If you run any business, you must be aware of holding inventory. Holding inventory comprises almost 20-30 % of the total inventory cost. If a company successfully cracks the code of holding only the amount of inventory needed to meet customer demand and maintain a smooth supply-and-demand chain without stockouts or overstocking, then it’s safe. Otherwise, you risk your bottom line.
According to Myos, up to 37% of businesses in the USA don’t have accurate inventory management, which means they either face stockouts or overstocking. Therefore, a business has to identify the costs associated with holding inventory in its warehouse to manage it because managing stockouts and understocking alone can reduce 10% of the inventory cost.
In this guide, you will learn how to calculate the holding cost using a holding cost formula and maintain a smooth inventory flow.
What is the holding cost?
Holding cost, or carrying cost, represents all the costs associated with unsold inventory sitting in the warehouse.
✅ What’s included in holding cost?
- Warehousing expenses (rent, utilities)
- Insurance premiums
- Labor costs for inventory management
- Capital costs (money tied up in inventory)
- Risk costs (damage, theft, obsolescence)
- Transportation and handling costs
- Opportunity costs of invested funds
❌ What’s not included?
- Ordering cost
- Purchase price
- Stockout or shortage costs
- Transportation (unless you’re storing in-transit goods)
Why is calculating holding cost important?
Tracking inventory is one of the most important parts of calculating the total inventory cost. Supply Chain Dive stated that if a business fails to track inventory properly, it can affect its finances by 62%. That means you have to manage your supply and demand accurately. Without a proper balance, a business can face outcomes like shutting down or facing bankruptcy. To prevent such scenarios, 36% of supply chain professionals optimize their supply chains to keep a well-stocked inventory.
What is the holding cost formula?
The holding cost formula explains the cost associated with the percentage of inventory value spent on holding inventory.
Holding Cost Percentage = (Inventory Holding Sum / Total Value of Inventory) × 100
Holding cost comprises 4 major components;
- Storage space costs: Warehouse rent, utilities, and related expenses
- Capital costs: Money invested in acquiring inventory
- Inventory service costs: Insurance and taxes on inventory
- Inventory risk costs: Potential losses from depreciation, obsolescence, or damage
How to calculate holding cost
- First, identify the cost associated with the individual component
Let’s take this example;
- Capital cost: ₹50,000 (cost to purchase inventory)
- Inventory service cost: ₹2,000 (insurance and taxes)
- Risk cost: ₹3,000 (obsolescence and loss insurance)
- Storage cost: ₹5,000 (warehouse expenses)
- Now add them all to find the holding cost
Add all components together:
₹50,000 + ₹2,000 + ₹3,000 + ₹5,000 = ₹60,000
- Find out the total inventory value
Let’s say your total inventory is worth ₹200,000.
- Now apply the holding cost formula
Holding Cost Percentage = (₹60,000 / ₹200,000) × 100 = 30%
The above example shows that storing inventory will cost you 30% of your total inventory value each year. This is a major expense that shows why optimizing your inventory is important.
Daily and Annual Holding Cost Calculations
Now that we have calculated the average holding cost against the inventory value. If you want to calculate the holding cost for a single day or for the entire year, then the formulas will change accordingly. Finding the daily holding cost will give you a more accurate view of your supply chain cycle and help you manage your inventory levels more precisely.
Daily holding cost:
Daily Holding Cost = Annual Holding Cost / 365
Yearly holding cost
Average Holding Cost = Holding Cost Percentage × Average Inventory Value
Cycle stock holding cost
Cycle stock only accounts for regularly used inventory (not safety stock).
Cycle Stock Holding Cost = (Cycle stock value) × (Carrying rate)
Don’t confuse cycle stock holding costs with total inventory costs; they’re different. Because cycle stock represents the inventory needed to meet demand for some time, while total inventory includes all the costs associated with inventory.
Holding cost formula in EOQ models
The Economic Order Quantity (EOQ) model helps you find the optimal order quantity by comparing ordering and holding costs.
This way, you can run a smooth supply and demand balance while maintaining your bottom line.
EOQ = √(2DS/H)
Where:
D = Annual demand quantity
S = Fixed cost per order
H = Annual holding cost per unit
Understanding this relationship helps optimize order quantities to reduce total inventory costs.
Holding cost in ACCA
If you’re studying ACCA, it’s important to know about holding costs. These costs are part of the bigger group known as indirect costs or overheads. They come from various sources and can affect your business finances.
Here are the main types of holding costs you should keep in mind:
Storage expenses: This includes the cost of renting or maintaining a space where you keep your inventory.
Admin and insurance costs: You also have to factor in administrative costs and insurance for the items stored.
Depreciation of storage equipment: If you’re using equipment to store goods, its value decreases over time. This loss in value is another cost.
Obsolescence and waste: Sometimes, items may go out of date or get damaged. These losses are also part of holding costs.
