Inventory Carrying Cost: Formula, Examples, and Tips to Lower It

What Is Inventory Carrying Cost?

Inventory carrying cost, or holding cost, is an accounting term that identifies all of the business expenses related to holding and storing unsold goods. Total carrying costs can include the applicable costs of warehousing, employee salaries, transportation and handling, taxes, and insurance as well as depreciation, shrinkage, and opportunity costs.

Total carrying costs are often shown as a percentage of a company's total inventory in a particular time period. The figure is used by businesses to determine how much income they may be able earn based on their current inventory levels. It can also help a business determine if it needs to produce more or less of something to maintain a favorable income stream.

Understanding Inventory Carrying Cost

Inventory carrying costs are often referred to simply as holding costs. As mentioned, a company's inventory carrying cost can be expressed as a percentage. It is calculated by adding up the total carrying costs and dividing that figure by the total value of the inventory, then multiplying by 100 to arrive at a percentage.

The resulting figure can be used to determine if inventory carrying costs are optimum or whether they can be reduced. Carrying costs generally run between 20% and 30% of the total cost of inventory, although that varies depending on the industry and the business size.

For retailers in particular, inventory and its associated costs represent a substantial percentage of current assets on the balance sheet. As such, the management of inventory flows can greatly influence the costs of carrying that inventory. Carrying costs also can have a direct impact on the cost of capital and future cash flows generated by the company.

When a company is public, analysts may monitor its inventory carrying costs over time for any big changes and also compare its inventory carrying costs against those of others in its peer group.

The Intangibles

The tangible costs of storing inventory, such as storage, handling, and insuring goods, are obvious. Less obvious are the intangibles, such as the opportunity cost of the money that was used to purchase the inventory and the cost of deterioration and obsolescence of goods sitting around in storage.

Opportunity cost in this instance is generally defined as the price of forgoing other, possibly more advantageous uses for money that is being tied up in the stored goods. Businesses should consider opportunity costs when analyzing their inventory carrying costs, just as they do with other investments and potential investments.

Example of Inventory Carrying Cost

As an example, suppose ABC Company has an annual inventory value of $1 million. Its carrying cost is 20% of its annual inventory. The annual inventory carrying cost for ABC would, therefore, be $200,000, or 20% of $1 million.

Like ABC Company, XYZ Company has an annual inventory value of $1 million. But its carrying cost is 25% of its annual inventory. The annual inventory carrying cost for XYZ would, therefore, be $250,000, or 25% of $1 million.

If ABC and XYZ are in the same industry, an analyst might conclude that ABC is more efficient with its use of inventory, given that its carrying costs are lower. However, there could also be other explanations worth looking into.

The Bottom Line

Inventory carrying cost is an important metric that companies can use to determine how efficiently they are making use of their inventory. It includes both tangible and intangible costs, such as opportunity costs. It can also help a business determine if it needs to ramp up or ratchet down production in order to maintain a favorable income stream. Analysts can compare inventory carrying costs as one measure of the relative efficiency of different companies in the same industry.