Last updated on Jan 6, 2024
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Basic formula
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Variable and fixed costs
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Economic order quantity
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Safety stock
5
Inventory turnover ratio
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Here’s what else to consider
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Holding costs are the expenses associated with storing and maintaining inventory over a certain period of time. They can include rent, utilities, insurance, taxes, depreciation, obsolescence, spoilage, and opportunity costs. Calculating holding costs accurately is essential for inventory management, as it helps you optimize your inventory turnover and minimize your total cost of ownership. In this article, you will learn about the most effective ways to calculate holding costs for different types of inventory and scenarios.
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- Anish Kumar, MS, MCIPS Chartered Head of Procurement at University of Sharjah 5
- Amin Alirezaee Supply Chain Planner @ ELDORA | Supply Chain, Data Science, Strategy |Podcaster 3
- Hervé Lilima Osalek Spart Parts Inventory Manager chez CFAO RDC 1
1 Basic formula
The basic formula for calculating holding costs is to multiply the average inventory value by the holding cost percentage. The average inventory value is the sum of the beginning and ending inventory values divided by two. The holding cost percentage is the annual rate of the holding costs as a proportion of the inventory value. For example, if your average inventory value is $100,000 and your holding cost percentage is 25%, your holding cost is $25,000.
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- Amin Alirezaee Supply Chain Planner @ ELDORA | Supply Chain, Data Science, Strategy |Podcaster
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Calculating holding costs involves considering various factors. Start by determining the cost of capital, including interest rates and financing expenses. Factor in storage costs, such as rent, utilities, and insurance. Analyze inventory carrying costs, which encompass obsolescence, shrinkage, and deterioration. Consider handling costs related to labor and equipment. Calculate the opportunity cost of tying up capital in inventory instead of investing elsewhere. Regularly review and adjust these parameters to reflect changes in the business environment. Employing accurate data and a comprehensive approach ensures a more precise calculation of holding costs in the supply chain.
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2 Variable and fixed costs
However, the basic formula may not capture the full picture of your holding costs, as some costs may vary depending on the quantity and type of inventory you have, while others may be fixed regardless of your inventory level. Variable costs are those that increase or decrease with your inventory volume, such as storage space, handling, and spoilage. Fixed costs are those that remain constant regardless of your inventory volume, such as insurance, taxes, and depreciation. To calculate your holding costs more accurately, you need to separate your variable and fixed costs and apply different rates to your average inventory value. For example, if your variable cost rate is 15% and your fixed cost rate is 10%, your holding cost is $15,000 plus $10,000.
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3 Economic order quantity
Another way to calculate your holding costs more effectively is to use the economic order quantity (EOQ) model, which helps you determine the optimal order quantity that minimizes your total inventory costs, including holding costs and ordering costs. Ordering costs are the expenses associated with placing and receiving orders, such as shipping, processing, and inspection. The EOQ model assumes that your demand, holding cost percentage, and ordering cost are constant and known. The formula for EOQ is: EOQ = sqrt(2 x D x S / H) where D is the annual demand, S is the ordering cost per order, and H is the holding cost per unit per year. To calculate your holding costs using the EOQ model, you need to multiply the EOQ by the holding cost per unit per year and divide by two. For example, if your EOQ is 1,000 units, your holding cost per unit per year is $5, and your annual demand is 10,000 units, your holding cost is $2,500.
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- Anish Kumar, MS, MCIPS Chartered Head of Procurement at University of Sharjah
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In many modern inventory management, where JIT systems are prevalent, the EOQ model's focus on minimizing inventory might conflict with JIT principles aiming for leaner, just-in-time inventory levels. Recently, after the COVID-19, many organizations have also leaned into JIC (Just-in-case) approaches.
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4 Safety stock
Safety stock is the extra inventory that you keep to prevent stockouts due to unpredictable demand or supply fluctuations. Safety stock can increase your holding costs, as it occupies more storage space and incurs more risk of obsolescence or damage. However, safety stock can also reduce your ordering costs, as it reduces the frequency and urgency of ordering. To calculate your holding costs with safety stock, you need to add your safety stock level to your average inventory value and multiply by your holding cost percentage. For example, if your average inventory value is $100,000, your safety stock level is $20,000, and your holding cost percentage is 25%, your holding cost is $30,000.
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- Anish Kumar, MS, MCIPS Chartered Head of Procurement at University of Sharjah
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They say, having a Plan B makes you lose focus on the main plan which is to reduce inventory and working capital. There are lots of risks if safety stock is not managed well. Costs of obsolescence, complex inventory management practices and opportunity costs are just the tip of the iceberg.
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5 Inventory turnover ratio
The inventory turnover ratio is a measure of how efficiently you manage your inventory, as it shows how many times you sell and replace your inventory in a given period. A higher inventory turnover ratio means that you have less inventory on hand and lower holding costs. A lower inventory turnover ratio means that you have more inventory on hand and higher holding costs. The formula for inventory turnover ratio is: Inventory turnover ratio = Cost of goods sold / Average inventory value To calculate your holding costs using the inventory turnover ratio, you need to divide your annual holding cost percentage by your inventory turnover ratio. For example, if your cost of goods sold is $500,000, your average inventory value is $100,000, and your holding cost percentage is 25%, your inventory turnover ratio is 5 and your holding cost is $5,000.
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- Hervé Lilima Osalek Spart Parts Inventory Manager chez CFAO RDC
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Il est important de noter que le taux de rotation des stocks peut varier selon le secteur d'activité et la nature des produits vendus. Il est donc recommandé de comparer le taux de rotation des stocks avec d'autres entreprises similaires dans le même secteur pour obtenir une perspective plus précise.
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6 Here’s what else to consider
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