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Inventory Holding Cost — The Ultimate Guide of 2023
Inventory holding costs are one of the fees that an organization or business incurs. But how do businesses incur these costs?
In this article, we will discuss what inventory holding cost is. We will check how organizations compute this cost and why it is important to calculate it. Additionally, we will explain the components of inventory carrying costs and how they can be reduced.
Once you finish reading this article, you will be able to know how to calculate the inventory holding cost of your company. You will also learn how to reduce inventory carrying costs that will contribute to the growth of the organization.
What is Inventory Holding Cost?
Inventory holding costs, also known as carrying costs, are fees that you incurred for storing goods or inventory in a warehouse. In simple terms, it is the amount of money you need to pay in order to store your unsold goods or inventory in a warehouse.
Commonly, the inventory holding costs comprise 20 to 30% of the total inventory value. Additionally, it increases the longer the time you have stored an item before selling it.
The percentage is determined based on the number of items that the business sells, the location of the warehouse, inventory turnover ratio, and storage requirements.
Inventory holding cost is a significant metric to determine if you are running an effective operation. Having a high inventory cost could mean that you have more items on hand than your demands.
When this happens, you need to adjust the number of your orders or keep the stocks moving to lessen the costs.
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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.
+ What is the meaning of inventory holding cost?
It is the amount of money you need to pay in order to store your unsold goods or inventory in a warehouse.
+ Why is it important?
It is important as it holds 25% of the overall inventory spending which can affect the financial health of an organization.
+ How to calculate the inventory holding cost?
To calculate the holding cost, you must take the inventory holding sum and divide it by your inventory’s total value and multiply the figure by 100.
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