Inventory holding costs—the price your business pays to store inventory—can’t be avoided. After all, your business has to keep its inventory somewhere. But there’s a difference between accepting holding costs as “the cost of doing business” and burning far too much cash storing inventory you don’t need in expensive storage areas that don’t make sense for your business.
In this article, we’ll help you better understand inventory holding costs, show you how to use the inventory holding cost formula, and share some of the best practices for keeping those holding costs as low as possible.
What is holding inventory?
Holding inventory is the practice of stocking inventory your business does not need immediately.
Businesses that “hold inventory” often hang onto that inventory to prevent potential stockouts. Perhaps the company has concerns about an unreliable supply chain, foresees a potential surge in demand approaching, or simply over-orders certain products because it does not fully understand what inventory they have in stock and how much of it they truly need.
Whatever the reason, one thing’s certain: holding too much inventory eats into your business’s profits. That’s why carefully evaluating your inventory holding strategy—and the costs associated with that practice—is essential.
What is inventory holding cost?
Inventory holding costs are the total of every cost your business incurs to store unsold inventory. This includes your costs for a variety of expenses, including:
- Warehouse, commissary, or other storage locations
- Transportation to and from storage areas
- Inventory shrinkage, including theft, damage, and obsolescence
Calculating inventory holding cost
You can use a simple formula to calculate inventory holding cost. But first, you’ll need to gather the correct information.
Preparing to calculate inventory holding cost
Talk to your accountant (or review your own books) to gather annual costs for these four expenses:
- Storage costs
- Labor costs
- Depreciation costs
- Opportunity costs
Storage and labor costs are tangible costs your accounting team can help you calculate for a given period of time. Storage costs are the expenses your business incurs by storing your inventory. This includes the costs of renting a warehouse, plus any related utilities, insurance, or other expenses. Labor costs include your payroll liabilities for the employees who handle holding inventory and who help maintain the building where holding inventory is stored.
Depreciation and opportunity costs are intangible costs, but your accountants can still help you solve them. Depreciation costs are the costs your business incurs as your holding inventory loses value over time. Opportunity costs, perhaps the trickiest to calculate, pinpoint how much it has cost your business to carry dead stock over more profitable inventory.
You’ll also need to calculate the total value of your annual inventory. To do this, simply combine the average value of every piece of inventory your business moves over a year.
Inventory holding cost formula
Inventory Holding Cost =
(Storage Costs + Labor Costs + Opportunity Costs + Depreciation Costs)
/ Total Value of Annual Inventory
Inventory holding cost formula example
Say an auto shop maintains a warehouse for storing its holding inventory. The shop sits down and determines the following annual costs for holding inventory:
- Storage costs: $35,000
- Labor costs: $200,000
- Opportunity costs: $30,000
- Depreciation costs: $25,000
The business also calculates its annual inventory value at $750,000.
Inventory Holding Costs = ($35,000 + $200,000 + $30,000 + $25,000) / $750,000
Inventory Holding Costs = .3867, or 38.7%
Need more information on inventory formulas and ratios? This quick guide reviews some of the most essential calculations for inventory management.
How to reduce inventory costs
Holding costs are different for every business across every industry. For example, a restaurant in New York City and a plumber in Arkansas will have both very different holding costs and very different definitions of an “ideal” holding cost.
Generally, businesses prefer to keep their inventory holding costs around 20% to 30% of their total inventory costs.
On that note, the auto shop in the above example might want to evaluate how much inventory they’re holding, where they’re holding it, and who they’re paying to maintain it. If they could find a way to reduce some of those costs, their business would become much more profitable.
Here are some of the best ways to reduce inventory holding costs:
Practice better inventory control
Inventory control is the practice of ordering just enough inventory to meet customer demand without spending unnecessary cash on inventory that’s not yet needed. To truly optimize inventory control, a business must fully understand its inventory needs, correctly forecast demand, implement an air-tight, perpetual inventory management system, and work with reliable, trustworthy suppliers.
Even if you’re already practicing good inventory control, your business may want to recalculate your safety stock levels, vendor lead times, and other key formulas. These numbers change, and your inventory ordering strategy will need to be adjusted when they do.
Tools like inventory management software can help you practice better inventory control by arming you with powerful automation features like low stock alerts, lighting-fast barcode and QR code scanning, and customizable reporting.
Optimize your storage space
Storing inventory, especially off-site, can quickly become expensive. One of the easiest ways to reduce inventory holding costs is to reduce inventory storage expenses.
Evaluate your storage areas and determine if reorganizing them more efficiently and space-consciously might be possible. Even little changes—such as investing in more intelligent, more vertical storage systems—can save your business money.
Negotiate with suppliers
Negotiating with your vendors isn’t always easy or even possible. And while your suppliers may balk at giving you a discount, there’s a chance they may be amenable to other actions that can reduce your business’s holding costs. For example, suppliers may “break” orders, hold inventory at their warehouse instead of delivering it to yours, or reduce your minimum order quantity (MOQ) in return for your loyalty.
Sortly is a top-rated inventory management app that helps businesses stay on top of all their inventory, even across multiple locations. If you’re looking to reduce your inventory holding costs, Sortly can help you do just that by empowering your whole team to practice better inventory control, stop unnecessary overordering, and understand what you’ve got on hand and in storage at any given time.
Ready to give Sortly a try? Unlock the inventory app’s most powerful features with a free, two-week trial today.