How is Holding Cost Calculated?

It’s universally agreed that there is cost to holding inventory, but very few companies have a good understanding of what that cost really is.  Optimizing inventory implies a trade off between the cost of carrying inventory with some benefit, such as being able to meet customer expectations, or a reduction in operating costs.  However, it’s often easier to articulate the benefits vs. the cost of the inventory, leading companies to carry more than they should.  Similarly, I have seen many business cases for inventory reduction that were fundamentally flawed in the way they addressed inventory related costs.

The goal of this article then is to demystify the concept of holding costs and get you asking the right questions to be able to use this concept in business decisions

Holding costs are usually expressed as a percentage of the inventory value.  This can be helpful as most inventory decisions are on a margin basis, i.e., adding or reducing a certain amount of inventory.  I’m not sure where this practice originated, but it may come from the simple fact that many components of the holding cost are also typically expressed as percentages.

Holding cost should include all of the costs related to financing, storing, and disposing of inventory.  Typically it consists of the following components:

• The cost of the money that is tied up in inventory
• Where applicable, the cost of property taxes paid on inventory
• The cost of insuring inventory or accepting the risk of loss
• The cost of obsolescence, including both the cost of the inventory itself and the cost of disposal
• The cost of physically storing the inventory

Each of these is discussed in turn below.  I leave the physical storage costs for last because these are the most problematic.

Cost of Money

The cost of money addresses the cash that is tied up in inventories. Inventory is a key component of working capital and consumes cash that could be used elsewhere: to pay down debt, to invest in a new business , to finance new capital equipment, to dividend to shareholders, etc.  As such, the cost of money should be viewed as an opportunity cost.  What else could I do with this cash if it wasn’t tied up in inventory?

Some companies use the company’s marginal, short term borrowing rate as the cost of money.  Today (in late 2020), that number is likely to be only a few percentage points.  I personally believe that this approach significantly understates the cost as it implies that the company has nothing better to do with extra cash than pay down short term debt.

A better approach is to use what is know as the Weighted Average Cost of Capital, or WACC.  The WACC represents the average return expected across all of a company’s sources of cash, weighted by the amount of cash from each source.  It incorporates not only the cost of short and long term borrowing, but also the return expected by shareholders.  In my experience, even with low borrowing costs it is common for WACC to be in the 9-12% range depending largely on a company’s size and ownership structure. 

Many companies publish their WACC for use in internal business cases, either as the discount rate for Net Present Value (NPV) calculations or as the expected minimum return or ‘hurdle rate’ for investments.  If your company does not publish a rate you can usually get it from Finance and particularly the Treasury department.

Property Taxes

The second element of holding cost is property tax. Some tax jurisdiction will assess property tax on the value of inventory.  Of course if you operate in multiple locations you may pay property tax in some and not others, and when you do pay the rates will almost certainly be different.  For simplicity, I recommend computing an average rate and using that.  Your company Tax team within the Finance organization can help you understand total annual inventory related taxes and you can divide this by the average inventory balance to get a percentage.

Insurance

Insurance is the next component.   Most companies will carry insurance against the risk of catastrophic loss.  The trick here is to identify all of the relevant insurance costs (don’t forget insurance for goods in transit) and separate out the portion that relates to the inventory from that which relates to liability or replacement cost of buildings.  Treasury is usually responsible for managing the insurance policies or you may want to contact your corporate Risk group.

Taxes and insurance can be a bit of work and it’s common to add 1% to cover both of these.  Not that that number has an particular scientific basis or validity.  If you want to be precise, the actual numbers should be easily available.

Obsolescence

Inevitably, at some point you will make or buy too much of something and it will sit in inventory (and sit, and sit).  When it’s clear that there is no more demand for a product or material, accounting principles require that a reserve account be setup to reduce the value of the inventory to zero.  What’s important in determining obsolescence cost is not the value in the reserve account, but the annual amount that is added to the account.  For example, a company may have $ 100 million in inventory and an inventory reserve of $15 million.  Each year the company charges (as an expense) $5 million to the reserve account and removes a similar amount as inventory is scrapped.  The number we want is the average amount added to the reserve annually.  Take this as a percentage of total inventory (in this example, $5m / $100m = 5%) as the holding cost due to obsolescence

Shrinkage

Another basic fact of inventory is that things disappear.  They get lost, or damaged, or worse pilfered.  Regardless of the reason, the result is the same: the lost inventory must be written off as an expense and removed from inventory.  To compute the shrinkage component of holding cost, take the annual cost of shrinkage and divide by the average inventory balance to get a percentage.

Physical Storage

At last we come to the physical storage costs, and this is where things get interesting.  Physical storage, and how you should think about it, is highly situational. Particularly if you are working on a business case for inventory reduction.  Let’s look at some possible situations as examples:

1. Your inventory is held in a shared warehouse where you pay a fixed fee per pallet per month for storage
2. Your inventory is held in a warehouse that you own or lease with 80% of the available pallet positions occupied
3. Your inventory is held primarily in a a warehouse that you own or lease, but the warehouse is completely full and 1,000 pallets are stored at a second warehouse where you lease space

These situations are not mutually exclusive.  Indeed I once worked at a company where all three situations existed at the same time but for different warehouses.

Situation #1 is the simplest in the context of holding cost as there is a very clear cost that is tied directly to the amount of inventory on hand.  In this case, simply take the annual cost per pallet and divide by the average value of a pallet to get a percentage.

Situation #2 is a bit more tricky.  For longer term, strategic decisions about inventory it would be appropriate to take the annual facility costs (not including labor) and divide by the average inventory value to get the holding cost percentage.  But here’s the catch: if you reduce inventory you won’t save any of this cost.  The warehouse is still there, it’s just less full.  The reduction in inventory hasn’t saved you a penny on the physical storage costs.  This is no good if you are trying to make a business case on inventory reduction!  From a business case perspective, you may still be able to make a case on cost avoidance.  For example, the inventory reduction prevents you from having to go out and lease more space next year as volumes increase (if that is actually true).  If there is another use for the space or the potential to lease less space going forward, then you can also apply an opportunity cost.  But if it’s just a simple case of inventory reduction your business case may be out of luck here.

Situation #3 is better, because the cost reduction opportunity is clear.  If you can reduce inventory by 1,000 pallets, you can eliminate the cost associated with the second warehouse.  And if this is strictly an overflow warehouse, you can eliminate the labor at that site and the cost of trucking material back and forth at the same time.  As with Situation #2, if you are looking to calculate a holding cost for strategic decisions (or, say to use in inventory optimization decisions) you can roll up all the facility costs and divide by the average inventory value to get a percentage cost for physical storage.  If you’re trying to make a business case for inventory reduction, you can build that case on the elimination (or downsizing) of the secondary warehouse as these are very real costs that can be eliminated if inventories can be reduced to the point that they fit in the primary warehouse.

As a final thought in this section, there is no physical storage cost for inventory in-transit.  Business cases that deal with reducing inventory by reducing transit time would not have a physical storage component to holding cost for in-transit inventory — though it would still be appropriate to apply physical storage costs to any resulting reduction in warehouse inventory due to the reduced lead times.