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Inventory Holding Costs Explained: Definition, Formula & How To Improve聽
In an emerging聽DTC trend, retailers are strategically (if you want to call it that) overstocking on 鈥渟afety stock鈥澛� to get ahead of supply chain delays and lock-in prices.
But with the market in flux (and at risk of聽economic downturn), odds are good that this inventory will take longer than usual to move. This will only increase brands鈥� holding costs.
Here鈥檚 why that鈥檚 such a massive problem: High inventory holding costs throttle a brand鈥檚 cash flow, putting its financial health at risk and potentially pushing it out of business.
An economic slowdown would only expedite these consequences.
In 2021 (during the pandemic鈥檚 peak),聽聽was the #1 reason brands went out of business. Similarly, the 2007 recession聽.
Meaning, overstocking right now 鈥� and the rising inventory holding cost that comes with the strategy 鈥� could leave smaller brands with their worst burn yet.
But what exactly are inventory holding costs? Why is it important to track this metric? And most importantly, how can brands calculate their holding costs? Let鈥檚 find out.
Inventory holding costs, or inventory carrying costs are all expenses associated with storing unsold inventory. This includes storage costs, labor, insurance, taxes, depreciation, and shrinkage.
It鈥檚 calculated as a percentage of your total inventory value, and most retail brands (depending on their industry and products) want carrying costs to hover around 15-30%.
For many direct-to-consumer brands, inventory holding cost is a major聽inventory management听肠丑补濒濒别苍驳别.
Why? Because the longer inventory sits, the more these costs add up and subtract from the brand鈥檚 bottom line.
But when brands keep inventory costs low, they improve profit margins and increase profitably. That starts by knowing what your inventory holding costs are in the first place.
To calculate your inventory holding costs, use the carrying costs formula:
| inventory holding cost = total inventory costs / total inventory value x 100 |
Start by adding up all your total inventory costs, including:
You can also include any other expenses unique to your inventory cost. For example, if you store cold goods, you must have service costs to keep them refrigerated.
Then, divide that sum by the total value of your inventory.
To determine your聽total inventory value聽for the increment you鈥檙e measuring, total your average inventory value from the same time frame you used to calculate your total cost of inventory.
You can do this by dividing the average number of units on hand by the number of units sold:
| total inventory value = number of units sold / average number of units on hand |
Lastly, when you鈥檝e divided your total inventory costs by total inventory value, multiple that number by 100. That is your inventory holding costs, represented as a percentage.
Polished Pups sells fashion-forward pet collars to their customers, and they鈥檝e noticed a few inventory items aren鈥檛 moving.
So, they decide to calculate their annual inventory holding cost to see how much these slow-moving products cost them.
First, they outline all of their inventory expenses:
After adding up all these expenses, the pet-collar brand has $50,000 in total inventory costs. Then, they calculate their total inventory value at $250,000.
According to the inventory holding formula, the pet-collar brand spends approximately 20% of its total inventory value on carrying costs, which is within the ideal 15-30% range.
inventory holding cost = ($50k in total costs) / $250k total inventory value x 100 = 20%
By tracking your inventory holding costs, you can take proactive measures to free up working capital, increase profitability, and maintain聽optimal inventory levels.
You can鈥檛 spend money that鈥檚 already invested in inventory (AKA, tied up) 鈥� even if that investment will eventually come back to you.
But you can free up working capital by regularly reducing your inventory holding costs. How? By only ordering the stock you have demand for.
This simple change can聽untie working capital, which you can then use to grow your brand (like by investing in聽new product launches聽or doubling down on your marketing efforts).
The longer you carry inventory, the more that stock costs you. Period.
So, when carrying costs go unchecked, it can lower a brand鈥檚 profitability by increasing your聽cost of goods sold (COGS).
But by tracking your inventory holding costs, you can see what products cost you more than expected.
Then, you can run marketing campaigns to聽increase demand聽for those products, so you keep carrying costs down and subsequently increases revenue.
High holding costs are a quick way to check if you鈥檙e overstocked. The higher your holding costs, the more聽excess inventory聽you鈥檙e carrying.
With this information, brands can be more strategic about maintaining聽optimal stock levels.
For instance, you might create聽product bundles to increase your inventory turnover before these items turn into dead stock.
Or, you might double down on your forecasting efforts to ensure you鈥檙e only ordering enough inventory to avoid stockouts.
On average, US retailers are sitting on聽for every dollar they generate. Meaning, the cost of capital (or the expected return on the company鈥檚 initial inventory investment) isn鈥檛 worth it.
Luckily, knowing your inventory holding cost is the first step toward improving this聽inventory management KPI. (After all, you can鈥檛 fix what you don鈥檛 know is wrong.)
Then, brands can reduce inventory holding costs (and free up capital) by calculating optimal quantity, forecasting demand trends, and more.
When brands calculate their economic order quantity (EOQ), they only order the most cost-effective amount of inventory to meet demand.
This minimizes the stock brands have on hand (along with related expenses) since they only reorder units that actually sell and reduce how long these items sit in storage.
