Inventory holding costs account for any expenditure that businesses have to bear while storing their unsold inventory. A number of factors contribute to these costs such as warehousing, insurance, labor, transportation, depreciation, opportunity costs, damaged or spoiled inventory, obsolescence, and inventory shrinkage.
To calculate these costs precisely, businesses use the inventory holding cost formula. If you have been wondering what exactly inventory holding costs, stick to our guide. This guide explains everything, A to Z about inventory holding costs, the formula, calculations, and factors affecting these costs.
How to Calculate Inventory Holding Cost?
There are various methods to calculate inventory holding costs. Let’s decode each of them.
Simple Storage Costs:
As the name suggests, it’s the simplest! It is the cost of storing inventory exclusively. For instance, at its simplest, inventory holding cost is just the cost of storing inventory. This basic overview helps in understanding inventory expenses better.
Example:
A clothing line and a retail store agree on keeping the brand’s articles on one of its shelves. This shelf has a fixed monthly rent that the brand is bound to pay. In this case, calculating the inventory hold cost is super simple.
Now in another scenario, the inventory holding costs are complex if the same brand acquires a warehouse for inventory storage. In this case, it will have to pay multiple bills like rent, labor, utility costs ,etc.
Detailed Holding Costs
Detailed Holding Costs account for a more comprehensive approach that involves a formula that includes storage, employee opportunity, and depreciation costs.
| Storage Costs | Costs related to physically storing inventory such as rent, bills, and insurance |
| Employee Costs | This includes wages or salaries of employees managing the warehouse |
| Opportunity Costs | The potential profit loss from holding dead stock instead of more profitable items. |
| Depreciation Costs | These account for the decrease in inventory value over time due to obsolescence. |
The formula is represented as;
Inventory Holding Cost = (Storage Costs + Employee Salaries + Opportunity Costs + Depreciation Costs) / Total Value of Inventory.
Example:
A clothing store with an annual inventory value of $50,000 sells three different products i.e gents’ clothes, kids’ clothing, and women’s clothing. Over the last year, the business held 100 units of each product, adding up to 300 units in total inventory has the following costs:
- Storage Costs: $2000
- Employee Salaries Costs: $5000
To calculate opportunity Costs: = Return from unchosen scenario – Return from chosen scenario
$65000-$50000=$15000
To calculate Depreciation costs = Cost to make goods – Salvageable value) / Inventory lifespan
$35000-$25000/2=$5000
Inventory Holding Cost = ($2000 + $5000 +$15000 + $5000) / $50000
0.54 or 54%
This store has high inventory holding costs and should explore ways to reduce them.
Common Storage Options Likely to Increase Your Inventory Holding Charges
If you were initially operating from your house, garage, or room, you weren’t exposed to inventory holding costs. However, with growth and expansion, certain expenses increase, such as inventory holding costs especially when your business outgrows your personal space.
Here are a few inventory storage solutions that will eventually increase inventory storage costs, and you must get yourselves prepared for these.
Warehouses:
These are large storage spaces (typically 1,000+ square feet) that can be leased, bought, or built. Special features like temperature control may increase holding costs.
Storage Units or Facilities:
Smaller than warehouses, these storage spaces are suitable for businesses in transition or those growing quickly.
Fulfillment Centers:
Managed by third-party logistics providers, these centers store inventory and handle order fulfillment. They are not limited to storage but include the entire order fulfillment process.
How Much Are Holding Costs on Average?
Holding costs usually make up 20% – 30% of a business’s total inventory cost accounting for holding costs on average. Whereas the remaining 70% to 80% comprise the cost of goods sold and ordering cost.
Factors affecting holding costs include;
- Location of the warehouse: Urban or rural areas have different cost implications.
- Product size: Larger or heavier items may cost more to store.
- Number of SKUs: More products require more storage space.
- Units to store: Storing a year’s worth of inventory versus a month’s worth definitely makes a remarkable difference in inventory holding costs.
- Inventory turnover rate: Hot sellers move quickly, while slow-movers increase holding costs.
- Type of orders: Direct-to-consumer or business-to-business orders have different storage needs.
6 Tips to Reduce Holding Costs
If your inventory holding costs are too high just like the one we did for a business above, you must follow some of the best practices we’ve brought you here.
-
Optimize Inventory Levels:
Optimize inventory levels by;
- Avoiding overstocking by calculating safety stock levels, economic order quantities (EOQs), and reorder points for each SKU.
- Improving demand forecasting techniques
- Adopting an inventory management system (IMS) that tracks inventory movement, holding costs, inventory turnover, and sales trends.
-
Get Rid of Dead Stock:
- Move out obsolete, expired, or defective inventory.
- Sell the dead stock at a discount, bundle it with popular items, or donate it to charity for an inventory write-off.
-
Reduce Inventory Turnover Times:
- Keep inventory moving through the supply chain by stocking up on high-turnover products and reducing slow-moving ones.
- Purchase smaller quantities more frequently and offer promotions to boost sales.
-
Improve Warehouse Space Usage:
- Reorganize warehouse layouts for maximum efficiency.
- Research different storage models and racking systems
- Consider outsourcing to logistics providers for expertly organized warehouses.
-
Automate Inventory/Warehouse Management:
- Implement automation to track inventory, process orders, and optimize picking routes.
- Use an IMS or warehouse management system (WMS) with automation features to receive reorder reminders, update inventory counts, and streamline operations.
-
Find a Fair Inventory Storage Solution:
- Choose a storage provider with transparent pricing and only pay for the space you use.
- Evaluate the provider’s technology, fulfillment services, and analytics tools to ensure they meet your needs.
What Does Fair Holding Cost Pricing Look Like?
Finding a storage solution with fair holding costs is crucial for profitability. The cheapest option isn’t always the best. So instead of going for cheap options, consider the following when evaluating storage services:
No Hidden Fees:
Often warehouses will strike you with an unexpected fee, which always freaks out the businesses. Look for transparent pricing without surprise fees. Leading fulfillment companies are better in such cases as they often have straightforward pricing structures. With set monthly charges and flat rates for receiving and fulfilling orders, these bodies remain transparent in their warehousing dealing, saving you from any shoot in inventory holding costs.
Only Pay for Storage You Use:
Often businesses have to pay for the unused storage space, which increases their holding costs. Avoid overpaying for unused storage space. Select a provider that charges based on actual usage, with efficient storage practices and detailed billing.
In case you’ve outgrown your capacity, and need the extra space, you must communicate with the company to get you extra storage shelves or racks to utilize the extra space if you’re paying for it.
Demand Planning Insights:
Businesses must manage buying the inventory in a reasonable size to avoid high holding costs. Either buy in bulk, sell all of it, and pay the high holding costs through the profit. Another option is to buy small batches to avoid high inventory holding costs.
Also, accurate demand forecasting and economic order quantity (EOQ) calculations are essential for minimizing holding costs. Choose a provider that offers analytics and demand planning tools.
Final Thoughts:
Inventory holding costs are the charges a business has to bear for storing its unused or unsold inventory. Depending upon the size of the inventory and the complexity of the business, the inventory holding charges vary.
This guide explains the types of holding charges and gives you an easy way to understand and use the inventory holding cost formula for calculating these charges.
Meanwhile, you can go through the insightful tips to reduce inventory costs and take a better and more impactful path in scaling up your business without paying a greater proportion for inventory holding charges.
