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How do you calculate the cost of carrying inventory?

The cost of carrying or holding inventory is the sum of the following costs:

  1. Money tied up in inventory, such as the cost of capital or the opportunity cost of the money.
  2. Physical space occupied by the inventory including rent, depreciation, utility costs, insurance, taxes, etc.
  3. Cost of handling the items.
  4. Cost of deterioration and obsolescence.

Often the costs are computed for a year and then expressed as a percentage of the cost of the inventory items. For example, a company might express the holding costs as 20%. If the company has $300,000 of inventory cost, its cost of carrying or holding the inventory is estimated to be $60,000 per year.

The cost of carrying inventory will vary from company to company. For instance, if a company has a large cash balance with no attractive investment options, has excess space for storage, and its products have a low probability for deterioration or obsolescence, the company's holding or carrying costs are very low. A company with enormous debt, little space, and products subject to deterioration will have very high holding costs.

For decision making, such as determining the economic order or production quantity, it is important to determine the incremental holding costs for a year. In other words, what will be the additional holding costs expressed as an annual cost for the items being purchased or produced.