obsolete items and those that decay contribute to write-offs and augmented holding costs.
Insurance Premiums	A requirement for more extensive insurance coverage for greater inventories results in rising premiums.
Poor Inventory Management	Ineffective tracking, together with forecasting, causes excess stock and inaccuracies, increasing holding costs.
High Capital Costs	Putting resources into inventory generates opportunity costs, thus limiting chances to invest in important other areas.
Long Lead Times	Gathering more inventory to prevent stockouts arising from long supplier lead times has resulted in greater storage costs.
Seasonality	Large inventories needed for seasonal merchandise can trigger greater holding costs during inactive periods.
Transportation and Handling	Regular handling and ineffective systems can increase payroll costs and potential damage, adding to entire holding expenses.
Economic Factors	Companies may increase their inventory levels as a result of fluctuations in demand caused by economic changes, which can incur greater costs.

7 Ways to Reduce Inventory Holding Cost

1. Use Just-In-Time Inventory Management

When firms make inventory ordering for production or demand a priority, they are able to reduce their stock reserves and lessen storage costs.

2. Improve Demand Forecasting

Use more advanced forecasting tools to boost your perception of customer demand. This technique helps to prevent overstocking and the connected high holding costs.

3. Optimize Inventory Levels

Routinely check safety stock and reorder points to stop inventory from seizing for an excessive duration in production.

4. Enhance Supplier Relationships

Being in good standing with your suppliers will contribute greatly to smooth order fulfillment and help decrease the need for hefty buffer stock.

5. Utilize Drop Shipping

In the case of some products, think about drop shipping, which allows vendors to send items straight to customers while cutting down on the need for inventory.

6. Apply Economic Order Quantity (EOQ)

The Economic Order Quantity model helps determine the ideal quantity of inventory to purchase, lowering total expenses and responding to demand.

7. Reduce Product Variety

Minimize the assortment of products available. This cuts down the complexity of inventory management while also focusing awareness on leading items, which results in lowered holding costs.

Conclusion

Inventory Holding Costs (IHC) are an important component of Selling, General, and Administrative (SG&A) expenses and are necessary for their efficient management to safeguard organizational profitability. 

These fees include those for carrying, ordering, inspection, and acceptance, along with any associated costs. The applications of automation, stronger demand forecasting, and JIT inventory approaches help firms achieve effective IHC reduction. 

Cutting these costs frees up capital for different types of investments and simultaneously lessens the risks linked to overstocking, including both obsolescence and depreciation.