Holding CostsExplained & Defined
Holding costs refer to the costs of storing unsold inventory.
When a business calculates its total inventory costs, it must go beyond simply finding the costs of purchasing or making products since storing inventory entails an additional expense.
Holding costs include all of the costs associated with storing an item, including the costs of storage space, the labor involved with the storage, insurance, and damage and spoilage.
It is important to understand these costs in order to minimize the costs that can be tied up in maintaining excess inventory.
What Are Holding Costs?
Holding costs, also known as carrying costs, refer to the sum of all costs associated with storing unsold inventory.
A company’s inventory is an asset account that often involves a significant cash expense, and holding costs can, in many cases, represent more than 20% of inventory value.
As a result, decisions affecting the inventory expense can have a significant impact on a business’s cash flow, and minimizing these costs is an important component of supply chain management.
Holding costs can be a useful tool for determining the amount of profit a company is earning off of its inventory, as well as for determining the maximum period inventory can be held before it will result in a loss.
Holding costs can also be crucial for determining how much inventory a company should optimally keep on hand and the rate at which new products should be produced or purchased.
In order to calculate holding costs as a percent of total inventory, the following formula can be used.
Carrying Costs Percent = (Inventory Holding Sum / Total Value of Inventory) * 100
Components of Holding Cost
Inventory holding costs are made up of several components, including capital cost, storage space cost, inventory service cost, and inventory risk cost.
Here is a closer look at what these costs are:
- Capital Cost: Capital cost is the total expense that a business faces in carrying its unsold inventory, including the sum invested in the inventory as well as interest. This is calculated as a percentage of the costs of carrying inventory.
- Storage Space Cost: Storage space is the cost entailed in maintaining the space in which unsold inventory is stored. This includes the rent or mortgage as well as utilities associated with the facility and handling costs associated with the movement of inventory into and out of the warehouse.
- Inventory Service Cost: Inventory service costs refer to all of the costs associated with the insurance, taxation associated with unsold inventory, as well as any hardware and software management equipment used to maintain this inventory.
- Inventory Risk Cost: Holding unsold inventory entails a degree of risk that they could become unsellable before they can be sold and converted into cash. This could be due to theft as well as damage, spoilage, depreciation, or obsolescence.
Causes of High Inventory Holding Costs
When inventory is improperly managed, a company can end up with excessively high holding costs that reduce the amount of cash available for other uses.
Proper management of inventory is crucial to ensure that a company has enough inventory available to meet demand while still keeping holding costs at a reasonable level.
When holding costs are too high, it is likely that one of the following causes is present.
- Inadequate Inventory Management: This includes a failure to organize and maximize the use of existing inventory as well as failing to prevent loss and damage to unsold inventory.
- Excessive Inventory: It is crucial to ensure that enough inventory is kept on hand to meet demand; however, maintaining excessive stock will raise holding costs without benefiting sales.
- Inaccurate Sales Forecasting: In order to meet demand, management must create sales forecasts that predict the demand for products in order to maintain appropriate levels of stock. These forecasts are never completely accurate, but if they fail to represent actual sales by too large a margin, this can result in shortfalls or excessive levels of stock.
Methods of Reducing Holding Cost
It is crucial to manage and reduce inventory costs whenever possible to remove any inefficiencies.
This will keep costs down and free up cash flow for use elsewhere. These are a few of the most effective strategies to reduce high holding costs.
Reorganize Your Warehouse
Often as operations grow, a company’s warehouse management does not keep up.
By making physical changes to a warehouse’s storage space as well as applying improved organization strategies, existing space can often be much more efficiently utilized.
Changes such as investing in shelving to take full use of vertical space, placing more frequently needed inventory in easier-to-access locations, and using containers to hold certain items, storage capacity, and efficiency can often be greatly increased, and both labor and storage costs can be driven down.
Reduce Inventory On Hand
Though a just-in-time inventory strategy in which only the bare minimum amount of inventory is necessary may not be feasible for all companies, often, businesses may hold on to more stock than they need to avoid lost sales opportunities.
By examining historical sales trends, management can determine an optimal level of inventory to keep on hand as well as appropriate reorder points.
With accurate forecasting of demand, products with a lower level of demand can be held in reduced quantity, making room for a larger stock of faster-moving inventory.
With this information, a company can optimize its stock of inventory to avoid overstocking inventory while preventing lost sales opportunities.
Accelerate Inventory Turnover Times
Holding costs increase the longer inventory remains unsold, and these can grow quickly if inventory becomes incapable of being sold and generating revenue.
Perhaps the best way to reduce holding costs is to reduce your inventory holding period.
By analyzing trends and only holding onto inventory for the sales period, working with suppliers for optimal inventory lead times, and avoiding holding onto dead and excess inventory, turnover times can be kept to a minimum.
By keeping inventory turnover short, holding costs can be reduced, and inventory can be sold at its highest value.
When a company finds its inventory is moving too slowly, tactics such as promotions and bundles can help to clear it out.
Improve Inventory Management
Often one of the primary factors keeping inventory holding costs at a high level is inadequate inventory management.
Improved tracking of inventory, such as through the use of inventory management software, can help to track what is in stock and what is on order and where items are currently located.
This can help to ensure that the company is aware when inventory is present and is capable of ordering new stock at an optimal recording point.
This can also reduce labor costs associated with moving inventory in and out of the warehouse by tracking precisely where inventory is located.
Example of Holding Costs
As an example of holding costs, let’s assume that the XYZ Electronics Retail company stores its inventory in a warehouse that it leases.
XYZ is responsible not only for paying rent on the location but also for utilities and insurance for the building.
In addition, because the inventory XYZ Electronics stores in the warehouse have a high value, it pays security to guard its merchandise.
XYZ must also pay staff to move inventory it purchases into the warehouse and then transport it out again once it is needed to stock the retailer’s shelves.
At all of these points, the company faces a risk of damage to the merchandise; plus, because electronics advance so quickly, XYZ’s merchandise depreciates rapidly during the period it is held.
Holding costs are a critical component of a company’s total cost of doing business.
By regularly calculating holding costs, it is possible to identify inefficiencies that reduce profit and provide valuable data for making financial decisions.
By reducing holding costs, profit margins can be improved, and cash flow can be freed up for other uses, including further investment in growth and reduced product pricing.
- Holding costs are the sum of all costs involved in storing unsold inventory.
- Holding costs include the storage, insuring, damage and spoilage, depreciation, and labor associated with storing unsold inventory.
- Managing holding costs is an important component of the supply chain management strategy.
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Cornell Law School "Duality in staffing problems: Between holding costs and waiting constraints" Page 1 - 35. August 11, 2022