Every business that handles physical products—whether raw materials, work-in-progress, or finished goods—must manage inventory efficiently. Why? Because inventory ties up capital and affects profitability more than many realize.
So, what are the two types of costs associated with inventory? It’s a question many businesses ask when trying to optimize their operational costs. The answer forms the foundation of smart inventory management: knowing these two cost types helps you strike the right balance between having enough stock and avoiding unnecessary expenses.
What are the Two Main Types of Inventory Costs?
Holding (carrying) costs and ordering costs are the two main types of inventory costs. These two types form the base of all inventory management decisions and represent the fundamentals that every trade-off business must understand and navigate.
Also, finding the optimal balance between these costs leads to:
- Improved cash flow
- Better resource allocation
- Increased profitability
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Holding (Carrying) Costs
Holding costs account for the expenses incurred when inventory is stored until it’s used or sold. These costs increase proportionally with inventory levels – the more inventory you maintain, the higher these costs climb.
Components of Holding Costs
| Capital Costs | Storage Space Costs |
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Calculating Holding Costs
The annual holding cost is typically expressed as a percentage of inventory value:
Annual Holding Cost = Average Inventory Value x Holding Cost Percentage
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Ordering Costs
Ordering costs represent the second major category of inventory expenses. These costs are incurred every time inventory is replenished, irrespective of the order size. Ordering costs are fixed costs per order.
Understanding these expenses is equally crucial for businesses since it helps them determine optimal order frequencies and quantities.
Components of Ordering Costs
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Procurement Process Costs
Procurement process costs are the expenses involved in getting an order ready until it’s sent to the suppliers. These can consist of indirect costs such as procurement staff costs, audit costs, and supplier bidding processes.
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Transportation and Receiving Costs
These involve the costs of getting inventory from your supplier to the workplace. The following, all together, contribute to transportation and receiving costs:
- Shipping fees are your expenses of transporting goods to your location to transport goods to your location.
- Import costs are the customs duties and taxes for international orders.
- Insurance involves protection in case products are damaged during shipping to the customer.
- Receiving staff accounts for the people who unload trucks and check incoming goods
- Quality checks are all about assuring the quality and checking if the received order meets the standards. (It all costs money.)
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Administrative Costs
These are the office and paperwork costs for each order:
- Processing invoices: Checking and paying supplier bills
- Record keeping: Entering purchase information into your accounting system
- Filing: Storing and organizing order documents
- Order communication: Emails, calls, and meetings about orders
- Tracking systems: Following orders from placement to delivery
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Supplier Management Costs
These are the expenses related to working and dealing with your supplier. Costs involved in evaluating suppliers, relationship building, quality programs, and adding new suppliers all contribute to supplier management costs.
Calculating Ordering Costs
Ordering cost is calculated on a per-order basis and then projected annually for a better understanding of its full financial impact on the procurement process and cost.
Here’s the formula, providing a straightforward way to quantify these expenses:
Total Annual Ordering Cost = Cost per Order x Number of Orders Per Year
The Trade-off Between Holding and Ordering Costs
Inventory management is all about balance, and one of the most important balances is between holding and ordering costs. Larger, less frequent orders reduce ordering costs but lead to higher holding costs due to excess inventory. Smaller, more frequent orders do the opposite: they keep storage costs low but drive up ordering expenses through more transactions.
This is where the Economic Order Quantity (EOQ) model comes in. EOQ helps businesses find the sweet spot, the optimal order size that minimizes the total cost of ordering and holding inventory. Instead of relying on guesswork, companies can make smarter, data-driven decisions using this proven formula.
The EOQ Formula
The Economic Order Quantity formula helps you calculate the optimal size by finding the point where holding and ordering costs are balanced:
EOQ = √(2DS/H)
Here:
- D represents the annual demand in units
- S means the ordering cost per order
- H stands for the annual holding cost per unit
Strategies to Optimize Inventory Costs
Implementing the following strategies for reducing overall inventory expenses while maintaining appropriate stock levels can help businesses make a huge difference.
