Definition: Holding costs are the additional costs involved in storing and maintaining a piece of inventory over the course of a year. Holding costs are computed in the economic order quantity calculation that businesses use in order to decide the optimal time to order new inventory.
What Does Holding Cost Mean?
The holding costs concept is pretty simple. Businesses have to store inventory that isn’t in use or on the showroom floor. So if a company orders too much of a product, the extra inventory has to be put in the back warehouse until it can be put out on the shelves for customers to buy.
Not only do businesses have to pay for the warehouse storage space, but they also have to pay for security, insurance, and protection of the inventory. For instance, the warehouse could be broken into or, even worse, employees could steal inventory from a disorganized storage room. All of these costs are considered holding costs.
Holding costs are the true cost of ordering too much inventory. That is why inventory turnover and economic order quantity calculations are so important. Companies should strive to only order enough inventory for 90 days. Inventory that sits around in storage for longer than 90 days creates added holding costs that are unnecessary.
Large quantity discounts can be negated by hidden holding costs. That is why companies need to carefully plan what inventory to buy and how frequently to buy it. Buying inventory is a tightrope walk between incurring additional holding costs and foregoing large quantity, purchase discounts.