What Are Holding Costs?
Let me explain holding costs directly to you: these are the expenses you incur when your company stores inventory that hasn't sold yet. They're part of your total inventory costs, right alongside ordering costs and shortage costs.
In your firm's case, holding costs cover the price of goods that get damaged or spoiled, plus the costs for storage space, labor, and insurance. You need to account for all of these to manage your inventory effectively.
Understanding Holding Costs
You should know that minimizing inventory costs is a crucial strategy in supply-chain management. Inventory ties up a lot of your cash as an asset, and how you handle spending on it directly affects the cash you have available for other parts of your business.
For instance, if you increase your inventory balance by $10,000, that's less cash you have each month to run operations—this is what we call an opportunity cost, and it's something you want to avoid.
Holding Costs Example
Consider this example to see it in action: suppose ABC Manufacturing produces furniture that's stored in a warehouse before shipping to retailers. They have to lease or buy warehouse space and cover utilities, insurance, and security for it.
On top of that, they pay staff to move inventory in and out, and there's always the risk that the furniture gets damaged during handling. This is the reality of holding costs you might face in your own operations.
Holding Cost Reduction Methods
One straightforward way to keep sufficient cash for your operations is to sell inventory and collect payments as quickly as possible. The faster you get that cash in, the less you need to dip into your own funds to keep things running. You can measure this with the inventory turnover ratio, calculated as cost of goods sold divided by average inventory.
Take a company with $1 million in cost of goods sold and $200,000 in average inventory—that gives a turnover ratio of five. Your goal should be to boost sales and cut down on inventory levels to increase this ratio.
Another key strategy is calculating a reorder point, which is the inventory level that signals you to order more from suppliers. Getting this right lets you fulfill customer orders without overspending on storage. It helps you avoid shortage costs, like losing orders due to low stock.
The reorder point factors in supplier lead times and your weekly or monthly sales rates. It also aids in figuring out the economic order quantity, or the ideal amount to order, which you can compute using inventory software.
Key Takeaways
- Holding costs are the expenses tied to storing unsold inventory.
- They include storage space, labor, insurance, and the cost of damaged or spoiled goods.
- Minimizing these costs is essential for supply-chain management.
- Use strategies like quick payment collection and accurate reorder points to reduce them.
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