Reducing Holding Costs
Just-in-Time Inventory Management
With JIT, goods arrive only when needed—no more storing excess stock. It’s a smart way to cut storage costs and free up space.
Drop-Shipping
You sell, the supplier ships. No inventory to hold, no warehouse to manage. Drop shipping takes holding costs out of the picture.
Consignment Inventory
Stock stays with the supplier until sold, so you don’t pay until revenue comes in. It’s a low-risk option, especially for high-value or slow-moving products.
ABC Analysis
Not all inventory deserves equal attention. ABC analysis helps you focus on the top-performing items that drive the most value, so you’re not overinvesting in the wrong stock.
Improved Forecasting
Better predictions mean smarter inventory levels. With tools like demand planning and analytics, you can lower safety stock without missing a beat.
Regular Inventory Audits
Regular audits help you spot what’s not selling. Clearing out slow movers, whether through discounts or liquidation, keeps holding costs under control.
Reducing Ordering Costs
Electric Ordering Systems
Switching to electronic ordering systems automates routine tasks, reduces paperwork, and minimizes the need for manual input. Orders can be generated and approved without the usual back-and-forth. This can be part of an ERP system.
Vendor-Managed Inventory
Let suppliers handle restocking! They track inventory levels and refill as needed, saving your team time and reducing stockouts..
Blanket Purchase Orders
Blanket purchase orders refer to the process of establishing a single contract for multiple deliveries over time. So you’re not creating new paperwork for every shipment. It’s simple and efficient.
Strategic Relationships with Suppliers
Working closely with a few reliable suppliers builds trust, improves pricing, and simplifies communication, all of which help trim costs.
Order Consolidation
Order consolidation combines requirements from multiple departments or locations into a single order. Merging orders from different teams or locations means fewer transactions, fewer shipments, and lower overall costs.
Standardized ordering Procedures
When everyone follows the same playbook, things run smoother. Clear steps mean fewer mistakes and faster processing.
Modern Approaches to Inventory Cost Management
Staying competitive today means going beyond the basics. Managing inventory costs isn’t just about trimming the fat — it’s about working smarter with the right mix of tech and proven strategies. Here’s how modern businesses are getting it done.
1. Technology Solutions
a. Inventory Management Software
Today’s software does more than track stock — it gives you a live view of your entire supply chain. From carrying costs to ordering patterns, it helps you spot what’s working (and what’s not).
b. System Integration
When your systems talk to each other, everything runs smoother. Integrated platforms cut back on admin work and make decision-making faster and more data-driven.
c. Automated Reordering
No more watching inventory levels manually. Smart systems reorder stock when it dips below your set point — saving time and reducing the risk of stockouts or overordering.
d. Barcode & RFID Tech
These tools make tracking inventory fast and accurate. Although there may be some investment costs at the start and time to set it up, you spend less time counting and correcting mistakes and more time focusing on what drives revenue.
e. Predictive Analytics
By analyzing past trends, seasonal shifts, and market behavior, predictive tools help you get ahead of demand instead of just reacting to it.
2. Methodological Approaches
a. Lean Inventory Management
Cut the clutter. Lean methods help you get rid of steps that don’t add value, keeping inventory levels tight and costs low, without sacrificing service.
b. Six Sigma
Using data and disciplined processes, Six Sigma helps smooth out inconsistencies and reduce those last-minute inventory surprises that throw off your whole operation.
c. Theory of Constraints
Find the one thing slowing everything down, and fix it. This approach helps you tackle bottlenecks so your inventory flows better and works harder for you.
d. Agile Supply Chains
In fast-moving markets, flexibility is everything. Agile methods help you adjust quickly when demand shifts, so you’re not stuck with too much stock (or not enough).
Final Thoughts
So, what are the two types of inventory costs? You’re now quite familiar since we went into the details quite far. Understanding and managing the two primary inventory costs – holding costs and ordering costs- is essential for business profitability and operational efficiency.
So, here’s a key takeaway for businesses! Mastering these fundamental inventory costs will help you make better decisions and improve your bottom line.
