Inventory holding costs refers to “costs” associated with storing inventory that remains unsold. These costs are one component of total inventory costs, along with ordering and shortage costs. A company’s holding costs can include a number of different elements;
- Prices on damaged goods
- Labor cost
- Storage cost
- Insurance cost
Holding Costs Definition: Holding costs are the additional costs involved in storing and maintaining a piece of inventory over the course of a year. Holding costs are computed in the economic order quantity calculation that businesses use in order to decide the optimal time to order new inventory.
Holding costs is an important component of inventory management. To really understand it, we need to go one more level deeper and talk about why companies hold inventory.
It’s fair to ask, why would a company want to hold inventory? There’s really 5 main reasons;
- Seasonal Demand – The company needs the inventory for a particular period (summer, holiday, storm)
- Safety Inventory – The company keeps safety stock in place for a great selling product so they don’t run out.
- In-Transit Inventory – Companies may purchase inventory in bulk because it takes a long time to get to the company.
- Dead Inventory – This would include outdated inventory that few customers buy.
- Cycle Inventory – This can help a company save money and act like a buffer when the company needs to order more supplies.
Understanding Holding Costs
Reducing inventory costs is an important supply chain management strategy. Inventory is usually always a company’s biggest investment. It’s an asset account that requires a large amount of cash out and decisions about inventory spending are vital as it can reduce the amount of cash you have available for other purposes. For example, if you’re increasing the inventory balance by $30,000, this is going to mean there’s less cash available to operate the business each month. This scenario is considered an opportunity cost.
Reducing Holding Costs
One way a company can ensure it has sufficient cash to run operations is to sell inventory and collect payments quickly. The quicker you can sell your inventory and collect cash, the better. When you can collect cash from your customers quickly, the less total cash your company will need to come up with to continue operations. Businesses measure the frequency of cash collections using what we call the inventory turnover ratio, which is calculated as the cost of goods sold (COGS) divided by average inventory.
Finding your turnover ratio isn’t complicated, its just basic math. For example, let’s say DEF Company has $2 million in cost of goods sold and an inventory balance of $200,000, this means their turnover ratio would be 10. Your company goal should be to increase sales and reduce the amount of inventory you have so that your turnover ratio increases.
Another important strategy to minimize holding costs and other inventory spending is to calculate a reorder point, or the level of inventory that alerts your company that more inventory is needed from a supplier. An accurate reorder point allows your company to fill customer orders without overspending on inventory storage. We’ve discussed inventory storage costs in prior articles. Using a recorder point helps your company avoid shortage costs, which runs the risk of losing a customer order due to low inventory levels. You don’t want that, the goal is to keep customers happy.
Now, the reorder point considers how long it takes to receive an order from your supplier, as well as the weekly or monthly level of product sales. A reorder point also helps the business compute the economic order quantity (EOQ), or the ideal amount of inventory that should be ordered from a supplier. Your EOQ can be calculated using some type of inventory software.
Holding Costs Examples
We’re going to assume that XYZ Manufacturing is producing green furniture that is stored in a warehouse locally and then shipped off to retailers later. Now, XYZ has two options from here, they’ll need to either lease or purchase warehouse space. They’ll also need to pay for utilities, insurance and security for the location. The company must also pay staff to move inventory into the warehouse and then load the sold merchandise onto trucks for shipping. The firm incurs some risk that the furniture may be damaged as it is moved into and out of the warehouse.
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