In accounting, all these holding costs usually show up on income statements under “inventory expenses.” Correctly identifying these costs helps you calculate your overall holding costs. Being clear about them can help you manage your budget better and make informed business decisions.
How to manage inventory cost
Depending on your business and inventory size, you can more accurately manage your inventory levels based on the storage area.
Warehouses
If you have a large-scale business with large inventory volumes, then the most cost-effective option will be to have a warehouse as storage space. Warehouses mostly come with features like climate control and security that eliminate the outsourcing cost.
Storage units
Storage units are mostly ideal for businesses with short-term needs. They are quick to set up and easy to terminate without long-term commitments.
Fulfillment centers
Businesses that operate online or undergo order fulfillment through various online channels, like most e-commerce businesses, often have fulfillment centers.
These businesses outsource their fulfillment processes, from warehousing and packing to shipping.
These fulfillment centers are managed by third-party logistics providers. While these centers are considered convenient, their comprehensive services come with higher costs.
How can you reduce your inventory cost?
- Manage your inventory levels
To reduce your holding cost, the first step is proper management of your inventory level. Most businesses are using inventory management systems and AI-enabled supply chain management to optimize their supply chains, which means they can identify the real-time stocks, reorder points, and safety stock levels that ultimately impact their inventory levels. Businesses with AI-integrated systems have seen 35% faster supply chains as compared to others using outdated methods like Excel sheets. By keeping the inventory level in check, businesses can track their inventories across multiple locations and prevent stockouts or excess stocks.
- Prevent dead stock
With proper inventory management, you can easily identify your dead stock – stock that is being discontinued or out of season. This prevents you from ordering stock that is no longer in demand, and you can also put sales on the stock that is sitting in your storage space, eating your profits for more than six months or so. With proper demand forecasting, your business can save a lot of capital that could be used for other purposes.
- Increase inventory turnover
Focus on high-turnover items and reduce slow-moving stock. Higher turnover rates mean inventory spends less time in storage, directly reducing holding costs.
- Choosing the right warehouse
Choosing the right warehouse for storage purposes is more important than it sounds. Based on your business, you have to choose a cost-effective warehouse, reduces per-unit costs and fulfills your maximum needs without the need to outsource a lot.
Choose a warehouse whose layout matches your inventory model. This will make it easy for the staff to streamline the fulfillment process with minimum manual errors. The warehouse should also be adaptable to changing demands and inventory models (if needed).
- Automate your inventory management
Having an inventory management system is important because it allows you to optimize your supply chains. 79% of businesses with high-performing supply chains are more profitable than average businesses in that same industry.
By getting real-time insights into stock levels, you can automate your fulfillment process and reduce human errors. With a quick eye on every little detail, you can choose to manage demand and inventory, which ultimately reduces your inventory costs because you are making smart decisions based on factual data. No extra inventory, no stockouts, no longer lead time and fulfillment cycles, and minimum manual error – all because you chose to automate your management process.
- Adopt Just-In-Time (JIT) Model
By using the JIT (Just In Time) model, where you order inventory in smaller quantities, you can avoid both dead stock and overstocking. But this process is more complex than it sounds. You need to negotiate with suppliers for wholesale prices, even when ordering small amounts, to maintain a healthy profit margin. Many suppliers do not deal with small orders, so building a long-term relationship with them is key.
Conclusion
Using the holding cost formula correctly can help you avoid tying up capital in dead stock. Every item in your inventory consumes your capital. On average, the holding inventory comprises a total of 20-30% of your total inventory value. According to Unleashed, the average business holds $142,000 worth of excess stock; more than they actually need to maintain a healthy supply chain. This situation is not ideal for any business. So if you have dead stocks, eliminate them right away.
To build a successful business, choose the right tools (Like an inventory management system) that provide real-time insights into stock levels, prevent overstocking and stockouts, calculate your holding cost, reduce manual errors, and choose the right storage space.
FAQs
What is holding cost?
Holding cost, or carrying cost, represents all the costs associated with unsold inventory sitting in the warehouse.
How to calculate holding inventory cost?
By applying this formula, you can calculate the average holding inventory cost associated with unsold stored stock: Holding Cost Percentage = (Inventory Holding Sum / Total Value of Inventory) × 100.
What’s the difference between holding costs and carrying costs?
These terms are commonly mixed up. Both relate to the costs of keeping unsold products, but businesses might calculate holding costs differently. Make sure your team is clear on what counts as holding costs for better financial planning.
How do holding costs affect cash flow?
Holding inventory uses up cash that could be spent on other areas of your business. For instance, if you add ₹10,000 worth of products to your inventory, you’ll have less cash available for day-to-day operations and will also incur higher storage costs.
What’s a typical holding cost percentage?
Holding costs for businesses usually range from 20% to 30% of their inventory value each year, though this can differ by industry. For specialized or perishable products, these costs can be even higher.
