Holding costs are those associated with storing inventory that remains unsold. These costs form one component of the total inventory costs, joined by ordering and shortage costs.
A firm’s holding costs include the price of goods damaged or spoiled, as well as the cost of storage space, labor, and insurance.
Key Takeaways
- Holding costs are costs associated with storing unsold inventory.
- A firm’s holding costs include storage space, labor, and insurance, as well as the price of damaged or spoiled goods.
- Minimizing inventory costs is an important supply-chain management strategy.
- Strategies to avoid holding costs include quick payment collection and calculating accurate reorder points.
Understanding Holding Costs
Minimizing inventory costs is a crucial supply-chain management strategy. Inventory is an asset account that requires a large amount of cash outlay, and decisions about inventory spending can reduce the amount of cash available for other purposes.
For instance, increasing the inventory balance by $10,000 means that less cash is available to operate the business each month. This scenario is known as an opportunity cost.
Inspirational Example of Holding Costs
Imagine ABC Manufacturing produces furniture stored in a warehouse before being shipped to retailers. ABC must either lease or purchase warehouse space and pay for utilities, insurance, and security for the location.
The company must also pay staff to move inventory into the warehouse and then load the sold merchandise onto trucks for shipping. Additionally, the firm incurs some risk that the furniture may be damaged when moving in and out of the warehouse.
Holding Cost Reduction Methods
One effective method to ensure a company has sufficient cash to run its operations is to sell inventory and collect payments quickly. The sooner cash is collected from customers, the less total cash the firm must generate to continue operations. Businesses measure the frequency of cash collections using the inventory turnover ratio, which is calculated as the cost of goods sold (COGS) divided by average inventory.
For example, a company with $1 million in COGS and an inventory balance of $200,000 has a turnover ratio of five. The goal is to increase sales and reduce the required amount of inventory so that the turnover ratio improves.
Another critical strategy to minimize holding costs involves calculating a reorder point, or the inventory level that triggers a reorder from a supplier. An accurate reorder point enables the firm to meet customer orders without overspending on inventory storage. Companies that implement a reorder point efficiently can avert shortage costs and avoid missing out on customer orders due to low inventory levels.
The reorder point factors in the time taken to receive an order from a supplier and the weekly or monthly level of product sales. It also aids in determining the economic order quantity (EOQ), which is the ideal amount of inventory to order from a supplier at any given time. EOQ can be precisely calculated using inventory software.
Related Terms: inventory management, cost reduction techniques, supply chain optimization.
