Struggling with cash flow? Inventory holding costs are likely in your way. Here's how to lower your carrying costs while increasing profitability.
In an emerging DTC trend, retailers are strategically (if you want to call it that) overstocking on “safety stock” to get ahead of supply chain delays and lock-in prices.
But with the market in flux (and at risk of economic downturn), odds are good that this inventory will take longer than usual to move. This will only increase brands' holding costs.
Here's why that's such a massive problem: High inventory holding costs throttle a brand's 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's peak), running out of capital was the #1 reason brands went out of business. Similarly, the 2007 recession claimed a whopping 170,000 companies. Meaning, overstocking right now — and the rising inventory holding cost that comes with the strategy — 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's find out.
What is inventory holding cost?
Inventory holding cost (AKA, inventory carrying cost) is the sum of all expenses associated with storing unsold inventory, including storage fees, labor, insurance, taxes, depreciation, and shrinkage. It's 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 inventory management challenge. Why? Because the longer inventory sits, the more these costs add up and subtract from the brand's 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.
How to calculate inventory holding cost
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:
- Capital costs: The costs for buying raw materials to manufacture products or investing in inventory, including any financing fees and taxes
- Warehouse costs: The expenses incurred for renting storage space for unsold inventory, including storage space, utilities, and insurance
- Employee costs: The costs associated with your warehouse personnel, including their salary, wages, and benefits (if you manage your own fulfillment)
- Opportunity costs: The intangible costs of storing inventory that’s unsellable instead of a hot-selling item or forgoing new opportunities since cash is tied up
- Depreciation costs: The intangible costs accrued as products lose value over time
- Inventory risk costs: Expenses, including shrinkage (inventory that's lost due to theft or damage before it's sold to customers) and product obsolescence
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 total inventory value for the increment you're 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've divided your total inventory costs by total inventory value, multiple that number by 100. That is your inventory holding costs, represented as a percentage.
Inventory holding cost calculation example
Polished Pups sells fashion-forward pet collars to their customers, and they've noticed a few inventory items aren't 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:
- Warehouse costs: $40,000 for renting space, including utilities and insurance
- Employee costs: included in the warehouse costs
- Opportunity costs: $5,000 for the lost opportunity of stocking better SKUs
- Depreciation costs: $3,000 for the cost of aging inventory
- Inventory risk costs: $2,000 for shrinkage and obsolete products
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%
Why you need to know your inventory holding costs
By tracking your inventory holding costs, you can take proactive measures to free up working capital, increase profitability, and maintain optimal inventory levels.
Free up working capital
You can't spend money that's already invested in inventory (AKA, tied up) – 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.
The longer you carry inventory, the more that stock costs you. Period.
So, when carrying costs go unchecked, it can lower a brand's profitability by increasing your 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 increase demand for those products, so you keep carrying costs down and subsequently increases revenue.
Maintain optimal inventory levels
High holding costs are a quick way to check if you're overstocked. The higher your holding costs, the more excess inventory you're carrying.
With this information, brands can be more strategic about maintaining optimal stock levels. For instance, you might create 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're only ordering enough inventory to avoid stockouts.
How to reduce inventory holding cost
On average, US retailers are sitting on $1.29 in inventory for every dollar they generate. Meaning, the cost of capital (or the expected return on the company’s initial inventory investment) isn’t worth it.
Luckily, knowing your inventory holding cost is the first step toward improving this inventory management KPI. (After all, you can't fix what you don't know is wrong.)
Then, brands can reduce inventory holding costs (and free up capital) by calculating optimal quantity, forecasting demand trends, and more.
Calculate optimal quantity
When brands calculate optimal order quantity, 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 = the square root of ([2DO] / H)
Note that in this equation:
- D = Annual unit demand
- O = Order costs per purchase
- H = Holding costs per unit
The challenge is that this method is prone to human error and is time-consuming. That's because brands need to constantly recalculate this metric every time they place a purchase order (since the variables within the formula change all the time).
Alternatively, Cogsy 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 optimal PO and calculate the ideal reorder point. That way, you always reorder inventory in time to avoid a stockout.
Brands that accurately forecast demand trends 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't sell. And since you've purchased the right amount of inventory to meet customer demand, you eliminate items sitting in storage, racking up holding costs.
Brands can implement trend forecasting by manually forecasting inventory with Excel. But again, this is time-consuming. Or, a tool like Cogsy can accurately predict this demand for you, using your historical sales data and real-time inventory trends.
Selling on backorder
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's important to have a backup plan when these stockouts occur. Enter 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're out of stock. (Alternatively, brands that don't sell on backorder drive 21-41% sales opportunities to buy from a competitor.)
Brands can easily set up backordering with Cogsy 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.
Finding the right storage solution
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 $7.96 per square foot (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's worth it.
Renegotiate vendor contract terms
Sometimes it's your minimum order quantities (MOQ) that's leaving you overstocked.
When this is the case, try negotiating better vendor contract terms. Namely, terms that lower your MOQ (most suppliers won't 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 (Cogsy can help build this operational plan 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's 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 — 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's worth paying a few extra cents per unit to hold them overseas versus several dollars domestically.
Does this really work? Sure does – Lalo, a leading retailer in the baby and toddler space, reduced its vendor down payments by 50% using this strategy. And by freeing up that capital, Lalo's been able to experiment with new growth initiatives (like opening up a flagship store) and unlock 400% year-over-year growth.
But don't take our word for it – try Cogsy free for 14 days.
Inventory holding costs FAQs
Get answers to the most common inventory holding costs questions.
What are the factors of inventory holding cost?
Inventory holding cost is the sum of all inventory expenses, including storage space costs, labor expenses, opportunity costs, depreciation, shrinkage, and obsolescence.
What is the average inventory holding cost?
The average inventory holding cost depends on your brand's industry and products. But generally, retail brands want inventory holding costs to be 15-30% of their total inventory value.
Why is inventory holding cost important?
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.
What causes inventory holding costs to increase?
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.
What is the difference between holding cost and carrying cost?
Holding costs and carrying costs are synonymous terms for describing the inventory expenses related to storing unsold items.