Why is it Important to Calculate the Carrying Cost?

The carrying cost makes up almost 25% of the overall inventory spend. Due to this, it can greatly affect the financial health of the organization. 

If the organization cannot quantify the cost of keeping stocks on hand, it may end up having problems with its cash flow. 

In addition, the company could miss out on an opportunity as it has too much money tied up in the inventory. Once this happens, organizations realize that the carrying costs are holding back their development. 

Components of Inventory Holding Cost

1. Cost of capital

This is typically the biggest portion of inventory holding cost. The cost of capital is expressed as a percentage. It includes interest and the cost of money invested in the unsold items in the inventory. 

2. Inventory service cost

This refers to expenses that are related to tax and insurance. The more inventory you hold, the higher your taxes will be. The same is true with insurance. When many products are lost in the warehouse, the more the insurance policy will be. 

3. Storage space cost

This cost refers to the rent that you pay for a warehouse to store your unsold items or inventory. In addition, it also refers to fees such as utility and transportation expenses.

4. Inventory risk cost

This cost refers to any product value depletion, administrative errors, inventory theft, or inventory shrinkage due to some circumstances that are unrelated to sales. 

How to Calculate the Holding or Carrying Cost?

Learning to calculate the holding cost of your company will help you know the profit you are making from your inventory. In addition, you can avoid incurring losses from holding on to your inventory for too long. 

The first step in calculating the holding cost is to determine your inventory service costs, capital costs, storage space costs, and inventory costs. 

After this, you must find your inventory holding sum. To get this, you must add the inventory holding components you have determined in the previous step. Here is an example to help you visualize:

Capital Cost + Inventory Service Cost + Storage Space Cost + Inventory Risk = Inventory Holding Sum

Once you are done, the next step is to find out how many unsold products or inventories you have in your storage and determine all of their worth.  

The last step is to take the inventory holding sum and divide it by your inventory’s total value. Then multiply the figure by 100 to get the percentage. Here is an example of the calculation:

(Inventory Holding Sum/ Total Value of Inventory) x 100 = Holding Cost

Ways to Reduce Inventory Carrying Costs

1. Minimize the inventory you have on hand

Even if the pandemic has shown the risks of a just-in-time inventory strategy, many organizations still hold too much stock or wrong products. 

To fix this, you can start by using inventory key performance indicators to help you evaluate each stock-keeping unit (SKU) to determine if it has a place in the warehouse. Additionally, it will help you determine the right amount of quantity to keep on hand. 

2. Rearrange or redesign your warehouse

Some organizations do not maximize the space of their warehouse. You will be surprised how physical changes in the warehouse can reduce holding costs. 

By adding shelves or using containers, you can increase the space of your storage. These methods can help you lower down labor and storage costs. 

3. Employ a warehouse management system

Advancements in technology are meant to change the traditional procedures into a more efficient and fast processes. Implementing a warehouse management system can help provide a real-time picture of the status of the inventory levels. 

The visibility that it offers helps employees to know when to replenish the products and track metrics like inventory turn and sales volume.

4. Renegotiate with your suppliers

This is another method to lower the holding cost of your inventory. You must make sure that you do not bear all the unavoidable risks. For example, you can negotiate with your supplier to have structured contracts so that they are responsible for damage, theft, or administrative costs while they still have the goods.