Definition: Holding costs are the additional costs involved in storing and maintaining a piece of inventory over the course of a year. Holding costs are computed in the economic order quantity calculation that businesses use in order to decide the optimal time to order new inventory.
What Does Holding Cost Mean?
Contents
The holding costs concept is pretty simple. Businesses have to store inventory that isn’t in use or on the showroom floor. So if a company orders too much of a product, the extra inventory has to be put in the back warehouse until it can be put out on the shelves for customers to buy.
Not only do businesses have to pay for the warehouse storage space, but they also have to pay for security, insurance, and protection of the inventory. For instance, the warehouse could be broken into or, even worse, employees could steal inventory from a disorganized storage room. All of these costs are considered holding costs.
Components of Holding Costs
Storage Costs: The most apparent holding costs are those related to the physical storage of inventory. This includes warehousing fees, utilities, security, and other operational costs necessary to maintain the inventory in sellable condition.
Capital Costs: Inventory represents tied-up capital that could otherwise be used for investment opportunities. The cost of capital encompasses the interest on this tied-up capital and the opportunity costs of not investing this capital elsewhere.
Service Costs: Holding inventory also incurs service costs, such as insurance premiums to protect against loss, damage, or theft, and taxes related to inventory storage.
Risk Costs: Inventory carries inherent risks, including obsolescence, shrinkage due to theft or loss, and depreciation in value. These risks translate into costs that businesses must manage effectively.
Example
Holding costs are the true cost of ordering too much inventory. That is why inventory turnover and economic order quantity calculations are so important. Companies should strive to only order enough inventory for 90 days. Inventory that sits around in storage for longer than 90 days creates added holding costs that are unnecessary.
Large quantity discounts can be negated by hidden holding costs. That is why companies need to carefully plan what inventory to buy and how frequently to buy it. Buying inventory is a tightrope walk between incurring additional holding costs and foregoing large quantity, purchase discounts.
Calculating Holding Costs
To calculate total holding costs, businesses must sum up the individual components. For example, if a company incurs $10,000 in storage costs, $5,000 in capital costs, $2,000 in service costs, and $3,000 in risk costs annually, the total holding cost would be $20,000.
This calculation helps businesses understand the financial impact of inventory management decisions.
Impact of Holding Costs on Financial Statements
Holding costs directly affect a company’s balance sheet and income statement. They influence the cost of goods sold (COGS) and, consequently, the net income. High holding costs can reduce the net income, signaling inefficiencies in inventory management.
Managerial accountants must keep a keen eye on reducing holding costs throughout the year in order to make sure the company isn’t wasting its resources needlessly.
Strategies for Reducing Holding Costs
Inventory Management Techniques: Implementing strategies like Just-In-Time (JIT) inventory can significantly reduce holding costs by aligning inventory orders closely with production schedules and customer demand.
Technology and Automation: Modern inventory management software can forecast demand more accurately, reducing excess inventory and associated holding costs.
Supplier Relationships and Logistics: Negotiating better terms with suppliers and optimizing logistics can lower procurement and transportation costs, thereby reducing overall holding costs.
Case Studies
Companies like Toyota have successfully implemented JIT inventory systems, significantly reducing their holding costs and increasing efficiency. Such real-world examples provide valuable insights into effective inventory management practices.
Bottom Line
Understanding and managing holding costs is vital for businesses to maintain a healthy balance between having sufficient inventory to meet demand and minimizing the costs associated with storing that inventory. By carefully analyzing and strategizing around holding costs, companies can enhance their operational efficiency and profitability, striking the right balance for their specific market and operational conditions.
