What is Inventory Holding Costs?

Inventory holding costs are the various costs a business incurs to store unsold inventory in a warehouse, which includes raw materials, work in progress inventory, and finished goods, and is calculated as a percentage of total inventory value to understand the true liability of holding inventory.

Your inventory holding or carrying costs have a direct impact on business profitability and operational efficiency. When you know how much does it cost to store your inventory, measures can be taken to optimize the cost, free up excessive capital tied up in inventory and divert funds towards strategic investments.

Why You Must Calculate Inventory Holding Cost?

According to the recent report published in the Economic Times, for Indian steelmakers, an inventory pile up of Rs. 89,000 crore has become a major cause for concern due to the import-export trade imbalance. This highlights how important it is to calculate inventory holding costs because unsold inventory can form a significant portion of working capital.

Now, let’s understand why you must determine inventory holding costs.

1. Financial Planning

Having an accurate cost of carrying your inventory with the help of ERP software?allows you to draw long-term financial plans for your company. It helps you form a realistic operational budget, calculate tax liabilities, and assess the risk associated with holding inventory.

2. Inventory Levels

Are you one of those who generally keep higher inventory levels to prevent the risk of shortage? While having a safety stock is necessary, having too much of it significantly adds to your carrying costs. One of the most effective methods to optimize inventory levels is to know your carrying costs.

3. Profitability

As inventory carrying costs are non-production costs, they do not reflect in the cost of goods sold (COGS), which are direct costs associated with inventory production. Nonetheless, they have a profound impact on your profitability margins. You would surely want to keep them as low as possible.

4. Competitive Advantage

Inventory holding costs are part of your operational expenses, often hidden from plain view. Perhaps, your focus is completely on reducing the cost of production. However, you will be surprised that your competitors are able to offer better product prices by keeping their carrying costs low.

5. Informed Decision-Making

Decisions on holding inventory become even more crucial when inventory occupies large storage space and requires specific temperature and humidity conditions as in the case of chemicals. Using ERP for chemical manufacturing, chemical manufacturers can make more informed choices.

Also Read: Costing methods and techniques?

What Are the Challenges of Calculating Inventory Holding Costs?

1. Variable Costs

Inventory holding costs can vary significantly. Whether it is the storage costs of leasing a warehouse, labour wages or utility costs, keeping the costs updated in your ERP system ensures accuracy.

2. Estimation Errors

Your cost estimations can go wrong, especially when the cost is allocated towards shared resources. Possibly, you have a common warehouse for different business units with shared labor resources.

3. Inventory Loss Prediction

For many businesses, a portion of inventory does get wasted, like perishable food items. Tracking inventory waste can be difficult for multiple food items with different shelf life without a food ERP.

4. Data Integration

When don’t you have a single view of all your data across departments, carrying costs estimation is not easy. One of the foremost benefits of ERP is bringing data to a common platform for a unified view.

5. Inventory Valuation

Depending on what inventory valuation methods you use, such as FIFO, LIFO, and weighted average cost, your holding costs can differ accordingly. Whichever method you use, maintain consistency.

What Are The Key Components of Inventory Holding Cost?

There are four key components of inventory holding costs, whose understanding is necessary before you proceed to calculate your inventory holding costs.

1. Storage costs

Storage costs comprise warehouse expenses, which could be on rent or your own. Additionally, all costs associated with maintaining and operating the warehouse using a warehouse management system, labor and utility expenses are part of storage costs.

2. Capital Costs

Capital costs represent the opportunity costs of capital tied up in inventory. It’s the potential return that could have been earned if the same capital was allocated to other investments. Also, even if you borrow money from banks to buy inventory, the interest paid forms part of capital costs.

Learn everything about opportunity costs here and how to calculate it.

3. Inventory Shrinkage

Many businesses lose a significant amount of money due to inventory loss. It could be due to theft, damage to inventory during handling and storage, or missing inventory due to inventory recording errors. Inventory depreciation costs too are part of inventory shrinkage expenses.

4. Inventory Service Cost

Storing your inventory incurs expenses which are part of inventory service costs. It includes insurance premiums for financial protection against inventory loss or security measures you take to run your warehouse. In certain cases, your unsold inventory can incur taxes too.

How to Calculate Inventory Holding Costs?

Follow this step-by-step approach to calculate inventory holding costs.

1. Calculate Inventory Cost Components

Determine the value of every inventory holding cost component, including storage, capital, inventory service and shrinkage costs. Use your inventory management software to get accurate values.

2. Sum Up Inventory Cost Components

Adding the different components of carrying costs will help you arrive at inventory holding sum. Make sure you include every cost only once to avoid inaccurate financial insights.

3. Evaluate Total Inventory Value

Calculate the total value of your unsold inventory, including raw materials, work-in-progress, and finished goods, the data for which you will find in your inventory management system.

4. Calculate Inventory Holding Cost

To do this, divide the inventory holding sum calculated in the second step by the total inventory value in the third step. When you multiply this value by 100, you will get inventory holding costs.

Inventory Holding Cost Formula

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

Example of Inventory Holding Costs

Let’s understand inventory holding costs with an example from the pharmaceutical industry. For a pharmaceutical company, the types of inventory holding costs typically include the following:

• Regulatory Compliance Costs: Pharmaceuticals must comply with strict regulatory standards, which may require additional testing, record-keeping and storage protocols to maintain product integrity.
• Storage Costs: Medicines often require special storage conditions, like temperature-controlled environments, adding to warehousing costs.
• Insurance Costs: Coverage for high-value inventory against risks like theft, damage and product spoilage.
• Capital Cost: These are the opportunity costs of capital tied up in inventory, which could otherwise be invested in research and development, or other expansion plans.
• Obsolescence Costs: Medicines and other pharmaceutical products have a limited shelf life, leading to potential losses if inventory expires before being sold.

So, if the sum of all the above components of inventory carrying costs is Rs. 2 crores and the total value of the inventory is Rs. 10 crores, the inventory holding costs as a percentage of the total value of inventory is 20 per cent. Managing the carrying costs is crucial for profitability due to the sensitive and high-value nature of pharma products.

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