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Page Title- What Are Holding Costs? Definition, How They Work, and Example

Holding costs are an important part of inventory management because they provide valuable insight into the financial effects of holding products. In this detailed guide, we'll understand inventory-holding cost formulas, why they're important, how to calculate them, and real-world examples to show how they work.

This guide will provide useful information for improving inventory management techniques, whether you're looking to understand inventory holding costs, calculate them efficiently, or differentiate between carrying and holding costs.

What Is Holding Cost?

Holding costs are the expenses involved when merchandise remains unsold. These costs make up a percentage of the overall cost of the inventory. The cost of damaged or spoiled goods and storage space, labor, and insurance are all included in a company's holding expenses. Here are further details of what is included in inventory holding costs:

• When a business keeps unsold inventory in storage, it adds to holding charges.
• When a product is ruined or damaged, the price of that is included in a company's holding expenses.
• Labor, insurance, and storage charges.

Understanding Holding Costs

The main part of understanding holding costs includes best practices to reduce them. Reducing inventory expenses is a smart move in supply-chain management. Inventory ties up a lot of money, and how you handle it can affect your cash flow for other needs. For example, if you add Rs.10,000 worth of goods to your inventory, you'll have less cash available for day-to-day business, and it will also increase your inventory holding.

Holding Costs Example

Assume AB Manufacturing creates furniture that is sent to retailers after being kept in a warehouse. In addition to paying for utilities, insurance, and security for the facility, AB must either rent or buy warehouse space.

Additionally, the business must pay employees to transfer inventory into the warehouse and load the sold goods onto trucks for transportation. When moving furniture in and out of the warehouse, there is a small risk of physical damage.

Therefore, all these expenses associated with storing inventory in a warehouse until it is sold or used indicate holding costs.

How to Calculate Inventory Holding Costs?

There are many ways to calculate holding costs. Following are a few of those:

1. Simple storage costs

The simplest definition of inventory holding costs is that they are just the cost of holding inventory or storing it. Although this is oversimplified and doesn't fully describe the situation, it offers retailers a helpful place to start and may give them fresh ideas about inventory costs.

Example

In one situation, a company outsources its storage needs to a third-party logistics provider and pays a price for each bin, shelf, and pallet utilized to hold its products. These storage expenses would be considered inventory holding costs.

In another situation, a different company manages its warehousing and covers costs, including rent, utilities, insurance, security, labor, and racking infrastructure. These charges would be considered a part of the inventory holding costs in this situation.

However, determining holding costs in the second situation is more difficult; for example, if just a portion of a warehouse is used for storage (and the remainder is used for offices, break rooms, etc.), rent for that portion of the warehouse would not be included in the holding costs.

2. Detailed holding costs

For a more thorough calculation of inventory holding costs, you can use a formula that considers opportunity, employee, storage, and depreciation expenses. Here, we have explained the same formula that shows the detailed way of calculating holding costs:

The inventory holding cost formula is combined and stated as a percentage of the total value of your inventory:

Inventory Holding Cost = (Storage costs + Employee salaries + Opportunity costs + Depreciation costs) / Annual Inventory Value. Below we have defined each component of this formula:

• Storage costs cover all the expenses tied to physically storing your inventory, like rent for your storage space, utility bills, and insurance.
• Employee costs mainly involve paying the salaries or wages of the folks in your warehouse. They're the ones who look after the place, keep an eye on inventory, and make sure orders get filled.
• Opportunity costs are a bit abstract. They're about the price you pay for hanging onto stuff that doesn't sell well, instead of investing in stuff that makes you more money.
• Depreciation costs are also a bit tricky to see. It's about how the value of your inventory naturally goes down over time and how some products become outdated.

Lastly, you need to add these subtotals and divide that total by how much your whole inventory is worth in a year. The result, when turned into a percentage, is your inventory holding cost.

Example

An electrical manufacturer produces light bulbs, switches, and wires. They had 100 of each item last year, so 300 items in total. They want to know how much it costs them to keep these items for a year.

From their records:

• Total value of items: Rs. 100,000
• Cost for storage (like rent and utilities): Rs. 20,000
• Employee salaries: Rs. 30,000

They also want to know if they lost any money by not selling more of the popular items. They sold all items and earned Rs. 100,000. But they could have earned Rs. 115,000 if they had more wires and fewer switches. So, they lost Rs. 15,000 by not doing that.

Next, they looked at how much the value of their items decreased over time. They spent Rs. 40,000 to get the items, and after two years, they could sell them for Rs. 20,000. So, the value decreased by Rs. 10,000 in a year.

To find out the total cost of keeping the items, they added all these costs and divided by the total value of the items:

Total cost = (Storage + Salaries + Lost money + Decreased value) / Total value = (Rs. 20,000 + Rs. 30,000 + Rs. 15,000 + Rs. 10,000) / Rs. 100,000 Now, to calculate the total cost percentage of keeping the items for a year:

Add up all the costs:

• Storage: Rs. 20,000
• Salaries: Rs. 30,000
• Lost sales: Rs. 15,000
• Depreciation: Rs. 10,000
• Total = Rs. 75,000

divide the total costs by the total value of the items: (Rs. 75,000 / Rs. 100,000) x 100 = 75%

So, the cost of keeping the inventory for a year was 75% of the item's total value. This is quite high, as typically, the cost should be only 20-30% of the inventory's value.

