Running a business is a balancing act.
You need enough inventory to meet customer demand, but too much can eat away at your profits. That's where inventory holding costs come in.
An increase in demand is a great sign for any small business, but it comes with higher overheads. A significant amount of cost is usually tied up in your growing inventory. Reducing overall inventory holding costs is a great way to free up and reallocate capital.
Managing inventory is costly.
Paying for warehousing, accounting for breakage, shrinkage, and quality control (as well as other inventory costs) can be expensive – especially when adding more products and new collections to your growing business. Making use of inventory control software can help you keep track of growing and hidden expenses.
What is inventory holding cost?
Inventory holding cost, also known as carrying cost, refers to all the expenses associated with storing unsold inventory. It's essentially the price you pay for having stock sitting on your shelves.
By understanding inventory costs, businesses can develop strategies to minimize them. This might involve inventory optimization, implementing just-in-time inventory management, or negotiating better storage deals.
How to calculate inventory holding cost
Calculating inventory holding costs involves summing up various expenses related to inventory management and dividing it by the total value of your inventory. Here’s a step by step breakdown to help calculate costs.
- Identify your inventory holding cost components. This might include:
- Storage costs: Rent, utilities, and maintenance
- Labor costs: Salaries of employees involved
- Insurance costs: Costs associated with insuring your inventory against damage, theft, or loss
- Capital costs: Interest rates, investment opportunities
- Obsolescence costs: Historical data of how often you've had to write off outdated inventory, or the risk of a product becoming obsolete in your industry
- Shrinkage costs: Inventory loss due to damage, spoilage, or theft
- Calculate the annual cost for each component: Multiply the cost per unit (monthly rent, hourly wages) by the corresponding timeframe (number of months in a year, total hours worked) to get the annual cost for each component.
- Sum up all the annual costs: Add the annual cost for each inventory holding cost component identified above.
- Find the average value of your inventory: Calculate the average value of inventory through a simple average or a weighted average method.
- Calculate your inventory holding cost as a percentage: Here’s a simple inventory holding cost formula.
Inventory Holding Cost (%) = (Total Annual Inventory Holding Costs) / (Average Inventory Value) x 100
6 ways to reduce inventory holding costs
Small and medium sized businesses (SMEs) that are experiencing hyper-growth for the first time can be caught off guard by snowballing inventory costs. So we’ve put together six ways to keep costs low while optimizing your inventory performance.
How to reduce inventory cost
- Improve demand forecasting: Use historical data and market analysis to predict customer demand accurately, minimizing overstocking and stockouts.
- Implement just-in-time (JIT) inventory: Align inventory orders closely with production schedules to reduce holding costs and excess stock.
- Optimize order quantities: Calculate the economic order quantity (EOQ) to determine the ideal order size that minimizes total inventory costs.
- Classify inventory using ABC analysis: Prioritize management efforts on high-value items (A), moderate control on mid-value items (B), and simplified control on low-value items (C).
- Improve supplier relationships: Collaborate with suppliers for better terms, reliable lead times, and potential consignment inventory arrangements.
- Automate replenishment processes: Use inventory management software to automate reordering, ensuring timely replenishment and optimal stock levels.
- Remove obsolete stock: Conduct periodic audits to identify and dispose of slow-moving or obsolete items, freeing up storage space and capital.
- Reduce lead times: Work with suppliers to shorten delivery times, which will allow for lower safety stock levels and more responsive inventory management.
- Implement vendor-managed inventory (VMI): Allow suppliers to monitor and manage inventory levels, ensuring optimal stock and reducing carrying costs.
1. Get the right reorder point
Understanding the right time to reorder products and the right volume at which to do so is an easy way to make sure that you are not holding more inventory than you can sell or having too little stock to fulfill demand.
One way to determine your reorder points is to use a demand forecasting tool. Look at the sales data over the past few years, factoring in seasonality, geography, and what channels customers most often purchased on. Additionally, you can take a look at what businesses with similar sales models and cycles as yours have to say about setting up the right reorder points.