Some brands calculate this manually using the economic order quantity (EOQ) formula:
| optimal order quantity = 鈭� ([(2DO) / H]) |
Note that in this equation:
The challenge is that this method is prone to human error and is time-consuming.
That鈥檚 because brands need to constantly recalculate this metric every time they place a聽purchase order聽(since the variables within the formula change all the time).
Alternatively, 吃瓜黑料 runs this calculation in real-time, so you always have the most up-to-date data.
Then, the inventory management software alternative uses that information to build an聽optimal PO聽and calculate the ideal reorder point.
That way, you always reorder inventory in time to avoid a stockout.
Brands that聽accurately forecast demand trends聽are better positioned to avoid overstocking.
How so? Because with this information, you can strategically purchase the right amount of inventory (nothing more, nothing less).
This prevents you from investing too much capital in stock that won鈥檛 sell. And since you鈥檝e purchased the right amount of inventory to聽meet customer demand, you eliminate items sitting in storage, racking up holding costs.
Brands can implement trend forecasting by manually聽forecasting inventory with Excel. But again, this is time-consuming.
Or, a tool like 吃瓜黑料 can accurately predict this demand for you, using your historical sales data and聽real-time inventory听迟谤别苍诲蝉.
However you go about it, you can then use those forecasts to proactively place optimized POs that consider factors like聽order lead time听补苍诲听seasonality.
Having your best SKUs in stock (at all times) is best practice. But keeping your inventory holding costs down typically means running lean operations, which could lead to more stockouts.
Rather than overstocking to overcompensate, it鈥檚 important to have a backup plan when these stockouts occur. Enter聽selling on backorder.
Selling on backorder takes some pressure off of always needing to stay in stock by ensuring you can still generate revenue, even when you鈥檙e out of stock.
(Alternatively, brands that don鈥檛 sell on backorder drive聽聽to buy from a competitor.)
Brands can easily set up聽backordering聽with 吃瓜黑料 to ensure customers can still purchase sold-out products when they want them.
Plus, the ops optimization tool automatically populates the next shipping date based on when your next replenishment arrives at your warehouse.
Storage fees are the 2nd-largest portion of holding costs (besides the initial capital investment). And right now, the cost of outsourcing your inventory storage is rising.
The average warehouse space service fee is聽聽(compared to $6.53 in 2017).
Brands that manage their own warehousing can try reimagining their storage layout. Sometimes, it just takes a bit of ingenuity and Tetris-like skills to make more room for inventory.
Meanwhile, brands that use a 3rd-party logistics provider should work with their 3PL to make this happen or pair down their inventory to save on overall space needed.
You can always shop for other 3PL to find the most competitive warehouse partner. Just remember to calculate the cost to move your inventory and if that鈥檚 worth it.
Sometimes it鈥檚 your聽minimum order quantities (MOQ)聽that鈥檚 leaving you overstocked.
When this is the case, try聽negotiating better vendor contract terms. Ideally, terms that lower your MOQ (but most suppliers won鈥檛 go for this one) or create an alternative arrangement that works to your advantage.
But make sure you share your operational plans for the next 12 months or so as part of your negotiation tactics (吃瓜黑料 can help build this聽operational plan聽for you).
That way, vendors are more willing to work with you if it means they can retail that business.
For instance, by sharing your operational plans, your supplier might be willing to hold onto part of the production run.
So, let鈥檚 say your MOQ is 5,000 units, and you only need 1,000 units per month. Your vendor could hold onto the extra 4,000 units and send you 1,000 replenishment units at a time until you need a new production run.
This means the vendor is absorbing some of the holding costs 鈥� not your brand.
And while you might pay a little more per unit for this amenity, the holding costs should be less than carrying this inventory yourself (especially if you use an international supplier).
So, it鈥檚 worth paying a few extra cents per unit to hold them overseas versus several dollars domestically.
Does this really work? Sure does 鈥撀�Lalo, a leading retailer in the baby and toddler space, reduced its vendor down payments by 50% by doing this with 吃瓜黑料.
And by freeing up that capital, Lalo鈥檚 been able to experiment with new growth initiatives (like opening up聽) and unlock 400% year-over-year growth.
But why not see for yourself?
Inventory holding cost is the sum of all inventory expenses, including storage space costs, labor expenses, opportunity costs, depreciation, shrinkage, and obsolescence.
The average inventory holding cost depends on your brand鈥檚 industry and products. But generally, retail brands want inventory holding costs to be 15-30% of their total inventory value.
Inventory holding cost is important because it shows brands how long they can hold inventory before those items are no longer profitable. It also helps brands maintain optimal inventory levels by knowing how much they need to buy and sell to meet demand without overstocking. Both of these strategies eliminate costs, free-up capital, and increase revenue.
Inventory holding cost increases the longer items sit in storage. Luckily, when brands regularly track their inventory holding cost, they can proactively get rid of slow-moving products before they turn into dead stock.
Holding costs and carrying costs are synonymous terms for describing the inventory expenses related to storing unsold items.
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