Inventory Holding Cost — Definition

Inventory Holding Cost - Definition

Inventory Holding Cost : no inventory, no costs?

If you have no inven­to­ry, you have no costs. Con­verse­ly, the more you increase your inven­to­ry, the more your car­ry­ing cost will increase. 

As you can see, inven­to­ry car­ry­ing costs are the costs asso­ci­at­ed with stor­ing and main­tain­ing inven­to­ry for a cer­tain peri­od of time. 

Gen­er­al­ly, they are defined as a per­cent­age of the val­ue of the inven­to­ry and they vary great­ly depend­ing on the field of activ­i­ty of the com­pa­nies. It is com­mon­ly accept­ed that stor­age costs rep­re­sent up to 25% of the val­ue of the avail­able stock. 

Stock definition

Stock is any item or prod­uct held by a com­pa­ny, which is the result of the dif­fer­ence between the inflow of items and their outflow. 

  The out­put flow cor­re­sponds to the con­sump­tion of cus­tomers for fin­ished prod­ucts and the con­sump­tion by pro­duc­tion for raw mate­ri­als. The orders and/or fore­casts will define the stock require­ments to meet the cus­tomer’s demand in time, qual­i­ty and quan­ti­ty. This flow cor­re­sponds to the orders is not “con­trol­lable” by the com­pa­ny. It can fluc­tu­ate sig­nif­i­cant­ly from month to month. The input flow cor­re­sponds to the orders placed by the pro­cure­ment and inven­to­ry man­age­ment teams. This is the only flow that any com­pa­ny can real­ly con­trol.

The com­pa­ny there­fore has only one lever to reg­u­late its stock. Indeed, if it con­trols the incom­ing flow cor­rect­ly, it avoids the risk of cre­at­ing either over­stock or stock-outs. 

About the need to have a stock ?

The exis­tence of the stock could be sum­ma­rized as fol­lows: the fact that the com­pa­ny wants to sat­is­fy the cus­tomer demand. 

Thus, the stock allows the com­pa­ny to con­tin­ue to sat­is­fy cus­tomer demand even if there is a gap between the incom­ing flow (sup­plies) and the out­go­ing flow (cus­tomer orders). Indeed, it can often be seen that the time to obtain mate­ri­als and pro­duc­tion is greater than the time to process the cus­tomer’s order. But that’s not the only rea­son why a com­pa­ny builds up inventory. 

Stocks and functions

  • Reg­u­la­tion: stocks allow the smooth­ing of irreg­u­lar­i­ties in sup­ply and/or pro­duc­tion, reduce the risk of stock-outs and help main­tain a con­tin­u­ous activity

  • Logis­tics: the stocks allow to keep the arti­cles close to their place of con­sump­tion. They sig­nif­i­cant­ly reduce wait­ing times

  • Eco­nom­ic func­tion : when the sup­pli­er grants impor­tant dis­counts for large quan­ti­ty pur­chas­es, stor­age can be use­ful. In the same way, in order to opti­mize sup­plies, the con­sti­tu­tion of a stock is gen­er­al­ly an appro­pri­ate solution

  • Antic­i­pa­tion: stor­age allows to man­age price increas­es of mate­ri­als or prod­ucts bought or sold. These are sea­son­al stocks

  • The tech­nique: the stock can be linked to a process con­straint before the con­sump­tion of the arti­cles. This is the case for the dry­ing of wood, the ripen­ing of fruits and veg­eta­bles, the fer­men­ta­tion of wines…

The prob­lem of over­stock is pri­mar­i­ly finan­cial. All inven­to­ry costs the company.

Inventory Holding Cost

Most logis­ti­cians and busi­ness lead­ers agree that inven­to­ry costs, but few know the details of their own stor­age costs. 

It is esti­mat­ed that the inven­to­ry costs between 15 and 35% of its val­ue per year. This per­cent­age, called the “Pos­ses­sion Rate” is a quick way to give an overview of the finan­cial bur­den of an inventory. 

  In the­o­ry this esti­mate is suf­fi­cient, but in prac­tice this pos­ses­sion rate can­not be used alone. In effect, it makes the cost vary lin­ear­ly with the quan­ti­ty of items in stock. How­ev­er, the cost of own­er­ship can vary in steps and not linearly. 

  For exam­ple, if you need to build a new ware­house or bring in a new con­trac­tor (3PL) to increase your stor­age capac­i­ty, you will have to make an invest­ment that will affect your over­all inven­to­ry costs, see below the stor­age costs. 

This cost is composed of 3 elements

  • Finan­cial costs: own­ing stock means advanc­ing mon­ey until the fin­ished prod­uct is sold. In addi­tion, some com­pa­nies bor­row to finance their inven­to­ry, which results in addi­tion­al costs
  • Ware­hous­ing costs”: this item cov­ers all costs relat­ed to stor­age. We will find the salaries of the store­keep­ers, the carts main­te­nance costs, the build­ing or insur­ance cost, the infor­ma­tion sys­tem cost …
  • “Depre­ci­a­tion costs”: these costs rep­re­sent expens­es relat­ed to changes in inven­to­ry over a period.
All of these expens­es rep­re­sent the direct and indi­rect costs of a stock to the company.

It is impor­tant to mon­i­tor this ele­ment as well as the logis­tics per­for­mance indi­ca­tors because they are a good way to eval­u­ate the impact of the inven­to­ry man­age­ment pol­i­cy on the com­pa­ny’s finances. 

  The cal­cu­la­tion of inven­to­ry car­ry­ing costs on Chris­t­ian Hohman­n’s blog






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