Integral Logistics Management — Operations Management and Supply Chain Management Within and Across Companies

11.4.1b Carrying Cost

Intended learning outcomes: Explain carrying cost and carrying cost rate. Produce an overview on costs of financing or capital costs, storage infrastructure costs and the risk of depreciation.

Continuation from previous subsection (11.4.1)

Carrying cost, or holding costs, are all costs incurred in connection with holding inventory.
Carrying cost rate, or holding cost rate, is the rate for the carrying cost, usually defined as a percentage of the dollar value of inventory per unit of time (generally one year).

See also Section 1.1.6. Carrying cost includes:

  • The costs of financing or capital costs: Inventory ties up financial resources. Cal­cu­lation using an interest rate yields the costs of immobilizing money in inventory. This rate corresponds to either the percentage of the mean return on investment if the inventories are financed using internal capital resources, or to the bank interest rate, if the inventories are financed by a third party. For calculation purposes, take interest rate values between 5 and 15% of the average value of the inventory.
  • The storage infrastructure costs are incurred for the infra­structure necessary to store a particular product: buildings, installations, warehouse employees, insurance, and so on. The costs for inventory transactions, in contrast, are seen as ordering costs.
    • The first cost driver for storage infrastructure costs is batch size, as enough surface area or volume for the whole batch size must be provided. In a first approach, it is possible to express storage infrastructure costs proportio­nally, as a percentage related to the average inventory, because the average inventory corresponds — apart from safety stock — to half of the batch size, according to the formula in Figure More commonly used is a percentage related to the mean inventory value. In the machine tool industry, percentages between 1 and 3% are common.
    • Further cost drivers are storage type and valuation basis (see Section 11.1.1). The storage infrastructure costs rate can be much higher for inexpensive and voluminous products (insulation materials and other construction materials) than for very expensive and possibly easy-to-store products. For more precise figures, then, the calculation should include at least some separate values, such as for information and documents, raw materials, purchased parts, semifinished goods, and end products. However, there are limits to diversifying storage infrastructure costs into as many different storage unit cost rates as possible, due to the expense involved in recording the incurred costs per separate category as well as for data maintenance, if, for example, a separate storage cost percentage were kept for each item.
    • A large part of these costs is out of proportion to the value of the stored goods. Since warehouses involve specialized construc­tions, building a warehouse represents a long-term investment. A company will make the investment if it has exhausted exis­t­ing warehouse volumes. This leads to a jump in costs. In contrast, reducing in­ven­tory value does not automatically lead to a reduction of personnel needed for ware­house management. Even so, in practice, a proportional relationship is common.

  • The risk of depreciation: This is again expressed as a percentage of the inventory value. It includes, firstly, technical obsolescence that results from changes in standards or the emergence of improved products on the market. Secondly, it inclu­des expiration due to perishability: Certain items can be stored only for a particular, limited period of time (shelf life). This is the case with “living” products such as groceries or biological pharma­ceuticals, but also with “nonliving” products such as certain electronics items. Thirdly, it includes damage, spoilage,or destruction due to unsuitable handling or storage such as, for example, the rusting of sheet metals.
    • The percentage of the risk of depreciation may be very large under certain circumstances. For short-lived items, it must be set at 10% or more. However, the percentage is generally dependent on the duration of storage.

It is not unusual for the carrying cost rate to be on the order of 20%. For goods with a high risk of depreciation, it may reach 30% and higher.

Course section 11.4: Subsections and their intended learning outcomes