2. Make minimum order quantities work for you
Minimum order quantities (MOQs) allow wholesalers to enjoy the benefits of economies of scale; the more they order, the cheaper the price of each unit. However, this can be challenging for the wholesaler. Larger wholesalers have regulated cash flow and excess capital, so placing orders for a large production run is easy.
For SMEs, cash flow is usually less reliable, leaving them with three options:
- Accept the MOQ and risk being stuck with an excess of stock
- Don't make the right order and lose potential revenue
- Negotiate the order
Negotiation is the best option for SMEs. You may not be able to pay for the volume of products listed in the MOQ. However, by reaching out to the supplier, you may be able to offer a slightly higher price per unit for a much smaller number of units or find other buyers who need the same products and make a bulk purchase with your combined resources.
3. Avoid overstocking
If you are spending a sizable portion of your budget on replenishing your stock, you could be missing out on new opportunities to grow your business.
Suppliers often drive a hard bargain with larger discounts for higher volume orders, deals on new and promotional items, and even free products on certain orders.
You can’t say no to a good deal right? Wrong.
It may seem as though you are saving money by accepting deals and discounts because you think you will need to reorder products at some point anyway. However, if your products aren’t constantly flying off the shelves, you will be left what’s known as deadstock. That is the price of paying for products that are sitting in storage.
The money spent on storing deadstock could be spent trying out new products or running a new marketing campaign. Supply chain planning software can help you better organize and avoid restocking. Run a smarter business by ordering the right amount of stock, business forecasting, and using the freed up capital to sell on new channels or diversify your inventory.
4. Get rid of your deadstock
Did you already accept that hot deal from your supplier and are now stuck with stock that just won’t budge and is hovering above your head like a giant cloud? Here are some easy ways to get rid of deadstock and clear the inventory skies.
If you’re looking to get rid of your deadstock, you can:
- Bundle it as free gifts when customers purchase popular items
- Return it to your supplier if their return policy allows for it. However, some suppliers charge a penalty for returning items or only provide refunds in the form of store credit
- Donate it and enjoy tax deductions for contributions to charities
Giving away products for less than the cost price is never a great feeling. However, just like Elsa in Frozen, you have to let it go. Free up your inventory for new and potentially more profitable products while reducing the cost of your warehousing.
5. Decrease supplier lead time
One creative way to reduce inventory holding costs is to reduce supplier lead time. Let’s say you can get a new shipment to your warehouse in seven days instead of 10. You will be able to reduce the amount of stock you hold on hand because of the new lead time.
With more shipments, you can also look at reducing the order quantities per shipment and reduce carrying costs because you no longer need large amounts of storage space.
Assuming you have developed a good relationship with your supplier, highlight the fact that you are going to be making repeat orders for a long time, guaranteeing them recurring revenue. The new model also means more frequent shipments, which may work to their benefit.
6. Use inventory management software
Inventory management software helps you determine optimal order quantities based on historical sales data, lead times,and demand forecasts. This minimizes the amount of unnecessary inventory you hold, reducing storage costs, insurance costs, and the risk of obsolescence. Some software offers warehouse management functionalities, optimizing storage layouts and picking processes. This can lead to increased efficiency, reducing labor costs associated with inventory handling.
How does inventory management software work?
- It helps companies run smarter with real-time updates on stock movements across all sales channels. You and your team no longer need to dedicate hours each day manually managing stock levels.
- It helps companies grow faster by pulling granular reports on sales performance, product sales by channel, location, and more, and decide what is the next best step to generate more revenue.
- It helps companies sell more with a vast, fully integrated app ecosystem. Connect your inventory management with multiple sales channels, accounting, shipping, fulfillment apps, and more to sell everywhere your customers are.
Optimize inventory management
If your business has not invested in a inventory control software solution, it’s time to consider signing up for the fastest, most cost-effective way to save on inventory holding costs. Take time back in your day to focus on building an amazing business with automated inventory management.
Supply chain planning can also help understand your needs in advance and help you stay ahead of the game.
This article was originally published in 2019. It has been updated with new information.
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