Inventory Holding Cost Formula: The Ultimate Guide in 2023
In this article, we will explore what the inventory holding cost formula is and its importance. We will also cover how to apply the formula using an example. Read on to learn more.
What is the Inventory Holding Cost Formula?
The inventory holding cost formula calculates the total cost associated with storing and maintaining an inventory over a certain period. It helps companies understand the total cost incurred for holding stock and aids in making informed decisions about inventory levels.
The formula for calculating inventory holding cost is:
Where:
- Average Inventory: It is the average amount of inventory held over a specific period. It can be calculated as [ (Beginning Inventory + Ending Inventory) / 2 ].
- Holding Cost per Unit per Year: It includes costs like storage, insurance, spoilage, obsolescence, and other costs associated with holding the inventory. It can be either a fixed value provided or calculated as a percentage of the unit cost.
In instances where the holding cost is expressed as a percentage of the total value of inventory, an additional formula is applied:
Where:
- Inventory Holding Cost: This represents the total expenses incurred in storing and maintaining inventory over a specified period.
- Total Value of Inventory: This refers to the aggregate monetary value of all inventory items held by the company.
How to Apply the Inventory Holding Cost Formula?
Here are our steps to apply the inventory holding cost formula:
Step 1. Gather Data:
Collect necessary data including the Average Inventory, Holding Cost per Unit, and the Total Number of Units Held.
- Average Inventory: Calculate the average number of units held in inventory during a specific period.
- Holding Cost per Unit: Determine the cost associated with holding each unit of inventory for the period, considering expenses like storage, insurance, and obsolescence.
- Total Number of Units Held: Ascertain the total number of units that were held in inventory.
Step 2. Apply the Formula:
The formula for inventory holding cost is given as:
Inventory Holding Cost = Average Inventory × Holding Cost per Unit
or it can be expressed as a percentage of the total value of the inventory:
Inventory Holding Cost Percentage = [ (Inventory Holding Cost / Total Value of Inventory ) × 100 ]
Step 3. Perform the Calculation:
For instance,
- Average Inventory: 500 units
- Holding Cost per Unit: $5
- Total Value of Inventory: $25,000 (assuming each unit’s value is $50)
Plug these values into the formula:
Inventory Holding Cost = 500 units x $5/unit
Inventory Holding Cost = $2500
To calculate the holding cost as a percentage of the total value of the inventory:
Inventory Holding Cost Percentage = ($2500/$25000) x 100
Inventory Holding Cost Percentage = 10%
Step 4. Analysis and Interpretation:
With a holding cost of $2500 or 10% of the total inventory value, analyze how these costs impact the overall profitability and efficiency of the inventory management system. Evaluate whether reducing holding costs or optimizing inventory levels would be beneficial.
Example
GreenThumb Landscaping wants to optimize inventory levels and reduce its holding costs. Here’s how the company calculated its inventory holding cost:
Step 1. Gather Data:
The collected data of the company includes:
- Average Inventory: 2,000 units (calculated as the average between the beginning and ending inventory for the year)
- Holding Cost per Unit: $10 (includes costs for storage, maintenance, insurance, etc.)
- Total Value of Inventory: $100,000 (assuming the cost price of each unit is $50)
Step 2. Apply the Formula:
We use the inventory holding cost formula:
Inventory Holding Cost = Average Inventory × Holding Cost per Unit
Step 3. Perform the Calculation:
Using the data,
- Average Inventory: 2,000 units
- Holding Cost per Unit: $10
- Total Value of Inventory: $100,000
Plugging these values into the formula:
Inventory Holding Cost = 2,000 units x $10/unit
Inventory Holding Cost = $20,000
To calculate the holding cost as a percentage of the total value of the inventory:
Inventory Holding Cost Percentage = ($20,000/ $100,000) x 100
Inventory Holding Cost Percentage = 20%
Step 4. Analysis and Interpretation:
GreenThumb Landscaping incurred a holding cost of $20,000, which is 20% of the total inventory value. The management needs to analyze whether this cost is within an acceptable range. They should assess if there are opportunities to reduce the holding cost, perhaps by optimizing storage solutions or improving inventory turnover.
Importance of the Inventory Holding Cost Formula
Calculating the inventory holding cost is important for a number of reasons, some of the most common reasons include:
1. Resource Allocation:
Calculating inventory holding costs helps businesses allocate resources efficiently to ensure that excess capital is not tied up in stored goods. This aids in optimizing storage, handling, and insurance costs to free up funds for operational enhancements and investments.
2. Demand Forecasting:
Assessing holding costs aids in fine-tuning demand forecasting and inventory planning. It ensures that companies maintain optimal inventory levels to meet customer demand without incurring excessive storage costs.
3. Profitability Analysis:
Knowing the inventory holding costs enables a more accurate profitability analysis. Companies can price their products to not only cover the cost of goods sold but also the expenses associated with storing, handling, and insuring the inventory.
4. Risk Mitigation:
Calculating holding costs helps in identifying and mitigating risks associated with inventory obsolescence, damage, and theft. Companies can develop strategies to minimize these risks to ensure that inventory retains its value over time.
We hope that you now have a better understanding of what the inventory holding cost formula is and how to calculate it.
