Inventory Management Review: Inventory Holding Costs Quantified

September 15, 2005

Inventory Holding Costs Quantified

I have been receiving a lot of inquiries regarding the specifics of calculating holding costs. By and large, you can read about what drives holding costs in my article A Simplified Look at the Pros and Cons of Inventory. This article is intended to provide greater detail regarding the quantification of holding costs. The first section is going to discuss rough estimates and the second section will discuss methods involved with detailed holding cost analysis.

Rough Estimatations

Typically, holding costs are estimated to cost approximately 15-35% of the material's actual value per year. The primary factors that drive this up include additional rent needed, great insurance premiums to protect inventory,opportunity costs, and the cost of capital to finance inventory.

A More Detailed Look at Holding Costs

First of all, it is generally best to think of holding costs in terms of their annual costs. To do this, you will need accurate representations of your annual inventory levels. My previous article, Average Inventory Levels, details this step by step. Personally, I suggest tracking inventory month by month and using these values to find the average holding cost as opposed to taking the year's beginning, the year's end and averaging the two.

So now you have your average inventory. This needs to be performed for finished goods, work in process, and raw materials inventory.

Now, you need to figure out what percentage of the total value of the good is being incurred as a holding cost. Cost of capital and opportunity costs should be the first things you think of. If you are financing the goods with a 10%/year loan then the holding costs are at least 10% annually. When you are evaluating the total value, include the value of any labor that has been added to the goods.

Next step would be to consider the cost of storage. Based on the inventory you need to carry, how much space do you need and how much does that space cost per unit as a percentage of each good.

Again, determine the insurance cost that should be allocated to each good as a percentage of that good.

Evaluate the probability that a good will rot, or otherwise become obsolete and assess the average rate at which this occurs and use this to quantify the average holding cost per good as a percentage of that good on an annual basis.

Determine if there are any other costs you can think of that are incurred simply by being in possession of a good. If you can think of any, treat them as holding costs.

Add up all of these percentages and together they make your holding costs.

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September 15, 2005 in Inventory Basics | Permalink

Comments

Do you email your weekly editions?

Posted by: Lynette | Mar 2, 2006 1:31:42 AM

Lynette,

My weekly additions are generally posted on this site. I am currently between computers so postings will be limited for a few weeks. I will return with more material soon.

Thank you,
Charles Atkinson

Posted by: Charles Atkinson | Mar 4, 2006 12:59:05 AM