What are 'Holding Costs'
Holding costs are the costs associated with storing inventory
that remains unsold, and these costs are one component of total
inventory costs, along with ordering costs and shortage costs. A firm’s
holding costs include the cost of goods damaged or spoiled, as well as
the cost of storage space, labor and insurance. Minimizing inventory
costs is an important supply chain management strategy.
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and accounts receivable are two asset accounts that may require a large
amount of cash, and decisions about inventory spending reduce the
amount of cash available for other purposes. For example, increasing the
inventory balance by $10,000 means that less cash is available to
operate the business each month. This situation is considered an opportunity cost.
Factoring in Inventory Turnover
One
way to ensure a company has sufficient cash to operate is to sell
inventory and collect payments quickly. The sooner cash is collected
from customers, the less total cash the firm must come up with to
continue operations. Businesses measure the frequency of cash
collections using the inventory turnover ratio, which is (cost of goods
sold) / (inventory). For example, a company that has $1 million in cost
of goods sold and an inventory balance of $200,000 has a turnover ratio
of 5. The goal is to increase sales and reduce the required amount of
inventory, so that the turnover ratio increases.
Examples of Holding Costs
Assume
that ABC Manufacturing produces furniture that is stored in a warehouse
and then shipped to retailers. ABC must either lease or purchase
warehouse space, and pay for utilities, insurance and security for the
location. The company must also pay staff to move inventory into the
warehouse, and then load the sold merchandise onto trucks for shipping.
The firm incurs some risk that the furniture may be damaged as it is
moved into and out of the warehouse.
How to Calculate the Reorder Point
Another
important strategy to minimize holding costs and other inventory
spending is to calculate a reorder point, or the level of inventory that
alerts the company to order more inventory from a supplier. An accurate
reorder point allows the firm to fill customer orders without
overspending on inventory. Companies that use a recorder point avoid
shortage costs, which is the risk of losing a customer order due to low
inventory levels. The reorder point considers how long it takes to
receive an order from a supplier, and the weekly or monthly level of
product sales. A reorder point also helps the business compute the
economic order quantity (EOQ), or the ideal amount of inventory that
should be ordered from a supplier. EOQ can be calculated using inventory
software.
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