With this in mind, the manufacturer should consider measures to reduce their inventory holding costs, such as improving demand forecasts, reducing the space needed for extra warehousing, or outsourcing inventory management to a third party.

Where Do We Encounter Inventory Holding Costs?

Inventory holding costs contribute to the supply chain management system, affecting businesses across various industries. These costs cover the expenses associated with storing and maintaining inventory until it is sold or used in production. Understanding where we encounter inventory holding costs is necessary for businesses seeking to improve their operations and increase profits.

Here are 3 typical storage options where you can encounter holding costs:

Warehouses

Business owners can rent, own, or construct warehouses, which have huge storage areas (usually at least 1,000 square feet) to keep their merchandise. If you want a warehouse with specialized features like temperature control, it will raise your holding costs depending on the inventory you keep in storage.

Storage Units or Facilities

You can rent or buy short-term storage lockers to retain goods when your home is no longer big enough to fit your goods. Individual storage containers or units in a specialized storage facility are excellent solutions for businesses growing quickly or transitioning, even though they are normally much smaller than warehouses.

Fulfillment Centers

Third-party logistics (3PL) companies or expert logistics service providers actively fill orders for the companies they work with in fulfillment centers, which are real-world facilities.

It's necessary to understand that a fulfillment center is quite different from an on-demand warehousing service or a marketplace that connects companies in need of short-term storage with vacant, available warehouse space.

Instead, a single operator oversees fulfillment centers, which pick, pack, and ship customers' orders the same way (even across various locations using the same technology, processes, SLAs, and support) in addition to storing a company's inventory for them.

How Much Are Holding Costs on an Average?

Typically, holding costs account for 20% to 30% of a company's overall inventory cost, with the remaining 70% to 80% being the cost of goods sold and ordering expenses. Holding costs can vary greatly based on many variables, including:

• The warehouse's location (including whether it is in a city or a rural area)
• The size of the goods being housed (storing large or even heavy items may be more expensive than storing small items)
• Your SKU (stock keeping unit) count (the more things you sell, the more storage you'll need, and the more expensive it will be)
• The volume of inventory you must store (whether a year's worth or a month's worth)
• How quickly the product is sold or rotated
• What kind of orders do you receive (DTC (direct to customer) orders that require few units per order or B2B (business-to-business) orders requiring multi-tier inventory storage)
• Whether the facility offers only storage services or additional services at a premium

Holding Cost Reduction Methods

Holding Inventory cost reduction is a crucial supply-chain management tactic. Quick payment collection and accurate reorder point calculation are two tactics to reduce holding costs, but below are some other common practices you should consider:

1. Keep the Right Amount of Goods

Having too much of one thing can cost you a lot and hurt your profit. You must have enough goods to meet demand and some extra for sudden demand fluctuation, but not so much that it becomes useless. To avoid this, calculate how much you need as a safety stock when to reorder, and what's selling best.

2. Say Goodbye to Useless Stuff

If you've got goods that nobody wants, get rid of them. You can sell it cheap, bundle it with popular products, or even give it away. Donating it to charity can also help you save on taxes.

3. Keep Inventory Turnover in Check

Don't let the items sit around too long. Buy smaller amounts more often to keep things moving. If things aren't selling, offer deals to get them moving and sold out quickly.

4. Use Space Wisely

Organize your space smartly to save on rent. Look into different storage options and layouts. Keep things organized to make employees' lives easier in the warehouse.

5. Go for Warehouse Automation

Automation can stop you from forgetting important stuff. It can also make things run smoother. Think about getting warehouse management tools that remind you to reorder and track your goods.

6. Get an Inventory Management Solution

Sometimes it's better to use inventory management solutions to handle and track your stuff. A logistics and inventory solution provider can save you time and money.

Managing Holding Costs With TranZact

Businesses must understand and manage holding costs. TranZact will assist you in carefully analyzing variables, including storage space, turnover rates, and ordering techniques, to lower these expenses.

When calculating and managing these costs while considering other options, such as lean inventory management, the holding cost formula is helpful. TranZact offers inventory management software, providing efficient inventory management.

FAQs on Holding Costs

1. Are carrying costs and holding costs the same?

No, carrying cost vs holding cost are different. The holding cost is A part of the carrying cost. Carrying cost refers to all costs related to retaining inventory, including holding costs, finance, and opportunity costs. But holding costs only include costs like storage and labor.

2. How do holding costs work?

The costs associated with holding inventory, such as storage space, labor, and insurance, are included in holding costs. As long as inventory is maintained, these expenses add up and affect a company's profitability. Effective inventory management minimizes holding costs by controlling inventory levels and cutting associated expenses.

3. Is the holding cost a fixed cost?

Holding costs are often described as variable costs since they can change depending on the quantity of inventory, how long it is stored, and certain expenses. Even though some holding costs may remain fairly steady, they are typically not fixed and are subject to fluctuation depending on the situation.